An Early Warning System for Your Investment Portfolio

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It’s every investor’s worst nightmare. You check your portfolio one morning and find it’s worth much less than you thought, or has lagged the market significantly. In my experience, that usually happens due to a lack of diversification. Imbalances of different kinds can sneak up on even the most experienced investor. (I’d categorize my most significant investing mistakes as errors in diversification.) Wouldn’t it be nice to have a simple system in place that could tell you if you’re veering off track? Well, I don’t know of a completely automatic and foolproof system — other than perhaps investing your entire portfolio in a target date fund. But the measures described below can go a long way to keeping you out of trouble.

Diversification is one of the handful of core investing principles. But how do we measure or quantify it? There are more academic approaches, but for everyday management I like a simple collection of percentages, measuring what portion of a portfolio is invested along certain key dimensions. Together these metrics can form an “early warning system” for your portfolio, alerting you if you’re becoming dangerously concentrated in any one area. Just like warning lights at sea, or on a car’s dashboard, they will alert you if your portfolio needs attention.

Each of these diversification metrics takes the form of some quantity as a percent of your stock holdings (all stocks) or of your portfolio (all investments) or of your total net worth (all investments + personal property). Here are the measures I’ve found most useful:

  • stocks/portfolio: the allocation between stocks and bonds may be the most important distinction in your portfolio. This division will have a fundamental impact on your expected long-term returns, and volatility. Keep this number in prominent view at all times.
  • individual security/portfolio: for each individual security you own, you should know what percent it represents of your total portfolio. Extremely small positions may not be worth your time. Even if one does spectacularly well, you haven’t put in enough money to have a significant impact on your overall return, in most cases. Extremely large positions, on the other hand, represent risk, unless they are well diversified.
  • growth/all stocks, value/all stocks: “growth” and “value” separates stocks in the investing universe based on book values or earnings. If you invest in the entire market, then, of your stocks, 50% would be growth and 50% value. Many studies have found that value stocks have higher returns over the long haul. Overweighting them may give you better long-term performance, yet they are cyclical, so that can also cause your portfolio to underperform for long periods.
  • asset class/portfolio: there are two significant asset classes beyond stocks and bonds that I recommend investigating, once you move beyond entry-level investing: real estate and commodities. But both can be volatile, and cyclical. If and when you do invest, watch your allocations carefully.
  • actively managed/portfolio: few active fund managers are able to beat their associated index. However some of us may have actively managed funds in our portfolio anyway. Perhaps we bought them long ago, or received them as gifts, or as an inheritance. Or perhaps we are simply hedging our bets on index investing. At any rate, given the costs vs benefits of active management for most asset classes, I would recommend ensuring that the bulk of your portfolio is in low-cost passive index funds.
  • non-dollar/net worth: just as you would not put all your investments in the stock of a single company, you should not have all your assets in a single country. Long-term demographic and economic trends do not favor the U.S. Any number of unpredictable short-term events could hurt the dollar. So it is advisable to have a meaningful portion of your net worth in assets that are not tied to the health of the U.S. or the dollar.
  • government/net worth: though long-term trends may not seem to favor the U.S., don’t count us out. Legendary investor Warren Buffet continues to feel that the U.S. has the best economic and political system in the world. And any number of short-term events, from global depression, to European defaults, to wars or disaster overseas, could send the world packing into the historical safe havens of the past century — the U.S. dollar and Treasury bonds. Hence it is wise to have a meaningful portion of your portfolio in safe, familiar U.S. bonds, Treasuries, or other government obligations.
  • inflation-protected/net worth: inflation is the termite of the financial world, silently eating away at your nest egg until one day there is much less floor underneath than you thought. Inflation is the primary risk factor in investing too conservatively. So it is wise to track which assets in your net worth carry some degree of inflation protection. For starters, you should include any inflation-protected bonds or commodities that you own, as well as real estate, and even some stocks in this number. All of these have been historically resistant to inflation.

So those are some of my favorite simple indicators for managing risk in an investment portfolio. For more detail on exactly how to compute these quantities, what to include and what to exclude, stay tuned here for more on the topic.

And now, how about you? Have you ever been burned by a lack of diversification? Do you have any favorite measures for keeping your portfolio off the shoals?