The Good, The Bad, and The Ugly Reasons to Change Your Portfolio

I often get asked during conversations with clients if they should make some changes to their portfolios.  It is probably the second most often question I hear. Usually when a client is concerned about making changes, it is an emotional reaction to some news headline or a normal market correction.

My clients always have had a diversified portfolio of stocks, bonds, cash and sometimes alternatives. It’s boring, but it has been successful for my clients for almost two decades.  Sometimes boring is good.

During this last month of hearing the question, I started to think about what would justify changing a diversified portfolio. I thought of the good, the bad and the ugly reasons to change a portfolio.

Good Reasons to Change Your Portfolio:

More diversification. Diversification lowers the risk of your portfolio without lowering its expected return. Every portfolio should be allocated across a wide variety of asset classes to provide the optimum balance between risk and return. Here are some ideas to improve diversification:

• If your portfolio is stock heavy, add bonds
• If your portfolio is mainly US stocks, add an international stock component
• If your portfolio is concentrated in a few stocks, move to a broad stock index fund

Lower fees. Expenses reduce returns and often investors do not understand all of the costs involved in the management of their portfolio.  These expenses can impact wealth accumulation and distribution.  All things being equal, I encourage clients to utilize the investment with lower expenses. Look at low cost ETFs as an option.

Adjust your risk tolerance. If you freaked out in 2008 and sold your portfolio, then you probably need to make an adjustment to your portfolio to better match your tolerance for risk. So you probably need to lower the amount of stocks you hold and increase your bonds and cash. You’re no less of a gun slinger with a smaller allocation to stocks.

Simplify. I love simple portfolios that are easy to explain. You don’t have to have a complex set of buy and sell decisions to be successful. Complicated portfolios rarely perform well and are usually more expensive. Find an investment that you are comfortable with, and above all, that you understand. Simplify, simplify…

Lower taxes. Sometimes a portfolio can be changed to reduce its tax liability. Moving taxable investments to tax-deferred vehicles can help. A common technique is changing taxable government or corporate bonds to tax-free municipal bonds.

Bad Reasons to Change Your Portfolio:

Hot tips from a friend or relative. Professionals with 30+ years experience have a hard time selecting successful investments. Do you really think your brother-in-law or co-workers really know more than they do? It really surprises me how many people will take this advice to heart.  Don’t be fooled by the hidden pot of gold.

Impatience with the markets or economy. Thanks to the internet, you can find terrifying and seemingly actionable financial news 24-7. Gold is a sure thing! Gold is a bubble! Runaway inflation! Double-dip recession! You can literally find a bullish or bearish expert for any type of asset on TV or the internet. None of them are any better than a crystal ball at predicting the future. I think a sideways market is the most frustrating.  As people we can understand and point to reasons the market improves or declines, but a market that goes nowhere over a period of months can make investors very impatient. They start to justify moving a portfolio for the hope of greener grass.

…and The Ugly:

Fear and greed

These are the two most powerful emotions when it comes to investing. Either emotion can dominate our thoughts and cause us to make catastrophic mistakes. Oil and gold have been the most recent greed plays by investors.  In 2011 almost every conversation I had with clients included whether they should buy gold at an all-time high. Greed often bates investors with making changes to the portfolio for the wrong reasons.

Just as an investor can become overwhelmed by greed, the same can happen with fear, and often does.  Fear is a very powerful emotion. In 2008 when the S&P declined 37%, many people thought it would continue and liquidated their portfolios. This mass exodus from out of stocks shows a complete disregard for a long-term investment plan. Investors changed their portfolio for a really ugly reason: the fear of further losses.
Any time you consider making a change to your portfolio, ask yourself: “Am I doing this to get more diversified, lower costs, bring my portfolio in line with my risk tolerance, get tax-efficient, or simplify my holdings? Or am I just stringing up my portfolio?