In today's market environment, it's especially important to help prepare your portfolio to weather whatever might come its way. In just the last few years, we've experienced geopolitical turmoil, rising market volatility, and the highest inflation in 4 decades—not to mention increased uncertainty about what to expect policy-wise out of Washington DC. Amid these challenges, many investors have felt unsure of where to turn.
As a result, it may feel like the fate of our financial futures depends on circumstances well outside of our control. And while it's true that there's little we can do about inflation or economic policy, we're not powerless. There are levers that all investors can move to help protect their assets, "battening down the hatches," so to speak, so that when the market enters rough waters, they may be able to sail through them with more confidence.
Investors should be conscious of a few subtle headwinds that can potentially reduce the overall efficiency of their portfolio. Here are 3 reasons why your portfolio may be underperforming relative to the markets and your expectations, and how you may be able to address them to help position your portfolio for success.
1. You may be holding too much cash
Holding some of your portfolio in cash or other short-term investments is often necessary, such as when you have a short-term goal in mind—that is, a goal you will need the money for in the next 3 years. However, holding more cash than you strictly need for such goals, or for daily spending or emergencies, can leave you vulnerable to a few less obvious risks. Chris Johnson, CFP®, CWS, a vice president and wealth management advisor at Fidelity says that in times of uncertainty, some investors may consider bailing out of the market completely and moving to cash as a means of managing risk. "That may be the worst thing they could do in a cycle like this," he says.
Inflation, for instance, can significantly erode the purchasing power of your dollars. This can be particularly insidious, because while the balance of your cash allocation may look stable, it is in fact losing value. For example, with an inflation rate of 2.5%, a cash balance of $100,000 could lose about $12,000 in value over 5 years. And by not being invested, you're missing out on the potential for long-term, compounding growth that could provide a chance to keep up with or even potentially outpace inflation.
2. You may be holding too much of a single stock
Some investors may have a significant amount of their portfolio tied up in a single stock, perhaps because they received it as compensation from their employer or have a sentimental attachment to a particular company. Even if you've seen excellent performance from such an investment in the past, it's important to recognize that a single stock can have 3 times as much volatility as a diversified index, potentially exposing you to significant risk.1
"I try to remind my clients that they shouldn't love something that can't love them back," says Marshall Baker, CFP®, CWS, vice president and wealth management advisor at Fidelity. "It's easy to get emotionally tied to an investment, but it's definitely not reciprocated. There's a disproportionate amount of risk in holding a single position." From 1980 to 2020, 40% of stocks within a diversified index lost 70% of their peak value,2 and in March 2020, 63% of individual stocks underperformed a diversified index.3
If you find yourself overly concentrated in a single stock, there are options that may help you to reduce your concentrated position—and the risk it can bring—in a thoughtful manner. This could include a multi-year selling strategy to help spread out realized gains, investing new funds into more diversified positions, or gifting shares to family members or charitable organizations.
If you're having trouble moving on from a position that's meaningful to you, Baker suggests asking yourself the following questions, which he often uses with his clients. "If you had a sudden windfall of cash, how much of it would you invest in this position?" he asks. "Hypothetically speaking, what would change about your lifestyle if your portfolio doubled or tripled, and what would change about your lifestyle if your portfolio lost half or two-thirds of its value?"
"The vast majority of the time," Baker says, "my clients say that nothing would change if their portfolios doubled or tripled, but that things would change dramatically if it lost half or two-thirds of its value. And what I tell them is that while that single position may have helped them build wealth, diversification may help them retain it."
3. You may be paying too much in taxes
While every investor is conscious of the role taxes play in their portfolio, sometimes it can be easy to forget exactly how much of an impact they can really have. A Morningstar study of pre- and after-tax investment returns from 1926 to 2020 showed that taxes may reduce portfolio returns by 2% on average for investors who do not account for them when making investment decisions.4
"Taxes are one of the biggest headwinds that investors need to overcome," says Johnson, "and one of the easiest to control, because it doesn't require changes to their lifestyle. It's entirely within the investor's control to make decisions to help mitigate the impact of taxes."
Investors looking to better prepare their portfolio for taxes may be able to take advantage of techniques such as tax-smart asset location to help ensure that they are placing particular investments in the type of account most appropriate for it—for example, placing dividend- or income-generating investments in tax-deferred or tax-exempt accounts. Tax-loss harvesting, to realize losses that may be used to offset the tax impact of realized gains, may also be an effective technique.
Work with your financial professionals
Cash, concentrated stock, and taxes can all act as a drag on overall portfolio performance, but it is possible to mitigate these headwinds and prepare your portfolio to help you feel confident that you're getting the most out of your investments. That said, before you determine the next steps for you and your portfolio, consult with your tax advisor and financial professionals and work together to identify the most appropriate approach for your specific situation.