By Dr. James M. Dahle, WCI Founder
[Editor's Note: The following was originally published as one of my monthly columns for MDMag.com entitled “Avoid Being an Investment Collector.” This is a surprisingly common affliction among advisors, but especially among DIY investors who don't have an investing plan put in place.]
What Is an Investment Collector?
A frequent mistake I see physicians and even their advisors make is that they become “investment collectors.” A collector is someone who sees something they like, buys it, and places it on a shelf where it can be admired. The next time they’re at a flea market, garage sale, or boutique, and see something else they like, they also buy it and put it up on the shelf. Eventually, every flat space in the home and even the shed out back is filled with a hodgepodge collection of knickknacks that at one point struck the collector’s fancy.
Where Is the Investment Plan?
While assisting a colleague concerned about underperforming investments recently, I was dismayed to learn that he, with the assistance of his apparently highly qualified, fee-only advisor, had assembled a collection of investments rather than a well thought out portfolio. The portfolio was divided into 2 parts — his 401(k) and his IRA, and making matters worse, the investments did not seem to take into account any of his spouse’s retirement investments or his other assets. The 401(k) consisted of 12-15 different mutual funds of various types. Many of the fund expense ratios were far too high, many of the investment strategies were questionable at best, and there was a great deal of overlap between the various investments. The IRA also had 12-15 different mutual funds of various types. Despite the ease of doing so, none of the specific investments were the same in both accounts, despite being invested in the same asset class. The IRA funds also all had a very high expense ratio of around 1%, not counting the advisory fee.
I asked my colleague if he had a written investment plan or asset allocation. There was no such plan, at least that he knew about. The advisor had also placed him into a variable annuity. While it wasn’t the worst variable annuity I had ever seen (and thankfully had no surrender charge), my colleague had no idea why he owned it. The issue was that he had a collection of investments, but no coherent investing plan.
I have seen similar portfolios where an investor owns dozens of individual stocks, bonds, mutual funds, ETFs, annuities and the like without any rational underlying investment philosophy. Sometimes the reason is they have mistaken a commissioned salesman for an advisor. Sometimes the reason is that the investor or his advisor has been engaging in the deleterious practice of performance chasing (buying what has done well recently without regard to its prospects going forward). But most often, it is simply that investments were selected prior to designing a proper asset allocation.
Successful portfolio design is simply not that complicated, especially in a situation such as the one my colleague was in where all of his assets were inside tax-protected accounts and he could choose from essentially any publicly-traded investment in the world. A reasonable portfolio should contain 3 to 10 asset classes. Each of those asset classes can be fulfilled with a single investment. In fact, in my colleague’s case, he could simply buy a low-cost fund, such as the Vanguard Total Stock Market Index Fund (TSM) in both accounts and be done. Are there some good reasons to consider making things a little more complicated? Sure, but he hardly needs 25-30 different investments for his relatively straightforward portfolio.
6 Principles for Successful Portfolio Design
#1 Appropriate Amount of Risk
The first principle is that the investor should be taking on an appropriate amount of compensated risk. As a general rule, taking a higher amount of appropriately compensated risk should lead to a higher return over the long run. A younger investor, further from his financial goals, should generally be taking more risk than an investor on the verge of retirement. A portfolio of 100% CDs or a portfolio of 100% small value stocks is likely not appropriate for either investor. However, a portfolio composed of 25% stocks and 75% bonds may be appropriate for the older investor but is probably completely inadequate for the younger one.
#2 Adequate Number of Asset Classes
There are dozens of different asset classes you can invest in, including US stocks, international stocks, bonds of various types, real estate, and others. An appropriate portfolio should contain between 3 and 10 of these asset classes. The lower the correlation between your asset classes, the better. This is so when one of your asset classes is zigging, the others are zagging, allowing the entire portfolio to enjoy a smoother ride, improving returns and investor behavior.
#3 Adequate Diversification Within an Asset Class
Even within an asset class, it is important to be diversified. Owning 5 or 10 individual securities is not adequate when you can easily own thousands by simply purchasing an index fund. Individual stock risk is considered “uncompensated” risk. Since that risk is easily diversified away, the market, on average, will not compensate you for taking that risk. There is no sense in taking risks you are not compensated for taking.
#4 Low Costs
Another great benefit of investing in index funds is that not only will you own thousands of individual securities, but you will be able to do so at a very low cost. The best index funds charge as little as 0.02-0.10% per year as an expense ratio (expenses of the fund divided by the total assets in the fund.) Many mutual funds charge 20-100 times as much. In investing, you get (to keep) what you don’t pay for. Every dollar you don’t pay in expenses is a dollar that remains in your account compounding toward a successful retirement.
#5 Simplicity
In investing, often times the best solution is the simplest solution. Investing does not have to be complicated. It is possible to have a low-cost, simple, yet sophisticated portfolio composed of as little as 1 to 5 mutual funds. If you choose to make your portfolio more complex, be sure there is a good reason for doing so.
#6 Occasional Rebalancing
Unless you have chosen the ultra-simple, one-stop, “fund of funds” solution, be sure to rebalance your portfolio every year or 2 back to its original allocation. This allows you to maintain your desired risk level going forward. You simply direct new contributions toward the asset classes that have recently done poorly, or, if necessary, sell some of the better performing asset class to purchase those which have done worse. This continually forces you to sell high and buy low, a recipe for successful investing.
A successful investor has a written, logical investing plan, not just a collection of investments.
Step 1: Realize that picking stocks is a losing game. Welcome to mutual funds and then to index funds.
Step 2: Read success stories like yours that it works.
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About those odd collections… I have to admit that I have over 700 original Nintendo games lining our walls. I do track their market value and buy and sell as a business.
Those two kayaks I bought seemed like a good idea at the time. Now they’re just collecting dust and taking up a heck of a lot of space. Maybe if I buy just one more, then we’ll use the others more often? Not unlike that Brazil market ETF that I bought just before the crash.
80% of my money is in index funds (US, international and bonds). 10% mutual funds with EJ. I am trying to convince my wife to let me take those out, how ever the guy is a family friend and she feels little ashamed to take the money out. 5% is my play money for index funds or ETFs. 5% is my play money for stocks.
You know they do that on purpose, right? Becoming friends I mean. Sales 101.
try explaining that to my wife, this guy is in my in-laws wedding. I call this part of my portfolio = charity portfolio.
Well, it might be 10% now, but if you don’t add new money it’ll be 5% later and eventually 1%, right? 🙂
When I started EJ was like 30-50% of my portfolio. Its down to 10% and hopefully even less with time.
charity portfolio, thats a good one.
Cheaper than a divorce.
On Rebalancing: What is the generally accepted time frame recommended for rebalancing? q month? q quarter? q year? every time the market takes a big dip or gain? (larger than 5%ish?) How often do you rebalance? How many times did you rebalance in the 2008-2009 time frame? How often in the 2010-2013 time frame? (all of these questions will assume that one has a large enough account to avoid trade fees)
I may be wrong, but dont rebalance too often, that way you can be part of momentum investing. I typically put my newer money in spots that arent doing well. Some day however newer money wont make up that difference.
Yearly at most is the generally recommended. I sort of rebalance every time I add new money though. In 2008 my portfolio was small enough I still didn’t do much selling.
https://www.whitecoatinvestor.com/rebalancing-the-525-rule/
I am a bit guilty of this. My husband and I have IRAs at Fidelity as well as 401Ks with different investment options. I selected funds I liked for each account and now have a little bit of a hodge podge. Overall, I think my asset allocation is okay, but you encouraged me to simplify it a bit.
I am a dividend growth investor but I have a lot of index ETFs. Right now, I am buying more Europe and Asia, although with the strong US dollar, VEA hasn’t done too well. However, my canadian VDU (I live in Canada) which is the VEA equivalent has done well. I like dividend growth investing and generally look at it as buying the same companies in an index fund. still my portfolio hasn’t done too badly.
Why are you buying more European and Asian stocks? Is that what your written investing plan calls for you to do? Does your plan call for you to have some percentage of your money broad market index ETFs and some of it in individual stocks that have had dividend increases in the past? How did you decide what percentage was going to go into each part of the portfolio?
The reason I ask is that a lot of the investors that I see who end up being “collectors” describe themselves as “dividend investors” or “value investors.” Before they know it they’ve got 75 different investments to keep track of.
It’s a part of my diversification plan. Most of my investable assets are North American. I need to diversify geographically.
I’m glad to hear you have a written investment plan and if it’s a reasonable plan, I encourage you to stick with it for the long term.
It can be hard not to be a collector for sure. The other thing you can use to remind yourself not to do it is once you over diversify (usually with similarly weighted/correlated issues anyway) you basically water everything down. Great job in picking that amazing winner, but at a small fraction of your portfolio it wont amount to much.
I cleaned house a bit this week myself, noticed I spread myself around a beaten sector, and while all were good buys and all were very positive for the year…whats the point of having 5-6 different stocks when they are really representative of the same thing (re,durables,energy,utilities,etc). So I sold the marginal positions and consolidated in the stronger remaining ones. The ones I sold will likely do fine, maybe even better, but they were redundant.
Nothing wrong with Europe/Asia as they are going through their QE, you just need to have a plan, some guidelines, and stick to it. A small portion of my portfolio (for fun section) is a globalish RSI and does include europe, emerging, frontier, international ex us, us equities, and bonds. Its always 5 o clock somewhere.
North american stocks are actually quite diversified when you get down to it (more true for large caps). Its a global economy, and its part of the reason earnings are expected to be awful this qtr (lucky us, sale!).
As a self employed 34 years old dentist, I have a SEP IRA thru Vanguard and I am 100% in their REIT index fund. I like the REIT for the high dividends. Also, Swensen from Yale’s endowment said most of a fund’s growth is thru dividends. Started investing in 2008 after the crash and it’s been doing amazing.
100% in one fund? Thats not recommended for anything. I would be particularly attuned to rate hikes coming up, even though thats temporary and it will likely do very well in the long run. Its just a lot of heartache for little gain. I would diversify immediately.
This is coming from someone that makes their own index mind you, so I am one of those crazy stock choosers and not an fervent index believer (but they have their place). Also, I hold a large percentage of my portfolio in REITs (all with much better dividend yields than VNQ for what its worth.
Why not do something safer and with possible volatility off setting? Maybe 25% in VNQ, 25 in their healthcare fund (excellent btw), 25 in S&P, etc…
I also invest in Vanguard’s REIT fund, and yes, returns since March 2009 have been amazing. However, I hope that’s not your only investment. It is extremely volatile. I lost 78% in that fund in 2008. That’s one thing that drives a lot of people into buying their own individual real estate investments- that much volatility really bothers them.
Also consider going to a solo 401(k) instead of a SEP-IRA so you can do backdoor Roth IRAs.