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What might not belong in your portfolio

I've written extensively on what goes into a portfolio: a diversified mix of asset classes that fit your risk tolerance and risk capacity, perhaps tilted towards factors of increased returns. Sometimes, though, it makes sense to talk about what might not belong in your portfolio.


Now, the emphasis here is on the word "might"; you may have your own reasons for holding a security that outweigh the factors I talk about below (e.g. individual stocks with a low cost basis), or the research may simply be inconclusive enough that you decide to go ahead anyway (e.g. cryptocurrency or commodities), or you may simply want to take a gamble (as long as you can afford to lose!) (e.g. IPO's). Before you do that, though, I just want you to be aware of why I don't just recommend these straight out of the gate!


A note before we begin: I'll be talking about "efficiency" a fair amount. When I use the word in the context of a portfolio, I mean specifically "being adequately compensated for risk". High volatility + low return = low efficiency; low volatility + high return = high efficiency.


A mishmash of mutual funds and other securities that you "like": First and foremost, please sit down and create an Investment Policy Statement. Determine what you want to hold, and in what proportions, and what you're going to eschew, and most importantly why. Again, it comes back to risk tolerance and risk capacity: how much risk do you want to take? How much risk must you take? How much risk can you afford to take? Build your IPS around that, and build your portfolio around your IPS, and don't let it accumulate random securities that don't fit. Now, if you want to assign a specific percentage -- say, 5% -- to "speculation", to lottery-ticket type securities that you think are going to go big, then that's fine. Just make sure you if your speculations go sour, it doesn't take your financial plan with it!


Individual stocks: Investment research is pretty clear on this front: speculation on individual stocks is not playing the odds in your favor. The market is efficient enough such that, long term, the chances of you consistently picking stocks (and selling them at the right time!) in such a way as to outperform the market are vanishingly small. Now, you may get lucky (just like in a casino), but the house will eventually win (also just like in a casino)!


Employer stock: Holding stock in your employer's company is doubling down on an already relatively-high-risk situation: if things go poorly for them, you could take a hit to your portfolio and your income! And, of course, you're speculating on an individual stock; see above.


Individual bonds: Similarly to individual stocks, there's little if any benefit to holding individual bonds. Sure, you can build your own bond ladder for "free", but the diversification, liquidity, simplicity, low trading cost, and efficiency of bond funds outweigh the benefit of the "DIY" approach the vast majority of the time.


Long-term bonds: Bonds with a maturity 10 or more years out exhibit a volatility often similar to stocks, but without commensurate expected returns. Now, they can provide some diversification benefit -- their volatility is quite uncorrelated with that of stocks -- but they should be handled with care, given their relative inefficiency.


High-yield bonds: These bonds are called "junk" bonds for a reason: this asset class has low expected returns relative to its volatility, and moreover has a tendency to be highly correlated with stocks at the worst possible times!


"Income"-based securities: There is advice floating around the that suggests that income-producing securities -- high-yield bonds, dividend-producing stocks, etc. are a Good Thing. And there are mutual funds built around this idea, often having "income" in the name of the fund to make that clear. While appealing, the idea is misguided on several levels: research indicates dividends have no effect on expected returns, "reaching for yield" can cause you to create a portfolio with undue risk, and from a tax perspective, generating ordinary income is almost unilaterally worse than generating capital gains!


Commodities: Commodities are extremely volatile and have low expected returns, and thus are often excluded from portfolios from a pure efficiency perspective. However, there's some research that indicates a diversification benefit to holding them, given their low correlation with both stocks and bonds, so while Seaborn doesn't currently build commodities into any of its portfolios, I won't shake my finger at anyone who holds a small amount!


Cryptocurrency: Like commodities, cryptocurrency is extremely volatile and appears to have a low correlation with other securities; however, unlike commodities, crypto is as of yet extremely ill-understood as an asset class, as well as being poorly regulated in may instances. So: if you're going to hold it, at least consider making the percentage of your portfolio small, and holding it at a reputable broker such as (as of this writing) Coinbase.


Margin: Margin isn't a security per se, but I'd be remiss if I didn't talk about it. Be extremely, extremely wary of using margin in your investments; almost by definition, it's money you can't afford to lose, so why in God's name are you putting it on the table? (This is one of several reasons I dislike Robinhood; its easy margin and overall design encourages the worst addictive tendencies!)


IPO's: Everyone likes buying a lottery ticket, right? And that's the problem: "lottery tickets" are popular, because everyone likes the idea of "winning big". This in turn bids up the asking price of lottery-like securities like IPO's, which in turn lowers their returns, such that in aggregate, they underperform relative to their volatility.


OTC/"penny" stocks: Stocks with an extremely low market price are ripe opportunities for bad actors engaging in "pump and dump" schemes, where they purchase the stock, spread misinformation and otherwise fraudulently bid up the price, and then sell their shares. Stocks that trade "over the counter" rather than on an exchange are even more susceptible to this. Add this to the fact that, like IPO's, they act like "lottery tickets" in a way that can unduly drive up their asking price, and you've got a recipe for potential disaster.


Having said all that...


It's worth repeating that I'm not necessarily saying that you shouldn't ever have any of these in your portfolio; rather, I'm saying that you should pause and consider before including them based on something you read -- or, worse, something you "just feel in your gut".


And if you're wondering what you should have in your portfolio, consider reading up on risk tolerance and risk capacity, modern portfolio theory, factor-based investing, and of course using those to build an Investment Policy Statement. And feel free to post a comment or a question here -- I answer all of them!

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