I ARGUED LAST WEEK that bitcoin wasn’t a great investment. The reality: Only a minority of investors hold cryptocurrencies, which is a good thing, in my opinion. But there are, alas, many other ways to get off track when building a portfolio.
In fact, if I ever wrote an investment book, it might be in the style of Dr. Seuss and titled Oh, the Investments I’ve Seen. Want to build a sensible portfolio and avoid common pitfalls? I’d aim for these five attributes:
1. Liquid. The recent downturn in bitcoin was triggered, in part, by a company called Celsius Network. It’s not quite a bank, and not regulated like one. But it was acting like a bank, offering interest rates of up to 18% to investors who deposited their bitcoin with Celsius. Everything seemed fine, until a few weeks ago, when Celsius announced that it was halting all withdrawals.
What happened? One knowledgeable observer explained it this way: Celsius “suffered a series of severe losses including over 38,000 ETH in a blunder related to Stakehound, followed by a $22 million loss in connection with the Badger DAO hack.”
If that doesn’t make much sense to you, you aren’t alone. If I were a Celsius depositor, I wouldn’t have found it very helpful. It would be cold comfort to hear from Celsius that it’s working “around the clock” to resolve the issue—but with no assurance when or if investors will be able to get their money back.
Celsius is today’s story, but it isn’t really a new story. Private funds, non-bank lenders like Celsius and other unconventional investments often have restrictive withdrawal provisions. Because they’re investing in non-standard investments, the risk of outright failure is also higher.
When private investment funds collapse, they usually affect only a small number of investors, so they don’t make headlines. But that doesn’t mean failures are rare. In my own work, I’ve seen two clients each lose a seven-figure sum in private funds. These weren’t Madoff-type situations. Neither involved criminality. They were just the result of unique and unfortunate circumstances.
The lesson: Novel investments can be alluring. Compared to ordinary stocks and bonds, they might seem a whole lot more interesting. But pay attention to the fine print. That’s where you’ll find the withdrawal terms. If you still decide to go ahead, I’d invest only an amount you’d be willing to lose.
2. Tax-efficient. Earlier this year, I described a situation in which an investment had generated great profits for an investor but nonetheless resulted in a loss when it was sold. This kind of curveball isn’t uncommon with tax-inefficient mutual funds.
In fairness, when you buy into a mutual fund, there’s no way to know in advance how it’ll perform, so there’s no way to predict how it will impact your tax return. There is, however, a way to minimize this risk: Look for investments with very low turnover. That’s a metric that you can find on fund companies’ websites and on research sites like Morningstar. It refers to the percentage of a fund’s holdings that the fund manager trades each year. It’s thus a good proxy for the potential tax impact.
Where’s the best place to look for funds with low turnover? As you might guess, index funds—and, specifically, broadly diversified index funds. Because their mandate is to simply hold a very large basket of investments and to make few changes, these funds give investors the best shot at controlling their tax bill.
3. Reasonable. This might sound like a vague concept. What constitutes a reasonable portfolio? I’ll start by describing what, in my view, isn’t reasonable. In the past, I’ve talked about portfolios that are “broker’s specials.” They consist of dozens of investments, often with overlapping holdings. The biggest issue with these stew-like portfolios is that they make it difficult for investors to know what they own.
Take mutual funds with names like “New Economy” and “International Explorer.” Such names might be good for marketing, but they don’t tell an investor what’s actually inside the fund. If you hold more than a few of these, it becomes that much harder to know the overall complexion of your portfolio.
A reasonable portfolio, on the other hand, consists of just a small set of simple holdings—small enough that the composition of the portfolio can almost be assessed with the naked eye.
4. Flexible. You may have heard of the three-fund portfolio. This strategy represents the ultimate in simplicity and would easily pass the “reasonableness” test. But there’s actually a virtue in having a portfolio that’s slightly less streamlined than that. In the portfolios I build, for example, I normally include 10 or so different funds. Why? In part, it’s to achieve certain investment objectives—by including an overweight to value stocks, for example. But there’s also a tax benefit.
Suppose you’re looking to withdraw cash from your portfolio and trying to identify investments to sell. If the only thing you own is a total stock market fund, and you’ve held that fund for a while, probably every share you sell will generate a gain. But what if you held all the stocks in that fund as individual holdings? Then, if you needed to sell investments, you’d have a lot more flexibility. You could pick and choose, selling some at losses along with some at gains. That would give you much better control over your tax bill than if you held just one fund.
That is the appeal of direct indexing, which entails owning all of the individual components of an index rather than purchasing an index fund. But that approach isn’t perfect either, and it isn’t for everyone. For that reason, a reasonable compromise is to hold a handful of funds—more than three, but far fewer than 30. You might, for example, own three separate funds to cover the U.S. market—a large-cap, mid-cap and small-cap fund—rather than a single total market fund. This wouldn’t make a portfolio much harder to manage, but it would provide some helpful flexibility when it comes time to sell.
5. Balanced. Is it possible to build a portfolio that meets all the criteria outlined above but is nonetheless imperfect? Yes. For better or worse, there are now thousands of index funds available. Many invest in narrow slices of the market—only mid-cap growth stocks, for example. I often see index fund portfolios that, on the surface, look reasonable, diversified and cost-efficient. But in combination, the resulting portfolio isn’t diversified at all.
For example, a portfolio might hold a large-cap growth index fund and a small-cap growth index fund. Both funds, on their own, are fine. But if that’s all an investor held, he’d lack exposure to about half the market—the value side.
The lesson: Index funds are great building blocks, but they need to be assembled in a balanced way. This, in fact, is another reason a simple portfolio is better than a complicated one. When you can see what you own with the naked eye, it’s much easier to spot imbalances.
In their book, In Pursuit of the Perfect Portfolio, Andrew Lo and Stephen Foerster interview 10 investment pioneers, ranging from Harry Markowitz to John Bogle to Robert Shiller. The book runs more than 300 pages. In the end, what’s their conclusion—what is the perfect portfolio? To answer this question, they map out 16 different investor archetypes for which different portfolios may be appropriate. That sounds complicated, but it makes sense. There’s no one-size-fits-all. Still, it’s helpful to favor the above five attributes, no matter what strategy you pursue.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
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Good article, Adam. Regarding Tax Efficiency, I used to use a handy tool with Morningstar that showed the tax impact on each mutual fund or ETF, also showing pre-tax and after-tax returns. Now they have discontinued it. Any other web sites that provide such a valuable service?
Thank you for this, Adam. “#4. Flexible” hit home with me. There is great beauty in the 3 fund (or similar) portfolio, but your point about the lack of tax flexibility is important.
Similarly, some flexibility in what’s held in what accounts is desirable. Years ago I heeded some pretty standard advice to populate my SIMPLE retirement plan with bond funds, in order to shield interest from taxes, and keep stock funds in my taxable brokerage account. But that meant that after a stock run up, if I wanted to lighten up on stocks and rebalance, I’d have to sell from the brokerage account and pay hefty capital gains. Lesson learned.
Isn’t it better to pay long term capital gains rates on relatively rare rebalancing in my taxable account then pay annual taxes on bond income which lands in the top bracket while still working? Too, keeping most of your bonds in tax exempt accounts might lessen the chance of painful RMDs in “long tail” bear market years. But I’m not yet retired so your comment makes me wonder if I’m thinking about this the right way.
David, good question. I should’ve mentioned that the bond money in my brokerage account is in muni. bond funds, nothing taxable.
Also, with the long and dramatic bull market we experienced in recent years, I found myself selling stocks more frequently than usual to rebalance.