While poor investment outcomes can result from a variety of reasons, there are a few common mistakes. The good news is that these mistakes can be avoided with a small amount of planning and discipline. See below the mistakes that I refer to as the “Big 3”:
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Inappropriate Asset Allocation
The most common way I see investors inflicting unnecessary pain on their portfolios is through inappropriate asset allocation, which can be an incorrect ratio of stocks to bonds, fixed income, and cash. While there is no one-size-fits-all approach, the appropriate mix should be a function of your timeline and goals/rate of return expectations and risk tolerance.
Recommendation: Determine when you will become reliant on your portfolio for cash flow and the amount of assets you will need to accumulate between now and then (To Calculate: Determine how much you think you need on an annual basis and divide that number by 0.04). With that number, you can determine your stock to bond mix based on your expected annual savings rate and expected rate of return on stocks. For illustration purposes, you could use an 8% planning assumption for stocks, and 2% for bonds, fixed assets and cash. This mix is now your baseline. It is not necessarily wrong to be more aggressive than your baseline but understand that you are adding downside risk along with your potential upside.
Lack of Diversity
Diversity within investment portfolios is well documented to reduce risk and add to investment returns over time, but many do not follow this axiom. While lack of diversity is often a conscious decision made by investors, investors often assume they are diversified when they are not.
Recommendation: Review your concentration of specific stocks and sectors of stocks within mutual funds and exchange-traded funds (ETFs). While many investment products present themselves as diversified, they are often lacking in that regard. If developing a portfolio of individual companies, look to invest in at least twenty companies (Preferably 30 or above) across multiple sectors and be willing to do your homework about their underlying fundamentals.
Letting Tax Avoidance Dominate Your Investment Decisions
Due to the strong bull market from 2009-2021, many investors with taxable investment accounts find themselves with concentrated investments they refuse to take profits from for tax reasons. While there are often good reasons to avoid tax events, (i.e., the elderly holding low basis stock positions where estates will experience a step up in basis upon death), I often find investors being stubbornly tax averse, which can lead to painful outcomes.
Recommendation: If you find yourself in this position, work with a Certified Financial Planner™, or tax advisor, to quantify your potential downside price risk with the tax liability associated with reducing the position and realizing taxable gains.
