Top Five Mistakes in Portfolio Design Part 1

Top Five Mistakes in Portfolio Design Part 1

When clients first come to us exploring the possibility of hiring a professional wealth manager, we ask them to bring copies of all of their investment account statements, so we can perform an analysis of their portfolio.

Being in business for over 23 years now, we have reviewed hundreds of portfolios, and we’ve seen many common investing mistakes repeated over the years.The portfolios vary widely based on who designed them. There are clear tendencies and attributes that signify a portfolio constructed by a professional money manager versus a do-it-yourself individual investor. Based on our extensive experience in analyzing portfolios, we have compiled a list of the top five investing mistakes we see from individual investors in the design of their investment portfolios:

  1. Too Much Cash

    “Cash is king” the old saying goes, and it still holds some truth, even in this 0% interest rate environment. Cash provides a buffer for emergencies, and a source of income in bear markets if you’re living off your portfolio and don’t want to sell at depressed values. Cash also gives you the ability to be opportunistic in declining markets by providing the liquidity necessary to buy when others are selling.

    But there is a limit to how much cash you want to maintain, especially in this 0% interest rate environment. We advise keeping six months to two years’ worth of non-discretionary living expenses in cash as a reserve fund. Add a bit more if you want to have an “opportunity fund” to have the liquidity to buy into declining markets, but cash should never exceed 10% of your total portfolio. At that point, it starts to become a significant drag on your returns given that it’s likely earning close to nothing.

    Unfortunately, we often see individual investors holding much more cash than that. In fact, it is not unusual to see cash comprise 30% or even 40% of an individual investor’s portfolio. The reason usually stems from a fear of losing money or an uncertainty of how to invest it.

  2. Overconcentration to One Stock

    Investors have a tendency to fall in love with certain stocks. This often stems from one of three factors:
    a. The stock has been in their portfolio for a long time.
    b. The stock has performed very well for them in the past.
    c. They work for the company.

    We often see situations in which one or more of these factors lead investors to hold a position in a stock that represents 50%, 60% or even 70%(!) of their investment portfolio. This is simply much too high an allocation as it flies in the face of the prudent principles of diversification, but it is unfortunately one of the most common investing mistakes we see. No matter how long the company has been around or how well it has done in the past, bankruptcy is always a risk for an individual company. That means the stock could lose all of its value at any point in time. That is why you want to diversify your portfolio across many companies as it significantly reduces your exposure to company-specific risk.

    As a product of prudent risk management, we recommend that no individual stock comprise more than 10% of a portfolio. This is especially true in the case of company stock. With company stock, you run the risk of losing your job if the company runs into financial difficulty. The last thing you want is to lose a significant amount of your portfolio at the same time you lose your income and benefits. Just ask the former employees of Enron or Worldcom.

  3. ❯ Check our blog next week for mistakes three through five of the most common investing mistakes and how to avoid them.

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