What’s one hallmark of a poorly designed investment portfolio? The answer is a portfolio that can’t perform well during a favorable stock market environment. It’s unrealistic to expect this type of portfolio would suddenly thrive during a bear market, when the going gets tough.
My latest portfolio report card is for D.P. in Los Angeles. He’s a 54-year-old married engineer.
He asked me to analyze his $696,000 portfolio, which is divided among a self-directed individual retirement account and a 401(k) plan. Around $16,272 is invested in his IRA, so the bulk of his money is in his 401(k) plan.
Altogether, D.P. owns 10 mutual funds, nine individual stocks and one exchange-traded fund. He told me his goal is to retire by age 60, and although he considers himself an aggressive investor, he wants to start getting more conservative.
Does his portfolio report card get a passing grade? Before I assign D.P. a final grade, let’s examine the five key areas of his portfolio together.
| DP’s IRA | ||
|---|---|---|
| Fund name | Expense Ratio | Asset Category |
| Fidelity China Region | $16,272 (0.98%) | China |
| DP’s 401(k) | ||
|---|---|---|
| Fund name | Expense Ratio | Asset Category |
| Janus Triton Fund Class T | $50,103 (0.92%) | Small-cap growth stocks |
| Powershares ETF | $39,232 (0.58%) | Pharmaceutical stocks |
| Fidelity Cash Reserves | $23,677 | |
| Fidelity Growth Company | $137,449 (0.71%) | Large-cap growth stocks |
| Fidelity Low-Priced Stock | $87,863 (0.72%) | Mid-cap value stocks |
| Vanguard Extended Market Index | $76,746 (0.08%) | Mid-cap stocks |
| PIMCO Total Return | $75,682 (0.46%) | Bonds |
| Vanguard Institutional Index | $41,348 (0.04%) | Large-cap stocks |
| Fidelity Diversified International | $21,613 (0.78%) | International stocks |
| Fidelity Retirement Money Market | $5,310 | Money market |
| Morgan Stanley Small Company Growth | $2,145 (0.97%) | Small-cap growth stocks |
| DP’s Brokerage window (inside 401(k) plan) | |
|---|---|
| Apple | $23,240 |
| Novo Nordisk | $15,008 |
| Johnson & Johnson | $14,826 |
| Stryker Corporation | $13,206 |
| Chevron Corporation | $12,285 |
| New York Community Bancorp | $10,170 |
| Exactech | $9,304 |
| Walgreens | $9,164 |
| Disney | $8,308 |
Cost. Keeping the tyranny of compounding investment costs to an absolute minimum is every investor’s job. The investment portfolios that deliberately reduce trading commissions, fund fees and other costs always win that battle.
D.P. told me he executes two stock trades or less per month, and pays a $7.95 brokerage commission.
For his mutual fund holdings, I didn’t find any real attempt by D.P. to minimize costs. Around $388,982 is invested in funds with elevated fund expenses. For instance, he pays 0.46 percent in Pimco Total Return Fund to own a bond fund, and 0.92 percent in Janus Triton T Fund to own small-cap stocks. Although he owns low-cost funds, such as Vanguard Institutional Index Fund and Vanguard Extended Market Index Fund, they represent a small part of the portfolio.
Diversification. Both D.P.’s IRA and 401(k) have exposure to most major asset classes, minus commodities and real estate. Yet, he has exposure to non-core assets, like individual stocks, such as Apple and Disney. Why?
Making sure your portfolio is fully diversified to core asset classes always comes first, and before investing in individual stocks. Put another way, you shouldn’t own individual stocks until your portfolio first has exposure to all of the major asset classes. D.P.’s diversification is sloppy.
Risk. A portfolio with the correct risk level always matches the risk limits and character of the investor. Is your portfolio compatible with your age, temperament, life circumstances, goals and liquidity needs?
D.P.’s overall asset mix is 84.4 percent stocks, 11 percent bonds and 4.5 percent cash. Although stocks have behaved well over the past few years, this is a very aggressive asset mix, even for a 54-year-old aggressive investor.
A stock market decline between 20 percent and 40 percent would expose D.P.’s retirement plan to potential losses of $116,000 to $233,000. As someone only six years away from retiring, I doubt those are the types of losses he can afford.
Tax efficiency. I’m glad to find D.P. has not demolished the tax benefits of his tax-deferred retirement plans by taking out premature distributions. Furthermore, he has no outstanding 401(k) loans, which could pose a tax threat to his money if he suddenly leaves his job. Overall, D.P.’s portfolio grades well on tax efficiency.
Performance. What’s the right standard of performance? It’s most certainly not distorted peer groups, which are common in the mutual fund industry. Rather, it’s how a person’s portfolio performs relative to a blended mix of passive index exchange-traded funds, that correspond to the person’s asset allocation.
In October 2013, D.P. had a combined portfolio value of $577,173, and one year later, his balance has increased to $696,000. After adjusting his performance for the $17,060 he contributed to his retirement plan over the past year, he gained 17.6 percent, versus our benchmark of 7.73 percent. Well done, D.P.
The final grade. D.P.’s final portfolio report card is a “B.” This is a good score, and it means that his portfolio is satisfactory. However, that doesn’t mean D.P.’s retirement plan is without flaws.
For example, his portfolio’s biggest weak spots are diversification and risk. Simply put, 84.4 percent exposure to stocks for a 54-year-old aggressive investor is way too high. Although it has helped his performance in a rising market, that exposure is likely to hurt in a declining market.
D.P. has done a great job of accumulating a nest egg, but now it’s up to him to protect it. Hopefully D.P. can make adjustments, and avoid anything that could suddenly derail his future.
Ron DeLegge is the Founder and Chief Portfolio Strategist at ETFguide. He’s inventor of the Portfolio Report Card which helps people to identify the strengths and weaknesses of their investment account, IRA, and 401(k) plan.
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Portfolio Analysis: A Risk-Heavy $696,000 Retirement Plan originally appeared on usnews.com
