Strive for Simplicity in Your Portfolio

Physician's Money Digest, February15 2003, Volume 10, Issue 3

Physician-investors' portfolios of a few milliondollars or more tend to be complex.Invariably, these portfolios include 30 ormore individual stocks; a few dozen mutual funds;a large number of taxable and tax-exempt bonds;and some complex securities to boot. Even with allthese securities, most of the portfolios Icome across are dangerously concentratedin a few highly risky sectors of themarket, and are not well diversified.

My greatest concern about suchportfolios isn't what they contain, butthe careless planning they represent.This isn't entirely the fault of investors,but of the financial services and mediaindustries. They bombard physician-investorswith conflicting, confusing,and often dangerous investment advice.

CHINESE MENU APPROACH

Most investors feel compelled to takethe Chinese menu approach to designingtheir portfolios—take a few thingsfrom column A, a few from column B,and so forth. They never feel confidentwith any recommendation to put muchmoney behind it and stick with it for the long run.

So they put bits of money in everything theyfind interesting, ending up with a big mess.They're never sure when they should sell any ofthese positions, so they either sell at the wrongtime or after some short-term disappointment,or hold on to them through steep declines andsometimes even bankruptcies. These add up tohigh risk and poor long-term returns.

Well-designed, simple portfolios are certain tooutperform almost all complex portfolios in thelong run. Managing a complex portfolio entailsmaking hundreds of buy-and-sell decisions overthe years, which is not just expensive in terms oftransaction costs and tax consequences, but itexponentially increases the chances ofmaking wrong decisions. Even WarrenBuffett says that he is capable of makingonly a few dozen good investment decisionsover his lifetime. So what are thechances that you and I, mere mortals,will be able to make hundreds of rightdecisions over the years? Slim to none.

PORTFOLIO IMPROVEMENT

Here are a few rules that will dramaticallycut down the complexity andcostly turnover of your portfolio, andimprove its long-term performance:

First, never buy any individual stock.No matter who recommends it, no matterhow much you like the company,there is no evidence that you or any ofyour gurus can consistently predictwhich stocks will shine in the future andwhich will fall by the wayside. Also, you need atleast 50, preferably closer to 100, randomly selectedstocks to have a well-diversified portfolio. Evenif your portfolio is large enough to hold 100 stockseconomically, you are not going to have the time toselect and manage that many stocks carefully. Youmay feel very enthusiastic and work hard on yourportfolio when the market is going up, but duringthe inevitable downturns, you will get dispiritedand let your portfolio wither while you try to distractyourself from the losses piling up. Rather thanbuying individual stocks, invest in mutual funds.

Second, follow the 10% rule. Never buy amutual fund unless you are willing to invest in it10% or more of your portfolio. If you do not feelcomfortable enough with a fund to do so, it's notfor you. This will automatically constrain yourportfolio to 10 or fewer funds, which is exactlywhat you want. This also means that you mustbuy well-diversified funds; otherwise, your portfoliowill get overly concentrated.

Third, buy a fund only if you feel confident thatyou will hold it for at least 5 years. Of course,things can change along the way, forcing you to sellearlier (eg, the manager you were counting onleaves). Upfront, if you do not like a fund enoughto think you will hold it for 5 years or more, it isnot for you. This also points out the danger ofinvesting in funds managed by "star" managers.Most of these stars are really not worth the billingsthey get. Betting on them may only increase youranxiety and your portfolio's turnover.

Fourth, recognize that bonds are at least ascomplex—if not more complex—than stocks. Thebond part of your portfolio needs to be well diversifiedtoo. So unless you have a large enough portfolioand know enough about bonds, you're betteroff holding bonds through mutual funds as well.That will reduce the complexity of your portfolio.

We ultimately learn from experience thatsimple is always better than complex. It's no differentwhen it comes to investing. Don't wastetime and money to learn that lesson by makingyour own mistakes.

Chandan Sengupta,

author of The Only

Proven Road to Investment

Success (John

Wiley; 2001), currently

teaches finance at the

Fordham University

Graduate School of

Business and consults

with individuals on

financial planning and

investment management.

He welcomes

questions or comments

at chandansen@aol.com.