Last week, I talked about bitcoin and argued that it wasn’t a great investment. The reality, though, is that only a minority of investors hold cryptocurrency. That’s a good thing, in my opinion. But still, there are many other ways to go off track in building a portfolio.
In fact, if I ever wrote an investment book, it might be in the style of Dr. Seuss and titled Oh, The Investments I’ve Seen. To help build a sensible portfolio, and avoid common pitfalls, below are five principles I would keep in mind.
1. Liquid. Part of the recent downturn in bitcoin was triggered by a company called Celsius Network. It’s not quite a bank, and not regulated like one. But it was acting like one, offering interest rates of up to 18% to investors who deposited their bitcoin with Celsius. Everything seemed fine, until a few weeks ago, when Celsius announced that it was halting all withdrawals.
What happened? One knowledgeable observer explained it this way: Celsius “suffered a series of severe losses including over 38,000 ETH in a blunder related to Stakehound, followed by a $22 million loss in connection with the Badger DAO hack.”
If that doesn’t make much sense to you, you’re not alone. If I were a Celsius depositor, I wouldn’t have found it very helpful. And it would be cold comfort to hear from Celsius that it is working “around the clock” to resolve the issue—but with no assurance when or if investors will be able to get their money back.
Celsius is today’s story. Unfortunately, it isn’t really a new story. Private funds, non-bank lenders like Celsius, and other unconventional investments often have restrictive withdrawal provisions. And because they are, by definition, investing in non-standard types of investments, the risk of outright failure is also higher.
When private funds collapse, they usually affect only a small number of investors, so they don’t make headlines. But that doesn’t mean failures are rare. In my own work, I’ve seen two clients each lose seven-figure sums in private funds. These weren’t Madoff type situations. Neither involved criminality. They were just the result of unique and unfortunate circumstances. And that’s just my own personal experience. Unfortunately, private funds fail all too regularly.
The lesson: Novel investments can be alluring. In contrast to ordinary stocks and bonds, they might look a whole lot more interesting. But pay attention to the fine print. That’s where you’ll find the withdrawal terms. And still, I’d invest only an amount you’d be willing to lose.
2. Tax-efficient. Earlier this year, I described a situation in which an investment had generated great profits for an investor but nonetheless resulted in a loss when it was sold. It was certainly an unexpected result. But this kind of curveball is not uncommon with tax-inefficient mutual funds.
In fairness, when you buy into a mutual fund, there’s no way to know in advance how it will perform. As a result, there’s no way to predict how it will impact your tax return. There is, however, a way to minimize this risk: Look for investments with very low “turnover.” That’s a metric that you can find on fund companies’ websites and on research sites like Morningstar. It refers to the percentage of a fund’s holdings that the fund manager sells each year. It’s thus a good proxy for the potential tax impact.
Where’s the best place to look for funds with low turnover? As you might guess, index funds—and specifically, broadly-diversified index funds. Because their mandate is to simply hold a very large basket of investments and to make very few changes, these funds give investors the best shot at controlling their tax bill.
3. Reasonable. This might sound like a vague concept. What constitutes a reasonable portfolio? I’ll start by describing what, in my view, is not reasonable. In the past, I’ve talked about portfolios that are “broker’s specials.” They consist of dozens of investments, often with overlapping holdings. The biggest issue with these stew-like portfolios is that they make it difficult for an investor to really know what they own.
Mutual funds with names like “New Economy” and “International Explorer” are good for marketing, but without some analysis, they don’t tell an investor what’s actually inside them. And if you hold more than a few of these, it becomes that much harder to know the overall complexion of a portfolio.
A reasonable portfolio, on the other hand, consists of just a small set of simple holdings—small enough that the composition of the portfolio can be seen almost with the naked eye.
4. Flexible. You may have heard of the Three-Fund Portfolio. This strategy represents the ultimate in simplicity and would easily pass the “reasonableness” test. But there’s actually a virtue in having a portfolio that is slightly less streamlined than that. In the portfolios I build, for example, I normally include ten or so different funds. Why is that? In part, it’s to achieve certain investment objectives—by including an overweight to value stocks, for example. But there’s also a tax benefit.
Suppose you’re looking to withdraw cash from your portfolio and trying to identify investments to sell. If the only thing you own is a total-stock-market fund, and you’ve held that fund for a while, then probably every share you sell will generate a gain. But what if you held all the stocks in that fund as individual holdings? Then, if you needed to sell investments, you’d have a lot more flexibility. You could pick and choose, selling some at losses along with some at gains. That would give you much better control over your tax bill than if you held just one fund.
That is the appeal of direct indexing, which entails owning all of the individual components of an index rather than an index fund. But that approach isn’t perfect either, and it isn’t for everyone. For that reason, a reasonable compromise is to hold a handful of funds—more than three but not thirty either. You might, for example, own three separate funds to cover the U.S. market—a large-cap, a mid-cap and a small-cap fund—rather than a single total-market fund. This wouldn’t make a portfolio much harder to manage, but it would provide some helpful flexibility when it comes time to sell.
5. Balanced. To explain this principle, I’ll start with a riddle: Is it possible to build a portfolio that meets all the criteria outlined above but is nonetheless imperfect? Yes. For better or worse, there are now thousands of index funds available. Many offer narrow slices of the market—growth stocks, for example. I often see index fund portfolios that, on the surface, look reasonable, diversified and cost-efficient. But in combination, the resulting portfolio isn’t diversified at all.
For example, a portfolio might hold a large-cap growth index fund and a small-cap growth index fund. Both funds, on their own, are fine. But if that’s all an investor held, he’d lack exposure to about half the market (the value side).
The lesson: Index funds are great building blocks, but they need to be assembled in a balanced way. This, in fact, is another reason why a simple portfolio is better than a complicated one. When you can see what you own with the naked eye, it’s much easier to spot imbalances like this.
In their book, In Pursuit of the Perfect Portfolio, Andrew Lo and Stephen Foerster interview ten investment pioneers, ranging from Harry Markowitz to John Bogle to Robert Shiller. The book runs more than 300 pages. In the end, what is their conclusion—what is the perfect portfolio? To answer this question, they map out sixteen different investor archetypes for which different portfolios may be appropriate. That sounds complicated, but it does make sense. Ultimately, there is no one-size-fits-all. These five principles, though, may be helpful to keep in mind regardless of which strategy you choose.