In a recent conversation with a 60 year-old professional man, he complained about the return he had received over the past five years in his portfolio. His returns were so bad that he was thinking of taking his money out of his retirement plan, paying the tax, and investing in real estate.
I expressed some surprise at this, in light of the fact that most diversified portfolios have shown double-digit five-year returns. We ended the conversation with me not believing his returns were as bad as he thought, and him thinking I was overstating reality. As a compromise, we decided he would bring in his portfolio and I would analyze it. What I found was shocking, at least to me.
His asset mix was not shocking: 7% cash, 32% US Stocks, 37% International stocks, and 24% bonds. The mix of US stocks was largely large-cap, with only 13% of the portfolio in mid-cap and a miserly 1% in small cap.
The problem, though, was that he had very few mutual funds. Almost all of his equity holdings were directly owned companies. Holding stocks directly is rarely a good idea for portfolios under $50 million, for at least three reasons.
First, a small investor cannot possibly do the research needed to know which company to buy and which to reject, and neither can his adviser or broker. When I served on the SD Investment Council, our average staff analyst followed 150 companies. I was told that the average Wall Street analyst only followed 30 companies. With over 20,000 companies to research, it is impossible for you or your broker to be able to know what to buy. In fact, I would suggest that any broker or investment adviser who engages in specific stock selection become your ex-adviser.
Second, owning specific securities means small portfolios are inadequately diversified and take on too much risk. While my friend owned just 35 companies, a diversified portfolio of mutual funds would represent the ownership of hundreds, if not thousands of companies. With diversification comes much lower volatility and lower risk. Rarely do I find that portfolios holding specific stocks garner superior returns.
Third, his portfolio had three major asset classes, a sure set-up for failure. Research, and my 25 years of experience managing money, indicate you need at least five major asset classes in a portfolio to achieve maximum return and minimal volatility.
I plugged his information into my “all-knowing, all-seeing” number-crunching portfolio analysis software and found the following information (this is actually fun to us anal retentive types): for the last five years his portfolio had a return of 1.12%, with a volatility (or standard deviation) of 11.41%. This meant that two thirds of the time, his annual return fluctuated from -10.28% to 12.53%.
I compared this to a model portfolio with seven asset classes and 13 mutual funds with about the same allocation of bonds as his current portfolio, just to be sure we had an apples-to-apples comparison. Here were the results. Over the past five years, the model portfolio returned 14.15%, with a volatility of 7.50%. This meant that two thirds of the time, the model portfolio’s annual return fluctuated from 6.65% to 21.65%.
Let me put this another way. This man started five years ago with a portfolio of about $1,000,000. For the past five years it earned about $10,000 a year, growing to $1,057,570. Had he diversified properly, investing in the top mutual funds in each asset class, he would have had a return of $140,000 annually, or a nest egg of just over $2,020,000. That is a difference of about $1,000,000—a figure as astounding as it is sad.