Do’s and don'tsRetirement planning

Portfolio Allocation: Avoid these 3 common mistakes

By May 14, 2019 No Comments

Proper portfolio allocation is very important. If you need a refresher, review our article about understanding the impact of portfolio allocation. In over 40 years in the business, we’ve seen a lot of good and bad when it comes to how investors allocate their portfolios. With those experiences in mind, here are 3 common mistakes investors make when it comes to portfolio allocation:

 

  1. Their investments are too similar
    1. If you invest an equal amount of money in Apple, Amazon, Google, Netflix, and Facebook you are invested in five different stocks. That might sound like diversification on the surface, but it’s really not. Why? Because all five of these companies are in the same sector (technology) and are highly correlated with one another. There are many overlaps between all five businesses:

      – Apple and Amazon are two popular streaming music giants
      – Amazon and Google are two giant cloud service providers
      – Google, Facebook, and Amazon are advertising behemoths.
      – Apple and Google offer the two most popular smartphone operating systems
      – Netflix, Amazon, and Google (Youtube) are the largest streaming video    providers

      An investment in any of these companies is a bet on certain economic trends continuing: consumer subscription models, smart phones, streaming, social media, etc… The market knows this, which is why all five of these stocks tend to move in tandem with each other. That is, when Google share price is going higher than the other four are usually going higher as well. When Apple’s share price is going lower, the other four are generally going lower at the same time too. They are highly correlated to one another.
  2. One investment is too big
    1. You never want your portfolio’s performance to be totally dependant on the performance of one specific stock or market segment. The cliche of not putting all your eggs in one basket comes to mind. We would change it a little bit and say don’t even put most of your eggs in one basket, but rather spread your eggs around in many different baskets.

      We often see an investor will have 25% or more of his portfolio tied up in one stock or market sector. This poses a risk that can be hard to notice when the portfolio is doing well, as this large allocation helps grow the portfolio. However, in a downturn, the results can be devastating.

      You have to be mindful of how your portfolio’s allocations can change even without your action. For example, say you invest 10% of your portfolio into a specific security and 12 months later that security has doubled in value. Meanwhile, the rest of your portfolio did nothing over that same time. In that situation your 10% allocation will have turned into a 20% allocation!

      So even though all you did was buy and hold, and you’ve made good money, the total risk in your portfolio has actually risen. That’s because your portfolio’s performance is now more greatly tied to the performance of this one security as a result of the now 20% allocation versus an original 10%. You’ve become less diversified, perhaps without even realizing it.  
  3. They either love or hate bonds
    1. Bonds are a great investment vehicle for many different types of investors. However, many investors do not have enough bond exposure, or they have too much. Younger investors tend to think of bonds as boring and low risk, and older investors tend to think of stocks as volatile and risky. The result is that we often see incorrect allocations to bonds, either being too conservative, or not conservative at all.

      The general rule of thumb to figure how much you should invest in stocks and bonds is to take the number 120 and subtract your age. That reveals the percentage amount you should have invested in stocks, with the remainder out of 100 allocated to bonds. For example, a 50 year old should have 70% in stocks (120-50 = 70) and 30% in bonds (100-70 = 30). Here’s a table that shows more examples:

      Equation: 120-age = stock allocation; 100-stock allocation = bond allocation
AgeInvested in stocks stocksInvested in bonds
3090%10%
4575%25%
6060%40%
7545%55%


Bonds typically help reduce volatility and add income to a portfolio. So it makes sense that the older you get, the more bonds you should have. But that doesn’t mean a young investor should ignore bonds completely. Conversely, stocks tend to offer much better protection against inflation than bonds do. So and older investor worried about the cost of living rising as they age would be making a mistake if they ignored stocks completely.
Of course, these numbers can vary on a case by case basis depending on an individual’s risk tolerance and investment objectives. In general though, one needs to be careful about ignoring bonds completely or favoring them too much.  

 

In order to have a diversified portfolio, you want to allocate to non-correlated investments. A common myth is that when the stock market goes down every single investment in it goes down, but that’s not true. There are areas of the market that perform better during different stages of the economic cycle.

 

You have to be careful about your portfolio living and dying with a single investment. We like to think of investments like having a reliable group of friends: If you only have one friend who can help you out during difficult times in your life, what are you going to do if that person isn’t available when you need them? The more friends you have and can rely on, the greater support system you have. A soundly diversified portfolio will work the same way during market downturns.

 

Investments in stocks and bonds accomplish different things, and how much you should invest in each definitely varies on a case by case basis. However, it’s rare to say that one person should only be invested in stocks, or only invested in bonds. When we evaluate portfolios and learn about people’s investment needs and objectives, we usually see reasons to invest in both stocks and bonds.

 

Make sure you review your own portfolio and see if you’re making any of these 3 common mistakes. And if you are, don’t panic; these mistakes are easy to fix with the right financial advisor’s help. Please contact us if you have any questions.

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