The Error-Proof Portfolio: 5 Tips for Fighting the Financial Complexity Complex

by: Morningstar

By Christine Benz

The discount retail chain Syms used to use the slogan "where an educated customer is our best consumer."

No doubt, there are many financial-services firms that not only concur, but also walk the talk. They supply their customers with educational articles and tools to help aid in decision-making and eschew trendy, ripped-from-the-headlines product types that they know won't make most customers any money when all is said and done. And recognizing that some consumers just don't have the time or inclination to make good financial decisions, many firms have rolled out sturdy, simplified products like target-date vehicles to help investors reach their goals with as little foul-up potential as possible.

But despite the presence of several good actors (and acts), I can't help but observe that there's a healthy contingent of the financial-services industry that, by its actions, is clearly gunning for a deeply confused consumer. Make that a deeply confused, desperate, trend-chasing consumer. Because the more confused you are, the more likely you are to venture into untested (and often pricey) investments, trade more frequently and pay more commissions than you need to, and clutter up your portfolio with unnecessary product types.

Being aware of what I call the financial complexity complex and its agenda is more than half the battle. Here are some rules to keep in mind.

Rule 1: Don't Buy New (or Evenly Gently Used) Stuff
At the risk of sounding like one of those folks who claim all the good music ended with Exile on Main Street and Abbey Road, truly great financial innovations tend to be few and far between. Target-date funds, as mentioned earlier, were a step forward, and plain-vanilla low-cost index funds and exchange-traded funds can also set investors up for success. But there have been many more failed financial innovations than there have been truly worthwhile ones, making it essential to approach new products with a healthy dose of skepticism and a sufficiently long time frame to evaluate them. Oftentimes purveyors of new products point to strong track records over relatively short, flukey time horizons. But a better gauge of success is solid risk-adjusted results over a complete market cycle featuring a variety of market conditions. Look for at least a decade's worth of performance before biting on a new product, fund, or manager, and an even longer track record if the market during a single decade was dominated by bulls (see: 1990s) or bears (the past decade).

Rule 2: Ask Lots of 'Dumb' Questions
Part of the blame for the flourishing financial complexity complex lies with investors themselves: They're uncomfortable asking enough questions--of themselves or whomever is trying to sell something to them--to fully understand what they're getting into. Oftentimes it's because they're afraid of looking stupid. "This guy does this full time and knows this stuff cold," they think, "and I don't." But truly, the essential questions are usually the most basic, such as "How does this work?" and "What could go wrong?" And you should never be ashamed to ask them. Before pulling the trigger on a new investment, you should be able to answer all of the questions on this checklist, and you should also be able to explain--in your own words--the how and why of that investment to an investing novice. If you can't satisfy that two-part test, pass until you can.

Rule 3: Edit Ruthlessly
One of the first things you probably learned about investing was the virtue of being diversified--that adding additional investments can improve your portfolio's risk/reward profile. That's true, but many participants in the financial complexity complex take that concept too far, recommending overly diversified portfolios and embracing new asset classes as beneficial, invariably after they've enjoyed strong recent performance. But assuming you've built a core portfolio consisting of well-diversified, low-cost core equity, bond, and cash holdings, adding small positions in additional investments is unlikely to deliver an appreciable improvement in your portfolio's risk/reward potential. True, being overly diversified isn't high on the list of the biggest investment sins, but the asset class du jour often has a high price tag attached to it, and having too many holdings imposes extra oversight responsibilities to boot.

Rule 4: Ask Yourself "Am I as Good as a Target-Date Fund?"
One check against an overly complicated portfolio is to benchmark your performance versus an uber-simple yardstick. Have your portfolio's extra moving parts helped or hindered its risk/reward profile versus a cheap, low-maintenance option such a simple balanced fund or a target-date fund geared toward someone with your time horizon? If, over time, you're lagging that benchmark, you may well ask yourself whether a simpler, more hands-off setup might get the job done better than your more complex portfolio. Of course, this exercise won't be particularly useful if your portfolio's asset allocation looks nothing like a target-date or balanced fund. For most of us, though, such a benchmarking exercise can serve as a good safeguard against overwrought portfolios.

Rule 5: If Someone Says They Have All the Answers, Run
One of the hallmarks of participants in the financial complexity complex is hubris--the tendency to assure consumers that they know the unknowable. ("You need us! You really really need us!") The end result is often overwrought products that overpromise, underdeliver, and cost too much. The truly talented investors, meanwhile, are usually among the first to circumscribe their missions. They'll focus on identifying underpriced stocks within the industries they understand, for example. Furthermore, they're quick to say that they can't predict macroeconomic events with any degree of acuity. If your aim is to reduce your portfolio's exposure to the financial complexity complex, cast your lot with the latter type of investor rather than the former.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.