Meet Allison and Keiko, longtime friends in their late 40s who also have been fierce competitors since their days on the college track team.
Over drinks one night, Allison tells Keiko about a “hot” stock she owns that has delivered impressive returns. It was up 35% in 2013, she says, and while it was down 10% last year, she’s confident it will surge to new highs in the year ahead.
Keiko thinks that sounds volatile, but she’s intrigued and a little envious. When was the last time her returns got anywhere near 35%? Why didn’t her financial advisor tell her about this stock? She wonders if she should consider a new advisor—or a more aggressive equity allocation like Allison’s.
Comparisons can cause trouble
The scenario above may be hypothetical, but this sort of comparison happens all the time. There’s a risk when you’re trying to beat the market—or beat your best friend’s portfolio, for that matter. When you stray from your own well-thought-out plan to chase higher returns, there is a chance that your portfolio’s performance will get worse, not better.
Why is that? Because strong emotions are rarely the best guide for making smart investment choices. Consider a phenomenon commonly called “the behavior gap,” which refers to the difference between market returns and investor returns. For example, although the S&P 500® Index gained 9% over the 20-year period ending December 2013, the average equity mutual fund investor was up only 5% during the same period, according to the 2014 Quantitative Analysis of Investor Behavior report from Dalbar.
This gap is largely the result of investors making impulsive or emotional decisions (just as Keiko was tempted by Allison’s stock). In fact, Keiko’s portfolio would likely fare better if she kept her investment plan rooted in her own needs and goals—as you’ll see from a closer look at the two friends’ lives and portfolios now.
Different lives, different allocations
Allison is a successful lawyer, married with two daughters, ages 11 and 13. Her husband Eli runs a small web design firm from his home office. They have little debt and more than $2 million in savings ($1.5 million in retirement assets and $500,000 in taxable accounts).
In the long term, Allison and Eli want to maximize their portfolio’s return; in the short term, they need cash to pay for their kids’ college education. Their current portfolio, spread across tax-deferred and taxable accounts, is allocated as you see in the graphic below:
Meanwhile, Keiko’s situation is quite different. She’s the chief technology officer of a startup. She has three children, ages 9 to 14, and the youngest has special needs. Her husband, Mike, recently left his job as an investment banker and took a part-time teaching position at a local community college so that he could better coordinate the care and education of their youngest.
Their savings are slightly lower than Allison and Eli’s: The family has $1.2 million ($500,000 in taxable accounts and $700,000 in retirement assets). They’ve been tapping some of the taxable accounts to supplement their newly lowered income—although they’re anticipating that Keiko could walk away from her job with a big payout in a couple of years.
Keiko wants to generate enough income to support her family’s needs. Keiko and Mike’s current allocation, across tax-deferred and taxable accounts, is illustrated here:
A portfolio critique
Both families’ portfolios could benefit from rethinking, given their different objectives.
Allison and Eli: Greater diversification
Equities constitute 85% of the family’s assets, and their portfolio is not well diversified—especially considering that equity correlations have risen over the past couple of years. A broader diversification to non-traditional asset classes could be beneficial, as you can see below.
Also, because their daughters are approaching their college years, Allison and Eli may want to consider more stable income in their portfolio since they haven’t saved separately for college expenses. Thus a bigger fixed income stake makes sense.
Allison wants to stick with her hot stock, but the trouble is she’s “anchoring” her view of it; that is, she’s focusing on the stellar 35% return back in 2013 and believes that recent poor performance provides an opportunity to invest at a discount. She should evaluate each investment based on its risk profile, not its past performance.
Keiko and Mike: Generate income
Keiko and Mike have a prudent allocation, which is a good start. They need to preserve capital while Keiko is working at the startup, and they need to generate more income from their portfolio now that Mike’s salary is lower. To that end, they should favor dividend-paying stocks (domestic and international) and seek other sources of income such as real estate investment trusts (REITs) and master limited partnerships (MLPs). Within their fixed income allocation, they should try to maximize tax efficiencies by putting tax-free muni bonds in their taxable account and corporate bonds in their retirement accounts.
Keiko would be wise to resist the temptation to follow in Allison’s investing footsteps. Her priority should be balancing her family’s short-term need for capital preservation with their longer-term need to generate income from their portfolio. Keiko and Mike have a child with special needs and need to continue to save for retirement.