3 Signs of a Dysfunctional Portfolio

Is your investment portfolio helping you or hurting you? The only way to know is conduct a brief exam of your holdings.

All dysfunctional portfolios have unwanted attributes that you should avoid. What are they? In this article, we'll look at three signs of a dysfunctional portfolio.

Underperformance

What if your investment portfolio (as a whole) has consistently underperformed major stock (NYSEArca: DIA - News) and bond (NYSEArca: BND - News) markets? It's probably the tell-tale sign of a dysfunctional investment portfolio. Official confirmation of this disorder is if the portfolio has displayed the tendency to underperform over various market cycles.

To find out if your portfolio's performance is sub-standard, you'll first need to do some performance comparisons.

You can use two methods; 1) Evaluating the portfolio's entire performance versus a blended benchmark of passive indexes that closely replicates your portfolio's asset mix or 2) Evaluating each of the portfolio's individual holdings versus a corresponding passive index.

Which comparison method is better? I prefer the first, because it gets gives you a fast bottom line answer. The second method is OK, however, it's easy to get distracted by individual holdings and to ignore the rest of the portfolio. The second method can also be problematic if the person doing the comparative work is using inappropriate measures, like peer group analysis, which is quite common in the analysis of mutual fund managers. 'The best way to measure a manager's performance is to compare his or her return with that of a comparable passive alternative,' said Nobel Prize winning economist, William F. Sharpe.

Here's an example of how you would execute the second method: If you own small cap funds, start comparing their historical performance versus ETFs following key small cap benchmarks like the Russell 2000 (NYSEArca: IWM - News), S&P Small Cap 600 (NYSEArca: IJR - News) and the MSCI US Small Cap 1750 Index (NYSEArca: VB - News). Always compare apples to apples and always compare performance over identical time frames.

Poor Asset Mix

Asset allocation is an exercise that attempts to obtain the correct investment mix for the end user. Serious investors understand that having the right mix of investments produces desirable results. On the other hand, having the wrong brew of investments is another sign of a dysfunctional investment portfolio.

Here's an example of what I mean:

Joe Investor is a 65 year old retiree with a $500,000 investment portfolio. His main goal is for the portfolio to generate income so he can supplement his other income sources. But one gander at Joe's portfolio reveal's some serious problems.

He's got 20 percent invested large cap growth stocks (NYSEArca: IWF - News), 20 percent in gold (NYSEArca: IAU - News), 10 percent in silver (NYSEArca: SLV - News), another 10 percent scattered among commodities (NYSEArca: GSG - News) and the remaining portion is in his money market account. Were you able to identify what's wrong with Joe Investor's portfolio?

Joe's portfolio owns investments that are incompatible with his main goal of generating income. In fact, none of his holdings generate any significant dividend income or cash flow. His portfolio is clearly dysfunctional.

Many people are making the same mistake as Joe Investor and as a result they have dysfunctional portfolios. What about you?

Taxes

Most investors are so preoccupied with trying to pick the best investments they overlook the tax consequences of their decisions.

A study conducted by Lipper found that buy-and-hold investors with mutual funds in a taxable account surrendered between 1.13 percent to 2.13 percent of their annual returns over a 10-year period because of hyper-active fund managers buying and selling securities. Where's the financial benefit of holding investments that sack you with a totally avoidable tax bill every single year?

Poor asset location is another contributing factor to dysfunctional portfolios. For instance, people that stuff their taxable brokerage accounts with tax inefficient investments like REITs (NYSEArca: ICF - News) and high yield bonds (NYSEArca: JNK - News) are hurting their bottom-line. By simply re-locating some of these assets into a tax-deferred account, it could save them a significant bundle.