| In our last On Pointe Wealth Management titled “Diversification vs. Worsification Part 1” we discussed how portfolios can become “worsified” vs. diversified. We examined how investing in several mutual funds, ETFs, stocks, and SMAs (SMA= Separately Managed Account*) tend to own everything in the market.
While an “own everything” strategy may seem like the right thing to do for diversification. In the end, you may experience muted performance because any “winners” in the portfolio may be counterbalanced with the “losers”.
Diversification is important. And our thinking is as advisors we need to help manage many different potential areas for risk. However, one risk that does not get talked about enough is opportunity risk.
Again, we do believe in diversification but in our observations, there appears to be a trend for this type of portfolio. Whether the average investor knows it or not.
So, here’s another story… years ago we had a client move his portfolio from one of the large firms. He had his reasons, and we were asked for a second opinion.
One issue was he was receiving 10-15 trade confirmations (small statements that verify trade details) a week. That equates to 40-60 trades per month or 480 to 720 annually. Can you imagine the 1099 at the end of the year??? Ouch…
The main problem with this portfolio was there were several SMAs or Separately Managed Accounts whereby each manager was managing their portion of the client’s portfolio. Not dissimilar to owning several mutual funds and ETFs. Each SMA, mutual fund, or ETF trades the portfolio based on a defined investment objective. In other words, they were trading their own sliver of the client’s portfolio.
Unlike mutual funds and ETFs, the SMAs act more like the trader, buying and selling on the client’s behalf. So, each buy and sell of a stock, the client owns or sells. Mutual funds and ETFs are not this transparent.
It gets more interesting… This same client called one day to direct us to sell a popular streaming service provider whose stock was tanking due to an increase in subscription rates.
Before our advisor got a chance to offer his point of view on the stock, he realized the client owned less than 1% of the stock! If the stock had doubled it would not have impacted on the account. This is the very definition of “worsification”.
Another story we have is from another client, a similar scenario… her portfolio gets transferred in and she had concerns over whether to take her profits in a particular computer/products company.
She knew she had held the security for a long time, and it was making all-time highs. So, she thought she’d “take some off the table” unless her capital gains were too much.
Since the portfolio was new to us, we looked at it to offer our assessment.
We noticed that she owns less than 1/2 percent worth of this stock! The stock had doubled yet had no impact on her overall performance. While she would likely have to pay capital gains, they weren’t even close to a level that would bring her an extra-large tax bill. As a matter of fact, it made more sense to buy more so that if it kept trending higher it may have a positive impact!
Last story but this may also be a scenario you may have come across.
A client out of the State of Washington came to us with a popular problem in the wealth management industry… he could not understand his statements (most people don’t and should review them with their advisor). Most importantly, every meeting he had with his advisory team took several hours to explain all the investments in his portfolio. He often left those meetings more confused than ever.
He got referred to us by his sister so he contacted my partner and asked if he could share his portfolio with him to get another opinion.
As it turned out, we could barely figure out how this guy’s portfolio worked. Way too many investments… several SMAs and several alternative investments. In our opinion, the portfolio has become too complicated with too much going on.
Even for a portfolio of his size, we knew we could drastically slim down the number of investments and still offer a more condensed version of diversification. We knew it would be easier for him to read his statements.
In my opinion, I don’t think we as advisors have to complicate things. Regular readers of On Pointe WM experience our many and varied analogies to help translate Wall St. to Main St.
While we may invest in SMAs, typically they will be investing in a similar way to us. Or we may bring in an SMA manager whose strategy may complement. What this does NOT mean is to keep adding and adding securities. In some cases, an ETF may be a better representative of a particular asset class, style, or market cap than another SMA. That helps to maintain diversification without adding another layer of individual stocks.
Simply put, you don’t need to complicate the portfolio and we believe it is best to have sensible, condensed diversification.
Look at your statements… how many mutual funds/ETFs/SMAs do you have? How many pages of securities do you have for your equities? Think about whether your portfolio is diversified or “worsified” and how this may affect your retirement goals. We can schedule a “Second Opinion Session” for an opinion on your portfolio construction… Book your Second Opinion Session HERE.
Take care,
James S. Gibbons
*Note-SMA or separately managed accounts are portfolios guided by an outside money manager who takes discretion over the portfolio. |
