A few years ago, a portfolio of conservative utility stocks was behaving like the biotech sector, so the widowed owner asked me to take a look. Her trust dividends had played a Houdini vanishing act and she couldn't figure out why. One particular utility had grown from a small problem into a big one. "My stock has fallen 97 percent in value. What shall I do?" she lamented.
Like so many investors who build their portfolio one stock at a time, she had been blindsided. She was so distracted by the individual holdings within her investment account, she lost sight of what was really wrong with her entire portfolio's architecture and trajectory. Sadly, she was unable to grasp the significance of even the most elementary concepts of prudent money management until it was far too late. What's the lesson? We should make important financial decisions as early as possible.
My latest Portfolio Report Card is for R.C. in Hollister, California. He's a 55-year-old writer and he told me he considers himself an aggressive investor because he started saving late in life.
Although R.C. is saving 11 percent of his paycheck annually, his retirement plan was interrupted by a stroke last year. Thankfully, he's back to work and his health is recovering.
He self-manages a 401(k) retirement plan with around $68,000 invested across six mutual funds. Does R.C.'s portfolio pass or fail? Before I assign his retirement portfolio a final grade, let's examine it together.
R.C.'s Retirement Plan Holdings
|AMERICAN EUROPACIFIC GROWTH R4||$15,858.05|
|EQUITY INDEX TRUST FUND CLASS C||$688.25|
|GROWTH STOCK FUND||$15,566.91|
|MID-CAP GROWTH FUND||$14,588.91|
|MID-CAP VALUE FUND||$2,056.52|
|SMALL-CAP VALUE FUND||$2,107.66|
Diversification. It's impossible to have a truly diversified investment mix if your portfolio is missing exposure to major asset classes. R.C. does a good job of covering the global stock market. He owns domestic stocks along with developed international and emerging markets. But unfortunately, his retirement plan lacks exposure to major asset classes like bonds, real estate and cash.
Risk. A portfolio should always match not only the alleged risk tolerance of a person (usually doled out via those impersonal but mandatory risk questionnaires), but a person's age, life circumstances and personality.
In this case, R.C.'s asset mix is 100 percent stocks. Put another way, R.C.'s current allocation is four scales riskier than most investors in his age group. His current portfolio is beyond "aggressive." It's hyperaggressive.
Cost. R.C.'s largest holding is the American Funds Euro Pacific Growth Fund. The fund's annual expense ratio is 0.84 percent, which includes a 12b-1 fee of 0.25 percent that gets paid to the servicing broker. All of the other funds he owns, like the T.Rowe Price Growth Stock, T.Rowe Price Mid Cap Growth and the T.Rowe Price Small Cap Value charge annual expenses between 0.70 percent and 0.98 percent, which is quite elevated compared to what index exchange-traded funds in the same equity categories charge.
Tax-Efficiency. Most 401(k) plans don't have any problems when it comes to tax-efficiency. But R.C.'s case is different. That's because he has a $17,766 outstanding 401(k) loan. If he terminates his job for whatever reason without paying off the full balance of the loan, the money becomes taxable income. And until he completely pays off the loan, it'll continue to be a potential tax liability that seriously threatens the health of his retirement account.
Performance. The correct standard of performance isn't distorted peer groups, which are common in the mutual fund industry, but rather how a person's portfolio performs relative to a blended mix of passive index ETFs that correspond to the person's asset allocation.
From June 2013 to June 2014, R.C.'s 401(k) portfolio gained 18.5 percent while a portfolio of passive index ETFs with R.C's approximate allocation gained just over 20 percent.
R.C.'s final portfolio report card is a "D." Unfortunately, his retirement plan's risk level (thanks to a portfolio 100 percent invested in stocks) is too high and so are the annual costs of his mutual funds. Gravitating toward lower cost funds within his 401(k)'s menu may help to reduce his fee burdens so he can keep more of his returns.
Furthermore, R.C.'s outstanding 401(k) loan will be a constant tax threat until he pays it off. And his portfolio's 1-year performance trailed a basket of index ETFs, which means he would have been better off with the latter choice.
Portfolios with a "D" are poorly designed and have major flaws that require immediate and major changes. Hopefully, R.C. can rework this investment plan and get his retirement portfolio back on track.
Remember: Ron grades family trust accounts, 401(k) rollovers, 457 plans, 403(b), UGMA accounts, and anything posing as an "investment." Hit the link below to get in touch with me.
Ron DeLegge is the founder and chief portfolio strategist at ETFguide.com. He invented the Portfolio Report Card to help people understand the strengths and weaknesses of their investment portfolios so they can make better choices. Ron is also a radio host of the Index Investing Show and author of "Gents With No Cents: A Closer Look at Wall Street, its Customers, Financial Regulators and the Media."