Avoid Being An Investment Collector

I have to admit, at times I feel like an investment collector. Well, it's partially because I feel the need to try out all sorts of different investment, especially in real estate. And how else can I talk about it on this site if I haven't tried it myself.

In any case, heed the words that follow carefully and you'll be on your way to a cohesive, well-thought-out investment plan.

Today's Classic is republished from the White Coat Investor. You can see the original here. 

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 of funds, such as the Vanguard Life Strategy Moderate Growth fund 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 to 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.