NEW YORK (CNNfn) - As the year creeps to a close, financial advisors recommend taking time for a review of your investments.|
"It’s winter, things do start to slow down, and it’s a good time to spend a couple of hours organizing your stuff,” said Dee Lee, who runs Harvard Financial Educators in Harvard, Mass.
Brokerages issue 1099 forms for stock sold during the year, and many provide year-end snapshots of investors’ accounts. Since you have the paperwork and you could start organizing for tax time, year-end is a good time to review how your assets are allocated, Lee said.
Assess whether your investments have lived up to reasonable expectations, she suggests, and see if there’s any reshuffling to be done. Lucky investors may also be deciding what to do with a Christmas bonus.
But many investors make the wrong comparisons when they’re evaluating what they hold and how their investments have done, financial advisors say. A few investors also come to the wrong conclusions, they say.
The indexes can be misleading
If you are investing for the long haul and want to make sure you aren’t taking unnecessary risks, rebalancing your portfolio is an important step, investment gurus say. Most recommend overhauling your portfolio at least once a year, preferably at a set time each year. At year-end, the task is a little simpler because statistics are easy to find.
"Rebalancing is a very important process in maintaining your risk allocation and ensuring you meet your goals,” said Marc Freedman, president of Freedman Financial Associates in Peabody, Mass.
The first mistake that many people make is to use the wrong benchmarks, financial advisors say. For instance, there’s normally a spate of stories about top-performing stocks, asset classes and mutual funds. Though it’s tempting to compare your performance with the high fliers, it’s also misleading, Freedman said.
He is only partly joking when he says investors would do better to compare their portfolio with the worst performing asset class for the year. That’s the last place they want their money. As long as they’ve done better than that, their asset-allocation plan is working to some degree, he pointed out.
Diversification means not matching the best
Most people look at investment performance the other way round, Freedman said. "Unfortunately, everybody compares their portfolio with the best-performing asset class.”
This year, for instance, investors may envy the performance of the Nasdaq composite index. It has roared away, posting a return of 77 percent through Dec. 21. That leaves the Dow Jones industrial average, the S&P 500 and the Russell 2000 in the dust, at 22 percent, 17 percent and 13 percent, respectively.
Don’t get bent out of shape that you haven’t matched that performance, Freedman said. The very idea of diversifying a portfolio guarantees that you won’t match the best-performing index or sector. But you beat the worst-performing indexes and investment classes, something investors who only look at the top performers forget.
"If you focus on a particular index, you’re comparing your one investment with a particular investment style,” Freedman pointed out. Nasdaq has benefited in 1999 from the tremendous performance of many technology stocks, for instance. Most investors should be leery of putting all their eggs in that basket, stock experts say.
Maria Scott, editor of the American Institute of Individual Investors’ AAII Journal, said investors should really consider taking an amalgam of index performances that matches their holdings.
For instance, if you’re 30 percent in small-cap stocks, 30 percent in large-cap stocks and 40 percent in bonds, work out the combined performance of a small-cap index, a large-cap index and a bond index "in proportion to the same allocation you’ve got in your portfolio,” she said.
Ask why your laggards performed poorly
When investors are evaluating performance, they should ask whether their investment has performed badly or whether the whole sector has dipped. That’s particularly important when it comes to mutual funds, Scott said, when you have to consider whether the fund is poorly managed or simply in a sector that is temporarily not doing well.
Investors tend to be very disappointed by the laggards in their portfolio. That’s understandable, Scott said, "but you have to realize you’re always going to have some of those sectors in there,” she said. "That just means you’re diversified.”
Rebalancing will also force investors to sell in areas of the market that have performed well. Investors are often reluctant to sell when a stock is up, or they will hold onto poorly performing investments that they hope will rebound, Lee said.
Sticking to an asset-allocation plan and measuring performance properly helps investors work out a sell strategy, which some financial advisers say is the No. 1 problem for most investors. "Selling is much harder than buying,” Lee agreed.
What’s a good range?
The asset allocations that you pick depend on your tolerance for risk, your age and whether you are looking for income or growth. In general, all investors should have at least a 50 percent commitment to equities, Scott said.
A retiree may want to consider designing the other half of their portfolio to provide income, through a laddered bond program or through high-dividend-paying, stable stocks they can sell regularly and are likely to hold their value. But even a 65 year-old retiree may well be in the market for another 20 years, Scott pointed out.
Young people who can tolerate risk can go as high as 90 percent in stock, Scott said, with the rest of their assets in cash or money-market funds or very short-term fixed-income investments, so they can tap a little cash as needed.
Consider putting at least 10 percent of your portfolio in each area of the market, she suggested, putting 10 percent into in small-cap and international stocks or funds, for instance, and blending growth and value approaches. Reserve the bulk of the portfolio in large-cap stocks, the core holdings. The rest "can vary depending on risk preferences and which area of the market you think will grow most,” Scott said.
Avoid chasing returns
Rebalancing is easier to do in tax-deferred accounts such as retirement accounts. Otherwise you should talk over the tax consequences of any sales you’re considering with your financial adviser, Lee said.
If you’re rebalancing your portfolio after some of it has performed well, "yes, you sell some of it and take it off the tables.” But try and avoid short-term capital gains on stock you’ve held less than a year, which are taxed at your marginal tax bracket rather than the 20 percent rate for long-term capital gains, she said.
Once you’re rebalancing, you’ll need to pick what to do with the proceeds of any parts of the portfolio that you sell. Avoid chasing returns, financial advisers insist, a mistake many investors make.
Lee calls it the "brother-in-law effect.” Over the holidays, investors get jealous of the stellar, market-topping performance their brother-in-law is getting from his top mutual fund. "He doesn’t tell you that in the other seven funds he has he only got 12 percent, or 2 percent,” Lee said.
All investors have read the boilerplate stating that past performance is no guarantee of future results. But there are reasons the boilerplate exists. First, a hot fund attracts a large influx of new money, which may make the investment objectives tougher to sustain, particularly if the fund invests in smaller companies. For that reason, some mutual-fund managers have taken to closing funds that get particularly popular.
And a fund that shoots up in one year is more likely to have erratic performance. "When you’re a home-run hitter, you also strike out a lot,” Freedman said. He looks to put his customers in funds "that hit singles and doubles consistently.”
Take the Van Wagoner Emerging Growth fund. It’s the third-best performing equity fund in 1999, according to fund tracker Wiesenberger, up 240 percent year to date. Time to jump in, right? But in 1998, it only had an 8 percent gain, and in 1997 it lost 20 percent. The fund is volatile, thanks to a concentration on technology, which suggests that buying in after a peak in its performance is a bad idea.
Most investors don’t think that way. "People do tend to place too much emphasis on what just happened, and let that cloud their thinking as to what areas they should be going into in the future,” Scott said.
John Gannon, acting director of the Securities and Exchange Commission’s Office of Investor Education and Assistance, also cautioned against chasing performance. "This year’s top performer is unlikely to be next year’s,” he said. "A very small fund can have an excellent short-term performance record. But you need to take into account how long you’re investing for.” Look at least five years, he suggested, and consider how volatile the performance has been, too.
Gannon said that investors should consider issues other than performance, too, particularly when it comes to mutual funds. Fees and expenses are vital to watch, he said. Investors will also want to avoid buying into a mutual fund around the time it makes its capital-gains distribution, which can cause a tax shock for investors.
A regular, organized asset-allocation plan and a good year-end review may also help you keep your investment goals a little more clearly. It should also stop investors hurting themselves through capital-gains taxes by selling too frequently.
"People need to post what their investment goals are and refer to them on a regular basis, rather than changing them because of what Peter Jennings says on the 6 o’clock news,” Freedman said.