Jason Stipp: I'm Jason Stipp for Morningstar. Morningstar's Christine Benz, director of personal finance, recently finished up a week of portfolio makeovers during which she uncovered a lot of common investor mistakes. She is here with five of the most common today and also some solutions. Thanks for joining me, Christine.
Christine Benz: Jason, great to be here.
Stipp: So it was a great Portfolio Makeover Week. You made a variety of portfolios for different types of investors. Along the way, you kind of found some common threads of pitfalls or common mistakes in portfolios. You have five of them today. The first one has to do with maybe the biggest decision that you make about your portfolio, what is that?
Benz: Well, this is asset allocation. So making sure that your stock-bond-cash mix is semi-sensible given where you are in your life, and I will say, Jason, our users are really smart. So most of the time, those people who wrote me seeking portfolio makeovers had kind of self-diagnosed what the problem was. They were coming to me and saying, "I'm getting ready to retire. I know I need bonds, but I don't know where to start." or "I have 80% of my portfolio in cash; I know that's a bad idea because I'm not earning anything on my cash."
So our users are very self-aware, but this is really the key decision that any of us make about our portfolio. Once you set aside the decision of how much you actually save, asset allocation is going to be the key determinant of how your portfolio behaves.
Stipp: So it seems like there's a couple of things here. One is identifying that something is a bit out of sync and the second is doing something about it. So on that first point, if you're not sure whether your portfolio is in sync or out of sync depending on for example when you plan to retire, how can you get a sense of that?
Benz: Well, this is such a personal decision. So I always say if someone needs help with this and wants customized help, a financial advisor is a great place to start. We have a number of tools on Morningstar.com. Our Asset Allocator tool is one. Also looking to target-date funds as a source of intelligence on asset allocation, I think is a decent place to start. These are one-size-fits-all funds for given time horizons, but still I think it's a decent starting point, just as a way of asking, "How do they portion, foreign versus U.S. stock? What's the stock-bond mix?"
Stipp: So you can check the fund Analyst Report pages on Morningstar.com for target-date funds such as Vanguard's and T. Rowe Price's, two of our favorites in that series, to see how those funds are positioned for your retirement year.
Benz: Right. So find the one that matches that year, roughly the year when you hope to retire. And then see what they're recommending because a lot of these firms have put a lot of thought and research into how they have allocated those assets. So I say why not piggyback on some of that work that they've done.
Stipp: So let's say you check some of these target-date funds or you use some tools and you feel like your portfolio is a bit out of sync, like maybe you're a little bit too light in equities for example and you want to get a little bit more exposure there. How should you go about realigning your allocation?
Benz: Well, I always say, take it slowly; if you can take the chicken way into anything, it's a good way to go about it. So depending on how much money you are needing to put to work in a given asset class, I would plan to space out the purchases over a number of months or even over a number of years, if it's a very large portion of your portfolio. And that way you can mitigate the risk of putting a lot of money to work in an asset class that in hindsight could be the wrong time.
So that's something that I think a lot of users are encountering with fixed income. They're looking at their portfolios saying, "I'm running these numbers, and it looks like I should have more in bonds than I actually do. But with the bond market right now, do I really want to be buying bonds?"
If you purchase your investments gradually, I think you'll mitigate that risk of buying bonds at what, in hindsight, could turn out to be an inopportune time.
Stipp: So improper asset allocation or misaligned asset allocation number one, number two has to do with cash and this is an important part of portfolios especially for folks who are nearing retirement. What are some common mistakes you were seeing as it relates to cash holdings?
Benz: Well, one is not having enough, so not enough of a backup liquidity plan. All the money is invested and there is not enough money to tide you over if you lose your job or have some calamity occur. So that's one end of the spectrum.
At the opposite end of spectrum--and I think this is maybe even more common among some of our users--for people who pulled back during the market crisis or maybe even before then, they are sitting there with way more cash than they want to have or should have, particularly given the possible corrosive effects of inflation on that very small payout that you earning on cash. So seeing people with one or the other problem--not enough cash or too much--is another big one that we run into.
Stipp: So it's obviously going to be different for every investor, but what's the good rule of thumb for how much cash someone who is near retirement or in retirement should have?
Benz: Well, two years has been the standard rule of thumb. I think when yields were a little higher, people were saying two to five years. Now that yields are so low on true cash, one thing I've been positing as a possible idea is thinking about, is to have one year in true cash, one year's worth of living expenses, and then maybe thinking about year two in a high-quality short-term bond fund where you will have some possible principal fluctuations but you'll also be able to earn a slightly higher payout. So I think that's maybe a way to split the difference and put that cash to work if you are retired or getting ready to retire.
Stipp: So Christine, the third common mistake that you saw has to do with the number of holdings that investors have. Investors a lot of times aren't consciously fixing their asset allocations, but instead they're kind of collecting investments here and there. And now they have a sprawling portfolio. What are some tips there?
Benz: Well, one trend I've seen, Jason, is that people have a lot of little starter positions in the portfolio. When you think about how that actual portfolio will behave, those positions will be such a drop in the bucket that they won't make any impact whatsoever. So I think a lot of people are running with portfolios that are a lot more diffuse than they need to be. I think if they do their homework, spend some time reading our Analysts Reports, looking at other tools, other metrics, they may be able winnow down that portfolio to their higher-conviction picks, so they are not having multiple investments that are geared toward a similar role in the portfolio.
Stipp: Streamlining a portfolio can also have other benefits, for example in your legacy planning.
Benz: Absolutely. So if you are expecting that or thinking that there may be a possibility you'll predecease your spouse, you may want to streamline the portfolio so your spouse isn't having to chase after all these small accounts at different providers or mind a lot of moving parts in the portfolio. You want a portfolio that could more or less could run itself for a period of time.
Stipp: Number four Christine has to do with company stock. This is an issue that you've addressed in makeovers and also in an article recently on Morningstar.com. What common mistakes do you see with investors and owning the stock of the company that employees them?
Benz: I think it's a common mistake to say, "Yes, I know the conventional wisdom about limiting my company stockholdings, but my company is different."
So, people oftentimes end up with a lot more risk and sometimes they end up with very strange sector permutations that can result from having that company stock. So, maybe their company is a big financial concern, for example, and it's 20% of the portfolio. And then these people could also have sort of a marketlike portfolio that is really giving them a lot of financials exposure, as well. So, to me I think that with company stock, typically trying to trim those positions to 5% or 10% of the overall portfolio is a good target. The key reason as you said, Jason, is that you've got so much of your economic well being and future stake with that company, you really don't want too much of your investment portfolio there either.
Stipp: So, that paycheck you are getting obviously is going to be sensitive to the sector and the company that you work for?
Stipp: If bad market time comes in that sector for that company you could lose your job and you could also see a big decline in your portfolio?
Benz: That's exactly right. That's the issue.
Stipp: The last thing, Christine, has to do with the fees that you are paying. You mentioned this recently during a Premium webinar about how to check up on the fees. It's a common mistake to overpay and it could have a big effect on your performance, correct?
Benz: That's right. So, with our X-ray tool on Morningstar.com, if you load all your holdings in there, you are able to see how much you are paying in terms of your average fund express ratio and then also see a projection in dollars and cents of what that portfolio is costing you per year. And to me I think just seeing that number in black and white can be very powerful. It's a powerful incentive to go through and prune individual holdings that might be costly and might be contributing to your total portfolio's cost drag. I think it's also a good reason to make sure that you are not overly diversified and running a portfolio that's acting a lot like an index fund but costing you a lot more than an index fund would. So, staying attuned to those costs is going to be to the one of the most impactful things you can do to improve your portfolio's results.
Stipp: Alright, Christine. Well, congratulations on finishing up the Portfolio Makeover Week and thanks for offering these tips on common investor portfolio mistakes and for being here today.
Benz: Thank you, Jason.
Stipp: From Morningstar, I'm Jason Stipp. Thanks for watching.