by Silicon Valley Blogger on 2012-05-25 13

Because of my interest in finance, Ive been approached by many family members, friends and coworkers to discuss a myriad of financial issues. Its usually a very lively and animated discourse that ends up with me excitedly promoting (or defending) the subject of long term index investing while being met with some skepticism and doubt by those who insist that such an approach is just too boring and slow growth for their taste. They then proceed to tell me that theyd rather do it their way by supercharging their portfolio with carefully picked hot stocks.

Okay, so I then prod them to show me their portfolio, and it typically looks like what Ill present below.

What My Friends Portfolios Look Like

Before I proceed, let me say that there are many ways to skin a cat, especially when it comes to investing. However, Id like to share what Ive found to be a common thread in many portfolios Ive had the chance to analyze and observe. It turns out that some investors are enamored by a particular form of asset allocation which I describe as passive aggressive (in fact, I tease my friends that this portfolio is schizophrenic).

As an example, I was shown a portfolio that was made up of 10% aggressive, individual stocks and 90% cash in CDs and money market funds. I dont think its an exaggeration to say that a lot of people have portfolios that bear a strong resemblance to this set up. When I ask my investor friends how their portfolios are doing, they immediately give me the awesome news that their stocks are going gangbusters, but under more careful scrutiny, I see that their overall returns are more lackluster. Let me add that those individual stocks are also churned very heavily in that portfolio, where any short-term capital gains become subject to taxes.

Lets see how the returns of this investors portfolio work out. The assumption is that cash is pegged at its recent return of 1%. So lets take a hypothetical basket of aggressive stocks that have done well and which represent the 10% allocation of this particular investment portfolio these stocks would have to return the equivalent of 75% to bring up the average return of the overall portfolio so as to match the returns of a simple index fund that tracks the U.S. Total Stock Market. Thats because the average annual return of the U.S. Total Stock Market has been between 8% to 9% over the long term.

Cash Return + Stock Returns = Overall Portfolio Return

(.01 X .90) + (.75 X .10) = .084, which if multiplied by 100% yields 8.4%

So we must ask ourselves: just how feasible is it to expect a 75% return from your stocks over the long term?

More realistically though, my colleagues stocks have returned 25% yearly at best (because they practice trading and only stay in these stocks for short periods of time throughout the year!). While on average, their returns have typically registered more around 15% before applying transaction fees from trading churn and the tax bite. If we plug in this 15% stock return to our portfolio calculations, what we get is an overall portfolio return of a measly 2.4%, very close to the equivalent return of a pure cash portfolio. Clearly, this allocation model shows the extreme dilution that is caused by an under-diversified portfolio.

(.01 X .90) + (.15 X .10) = .024, which if multiplied by 100% yields 2.4%

Lets go through a second example. You may recall that there was a time when the long term stock market results were 11% while savings rates for cash accounts hovered at 4%. Even then, it would have taken the equivalent of a 75% rate of return for a 10% stock allocation to yield an 11% total return for the entire portfolio.

Cash Return + Stock Returns = Overall Portfolio Return

(.04 X .90) + (.75 X .10) = .111, which if multiplied by 100% yields 11.1%

So were seeing similar outcomes here, despite some of the adjustments that have been made with performance returns over the years.

All that effort and energy spent on stock picking, trading and worrying was for nothing much, really, because in reality, this 10% aggressive portfolio is, on the flip side, really just a 90% cash portfolio.

What you see here are plays often done by ordinary individuals who believe they are investing in the stock market, when in fact they are committing the sins of:

• rampant trading
• portfolio under-diversification
• actively focusing on a small section of their portfolio

What Ive learned is that many people make the mistake of compartmentalizing their returns according to the type of assets they hold. Actually, Id been doing the same thing for quite some time and only after years of study. experience and losing money did I realize that I should really take a closer look at diversified asset allocation .

Dont Be Deceived By A Passive Aggressive Portfolio

It is very easy to become hyper-focused on a single type of asset for its gains or losses, when in fact, we arent seeing the true big picture. When looking at our net worth and asset allocation, it is very important to take stock of all our positions, liabilities and assets before we formulate any thoughts about our financial status. The basis for any further financial decisions we make may hinge on how we evaluate our current financial health. All too often, Ive seen people feel artificially over-confident about their situation (such that they formulate big spending and big budget plans, or proceed to make high risk bets) all because their confidence is boosted by a handful of well-performing stocks or the sudden found wealth generated in appreciating property values. But their account statements can tell an all too different story.

We could do much better if we shed the illusions we have over our money.

There may be better investment strategies, but the number of strategies that are worse is infinite. John Bogle

Categorized under: Investment Written by SVB