Avoid these common investing mistakes.
By Sue Stevens, CFA, CFP, CPA | 11-09-06 | 06:00 AM | Email Article

Whatever problems you encounter in your own portfolio, you're not alone. Plenty of other investors trip over the same stumbling blocks. Looking for the following weaknesses in your portfolio will help you think about it as a whole, and not simply as a collection of individual investments.

Sue Stevens, CPA, CFP, MBA, and CFA Charterholder, runs her own financial planning firm, Stevens Portfolio Design, and manages over $100 million in assets.

1. Undefined Objectives and Priorities
If you have owned funds and/or individual stocks and bonds in your portfolio for a long time, it can be easy to forget that those investments are there to do a job. Investors frequently own stocks to create capital appreciation over time and own bonds to generate income. You may not need to seek red-hot growth with the portion of your portfolio devoted to stocks, but you should make sure you've clearly defined your expectations.

Take the time to think about your objectives and priorities, as well as whether your needs or expectations for your portfolio have changed. If an investment hasn't delivered on your objectives for it, it may be time to evaluate potential replacements.

2. Lack of Focus
If you find yourself staring at a long list of funds and aren't really sure why you own them, your portfolio probably lacks focus. For each goal you have identified, you should have a core group of three or four funds that are proven performers. Simplify by focusing on a few funds that can deliver what you want and gradually add to the amount you've invested in them rather than adding more choices to your lineup.

A core holding should provide a solid foundation for the rest of your portfolio. Large-cap blend funds, which own big companies with middle-of-the-road stock prices, are core stalwarts. Core holdings can be index, exchange-traded, or actively managed funds. They can be stock or bond funds and can focus on foreign stocks as well as U.S. stocks. With a few exceptions, you're better off using funds for your core holdings as opposed to individual stocks or bonds.

For cautious investors, a balanced fund (part bond and part stock) can play a key core role in the portfolio. On the fixed-income side, short- or intermediate-term funds with high credit quality make for conservative choices.

For more aggressive investors, a large-cap growth fund or perhaps even a mid-cap growth fund may be able to play a core role depending on overall risk tolerance and individual goals. Aggressive investors may also want to invest in longer-duration or lower-quality bond funds, again depending on individual goals.

3. Too Many Extras
Use additional funds for diversification and growth potential. For instance, if your core is made up of large-cap funds, you might want to add mid-cap or small-cap funds for diversification. On the bond side of the portfolio, you may want to allocate a portion to an international fixed-income fund.

While you probably wouldn't want to put a significant portion of your portfolio in any one of these types of funds, they do allow for the possibility of extraordinary returns. Of course, they also generally carry a higher level of risk. But as long as you limit the riskier portion of your portfolio, you aren't likely to threaten the bulk of your nest egg. And for some people, core funds may be all they ever need.

4. Loss of Balance
If you want to protect your portfolio by being defensive, you should think about balance. If you see something that "sticks out," you need to determine whether it still fits your risk profile. Imbalance can happen when some categories do very well or very poorly or when you have an overconcentrated position in any one stock (especially company stock).

You can use Morningstar's Portfolio Manager tool to help you gauge if your portfolio is out of balance. Use the Instant X-Ray tool to see how your portfolio is distributed among asset classes and investment styles. Premium Members can also visit the  X-Ray Interpreter section for a report that will tell you how aggressive your asset allocation is and show you how your portfolio is balanced by style, sector, and type. While there, click on  Stock Intersection for a report that examines all your stocks and funds and gives you a breakdown of exactly which stocks your portfolio holds. If you hold more than 10% in any one stock, you may want to think about reducing that weighting.

5. Too Many Funds
Many investors know they have this problem--they just don't know what to do about it. Start by evaluating where the fund fits into your portfolio. Is it a core fund or not? If you intend it to be a core holding, do you have more assets invested in it than other noncore funds? Think about how you could reallocate some of your assets so that you would own fewer funds but have larger positions in the ones you keep.

6. Poor Choices Within Categories
What style are your funds? Do you see a pattern of owning too many funds in a particular category? Group your funds by style and make sure you have a good reason for holding so many in one category. If too many of your holdings use a similar approach and invest in the same kinds of stocks, keep the strongest and sell the weakest.

If you want some guidance on how your fund stacks up against the competition, take a look at our  Analyst Picks list. Do many of your funds make the cut?

7. Inefficient Tax Strategies
Long-term capital gains tax rates as well as tax on most dividends are relatively low right now. That means you should reassess where in your portfolio you're holding bonds and stocks. Bond interest will be taxed at ordinary income-tax rates, but most stock dividends will be taxed at the 15% rate. If you hold your stocks in a tax-deferred account, you don't have to recognize any income currently. But when you take money out of the account, you pay ordinary income tax at current rates up to 35%. So, you might benefit from holding stocks in your taxable accounts and bonds in your tax-deferred accounts. But consider this: If you're young and have a long time horizon, stocks may provide greater growth over that time period. That means you could be better off investing in stocks in a tax-deferred account even if they are taxed at a higher rate in the future.

Second, factor current tax rates into your decision to hold taxable versus tax-exempt bonds. To find the tax-equivalent yield of a muni bond or fund, divide the tax-exempt yield by (1 minus your tax rate). Or you can use Morningstar's Bond Calculator. Once you've evaluated the tax equivalency, you can choose the bond or bond fund that delivers the highest tax-equivalent yield.

8. Paying Too Much in Fees
If you have a choice between two similar funds, take the one with lower costs. Over time, the difference in performance between a fund with a 0.5% expense ratio and a 2.0% expense ratio can be dramatic.

For example, say you invested $10,000 in a fund that gained 12% per year before expenses and carried a 0.5% expense ratio. Your friend invested $10,000 in a fund that also gained 12% per year before expenses, but his fund carried a 2.0% expense ratio. Twenty-five years later, you'd have nearly $45,000 more than your friend, simply because your fund's annual fees were lower. No matter what anyone tells you, costs matter.

9. Poorly Defined Sell Criteria
Most of us learn best by making mistakes--or losing money. After experiencing the market downturn in 2000-02, you have a much better idea of what losses feel like. You can put that information to good use by setting up your sell criteria. Try to quantify how much you can lose before you panic. Perhaps you can live with a 15% loss, but 20% is too much. Think about other criteria, too. What happens if a manager leaves a fund you own? Do you automatically sell, or does the fund go on a "watch" list? With what benchmarks do you intend to measure your funds? How long will you accept performance below a benchmark before you sell? Thinking through the answers to these types of questions up front can make the difference between successful investing and just drifting. For more sell criteria, read "Creating Your Investment Policy Statement".

10. Reluctance to Seek Professional Help
Morningstar has always appealed to the do-it-yourself investor. But there are times when it pays to get professional guidance that focuses on your individual situation. Complex tax issues, retirement, or estate planning can necessitate a trip to a financial specialist. Check out "Seven Steps to Finding a Financial Planner" to help locate an advisor who's a good fit for you and your needs.

A version of this article appeared Oct. 13, 2005.

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Sue Stevens, CFA, CFP, CPA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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