Dos and Don'ts for Combating Portfolio Sprawl

Americans continue to accumulate more toys, furniture, and knickknacks than they know what do with. For proof, look no further than the growth in the self-storage industry. Although the pace of growth may be modulating, self-storage rentals have been one of the fastest-growing pockets of the real estate industry over the past 40 years. There are now about 50,000 self-storage facilities in the U.S., and one in 10 Americans has resorted to storing possessions offsite.

Judging from the many portfolios I review during Morningstar's annual Portfolio Makeover Week, many investors have a similar glut of "stuff" in their portfolios. For every single portfolio I receive that's whippet-thin--without an excess stock, fund, or ETF to spare--I come across 10 more that have 50, 60, or even 100 individual holdings.

Of course, in the scheme of investor problems, overdiversification isn't the worst sin. Having too many holdings won't wreak the same havoc that undersaving will, or overpaying, or performance-chasing. But portfolio sprawl can add to investors' oversight challenges. It can simply be difficult to keep track of the fundamentals of so many holdings, especially if those holdings include individual stocks or actively managed mutual funds. The investor with too many holdings may have trouble figuring out their asset allocations or knowing when or how to rebalance. Having too many stocks and funds can also compound the headaches for an investor's successors. Widows, widowers, and other loved ones may have difficulty untangling the web of the too-acquisitive investor.

Portfolio sprawl can also have negative repercussions for performance. If an investor amasses a lot of holdings, especially multiple diversified equity and bond funds, their performance within each asset class can become very indexlike very quickly. But if that same investor is paying active management fees, sales charges, or some combination thereof, the portfolio may well underperform a buy-and-hold portfolio consisting of simple index funds with ultralow costs.

In my recent article about New Year's financial resolutions, I suggested that investors put streamlining their portfolios on their to-do lists for this year. Here are some dos and don'ts to keep in mind.

Do: Collapse Like-Minded Accounts We're a nation of job-changers; the typical person has been on the job for just four years. Thus, it's no wonder that many investors hold multiple 401(k)s and IRAs that contain assets accumulated at former positions. Rolling all of these orphan accounts into a single IRA can be a great way to clean up the mess in a hurry, giving you just one major account to monitor on an ongoing basis. Not only will you be able to populate your IRA with nearly anything you like, but you'll also be able to cut out the administrative costs and above-average fund fees that come along with some 401(k) plans, especially those of smaller employers.

Start the process by deciding which fund company or brokerage you'd like to house your IRA; that firm can then coach you on the logistics of getting everything rolled over into a single account. Be sure to have your providers work with one another on conducting the transfer rather than receiving a check yourself. Here's a checklist for 401(k) rollovers.

Don't: Take It Too Far Even though combining orphan 401(k)s and IRAs into a single IRA can be a simple way to reduce the number of moving parts in a portfolio, it's not the right answer in every situation. In particular, assets in 401(k)s and other defined-contribution plans enjoy blanket protection from creditors. Meanwhile, the creditor protection of IRA assets will depend on the laws in your state.

In addition, 401(k)s and other defined-contribution plans may offer investment types that are unavailable to individual investors. You can't buy a stable-value fund--a cashlike investment that typically pays a higher yield than true cash instruments--outside of a company retirement plan. Your 401(k) may also offer ultra-low-cost institutional share classes that you couldn't buy on your own; however, with the advent of ultra-low-cost index products, that's less of a selling point for 401(k)s than it once was.

Do: Take the Best and Leave the Rest Holding assets in multiple silos--401(k)s, IRAs, and taxable accounts--is all but inevitable for most investors, compounding the potential for portfolio sprawl. And you can multiply that problem times two if you're part of a married couple, with each partner holding several distinct accounts. Many investors manage each of these subportfolios as well-diversified portfolios unto themselves, necessitating exposure to U.S. and foreign stocks as well as bonds.

However, you can reduce the number of holdings in your portfolio and ensure that each is best of breed by thinking of all of your retirement accounts as a unified whole. That's because it's the total portfolio's asset allocation that matters, not the allocations of the constituent portfolios. For example, if your 401(k) plan has terrific equity index funds but lacks solid bond options, you can load up on equities in the 401(k) and compensate by holding more bonds in your IRA. Morningstar.com users can use the "Combine" tool--in the dropdown menu under "Create" in Portfolio Manager--to view the total asset allocation of their portfolios, even if they have stored their subportfolios separately.

Don't: Take Consolidation Too Far Even as accumulators can get away with the type of streamlining I just discussed, intra-account diversification becomes more valuable if retirement is close at hand. Because you want to retain the flexibility to pull assets from any of your accounts during retirement--Roth, traditional, or taxable--you may have good reason to hold both more- and less-liquid asset types within each of your accounts. That way, you can be flexible about where you go for withdrawals in a given year during retirement. In a high-tax year, for example, you might like to take a tax-free withdrawal from your Roth IRA rather than paying ordinary income tax on a withdrawal from your 401(k). To account for potential withdrawals from the Roth, it may not make sense for that account to be 100% equity; you may also want to hold some safer securities, such as bonds and cash, too.

Do: Use Morningstar Analyst Ratings as a First Cut If you have multiple holdings fulfilling the same role within your portfolio and are contemplating some cuts, it's valuable to conduct a head-to-head comparison. One of the quickest ways to do so is to use Morningstar Analyst Ratings--the star rating for stocks and the medalist system for funds. These ratings are designed to provide a forward-looking assessment of a security's prospects. Of course, you may have good reason to hang on to securities that don't rate well--for example, you may have a very low cost basis in that 2-star stock you're holding in your taxable account, or your Neutral-rated small-cap fund may be the sole small-cap option in your 401(k). But the ratings provide a sensible starting point in the process.

Don't: Focus Exclusively on Trailing Returns If you find duplicative holdings and are conducting your own "cage match" of two securities that play in a similar space, be careful not to focus too much on trailing returns. Despite recent volatility, the market has rewarded risk-taking since it began to recover in early 2009. By focusing disproportionately on investments with happy-looking trailing returns--especially over the past three- and five-year periods--investors may inadvertently tilt their portfolios toward higher-risk, higher-volatility investments.

To help avoid that trap, make sure your due diligence encompasses an assessment of each investment's risk profile. Eyeballing returns in the year 2008 is a good first step; you can also take a look at Morningstar's upside/downside capture ratios for funds to see what kind of animal you're dealing with. Morningstar's analyst reports also aim to address the potential risks that accompany each investment. And if you're looking for a data point with the greatest predictive power for mutual fund performance, a fund's expense ratio is the best way to stack the deck in your favor. You can't go too far wrong by concentrating your holdings in the lowest-cost investments in your choice set.

Do: Employ Broad-Market Index Funds and ETFs Broad-market index funds and exchange-traded funds can be a great starting--and ending--point for investors aiming to streamline. A single total U.S. stock market or international index fund, for example, has at least some exposure to companies small and large, value- and growth-oriented. A total U.S. bond market index fund won't be quite as encompassing--it won't include Treasury Inflation-Protected Securities or junk bonds, for example--but it will provide representative exposure to the U.S. investment-grade bond market. As such, it could reasonably serve as a standalone bond holding for investors who are still in accumulation mode. Even if you also hold actively managed funds, by anchoring your portfolio in index funds, you'll be able to get away with fewer holdings and and bring your portfolio's average costs down.

Don't: Hold Individual Stocks If You're Just Not That Into It Many investors use mutual funds or exchange-traded funds for the bulk of their portfolios while also maintaining a smaller basket of stocks on the side. If that describes your setup, reflect on your past behavior and performance as a stock investor. If you have tended to do your homework on your companies and have generated strong performance with this part of your portfolio, that may argue for making individual stock holdings an even larger part of your portfolio than they already are. But if you have amassed a portfolio of individual equities more haphazardly--and monitored them not at all--it's a good time to ask yourself what those small positions are actually doing for you. If your total position is fairly small, it's adding to the clutter in your portfolio but doesn't have the potential to dramatically alter your bottom line, for better or for worse.