Six Common Portfolio Issues

Portfolio reviews can provide an excellent opportunity to review an individual or a family’s financial life.

They allow me to understand the family’s goals, concerns, and pain points. Advising individuals and families and examining their holdings and plans enables me to provide them with guidance and also helps me identify issues worth addressing in the future.

Through these experiences, I have come to appreciate that investors who come to me for advice often get more right than they get wrong. For example, they typically conduct their research and construct portfolios of low-cost mutual and exchange-traded funds.

Additionally, they tend to invest for the long term, reserving niche investments for only a small portion of their portfolios. I would not be surprised that people who seek the help of a financial planner already have a higher level of sophistication than the average investor. However, I generally don’t come across individual investors who chase returns, at least regularly.

Despite the overall positive aspects, recurring issues frequently emerge during these portfolio reviews. Some of the most common problems and potential solutions follow.

1. Too Many Accounts

One of the most common issues is having too many accounts, leading to too many similar but different holdings, redundancy, duplication, and ultimately unbalanced portfolios.

This problem often arises from leaving retirement plans behind when investors change jobs. The asset allocation and investments of account #1 are then supplemented by those of accounts #2 and then #3.

The investor may end up having accounts at several different institutions.

We are not that good at assimilating all these accounts and figuring out in our heads what the overall asset allocation is. More difficult still is understanding the imbalance in a portfolio when the investor has a large stock such as AAPL or GOOGL and significant positions in S&P 500 index funds. That situation can lead to risk and unexpected results.

A straightforward way to resolve this issue is to consolidate these accounts into one single IRA or separated into a Roth and a traditional IRA if both types are involved, and a single brokerage account if these are also involved.

Reducing the number of accounts can give the investor a better understanding of how they are actually invested. Then after the accounts are consolidated, the investor can perform a portfolio analysis to determine where they are overexposed or underexposed and act consequently.

2. Redundant Individual-Stock Portfolios

A corollary problem of having too many accounts that was alluded to in the previous point is having a stock portfolio together with mutual funds or exchange-traded funds. Because the funds often include the individual stocks, it leads to overexposure to companies and industries.

The problem arises because stock investing still resonates with many of us. We hear in our heads that funds provide easy and cost-effective diversification. But our heart tells us that stocks can make a difference in our portfolio. A difference it will make, but not always the one intended.

The problem also arises from investors having various stock options and Restricted Stock Units from their employers as part of their compensation. This is great but also affects asset allocation, especially when the awards are substantial.

The best way to deal with the issue is to remove the target stock from the allocation. That is usually feasible when the stock options or RSUs are a large cap. This will be the subject of another post. In the meantime, let me know if you need to know about it.

3. Emotional Decision Making

Even the most skilled investor is subject to behavioral biases. We may think that we are totally objective cold blooded investing machines. The truth is we trip over our own biases often without noticing.

Many investors will succumb to anchoring bias after buying a mutual fund or a stock. The information we had when buying the asset becomes the reference point by which we judge it. When it goes down, we “anchor” to that past information, even though it may no longer be relevant.

When the asset goes up, we become victims of confirmation bias, where our previous thinking is confirmed. We will seek out more information that confirms our previous thinking. When we find contradictory information, we tend to dismiss it.

Confirmation bias looks a lot like overconfidence bias. That’s when we overestimate our knowledge, skills, and ability to make profitable investment decisions. Many successful people fall victim to it, especially in analytical fields like engineering or medicine. As a result, overconfident investors often invest or divest with incomplete research or analysis.

Herd mentality is a less analytical bias. Sometimes it manifests as FOMO (Fear Of Missing Out). That’s when investors follow the crowd into investment decisions based on the actions of others. That bias often manifests with bubbles or near market tops.

Behavioral biases can lead us to make sub-optimal decisions that affect the risk and performance in our portfolios. Many other biases can hinder our investment performance. It isn’t easy to counter them without knowing about them and without someone holding us accountable.

4. Asset Allocation Misalignment

Another common issue, albeit more challenging to rectify, is when a portfolio’s asset allocation does not align with the investor’s actual plans. A typical scenario involves individuals nearing retirement or already retired who lack a sufficient allocation to safer assets to accommodate their anticipated spending needs. Many of these investors have experienced significant stock market gains. They are reluctant to risk their portfolios in favor of lower-return but lower-risk assets.

A similar scenario happens with investors closing in on retirement and switching disproportionately to bond investments. In reality, someone of retirement age will need that money for 20 or 30 years or maybe even longer. An investor facing retirement needs to balance risk and reward, including the risk of running out.

An excellent way to address the issue is to calculate the amount required in the relatively short term and invest with lower risk while investing the money needed for the longer term into higher projected return investments. That is often referred to as the “Bucket Method.” Let us know if we can tell you more about how that works.

5. Sequence of Return Risk Exposure

Sequence risk can be a substantial concern for those on the verge of retirement or newly retired. If the market happens to have a down year, the year you retire, you are more likely to run out of assets in your lifetime. That happens because when you first take a distribution, that adds to the portfolio caused by the market. As a result, it is more difficult for the portfolio to recover.

Since one of the critical goals of retirement planning is to not run out of money, that is obviously a key concern.

One of the ways to avoid that issue is, again, the Bucket Method. By investing near-term cash needs in low-risk investments, the investor can mostly avoid the early impact of the sequence of return risk. And then, investing long-term cash needs in high-return investments, the investor does his best to avoid the long-term impact of sequence of return risk.

Let us know if you have questions about applying the Bucket Method.

6. Know Your Credit Score

Investors often need to make more optimal asset location decisions. Asset location is the decision to place an asset in a tax-advantaged or a taxable account. Too often, investors place an investment in the wrong account. For example, a tax-free municipal bond in a Traditional IRA.

Because IRA distributions are taxed at ordinary income rates, they negate the advantage of a tax-free investment.

Similar issues happen with investments with a high income, such as REITs and high-yield bonds placed in taxable accounts.

There are five major types of investment accounts with different tax characteristics. Most investors end up having accounts in several, if not all, categories.

Among the major categories of accounts, tax-deferred accounts such as Traditional IRAs and 401(k)s allow an investor to reduce their taxable income at contribution. However, they are taxed as ordinary income when they take the distributions.

On the other hand, Roth accounts do not provide a tax reduction at contribution but also allow tax-free distributions.

Contributions to annuities do not reduce taxable income, and the distributions are a mix of tax-free return of capital and distributions taxable as ordinary income.

Lastly, contributions to taxable brokerage accounts are also made with after-tax money. Distributions can be tax-free as a return of capital, with profits taxed as capital gains. Usually, capital gains are taxed at a lower rate than ordinary income taxes.

It is also possible to have capital gains taxed even lower on average than the standard rate using harvesting techniques. Ask us how.

The most advantageous account is the Health Savings Account. Contributions are pre-tax. Growth is tax-free. And distributions are tax-free when used for qualified health expenses.

Investors should address Asset Location within the context of asset allocation. Generally, investments with high growth potential should be placed in the account with the lowest tax consequence. Investments with lower growth potential should be placed in accounts that have higher tax rates.

Asset location concerns within tax-sheltered accounts are relatively straightforward, as investors can make them without incurring immediate tax consequences. However, rectifying asset location problems in taxable accounts can be more challenging, as there is often a tax consequence to selling a security to reinvest in another.

Before undertaking any sales from taxable accounts, whether to address tax-related issues or to resolve other trouble spots, it is essential to assess the current and future tax implications of such actions.

Summary

In conclusion, by recognizing and remedying problem areas within their portfolios, investors can enhance their financial well-being, sometimes significantly. Addressing the multiplication of accounts, the complexities of individual stock portfolios, underperforming funds, aligning asset allocation with investment plans, and optimizing asset location are critical steps toward building robust and efficient portfolios. Regular monitoring and periodic adjustments can lead to significantly improved outcomes and better alignment with investors’ long-term goals.