Asset allocation errors often stem from over-concentration or diversification, ignoring personal risk tolerance, herd mentality (following market trends), infrequent rebalancing, and forgetting about fees/tax impact. Portfolios left unaltered can swing more than 20% from their original risk levels in a decade; after 30 years, paying just a 1% management fee could slice overall returns by up to nearly one-third. Indeed, avoiding these mistakes requires portfolio adjustments in keeping with risk tolerance that account for the long-term effects of fees and taxes.
Over-concentration or over-diversification
Over-allocating in investing means investing all that money in one asset class or individual stock. Prior to the 2008 financial crisis, for instance, a popular mistake among investors was over-allocating their money into real estate and highly leveraged financial stocks. These investors all suffered significant losses when the real estate market went bad. To give you some perspective, the S&P 500 index lost 37% in 2008, while the financial sector was down even more at 57%. Local money managers who had been overweight in financials were hit hard, with the biggest funds (not only here but everywhere) unable to exit positions quickly enough.
Over-diversification in investments means you have your funds spread too thin across multiple asset classes. After 20 individual stocks, however, the benefit of diversification starts to diminish significantly, and then we see very little increase in returns. Investors who held 50 different stocks in 2020 had an average annual return of 8.1%, while those who held only 20 stocks saw their investments grow by more than 8.5% annually, according to research conducted by Morgan Stanley. This shows that over-diversification could be reducing the performance of a portfolio.
Ignoring personal risk tolerance
Although risk tolerance varies from investor to investor, too often we overlook this and act against our asset allocation. Fidelity notes that over 60% of millennial investors were “overwhelmed with anxiety” during previous stock market volatility events, causing many to sell stocks before they should have and missing out on the subsequent gains. From 2009 to 2020, someone who owned the S&P 500 averaged a compound yearly return of 13.6%, while active traders on average only made about 4.25% per year during that same period. This low return results from a disregard of personal risk tolerance, for the most part.
Blindly following market trends
Another often-discussed issue is chasing market hotspots. Many investors started blindly buying “metaverse” stocks in early 2021, but in 2022, metaverse-related stocks underperformed badly, with the Metaverse ETF plummeting almost 50%. Investors who bought at high prices during the peak and sold low triggered by a market crash suffered significant losses.
Take, for example, the cryptocurrency market. Investors were attracted by the $750 billion market value of cryptocurrencies at the start of 2021, and according to CoinMarketCap, this market value ballooned to as high as $2.8 trillion by November. However, in 2022, a market crash wiped out over $2 trillion in value, causing significant losses for many investors who entered at the peak.
Lack of regular adjustments
Asset allocation evolves with the market and your financial situation. Such inertia could cause portfolios to drift over 20% away from their target risk level after a decade, according to Vanguard’s research. For example, if an investor defined a 60% stock/40% bond allocation in 2012 and made no changes at all, the balance might now be sitting at something like 75/25, which could far exceed their initial risk tolerance. It is vital to adjust the asset allocation according to market conditions to ensure a balanced portfolio and avoid overexposure to any particular category of assets.
Overlooking fees and tax impacts
While not a direct part of the investment itself, fees and taxes are important components of your potential return that many investors forget when considering where to invest their money. Over the long term, a fund with an average fee of 1% can reduce total returns by up to 28%, according to Morningstar data. For example, a $760,000 portfolio with an annual return rate of 7% over the course of 30 years will be depleted by about $200,000 if it has to pay as much in management fees.
Taxes also play a significant role and should not be ignored. For example, this can lead to higher tax incidence on capital gains if assets are sold without planning in advance with respect to tax optimization benefits. In the United States, long-term capital gains tax rates range from 15% to 20%, and not taking taxes into account correctly when fine-tuning assets can significantly reduce net returns.
