Are You Making These 5 Common Portfolio Mistakes?

My annual Portfolio Makeover series provides a bird’s-eye view of real people’s financial lives: their goals, their worries, and their pain points. It gives me the chance to interact with real people (my favorite part of the project) and it also affords me a close look at their holdings and their plans. In other words, I get to do a bit of snooping on the way to improving their portfolios. It definitely helps me figure out what topics I should work on in the future.

In my years of conducting these portfolio makeovers, I’ve observed that investors get a lot more right than they get wrong. They do their homework and they populate their portfolios with low-cost mutual funds and exchange-traded funds. They tend to be pretty hands-off, and if they delve into niche investments, they usually limit them to a small share of their portfolios. Of course, I wouldn’t rule out that Morningstar.com readers are more sophisticated than most investors, but I’d push back on the idea of the individual investors as dumb-money performance-chasers. It’s not just a caricature; I think it’s wrong.

At the same time, there are some issues that I see—and address—again and again in the course of these makeovers. Here are some of the most common ones.

Portfolio Sprawl

This is by far the biggest issue that I observe: too many accounts, too many holdings, too much redundancy. The unwieldy-portfolio problem isn’t just the domain of those who have been investing a long time and have amassed a lot of assets; I also see it with more-modest portfolios. (For the latter group, the armchair psychologist in me can’t help but wonder if holding a lot of securities—even if the amounts invested in them are quite small—provides people with a feeling of wealth.)

Tax-deferred retirement accounts are the most common source of account duplication, thanks to the fact that most people have multiple employers in their lifetimes so IRAs and 401(k)s stack up. Those can readily be collapsed into a single IRA (or one Roth and one traditional IRA, if Roth accounts are in the mix). For portfolios with more holdings than are truly necessary, I often find myself leaning on index funds as a simple way to clean everything up while achieving diversification and the desired asset-class exposures. (My Minimalist portfolios depict sensible asset-allocation mixes for retired and younger investors.) For smaller accounts—for example, the orphan spousal IRA with $15,000 in it—I often look to internally diversified all-in-one funds such as target-date or lifecycle funds.

A Redundant Individual-Stock Portfolio

A sub-problem I often see in cases of portfolio sprawl is a basket of large-cap individual stocks that all but duplicates what’s already in the mutual funds or ETFs in the portfolio. Mega-cap stocks like Apple AAPL, Amazon.com AMZN, and Microsoft MSFT are common holdings, and they’re also big positions in most U.S. stock funds; those three take up more than 16% of the S&P 500 and a bit less of total market indexes today. I suppose that some investors might have good reason to double down on the market’s biggest names, but I mostly see extra risk (the most highly valued stocks in the market usually don’t trade cheaply) and oversight responsibilities associated with monitoring the individual stocks. For those reasons, the “afterthought stock portfolio” usually goes on the cutting-room floor when I do makeovers.

Less common these days are the “individual investor/financial advisor as portfolio manager” portfolios—baskets of enough individual securities to populate a whole mutual fund. I know that plenty of longtime Morningstar.com readers build bespoke portfolios in this fashion, aiming to forgo the management fees that accompany funds and perhaps take advantage of the small investor’s biggest advantage: patience. But if you go this route, make sure you’re willing to put in the time to keep tabs on your holdings, and that you have a plan in place in case you’re no longer able to handle the management responsibilities. Also, do an honest accounting of your performance, comparing your long-run results to an inexpensive index mutual fund that’s focused on the same part of the market. (Everyone—not just individual-stock investors—should be using a custom benchmark to assess what value they’re adding with security selection.)

Also-Ran Mutual Funds

I mentioned earlier that investors generally do a good job of being hands-off with their investments, and that kind of patience usually redounds to the benefit of their long-run returns. But I’ve also observed cases when investors were too patient and hands-off: They purchased mutual funds and set up their portfolios a number of years ago and apparently never looked at or touched them again. The telltale signs are when a fund has had multiple manager changes, extended runs of poor returns, and huge asset outflows—sometimes all at once—and yet it still sits in the portfolio. I’m not talking about short-term underperformance, which can actually be a buying opportunity if the underlying management team and strategy remain solid; I’m talking about lemons that earn Negative ratings. The lesson is that even very hands-off investors should take a look at their portfolios once in a while to assess their overall asset allocations, make sure the savings or spending plan are on track, and yes, prune losers.

Asset Allocation Not Informed by the Plan

Another issue that I see frequently—but one that’s a bit harder to fix—is when a portfolio’s asset allocation doesn’t connect with the investor’s actual plans. The most frequent example is when an individual is getting close to or in retirement yet the portfolio doesn’t contain enough safe(r) assets to address the anticipated portfolio spending. Many such investors have enjoyed wonderful gains in stocks for decades, so they’re hesitant to derisk their portfolios in favor of assets with lower return potential. (And let’s be honest, bonds didn’t make a great case for themselves in 2022′s rising-rate environment.)

But sequence risk is a big issue for the soon-to-retire and newly retired, in that overspending from a portfolio that’s simultaneously declining reduces the probability that the assets will last through the whole of someone’s retirement time horizon. That’s why I like the idea of aligning the portfolio with anticipated spending needs, creating a runway of safe assets that the retiree could “spend through” if a bear market for stocks materialized early on in their retirements. That’s the Bucket approach to retirement portfolio construction that I often write and talk about, where I organize the portfolio from very safe (cash) assets for short-term spending needs to bonds for intermediate-term expenditures to volatile equity assets for long-term growth and inflation protection. In a similar vein, Morningstar’s new Role in Portfolio framework can help you think about your holdings through the lens of the purpose they serve in your portfolio.

Suboptimal Asset Location

In addition to issues with asset allocation, I also frequently spot asset location problems. That means that investors have housed tax-efficient assets (say, municipal bonds) in tax-sheltered accounts and, more commonly, tax-inefficient assets in taxable ones. The obvious example in the latter category is when investors store high-income-producing assets, especially those whose income is taxed at ordinary income tax rates, like high-yield bonds and REITs, in their taxable accounts.

It’s simple enough to adjust tax-sheltered accounts on an as-needed basis, because there are no tax consequences for any changes as long as the assets stay inside the account. Addressing asset-location problems with taxable accounts can be more tricky, though. That’s because the tax-inefficient assets may have appreciated since purchase, so switching to a more tax-efficient mix may trigger a tax bill in and of itself. Before embarking on any sales from a taxable account—to address tax issues or fix any other trouble spots—it’s important to gauge the current and future tax implications of doing so.