Top Five Mistakes in Portfolio Design Part 2

This is second part of our compilation of the top five most common investing mistakes committed by individual investors. Mistakes one and two can be reviewed in last week’s post, Top Five Mistakes in Portfolio Design Part

  1. Read this week’s post for mistakes three through five.
  1. Overconcentration to One Sector

    Sector overconcentration often stems from common investing mistake #2. Investors hold too much of a single stock, and whatever industry that stock resides in is also overrepresented in the portfolio.

    The familiarity bias plays a role in this common error. People invest in what is familiar and comfortable to them. Studies show that if you work in a specific sector that you are more likely to invest in that sector. This can lead to overconcentration. Studies also show that people like to invest in local companies. Being from the Bay Area, we often see overconcentration in stocks like Apple, Google, and Pandora, which leads to an overconcentration in the tech sector. If we were headquartered in Texas, it would likely be an overconcentration in the energy sector that we routinely encounter.

    Sector overconcentration is not as big an issue as an overconcentration in one stock because you still have enough diversification to avoid company-specific risk, but entire sectors do run into trouble from time to time. The Dow Jones US Technology Index lost over -80% of its value during the tech crash that occurred in the 2000-2002 bear market. During the 2007-2009 financial crisis, the Dow Jones US Banks Index lost a similar amount.

    To combat sector overconcentration, we suggest keeping the sector allocations in your portfolio within 10%-15% of its market allocation. For example, the health care sector comprises 13% of the S&P 500 Index. By following this diversification rule, you would have no more than 28% of your portfolio invested in the health care sector.

  2. Not Enough Foreign Exposure

    This is actually one common investing mistake that we regularly see from both professional and do-it-yourself investors. We believe it stems, in part, from archaic asset allocation advice that recommended 10% to 20% of equity portfolios be invested in foreign stocks many years ago. Interestingly, most portfolios we see today still have a foreign stock allocation in this range.

    The other culprit is the home bias. As described in mistake #3, people like to invest in what is familiar and comfortable to them. This means that U.S. citizens have more of an allocation to U.S.-based companies than they should. (Interestingly, this home bias shows up in other countries as well.)

    This mistake has not cost U.S. investors much because the U.S. stock market has been among the best performing markets in history, but things could change in the future. The Japanese stock market performed admirably for decades as the Nikkei Equity Index gained over 16% per year from 1950 to 1989. But since the start of 1990, the index is down almost -60%. Japanese investors who fell prey to the home bias have suffered miserably.

    From a diversification standpoint, it is important to have various geographic exposures as well. The U.S. comprises roughly half of the global market capitalization, so a diversified global equity portfolio would have half of its assets invested in foreign stocks.

  3. Inappropriate Level of Risk

    Part of the portfolio analysis we perform for each client when they first come to us is an assessment of risk in the portfolio. Often we find that the risk level of the portfolio differs greatly from the amount of risk the investor is comfortable taking and/or the amount of risk they need to be taking to reach their financial goals.

    Each investor has a specific comfort level with risk. Some can tolerate lots of volatility and significant losses; others cannot. It is simply a reflection of the fact that human beings are wired differently. A well-designed portfolio reflects this with a risk level that is tailored to the investor’s risk tolerance. However, we often see portfolios that contain levels of risk that are far from the investors risk tolerance. This applies on both ends of the risk spectrum—risk-averse investors with portfolios that are full of high-risk investments and risk-tolerant investors with portfolios that are full of low-risk investments.

    Not only is it important to have a portfolio within your risk tolerance, but it is important to have a portfolio that will likely produce the type of return necessary to meet your financial goals. In our analysis of portfolios, we often encounter situations in which investors who need high rates of return are invested in low-risk/low-return investments. We regularly see the flip side as well. Some investors are in such good financial shape or have such modest goals that they don’t need much in the way of return to succeed. However, these investors are often in high-risk portfolios designed to produce high levels of returns. But because they don’t need those high returns, why take the extra risk?

❯ To make sure your portfolio is in line with your risk tolerance and financial goals while avoiding common investing mistakes, it is best to consult a professional wealth manager who can help you figure out your risk tolerance and the required return to meet your financial goals with a financial plan.

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