A How-To Guide for Portfolio Review

With their champagne hangovers having worn off,^[i] many investors are now turning to more serious matters: Evaluating the past year. You might be doing the same! However, perhaps you're stuck on how to approach this task. What should you look at? What should you not focus on? Here are several tips to help frame your review as you weigh your investments for 2017 and beyond.

Assess Asset Allocation

Most year-end reviews fixate on performance. That is potentially an aspect to review, as we'll cover, but your review shouldn't start and stop at a backward-looking performance comparison. In our view, the place to start is reviewing whether your overall asset allocation-the mix of stocks, bonds, cash and/or other securities-is aligned with your investment goals.

For folks needing long-term growth to reach their goals or even just outpace inflation, holding some stocks is likely necessary. Yet widespread dour sentiment since 2008 has caused many investors to put too little in stocks relative to their goals and needs. Heck, with abundant speculation about interest rates in 2016's second half, folks increasingly fear bonds, too.

Regardless of the reason, holding large amounts of cash is a potentially large opportunity cost that diminishes growth. While holding an emergency fund or money targeted for a near-term purchase in cash is smart, don't get carried away. If you find you're holding more cash than necessary, investing it may be a smart long-term move.

Diversify Risk

Moreover, your holdings review could reveal the need for greater diversification. Your portfolio shouldn't be invested entirely in one geography or sector. Even if the country/sector is yuuuge and important (e.g., the US) or headline-making and prominent (e.g., Technology), it is still just a portion of a much bigger whole. Spreading your assets across multiple sectors is necessary, as stocks in the same sector usually act similarly.

Ensure you survey all your assets when you gauge this. Many times in recent years, we've encountered investors with substantial weightings in Energy stocks and a big chunk of their portfolio in Master Limited Partnerships-also a play on Energy. Or folks who have large REIT holdings, seeing it as diversification against stocks and not realizing REITs are stocks-they're included in the Real Estate sector, which amounts to just 2.9% of the S&P 500 and 4.3% of the Russell 3000.^[ii]

In our experience, a globally diversified portfolio optimally balances opportunity and risk management, using the market's sector and country weightings as a construction guide. You could use the MSCI World Index to gauge this. This doesn't mean matching the market's weightings exactly. If you believe certain categories will do better or worse, it makes sense to adjust your portfolio accordingly. Whatever your belief, however, you could always be wrong, so having broad exposure mitigates risk.

Leave One-Man Shows to Entertainers

Continuing on the diversification theme, no single company should exceed 5% of your portfolio's value. The higher the percentage, the more damage it could cause should things go awry, as Enron investors can attest. (Which reminds us: Don't load up on your own company's stock, no matter how great you think it is.) A red flag: We often see fixed income investors holding huge individual positions in corporate or municipal debt. Diversity matters in bonds, too.

Holding a diversified portfolio isn't easy-it can require you to sell "winners" and hold or buy "laggards," a decision at odds with human nature. "Order preference," a behavioral error, makes us want to see nothing but green arrows when we log in to our accounts. Yet all assets moving similarly shows a lack of diversity-a big risk.

On Return Calculations

With diversity and allocation reviewed and assessed, let's cover returns. First, a helpful reminder: If you contribute to or withdraw from your portfolio, your return calculations must account for these actions. Obviously, you can't just compare the beginning and ending values. You must use geometrically linked, time-weighted returns, which is as jargon-packed a phrase as you'll ever read on this website. It basically means: Each contribution and withdrawal has a performance impact you must remove. If you are making comparisons, ask your adviser to provide a correct calculation first. They should be able to do so easily. In addition, make sure you include dividends and interest.

The Calendar's Arbitrariness

When you start reviewing the previous year's numbers, don't assume a single year is all that telling. Most investors have much more than one year to plan for, and such short time periods likely don't tell you much about your strategy or portfolio. As for calendar cutoffs, no bull market in history began on January 1 and ended on December 31. There is nothing special about the calendar year-cycles, context and circumstances matter more. We'd humbly suggest a longer timeframe is much more telling.

An Apples-to-Apples Comparison

Whatever timeframe you choose, don't forget to use an appropriate measuring stick (or benchmark). This will depend on your asset allocation and the makeup of those holdings. If your portfolio is 70% equities (stocks) and 30% bonds, it is incorrect to measure returns against a 100% equity index. You'll need a blend.

Even within each asset class, make sure you are comparing like to like. Would you compare the return of an exclusively US stock portfolio to a Venezuelan index? Ridiculous, right? The same error-inappropriate comparison-underlies equating US gauges to global or all-foreign portfolios. If you're globally diversified and own all equities, you ought to compare to a global index. If you are all US, then a US index is appropriate. (And as noted earlier, we think global diversification is superior.) However, not all indexes are created equal: Under no circumstances should your benchmark be a broken index comprised of 30 randomly selected stocks with little resemblance to broader markets.^[iii]

In this same vein, comparing to things like your neighbor's portfolio is a mistake. Even if you're both the same age, grew up in the same neighborhood and are both Libras, she may have very different investment needs and goals, so her asset allocation may not resemble yours. Moreover, you don't know how she is managing for risk: She might own six stocks in concentrated positions with no risk controls-an unwise strategy.

A Final Factor

Finally, an important-yet-overlooked aspect of the annual review should be an appraisal of what you got right and wrong. If, for example, you feared Brexit, Trump and/or Deutsche Bank spelled doom in 2016, don't forget that. Embrace it. Human nature makes us want to shun errors, but they are great tools to learn from. Then, when similar fears crop up, you have valuable perspective to put them in before assessing the particulars.