Portfolio Analysis: A $381,601 Portfolio Weighed Down by Cost
Why are we so obsessed with the things in life we can't control? For people with a portfolio of investments, they too are victims of these lifelong obsessions: We're so absorbed on what we can't control that we ignore or forget about what we can control.
What kind of investment results would we get if we just tackled the things we can control? What if we just focused our attention on the things we can regulate, such as limiting the cost, risk and taxes on our investments? What type of wonderful results would follow? This week's portfolio report card is for Z.K., a 55-year-old real estate broker in Minneapolis, Minnesota. In my exchange with him, Z.K. told me he's a knowledgeable investor and that his main goal is to grow his money quickly.
Z.K.'s combined portfolios consist of two individual retirement accounts and a SEP IRA valued at $381,601. One of his traditional IRAs is invested with American Funds and the other IRA and SEP are invested in variable annuities with AIG and Pacific Life insurance companies. What kind of grade does Z.K.'s portfolio get? Let's find out.
Fund ticker | Allocation | Asset mix |
|---|---|---|
IRA account #1: AIG Polaris Choice IV Variable Annuity | $200,271 | 80% stocks/20% bonds |
IRA account #2: American Funds | ||
AMPCX | $28,979 | U.S. stocks |
BALCX | $14,905 | balanced |
AEPCX | $20,380 | international stocks |
IGICX | $26,418 | international stocks |
AICCX | $29,035 | U.S. stocks |
NPFCX | $21,029 | global stocks |
SEP IRA: Pacific Life Variable Annuity | $40,584 | 80% stocks/20% bonds |
Total | $381,601 |
Cost. The problem with many people is they make the erroneous assumption that performance will overcome whatever investment costs they are paying. That is rarely true. And with high-cost portfolios, like the extinct "Tasmanian tiger," it's never seen. For Z.K.'s traditional IRA held with American funds, he pays a 1 percent sales load, plus an average 1.5 percent in ongoing annual expenses. In his AIG Polaris Choice IV Variable Annuity, he pays 1.9 percent, plus another 0.72 percent to 1.71 percent in fund expenses, according to the prospectus.
Altogether, Z.K.'s combined portfolio cost is around 2.5 percent, which is unsatisfactory and well above our benchmark of cost. With his current cost structure, if Z.K. averages 8 percent over the next 10 years, he'll end up with $591,000 versus $734,034 with the same 8 percent return but lower costs. Remember: The cost of financial advice should never exceed the potential benefits. In this case, it clearly has.
Diversification. This portfolio has exposure to emerging market, international and U.S. stocks, bonds and cash. Although this is OK, the portfolio's diversification is still cluttered and clumsy. For example, Z.K. owns several different funds (American Funds AMCAP Fund, American Funds American Balanced Fund, American Funds Investment Company of America Fund and American Funds New Perspective Fund) that all have duplicated and overlapping exposure to U.S. stocks. No investment portfolio should ever have this condition of overdiversification, let alone a portfolio that was assembled by a licensed-fee gobbling financial advisor.
Properly executed, a diversified portfolio should own a variety of different assets, not the same kinds of assets masked behind different fund tickers with different names. Finally, Z.K.'s portfolio misses exposure to two major asset classes: commodities and real estate.
Risk. Z.K. told me he's an aggressive growth investor with a long-term view. Nevertheless, the risk of another 2008-like financial shock is one of his major concerns. Z.K.'s overall asset mix is the following: 85 percent stocks, 14 percent bonds and 1 percent cash. From what I see, this is not an age-appropriate asset mix for late 55-year-old "aggressive" investor, because the asset mix is beyond aggressive. It's hyper-aggressive.
A 20 percent to 40 percent correction in stocks would expose Z.K.'s current portfolio to approximately $76,000 to $150,000 in market losses. Can he really handle that kind of heat? Since he's just a few years away from retirement, losses of this magnitude would be a major setback.
Tax efficiency. All well-built investment portfolios don't just own the right mix of assets, but deliberately minimize the threat of taxes. Unfortunately, some investors, even those with tax-deferred accounts like IRAs and 401(k) plans, undermine the tax-deferral of their money through counterproductive behavior, such as premature distributions and loans. On a positive note, Z.K. has not made this fundamental mistake and he does well at tax efficiency.
Performance. All investment portfolios are guilty until proven innocent. Why? Because your portfolio's performance will either exonerate or incriminate your portfolio's design. Z.K.'s portfolio grew $4,749 ( up 1.3 percent) from January 2014 to January 2015 compared to a 3.94 percent rise from a blended index benchmark matching this same asset mix. Z.K.'s underperformance of 2.64 percent is unsatisfactory.
The final grade. This portfolio's final grade is D, which is poor. Tax efficiency scored the best, whereas cost and performance were the weakest grading categories. Paying for financial advice and getting substandard results should make Z.K. rethink his relationship with his financial advisor. Aside from the high fees, the opacity of the fees, with hidden 12b-1 fees, is problematic. Investors should always demand 100 percent transparency.
Clearly, Z.K.'s unsatisfactory performance incriminates his portfolio's design. Think about it this way: If he's unable to match or outperform a benchmark of passive index exchange-traded funds during a favorable market climate, it's doubtful he'll suddenly start to excel when market conditions worsen. The financial advisor he's hired has not earned his keep. Let's hope that Z.K. can find a way to improve his future results.
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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