The investment industry has its fair share of black sheep, and as a result there are an enormous number of poorly constructed portfolios. Problem portfolios come about for many reasons, but one thing is certain: they can lead to investments that cause more harm than benefit for investors. By investigating these problems, you will be better able to prevent portfolio construction abuses in your own investments.
Common Portfolio Problems
A one-sided approach results in portfolios containing only products from the bank or financial institution used by the investor. In other words, if you go to a particular bank and it represents a certain collection of funds, it is likely that those are the ones it will recommend, despite the fact that they may not be the most cost-effective or the best performers. Realistically, you are going to get a truly objective selection only from an advisor that is not tied to any specific product or bank. After all, that is what independent really means.
Another core problem is what economists call lumpy risks. This is a dangerous over-investment in a certain sector or asset class which means the value of your portfolio will go up or down in large, unwieldy chunks based on the movements of the over-invested sector. This presents a problem for investors because too much of any one type of investment is risky. It is important to note that diversification is not achieved by having lots of different types of equities or different types of bonds or any other asset class. Instead, diversification is achieved by a prudent mixture of non-correlating asset types, which means you generally need at least all three - bonds, equities and property - along with other funds.
A less obvious, but equally serious, problem is a lack of liquidity . This is created when there is a timing difference between investment goals and the need to access money from the portfolio. For example, an investment in equities for most investors should be made with a long-term focus. However, if you need money in the short- to medium-term (one to three years or even up to five) for a specific purpose such as buying a house or car, the funds earmarked for the purpose ought to be kept out of the equities markets. Nothing can be more disastrous than desperately needing money from an investment that is currently way below its purchase price.
Another common problem is home bias . Most investors rely too much on domestic investments, which places a limit on diversification. A good portfolio will not shy away from foreign investments. While they often seem riskier, in fact, they may carry no more risk than products back home and their non-correlation with domestic products can reduce the overall risk of a portfolio. In other words, even if a particular foreign fund is high risk in itself, having a sensible amount may lower the risk of your investments as a whole. However, keep in mind that foreign investments do come with their own specific risks, including currency translation risk.
If you or your portfolio manager fails to monitor your portfolio regularly, this can also be disastrous for your returns. The investment and capital markets can change rapidly and often substantially. There are times when it is good to have more equities than bonds and vice versa. Similarly, there are times when it is best to have relatively large amounts of cash, while at other times this is unwise. Monitoring also allows you to ensure that the reasons behind your investments remain intact and if they have changed, you will be able to make adjustments before your portfolio's performance is affected adversely. Therefore, nothing is more important than checking your portfolio regularly - doing so as often as every three months is usually necessary. Only by doing this can you ensure that the level of risk in your portfolio is appropriate to your needs and requirements, and that there are no investments that should be sold off.
An associated problem is portfolio drift , which means that your portfolio changes in nature and risk on its own. This danger is all too familiar to investors who got burned in the late '90s by owning portfolios that had become far too equity-heavy over the decade. In other words, you may start off the decade with a well-balanced portfolio, but if, over time, the value of your equities increases substantially and that of bonds does not, you will ultimately have a high-risk almost all-equity portfolio. Furthermore, this is likely to happen at precisely the time when equities are overpriced and likely to go down in value, or even crash. The main protection against this danger is to ensure that the proportion of your money in the equity markets is never more than you really wish to risk.
Finally, there is the awkward issue of having no loss control. Merely buying "good shares," even blue chips, does not protect against market losses; having a real strategy is the only way to do that. Many investors, particularly in the 1990s, assumed their brokers or fund managers had some kind of loss-prevention strategy in place when, in fact, this was rarely the case. This assumption led to some devastating losses.
Mediating Risk
It is not easy to find an appropriate strategy, but it is certainly worth trying. With equities, setting a lower limit on shares (stop losses) is one way of preventing disaster. If shares drop below a certain specified limit, you simply sell them. It is also possible to monitor ratios such as price or earnings and sell shares that seem overpriced. There are also so-called "package products," such as mutual funds, which tend to have some form of capital guarantee.
All these methods have their pros and cons, and none presents a perfect solution. Nonetheless, such strategies should certainly be considered and people need to know whether their money has any formal protection. A vague promise of professional management, fine stock-picking skills or even of rapid reaction to market change may mean little or nothing in practice. And by the time you discover this, it may be too late.
The Bottom Line
There are a few basic rules in portfolio construction that must be adhered to. All too often, so-called professionals do just the opposite. Yet, it is not particularly difficult to ensure that you have and maintain a well-balanced and sensible portfolio. However, you need to make sure this is what you really get. Many advisors simply do not bother to get things right, or they deliberately sell you what makes them the most money, rather than what you really want or need.
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