posted on May 29th 2015 in Austin CFP Team Posts & Your Financial Advisor with 0 Comments /

Mistake #1: Diversifying by Hiring Multiple Financial Firms

 

Many investors want their investments diversified. This is a good thing for those who want to reduce many of the risks associated with investing, but the mistaken perception of what diversification actually means causes investors to have some strange ideas.One of the things I’ve heard people say is: “I don’t want to put all my money in one basket, so I’m going to diversify with several different investment firms.”

 

This is a strange idea. There is no inherent correlation between the magnitude of diversification and the number of firms you hire. This strategy will most likely not help diversify your portfolio at all; in fact, it will most likely ensure that you have a dysfunctional strategy as opposed to a cohesive one. You may in fact have a smaller “basket” with multiple firms than you would with the right single firm.

 

A truly diversified portfolio that closely represents the world market should include upward of 12,000 individual securities, hopefully acquired via efficient low-cost enhanced index funds.

 

Now let’s say you place your investments with three different firms. You feel good because your money is in different places, but if the combined allocation of all your accounts represents well below that 12,000 securities-holding number, you are still much less diversified than working with one firm that will diversify your portfolio with 12,000 securities. This magnitude of diversification, for example, is typical of what we do for our clients.

 

You see, securities diversification has nothing to do with how many investment firms you work with, but everything to do with how many unique securities you own.

 

Another problem in working with multiple firms is that the left hand is usually not talking to the right hand, so you probably hold a lot of the same securities in one firm as you do in the other. Additionally, you may be missing important asset classes across your holdings. Why anyone would want to do this is puzzling.

 

Best practice: Find one firm whose investment philosophy will hold close to the number of securities in the global marketplace, so you have a truly diversified and cohesive strategy. Remember, any combined investment strategy that holds significantly less than 12,000 securities doesn’t cut it.

 

Mistake #2: Using Short-term Performance as a Gauge of Portfolio Strength

 

The troubling comments I often hear are: “I’ll watch it for a year and see how it performs.” or, “Let’s look at recent historical performance to compare.” If you think recent short-term performance of an investment is any indication whatsoever of the quality of a portfolio or how well it will do in the future, then you are unfortunately fooling yourself. Recent short- term performance gives you very little if any relevant information on the quality of your portfolio or its future prospects.

 

So, if looking at short-term performance doesn’t work, how are you supposed to evaluate your investment portfolio?

 

The answer is that portfolio structure will be the single best indicator as to the quality and the appropriateness of your investment portfolio.

 

Here’s a quick overview of how to do this. Let’s start with a little background on what the research tells us. Long-term historical data tells us that stocks have outperformed cash and bonds, small companies have higher expected returns than large companies, low relative price “value” companies have higher expected returns than high relative price “growth” companies, and companies with high profitability have higher expected returns than companies with low profitability. This has held true for the U.S., international, and emerging markets. In addition, there is a dynamic inflection point on the yield curve for bonds where the risk/return characteristics makes it difficult to validate extending duration for bonds beyond a certain point at any given time.

 

If you want to evaluate your portfolio, the best you can do is to take a look at how well your portfolio is capturing these characteristics and the number of securities you hold. If your portfolio does these things well with cost and tax efficiency, then you have the basis of a quality portfolio.

 

This concept is frustrating for many, as we are wired by the media, sales folks, and lucky Larry the neighbor to use recent performance as a proxy for portfolio quality and future returns. Unfortunately, there is no strong positive correlation between the two. The nature of investing is that there may even be extended time periods of performance you may not like. The truth is that the markets are not worried about your emotional health and they don’t announce in advance the good and bad periods that lie ahead.

 

What can be helpful in the short term is to compare the portfolio components to their relative indexes. Unexpected variations in your portfolio components (asset classes) relative to their indexes should be explored more thoroughly.

 

Best practice: Don’t consider short-term performance of investments as an indication of anything. If you get the portfolio structure right, history has shown us your performance will come.

 

Mistake #3: Avoiding Taxes Now When That Strategy Can Lead to Financial Ruin

 

Another statement I’ve heard people say, in so many words is: “I’d rather not pay taxes today than increase my probability of financial success for the future.”

 

Really? Let’s explore that thought.

 

Let’s say you have a pool of money you absolutely cannot afford to lose, like your retirement nest egg. Here’s a question for you. What if I told you that you could significantly decrease the likelihood you would have a financial disaster and lose everything or close to it. Would that be desirable? Most people will quickly and unequivocally answer yes.

 

But then I tell you there is work to be done. You have concentrated positions, you are not well-diversified, and we’ll have to change your portfolio allocation, so you’ll have to pay some taxes on capital gains this year to set you up for financial success for decades to come.

 

The oft-heard response is: “Oh no, I don’t want to pay any extra taxes, so no, I don’t want to make any changes.”

 

Forgoing a higher probability of achieving your life goals by paying taxes today is a disconnect in logic, but well understood. Taxes are high for many, and seem to be increasing every day. Many accountants are singularly focused on strategies that will defer and limit taxes today and we have that seared into our heads. Unfortunately, this narrow mindset  has ruined many financial lives.

 

Yes you should take advantage of any loss-carry-forwards and evaluate  gain recognition over more than one year but hopefully the point is clear.

Ongoing tax-efficiency is important in any non-retirement investment portfolio, but letting the tax-tail wag the investment-dog in lieu of long-term financial health is a situation that needs further thought. Another old adage applies here as well: better to pay some taxes on something now that improves your prospects for the future than paying no taxes at all because you lost everything.

 

Best practice: Be smart, but don’t shy away from paying taxes today when restructuring your portfolio will reap better risk and return characteristics for decades to come.

 

 

To speak with Morgan, click https://morgansmith.youcanbook.me/ to book an appointment.

 

about the author: Morgan H. Smith Jr. IMBA CFP®

Morgan Smith Jr. IMBA, CFPMorgan H. Smith Jr. IMBA CFP, who has been a fee-only financial planner for over 12 years, specializes in wealth management for successful families, business owners, retirement plans and institutions requiring a disciplined fiduciary process.

An Assistant Professor at the University of San Diego, Morgan has been a frequent speaker to many professional organizations and has appeared on CNBC, Fox Business New Live and is a founding member of the Strategic Trusted Advisors Roundtable.

Learn More and/or Contact Morgan

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