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Your financial life is complicated; Your portfolio shouldn't be

Christine Benz  |  07 Sep 2017Text size  Decrease  Increase  |  
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The more idiosyncratic your human and non-portfolio financial capital, the more "vanilla" your portfolio should be.


The uptake of index products has been widely hailed as an expression of investors' preference for low-cost investments. And a quest to lower total portfolio costs and cut out higher-priced, underperforming funds may well be the main driver of the enormous asset flows into passively managed products: It hasn't been lost on investors that most active funds, especially high-cost ones, don't beat their cheap index counterparts after fees.

Financial advisors, meanwhile, know that the best way to improve their own value proposition is to reduce their all-in charges; cutting costs at the fund level helps advisors maintain their own fees as they do so.

But even as the appetite for low-cost products has led the uptake of index ETFs over the past decade, I think there's another big factor in play: a desire to simplify. Investors aren't buying any old ETFs, after all. They're eschewing narrowly focused products and those employing overwrought strategies. Instead, they're purchasing the big broad-market building blocks: diversified equity and bond funds that cover a big chunk of the market, if not all of it.

Of course, such products also have low costs, so there's a chicken-or-egg phenomenon going on here. But the products that have been flying off the shelves are also simple and straightforward, enabling investors to build out a well-diversified portfolio with just a handful of holdings.

The case for using simplified, ultra-diversified investment products is even stronger if you have something complicated going on with the rest of your financial life, either with your human capital or your total financial portfolio. Maybe you receive a big share of your compensation in the stock of your employer, for example, or you have sunk a lot of your money into a rental property. The more such idiosyncratic risk factors you have, the stronger the case for keeping your investment portfolio vanilla and hyper-diversified.

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Morningstar Investment Management researchers David Blanchett and Philip Straehl addressed such idiosyncratic risk factors in their research paper, No Portfolio Is an Island. They wrote that investors would do well to think of their investment portfolios as their "completer portfolios"--to offset risky bets in the rest of their financial lives. For example, the person with a job in the technology sector should avoid ramping up exposure to companies in that same sector. The person with a lot of non-portfolio real estate holdings should skip the dedicated real estate ETF. And so on.

That's a valuable line of thinking. But I'd suggest that you could interpret the research even more broadly. Take stock of your whole financial life--your human capital as well as any assets you own in addition to your investment portfolio--a stake in your brother's company or a real estate rental, for example. The quirkier your non-portfolio assets, the more vanilla and stripped down your investment portfolio ought to be.

That doesn't mean that you necessarily ought to be more conservative from an asset allocation standpoint. If you're a 35-year-old entrepreneur, you need enough of a safe cushion in your investment portfolio to tide you through weak periods in your business, but you also need ample stock exposure in your retirement portfolio to give you some growth in case your business doesn't take off. Within that equity exposure, however, it's valuable to avoid big bets on individual securities or sectors, arcane investment strategies and niche investment products. Your business is your high-risk asset; your portfolio doesn't need to be a high-wire act, too.

There are several reasons this makes sense. As discussed above, maintaining a broadly diversified, highly liquid investment portfolio can ensure that you're not doubling down on some of the risks in your broad financial portfolio. The liquidity of a broadly diversified portfolio--say, a basket of total stock and bond market ETFs--can also serve as an antidote to the non-portfolio assets, which are usually illiquid.

Additionally, having a more complicated financial life--owning a small business, for example--likely means that you have less time to devote to your investment portfolio. Holding simple building-block investments helps ensure that your portfolio doesn't need a lot of monitoring on an ongoing basis.

As you survey your total financial life, take stock of the following idiosyncratic risk factors.

You own a small business

It's not unusual for small-business owners to invest the majority of their net worth in their businesses. That has implications for asset allocation, of course; small-business owners may have volatile earnings. All else equal, they'd want to hold more safe securities than non-business owners at the same life stage.

In addition, small-business owners should aim for extremely well-diversified exposure within asset classes, to help offset the huge company-specific risks inherent in their business ownership. Not only should the portfolio downplay the industry in which the small business operates, but it should avoid big sector-specific and stock-specific risks in general.

You are incentivised through company stock

In a similar vein, many employees are incentivised through ownership stakes in their firms; if the business does well, those positions can take up a sizable share of their net worth. Morningstar Investment Management's head of retirement research David Blanchett has said that the ideal percentage of employer stock in a portfolio is 0 per cent. Nonetheless, the employee may face tax consequences to unwind their concentrated equity holdings.

For that reason, employees with large weightings in their employer's equity should work to neutralise those exposures by keeping the rest of their portfolios scrupulously well diversified. As with the small-business owner, it makes sense to downplay the sector in which your company resides, as well as big bets on companies and industries within your investment portfolio.

You're getting close to retirement (or are retired)

Everyone knows about the virtue of lining up more safe assets as retirement approaches. But retirees still need ample equity exposure, to help improve their portfolios' longevity and offset inflation. What retirees don't need, however, are big bets on specific stocks or sectors, especially if their plan doesn't leave a high margin for error.

This article provides a vivid case study of the virtue of reducing idiosyncratic risks in a portfolio as retirement approaches. The retiree profiled here absolutely needs equity exposure to help ensure that she doesn't run through her fairly slim portfolio prematurely.

What she doesn't need, however, are big bets on individual companies. Even though well-chosen individual stocks have the potential to boost her returns well above the broad market's, they also have the potential to drive her results well below the market's, too.

Your real estate represents a large share of your net worth

In many households, an ownership stake in residential real estate is the largest single asset. But as David Blanchett discusses here, it's a fairly risky, illiquid asset. Many homeowners experienced this firsthand during the financial crisis, which was also a real estate crisis; their homes dropped in value at the same time their investment portfolios did. And while stakes in rental properties can provide an attractive source of cash flow, like any illiquid asset they can also be a source of risk if the investor needs to sell in a pinch.

At a minimum, investors with a sizable share of their net worth in real estate--their own homes or rental properties--should downplay real estate-specific investments in their portfolios. They should also bear in mind that total stock market indexes contain some real estate exposure already.

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Christine Benz is Morningstar's US-based director of personal finance.

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