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Top 10 Portfolio Pitfalls
So what's in it for you? Well, this column is an opportunity to hear about every aspect of portfolio building. Tips, traps, pitfalls, the works. It's also a chance to see what other investors are doing with their portfolios.
Let me tell you, whatever problems you encounter in your own portfolio, you're not alone. Plenty of other investors get tripped up by the same stumbling blocks. During my 6 years as a financial consultant, I've found that there are 10 mistakes that most investors make. Check and see if any sound familiar. Looking for the following problems in your own portfolio will help you think about your portfolio as a whole, not simply as a collection of individual investments.
1. Not defining objectives and priorities
After owning them for a long time, it's easy to forget that the funds in your portfolio are there to do a job. Take the time to think about what that job is, and whether your needs or expectations for that investment have changed. It may be time to sell some of those funds.
2. Lack of a focused core
If you find yourself staring at a long list of funds and aren't really sure why you own them, your portfolio probably lacks focus. For each goal that you have identified, you should have a core group of three or four funds that are proven performers. The bulk of your assets--typically 70% to 80%--should be in these funds. For most people, large-cap funds will probably make up the core of their portfolios. Simplify by focusing on a few funds that can deliver what you want and gradually add to your investment in them rather than adding more funds to your lineup.
3. Putting too much outside the core
Use additional funds for diversification and growth potential. For instance, if your core is made up of large-cap funds, you might want to add small-cap, international, and sector funds for diversification.
While you probably wouldn't want to put a significant portion of your portfolio in any one of these types of funds, they do allow for the possibility of extraordinary returns. Of course, they also generally carry a higher level of risk. But as long as you limit the more-risky portion of your portfolio, you aren't likely to threaten the bulk of your nest egg. And for some people, core funds may be all they ever need.
4. Imbalance
A well-constructed portfolio is a balanced portfolio. If you see something that "sticks out," you need to determine whether it still fits your risk profile. Imbalance happens when some categories do very well or very poorly.
A portfolio that was balanced three years ago would be totally out of whack today if it hasn't been rebalanced. If you had invested 25% of your portfolio in intermediate-term bonds, 10% in international stocks, and 65% in U.S. stocks, your allocation today would be starkly different: just 17.5% in intermediate-term bonds, 7.5% in international stocks, and a whopping 75% in U.S. stocks. That portfolio is much riskier today than it used to be.
5. Owning too many funds
Many investors know they have this problem--they just don't know what to do about it. Start by evaluating where the fund fits into your portfolio. Is it a core fund or not? It's critical that your core funds be strong performers, so if they lag behind their peers for three years, make a change. Try increasing the assets in your core funds and cutting out a few of the poorer-performing noncore funds.
6. Poor choices within categories
Morningstar's star ratings may get a lot of press, but Morningstar's category ratings are more important in my book.
Here's an example. Two large-cap blend funds, Principal Growth PRGWX and Goldman Sachs Capital Growth GSCGX, earned 4-star ratings through the end of July. They may seem like equally worthy funds. But their category ratings tell a different story. The Goldman Sachs fund has been a far better large-cap blend investment on a risk-adjusted basis than Principal Growth over the past three years. The Goldman Sachs fund's category rating clocks in at 5 versus a 2 for Principal's fund.
Evaluate your portfolio's performance at least once a year, comparing your funds' risk and returns against those of their peers. If a fund hasn't kept up with its peer group over the past three years, it's time to think about dropping it.
7. Inefficient use of tax strategies
Is your portfolio making the most of tax strategies? Some funds work better in tax-deferred accounts than in taxable accounts. In future columns, I'll discuss how to avoid penalties if you retire early, when to consider a Roth IRA, and other tax-related topics.
8. Paying too much in fees
Given two similar funds, I'd take the one with lower costs. You should never pay up-front loads when buying mutual funds.
9. Excessive stock overlap
I've seen many cases where someone owns a significant amount of their employer's stock in their 401(k) plan, unexercised stock options in their company, and mutual funds that also own that same stock. There's nothing wrong with holding some of your employer's stock, but do balance that investment with diversification in the rest of your portfolio.
10. Not knowing when to seek professional help
If you happen to be a do-it-yourself type of investor that’s great. But there are times when it pays to get professional guidance that focuses on your individual situation. Complex tax issues or estate planning can necessitate a trip to a financial specialist.
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