Good funds can make a bad portfolio

We’re often highlighting ‘classic’ investor mistakes here at Morningstar—being emotional human beings we tend to be our own worst enemy when it comes to making investment decisions. So with stock markets having rallied around 50% from March lows and the start of a new year presenting a popular time to reassess goals and portfolios, we’re again taking a look at five common ways in which investors slip up, and suggesting how best to avoid these mistakes.

1. Letting anxiety rule your head
Back in 2006 you could be forgiven for feeling nervous about the stock market, with equities at all time highs, and pondering whether it might be time to get out and move into the ‘safe haven’ of a share-free portfolio. Again, in early 2009, you may have found yourself thinking that markets couldn’t go much lower and it was time to plunge your funds back into equities. The chances, however, that you managed to accurately pick—and act on—the two turning points are very small and miscalculating these points can have a serious detrimental impact on the value of your portfolio.

Of course we understand that it’s difficult to ignore your emotions completely but the statistics prove that stock performances over time tend to improve and come back. (Read this article for tips on how to minimise human error.) If you’d been fully invested in bonds between 2000 and 2003, you might have been rubbing your hands with glee as you watched equities tumble amid the bursting of the tech bubble. But that same portfolio today would have substantially underperformed a mixed stocks and bond portfolio, even taking into account the stock market crash of the past two years. The key message here is threefold: taking a long-term view reduces the impact of volatility; trying to time the market leads to slip-ups; and diversification spreads risk.

2. Trying to time the market
As alluded to above, timing the market is a lot easier with hindsight. Sure, we all now know that if you’d invested fully in large-cap UK equities around March 3, 2009, you would have seen your portfolio add half its value again over the ensuing six months. But corrections do happen, and these work in both directions: setting your investment goals, picking your investment strategy and spreading your investment risk should over time lead to steady returns—returns that would have been substantially reduced if you’d missed, say, the best-performing month of each year. Trying to second-guess market movements is a risky and fraught investment style.

One particularly effective method of smoothing out short-term volatility is pound cost averaging—investing equal amounts of money on a regular basis, thereby bypassing the risk of making poor investment decisions during tumultuous times as you’re committed to investing whatever the weather. Pound-cost averaging can help investors limit losses, while also instilling a sense of investment discipline and ensuring that you're buying shares at ever-lower prices in down markets. Numerous studies have confirmed that it also results in better returns than strategies that involve moving in and out of the market.

3. Misunderstanding diversification
A common mistake to make is to think that because your portfolio contains 15 different funds, you’re well diversified. But diversification isn’t about the quantity of holdings. Use our Instant X-ray tool and you may be surprised at the overlap within your portfolio. Good funds can make a bad portfolio: diversification means spreading your investments across assets, regions, sectors, and investment styles. This table perfectly illustrates how one year’s ‘hot topic’ can become the next year’s dud. Anyone invested fully in one area, such as UK small-caps, would have watched their portfolio swing violently between notable gains and substantial losses over the ten years to 2006, but a savvy investor who had spread their money across a range of assets, sectors and regions would have achieved much smoother returns over the decade.

4. ‘Old age’ means time to pull out of stocks
By all means, as your investment time frame shortens you may want to move from a more aggressive investment style to a more conservative one, perhaps shifting assets into bonds and cash and out of more volatile equities. But just because you’re broaching retirement age doesn’t necessarily mean it’s time to focus your portfolio fully on fixed income. There are three key points to take into consideration here. Firstly, retirement income horizons are increasing—if you can afford to retire early then congratulations but for the majority, the State-set retirement age keeps being pushed back. Secondly, we’re living longer these days—in fact a couple aged 65 at present have more than a 25% chance that one of them will live into their late 90s so that’s more than three decades of living costs they need to have invested for. Thirdly, inflation erodes purchasing power. The value of a portfolio invested solely in fixed income will decrease over time, even at the current low rates of inflation, and increasingly so as inflation rises, as many expect it will do given the vast quantity of money injected into the system by way of the government’s economic stimulus programme. Keeping a portion of your portfolio in other assets such as equities can help protect again inflation-erosion.

5. Procrastination or inertia
“I can’t afford to invest right now, I’ll do it next year once the company reinstates bonuses.” Sound familiar? The problem with delaying is that it reduces the amount of time your money has to work for you and also reduces the long-term advantage of pound cost averaging. If you had invested £2,000 per year over the ten years to 2006, the value of your investments at the end of the time period would be far greater than had you started investing £4,000 per year halfway through that period.

An addition benefit of long-term investing is compound interest, exemplified by the oft-quoted trick question of whether you would rather have £1,000 per day for 30 days or a penny that doubled in value every day for 30 days. The savvy investor would pick the doubling penny and be looking at £5 million at the end of 30 days versus £30,000 if they opted for the £1,000 per day.

Hopefully you’ve noticed that these investor mistakes all lead to the same few suggested solutions: taking a long-term view, understanding that market corrections do happen, staying the course rather than attempting to time the market, taking advantage of pound-cost averaging and compound interest, successful portfolio diversification and, last but not least, acting rather than delaying. Additional articles on all these topics can be found by searching our article archive.