Do you have a portfolio or an investment collection?

Coin Collection

One thing that I’ve seen time and again when looking at people’s investments is that they could more accurately be described as “collections” than as “portfolios.”

Often, people seem to accumulate investments rather haphazardly over the years. By the time an investor is in his 40s or 50s, he (and his spouse’s) investments might look something like this:

Taxable Accounts:

• 100 shares of this stock
• 100 shares of that stock
• a $5,000 muni bond from a local government agency
• a handful of assorted mutual funds

Retirement Accounts:

• 3-6 different funds in his 401k
• 3-6 more funds in his spouse’s 401k
• 3-6 more funds in his IRA
• 3-6 more funds in his spouse’s IRA

It’s essential to know what you own.

In my experience, when an investor has an investment collection like the one above, he can’t even tell you what his stock/bond allocation is. Naturally, it’s only made worse when the funds involved are actively-managed funds such that it’s impossible to know precisely what’s in them at any given point.

In case it’s not obvious: This is a serious problem because it can mean that the investor is exposed to more risk than he’s aware of.

Further, when you own actively-managed funds, your diversification may not be as thorough as you’d expect, as the funds’ holdings may overlap significantly.

Complexity doesn’t increase return.

Of course, if you own 20 different mutual funds, it can be hard to keep tabs on what each of them own. The solution: Simplify.

Here’s a guideline I like to use: Outside of your 401k, if you own more than 6 mutual funds, you’re making things unnecessarily complicated. 6 funds should be plenty to provide you with sufficient diversification both among and within the major asset classes.

Moving from “collection” to “portfolio.”

If the bulk of your investable assets are in tax-sheltered retirement accounts, creating a cohesive portfolio is easy:

• Determine your ideal asset allocation.
• Sell everything.
• Buy the lowest cost funds that will provide that allocation. (Generally, these will be index funds, but within a 401k your options may be limited to actively-managed funds.)

If a significant portion of your holdings are in taxable accounts, however, things can be a bit trickier, as the “sell everything” step could result in sizable capital gains, thereby taking a significant bite out of your portfolio.

Often, a reasonable approach is to keep your taxable investments more or less in place, while adjusting the allocation in your retirement accounts around them. (Example: If your taxable account is primarily invested in domestic stock funds, consider keeping it there and using your retirement accounts to fill out the bond and international stock components of your portfolio.)

I would, however, caution strongly against putting tax considerations ahead of asset allocation considerations. (Example: If an emerging markets stock fund makes up an extremely oversized portion of your portfolio, it’s probably a good idea to sell some of it even if that means incurring capital gains.)