People don’t often share their investment mistakes. Can you recall the last time a friend or colleague mentioned how inept they are at managing their investments? First, most polite people have been raised not to openly discuss their finances. Second, most of us simply don’t care to publicize our blunders, especially those involving money. Yet, investment errors are fairly common. They’re not all catastrophic, and many can be easily remedied. Nonetheless, there are lots of them. In fact, the top-of-mind list is longer than one blog post will allow. So, let’s consider this the first in a series dedicated to common portfolio pitfalls. I’ll cover just three this time around, each of which surfaces far more often than you’ll hear about at your neighborhood barbeque.
The perils of benign neglect
I know you don’t mean to ignore your portfolio, but life happens. I understand. And I don’t judge. Maybe you randomly picked a few funds for your 401(k) plan three jobs ago, opened a brokerage account with a few “hot” stocks recommended by a friend, or inherited an IRA from a loved one without evaluating how your newly inherited assets fit into your existing portfolio. Fast-forward a decade or more, and suddenly you realize you’re holding a bunch of “stuff” that no longer reflects your financial goals. It happens to the best of us, but you’re relying on that collection of stuff to get you comfortably through retirement!
If you have the time and discipline, sort through your various holdings with the goal of creating a portfolio that reflects your current investment risk tolerance and time horizon. These two factors can be a starting point for setting proper asset allocation. If you need a little help, consider taking our investor risk questionnaire and reviewing these four investment principles. If you need a lot of help, consider hiring an advisor. You’ll pay for the professional assistance, but it might be worth it to get your portfolio back on track.
The danger of the single security
If any one security (or sector) represents a relatively large portion of your portfolio, you’re susceptible to concentration risk. In simple terms, your portfolio’s performance may rely too heavily on the market movements of that single stock or sector. To varying degrees, this can introduce more volatility than necessary to your portfolio.
The wisdom of holding a broadly diversified portfolio is fairly well documented.¹ Despite this, we consistently observe that even savvy investors don’t always construct their portfolios based on research findings. Instead, investment decisions are sometimes driven by emotion and complicated by the ties that bind us to the things and people we love.
Perhaps decades of dedicated company service leave you feeling determined to hold on to your company’s stock. And maybe your firm’s stock has performed well over the years, now representing one-quarter or more of your retirement savings. In that scenario, firm loyalty can sometimes outweigh the rational argument for reducing the position.
Taking that example one step further, maybe you’re the child who inherited that company stock from Mom or Dad. You may feel compelled to hang on to the position as a lasting tribute to your Dad’s hard work and family sacrifice. Your reluctance to part with the stock is understandable, but limiting the position to 10% or less of your equity holdings will effectively mitigate single security risk in your portfolio.² If it’s a particularly large holding and you’re not comfortable reducing it in one fell swoop, consider establishing a “sell discipline,” in which you commit to divesting a set number of shares per quarter, regardless of market conditions, until you reach your desired allocation. Parting with the holding may be momentarily painful, but your portfolio will be better positioned to maximize the benefits of diversification in the long run.
The downside of keeping money under your mattress
I know, I know…you’re not a market timer. You’re not watching every uptick or downtick in the market, rapidly shifting in and out of asset classes in an attempt to beat the index average return. While it’s not impossible to be successful at this strategy, it’s really hard.³
But, there are actually two kinds of market timers: The kind that I just described and what I’ll call the “unintentional” market timer. This investor isn’t interested in complex tactical asset allocation strategies —they’re interested in protecting their nest egg. And maybe they’re a little bit guilty of the benign neglect I described earlier, unwittingly holding a more aggressive portfolio than their situation warrants. In truth, these investors are more conservative than their heavy equity allocations would imply.
Extended periods of high market volatility and uncertainty can send these investors running for the exits, seeking refuge in cash rather than suffering the market’s gyrations. If this sounds like you, you’re not alone. No one likes to admit that they missed the market rebound that inevitably follows a big downturn, but plenty of investors did. In fact, some are still waiting for the “right time” to get back into the market. But, stuffing cash in your mattress (or in your low-interest savings account) introduces shortfall risk to your portfolio. If your holdings are too conservative for your time horizon, you run the risk of losing pace with inflation and outliving your assets.
To combat this risk, you’ll need to reinvest in the equity market at the level and pace that’s right for you, consistent with your goals and time horizon. Our research indicates that it’s generally best to bite the bullet and get back to your desired allocation quickly.⁴ This “lump sum” investing approach allows your portfolio to begin working for you at the proper asset allocation as soon as possible. But if jumping back into the market has you feeling just as skittish as when you jumped out, then take your time. A traditional dollar-cost averaging approach, in which you rebalance back into equities in smaller increments each month or quarter, may make you more comfortable. Regardless of your approach, the goal is simply to get back to your desired asset allocation…the sooner, the better.
Do any of these portfolio pitfalls hit close to home? Do your otherwise rational investment decisions occasionally take a back seat to your emotions? What other common investment mistakes should we discuss in part two of the series?
¹ Vanguard’s framework for constructing diversified portfolios (Vanguard, 2013)
² Investment solutions and alternatives for addressing concentrated equity (Vanguard, 2007)
³ The case for index-fund investing (Vanguard, 2013)
⁴ What’s the better way to invest—little by little, or all at once?(Vanguard, 2012)