We've all heard about the power of compound interest. Compounding mistakes can have the reverse effect: Rather than helping to build wealth, they can cause an erosion of riches. Small errors in judgment today can result in significant portfolio damage when magnified over time. Reviewing real-life portfolios held in an online account-aggregator service, analysts found some common investor errors. See if your portfolio contains the same faults.
Saturated with liquidity
Michael Ruderman is a marketing manager with Personal Capital, an online investment management platform founded in 2009 by tech heavyweights Bill Harris (formerly of PayPal and Intuit) and Rob Foregger (previously with Fidelity and Everbank). Ruderman has access to the analytics driven by the portfolios held by users of Personal Capital. The macro view reveals what the firm's analysts think is a glaring mistake: Many investors are out of the market and on the sidelines.
"Looking at a sample of Personal Capital dashboard users, we found that our users on average hold three times more cash than they need in their investment portfolio," Ruderman says. "The average user keeps 14% of their portfolios in cash. For nearly 10% of our users, we found that cash in brokerage accounts represented over 50% of their entire investment portfolio value."
Bank accounts were excluded from the analysis. Considering that cash or cash equivalents are low-yield investments typically held in money market funds, short-term bank CDs or Treasury bonds, Ruderman thinks the cash allocation is "alarming."
"Our investment committee generally believes that no investor should hold more than 5% cash in a long-term investment portfolio," he says. "There can always be an exception depending on a specific investor's situation, but we think that is just that -- an exception. Imagine how much more those individuals could be earning in the markets if they put that money to work!"
Too many mutual funds
This may come as a surprise to many investors, but Ruderman flags another portfolio penalty -- mutual funds:
We found that nearly 60% of Personal Capital dashboard users in our sample set have over half of their investment portfolios in mutual funds. Mutual funds are an expensive option for individual investors, with an average expense ratio of 1.16%. They were once cutting edge, providing the first way for individual investors to get a diversified portfolio back when they were introduced. But now, they are expensive and tax inefficient, compared to their more modern counterpart, the exchange-traded fund.
Although ETFs generally have lower expense ratios, there are still some situations where mutual funds can be a more attractive option. For example, many mutual funds are available with no transaction fees, whereas investors often must pay transaction fees when buying ETFs. Depending on the investment, the transaction fee might counteract the lower expense ratio. The lesson that investors should take away is that when making investments, they should be aware of all costs.
Nobel Prize-winning economist William F. Sharpe has long been an advocate of low-cost investments as a method to enhance potential returns. He revisited that theory last year in research published by The Financial Analysts Journal, quaintly titled "The Arithmetic of Investment Expenses."
His conclusion after all of these years was the same as his original thesis. "Under plausible conditions, a person saving for retirement who chooses low-cost investments could have a standard of living throughout retirement more than 20% higher than that of a comparable investor in high-cost investments," Sharpe wrote.
The prevalence of mutual fund investments in portfolios analyzed by Personal Capital warrants another important consideration, according to Ruderman:
We were also concerned when we saw this because, even without thinking of the lost compound gains due to expense ratios, mutual funds tend to be low-performing. According to the S&P 500 Indices Versus Active Funds indexes, mutual funds consistently lag year after year. In fact, there isn't a 10-year period on record when mutual funds have done better than their counterparts.
A risk mismatch
During account registration, Personal Capital profiles individuals regarding their risk tolerance. It's a familiar process to any investor, but one with a surprising result after further analysis of the aggregated portfolios by the firm's investment team.
"You'd expect to see individuals who state that they have a high risk tolerance to have more of their portfolios in more volatile assets -- such as equities -- and individuals with a stated lower risk tolerance to have more of their portfolios in safer assets, like bonds," Ruderman says. "But nearly 25% of Personal Capital users with a stated risk tolerance of 'aggressive' or 'highest growth' had less than 50% of their portfolios in stocks. And, shockingly, nearly 25% of users with a stated risk tolerance of 'conservative' or 'highest safety' had over 75% of their investments in equities."
If a broad cross-section of Personal Capital users are making these mistakes, other investors may be as well. Just these three factors can send your investments careening off track, so it's wise to review your own portfolio for these common errors. Consider if your cash allotment is appropriate for your investment goals, review your mutual fund holdings for exorbitant expense ratios, and confirm that the risk you are taking is equal to your comfort level.
The missteps found in these real-life investment portfolios may be a reality check for you, too.