Is Your Portfolio Space Efficient?

The key to Hong Kong survival is efficiency.  We have to be time efficient, cost efficient and – I think we can all agree – space efficient!  Take my closet for example, which is crammed with too many similar and/or “what was I thinking?” items; hardly the model of space efficiency.  It’s time I let go of misguided shopping decisions to make room for a wiser mix of wardrobe choices.  This sounds a lot like portfolio optimization.  Is your portfolio space efficient?  Here are some tell-tale signs that it could use a rethink:

 

Holding on to poor decisions.  Are you holding on to bad investment choices in hopes that one day you will recoup your losses?  This inability to let go of losing strategies is known as the “sunk cost fallacy.”  No one likes accepting a bad purchase, but there are ways to deal with this challenge[1].  The first is to accept that not every investment will be a winner.  You should also be mindful that while risk and return are related, not all risks are worth taking.  Or, if you can’t help yourself, at least ensure adequate portfolio diversification to balance the risk.  Lastly, don’t fall in love with your investments; stay disciplined in your approach.

 

Cash hoarding.  Yes, a rainy day fund is necessary but perhaps you’re letting the actual rainy Hong Kong weather get to you.  By parking too much of your wealth in cash, you will likely miss out on better return prospects, especially over the long term.   Take one-month U.S. treasury bills for example.  Since 1926, they have returned an annualized 3.4%, barely covering inflation at 2.9% and underperforming long-term U.S. government bonds at 5.5%, U.S. large cap stocks at 10.2% and U.S. small cap stocks at 11.5%[2].

 

Illiquidity.  Although it’s the polar opposite to cash hoarding, an excessive allocation to illiquid investments (e.g., property, private equity, thinly traded securities) also has its downsides.  What if all of a sudden you are in need of cash?  You may have to sell at an inopportune time.  Maintaining a healthy level of portfolio liquidity is key to successfully navigating unforeseen events.

 

Inadequate diversification.  If your portfolio is overly tilted towards investments that tend to move in the same direction (perhaps through sector or geographical biases), then you are exposing yourself to unnecessary volatility and / or downside risk.  Through portfolio diversification you can actually lower your portfolio risk, and, in some cases, without giving up expected return.  We have modern portfolio theory to thank for that.

 

Bottom line:  Don’t fall victim to wasted space in your portfolio.  A disciplined and well-balanced approach to asset allocation will lead to a more positive investment experience.


     

[1] “Unhealthy Attachments,” Jim Parker, DFA Australia Limited, October 2015.

[2] Based on monthly returns from January 1926 to December 2017.  US Small Caps is the CRSP 6-10 Index; US Large Caps is the S&P 500 Index; Long-Term Government Bonds is US Government Bonds with average maturity of 20 years; Treasury Bills are One-Month US Treasury bills; US Inflation is the Consumer Price Index. Source: Dimensional Fund Advisors after CRSP, S&P and Morningstar.


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