Portfolio Analysis: A $1.4 Million Portfolio Flunks on Risk
All of us are 15 years older since the Nasdaq passed 5,000 the first time, but are we smarter?
After analyzing and grading more than $50 million over the past year, I can definitely say that high-risk portfolios for people just a few years away from retirement has turned into a reoccurring theme. Yes, history does repeat itself. This time around, the same kind of aggressive risk-taking that characterized the investing public in the late 1990s is being aped today. The main difference is that everyone is 15 years older.
My latest portfolio report card is for a married couple, C.G. in Lake Orion, Michigan. He is 56, she is 48, and they asked me to grade their combined $1.4 million investment portfolio. C.G. told me they manage their own money and are aggressive risk takers. However, they also admitted that a 2008-styled stock market decline isn't something they can afford to let happen, especially as they get older.
C.G.'s combined portfolios consist of two individual retirement accounts and a trust account. C.G. owns one mutual fund, one individual stock and two exchange-traded funds. Do they have a healthy or unhealthy investment plan?
Let's do a portfolio report card for C.G. and find out.
$ allocation | asset class | |
|---|---|---|
Apple (AAPL) | $576,000 | U.S. stocks |
Nasdaq 100 (QQQ) | $80,000 | U.S. stocks |
$656,000 | ||
Nasdaq 100 (QQQ) | $287,000 | U.S. stocks |
S&P 500 (SPY) | $215,000 | U.S. stocks |
S&P 500 (VFINX) | $130,000 | U.S. stocks |
cash | $5,000 | cash |
$484,910 | ||
Nasdaq 100 (QQQ) | $250,000 | U.S. stocks |
cash | $10,000 | cash |
$260,000 | ||
total value | $1,400,910 |
Cost. The combined portfolios consist of just two ETFs, Powershares QQQ Trust and SPDR S&P 500 ETF Trust, one mutual fund, Vanguard 500 Index Fund, and one stock, Apple. The blended annual expense ratios of just 0.15 percent are low and trading activity isn't excessive. C.G's portfolio does well at minimizing investment cost.
Diversification. Real diversification is never about how many funds or stocks you own, but whether the assets cover a variety of different areas. Unfortunately, C.G.'s combined portfolios only have exposure to two areas: U.S. stocks and cash. Moreover, their portfolio suffers from overdiversification by owning too much of the same thing. They have an amazing 77 percent overlap in the stocks held in their Standard & Poor's 500 index funds and Powershares QQQ Trust.
Also, by making Apple roughly 40 percent of their total nest egg, they are simultaneously underdiversified. How? Their portfolio is so concentrated in Apple, that it has no exposure to other major asset categories like bonds, foreign stocks, commodities and real estate.
Overall, C.G.'s portfolio is nowhere close to getting a passing grade in this category.
Risk. A portfolio's risk character should always be 100-percent compatible with the risk profile of the person or people. How does C.G.'s portfolio do?
The combined portfolios have approximately 99-percent exposure to U.S. stocks and 1 percent to cash. This is an asset mix that is well beyond aggressive. It's hyperaggressive. Furthermore, it's not an age-appropriate asset mix, even for 56 and 48-year-old investors who believe they can handle lots of risk and volatility.
C.G. disclosed to me that they've had problems in the past with knowing when to exit certain investments. But that's only part of the problem. A 20 percent to 40 percent market correction, which has happened in the past and will happen again in the future, exposes C.G.'s highly concentrated portfolio to $275,000 and up to $550,000 in potential market losses.
Tax efficiency. All investment portfolios, whether taxable or tax-deferred accounts, should be built to minimize the negative impact of taxes to the greatest degree possible. Yet, some investors unwittingly undermine the tax efficiency of their tax-deferred accounts by making premature distributions, having outstanding loans or other behavior creates a tax-adverse situation. Thankfully, C.G.'s portfolio has no such problems.
Performance. The combined portfolios grew 13 percent ($172,000) over the past year, compared to a 12.5 percent gain for a passive index benchmark matching this same asset mix. Although the 1-year return is satisfactory, the portfolio's major shortcomings on risk and diversification aren't.
The final grade. C.G.'s final portfolio report card grade is a "C." This grade indicates significant structural weaknesses with C.G.'s portfolio design. The biggest problem areas for C.G. are uneven diversification and a hyperaggressive asset mix that's neither age appropriate nor compatible risk-wise with C.G.'s true risk profile.
It seems that C.G. has forgotten that financial markets fall faster than they rise. In 2000, the Nasdaq's bear market erased $5 trillion in just 31 months. How long did it take for the Nasdaq to get back to even? It took 15 years. Proper risk management always happens before the calamity, not during or after. Hopefully, C.G. can make the necessary adjustments to build a durable portfolio that holds up in any kind of market condition.
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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