It is interesting how often lessons are learned the hard way in both life and the investment world.
Take for example my recent trip to the ski hill during which I underestimated my age and overestimated my skill level (having just switched to snowboarding last year). Needless to say, I was rewarded with a nice Ski-doo and ambulance ride before being retrofitted with two new titanium plates in my forearm.
It’s no different in the investment world where overconfidence and inexperience can result in a severely broken portfolio. While there are some great surgeons (and managers) out there who can help repair the damage, prevention is always the most prudent course of action.
To help determine if your portfolio is on solid footing or about to take a nasty fall here are five red flags to look for.
1. Your portfolio has a lot of non-transparent holdings
These can include private investments and exempt market funds such as mortgage investment corporations and real estate plays. Many are problematic due to a lack of transparency in the underlying holdings, excessively high management fees and limited liquidity, meaning you cannot get your money out without large penalties.
Also don’t be fooled by the pitch that they offer great diversification (non-correlation) to existing portfolios because of their apparently stagnant net asset values. The real reason these net asset values don’t move is because there is no market to price the underlying positions until liquidation, which is often at some unknown date in the future and at a big discount.
To be honest, we see no need for such investments in the average investor portfolio. That said, very high net worth individuals can use private markets effectively, as many have the experience and capital required to underwrite their own deals, giving them the control needed to monitor such investments.
2. You own a lot of deal flow
We’ve seen many portfolios comprised entirely of a firm’s deal flow with the transaction history showing nearly every equity deal underwritten being placed in the client’s account. This isn’t surprising as equity financings are very lucrative to the broker or adviser as they get paid a large sales commission to sell the deal, often as much as 5 per cent.
The golden rule to remember is that there is no such thing as a hot deal for regular investors as capital markets groups will relinquish the commission to retail brokers and advisers only if they are unable to sell it to large institutional money managers.
3. Your portfolio is too concentrated
We once saw an 80 year-old grandmother’s portfolio at a bank-owned brokerage contain a 40 per cent weighting to a diamond mine company that went bankrupt with little compensation being provided when she complained to the manager and the ombudsman.
We’ve also come across our fair share of portfolios here in Alberta comprised entirely of oil and gas companies many of which have since fallen 50 to 90 per cent.
A proper portfolio should be well-diversified between bonds and equities according to risk tolerance with not too large of a weighting in any one particular sector or geographical region.
4. You pay excessive hidden fees
Most investors do not realize the nature of the investment fees they are paying until they try to transfer their portfolio to another adviser. Suddenly they are hit with massive deferred sales charges or excessive trading commissions to liquidate the portfolio.
5. You don’t know what an IPS is
Since a fiduciary duty for retail advisers is likely years away, if at all, we recommend that all investors create their own formal investment policy statement (IPS) that outlines their overall risk tolerance and sets the rules around how their portfolio should be invested.
It is an immediate red flag if your adviser has never completed an IPS with you or has not updated it in over a year.
Taking a few proactive steps can go a long way to improving your portfolio’s durability especially when challenging those steep and at times icy markets. - business.financialpost
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