Biggest Mistakes Made When Designing Investment Portfolios
1. OMITTING APPROPRIATE ASSET CLASSES AND ASSET SUBCLASSES. Numerous landmark studies have concluded that how you allocate your portfolio, rather than which investments you select or when you buy or sell them, determines the majority of your investment performance over time. As a result, make every effort to allocate your portfolio to all appropriate asset classes and asset subclasses.
2. SELECTING INAPPROPRIATE ASSET CLASS WEIGHTINGS. By selecting inappropriate asset class weightings a portfolio may earn a lower return and experience greater risk than expected. Consequently, be careful not to over or under weight any asset class, thus enhancing your portfolio’s risk and return trade-off profile.
3. UNDERESTIMATING THE IMPACT OF INFLATION. Inflation can erode the real value of your portfolio over time, thus placing your future financial security at risk. As a general rule, the longer your investment time horizon, the more you should allocate to equity investments. For shorter investment time horizons, emphasize fixed-income and cash and equivalent investments.
4. NEGLECTING THE EFFECTS OF PORTFOLIO MANAGEMENT EXPENSES. Over time, the compounding effect of portfolio management expenses can be quite large, thus depriving you of better returns. For this reason, you should focus on minimizing portfolio management expenses, specifically trading costs, advisory fees and taxes.
5. MAKING INACCURATE RETURN FORECASTS. Forecasting is the single most difficult task with designing portfolios. Although not a perfect solution, using historical returns rather than making forecasts is generally considered more appropriate for individual investors.
6. OVERESTIMATING THE LEVEL OF PORTFOLIO DIVERSIFICATION. Diversification is one of the ten cornerstone principles of asset allocation and is key to reducing risk, namely company-specific risk. To properly diversify, you should hold sufficient quantities of not-too-similar securities with comparable risk and return trade-off profiles. Consider broad-based index funds for a quick and easy solution.
7. MISJUDGING THE IMPACT TAXES HAVE ON NET RETURN. Taxes can have a severe negative impact on your net return. As a result, balance tax and investment considerations, but remember that suitability and appropriateness of an investment take precedence over tax consequences. Never hold an inappropriate investment.
8. CONFUSING DIVERSIFICATION WITH ASSET ALLOCATION. Many investors mistakenly believe that a properly diversified portfolio is a properly allocated portfolio. This is the leading misconception of asset allocation. Properly allocate your portfolio among the different asset classes first and then diversify the investments within each asset class.
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