Portfolio Enemy #1

From 1996 through 1999, a silent killer grew and overtook the portfolios of nearly all US investors.

I fear it’s on the move again.

Working quietly, like a kind of virus, this enemy enters your portfolio and slowly takes over.  By the time an uneducated investor realizes there’s a problem, it’s almost always too late.  Before I tell you the name of this villain, let me tell you a sad story.

During the late 90’s, advisers like me who promoted the use of multiple asset classes (like large companies, small companies and value companies for example) took criticism for that position.  US large companies were having a very hot four-year run.  During those years, depending on your mutual fund, if you had owned all or mostly all US large companies, your portfolio would have more than doubled.

Our story begins late in 1992.  An investor invested $100,000 into five mutual funds.  These five mutual funds were chosen as a result of their differences.  He owned small companies, value companies, bonds, large companies and an international fund.  He purchased $20,000 of each.  He was diversified and he felt good about it.

By 1997, his total portfolio balance was $125,000, but only one of the funds did very well at all.  The large company fund was almost $45,000 and the other four had gone up and down but stayed roughly the same. All four totaled not much more than the $80,000 they started out at in 1992.  Depressing!

He decided to get involved. Every magazine cover he looked at in 1997 showed investment returns like the returns he was getting in his large-company fund.  Over and over this new knowledge was confirmed.  He started listening to himself. “I new I should have put more in that one fund in 1992” His sub-conscience was condemning him.  Why did he allow that investment adviser to talk him into those other funds?  After all, shouldn’t an adviser be able to predict the next hot fund or sector?  What was he paying him for anyway?

By now, nearly all of the media attention “news” on the investor shows was on large US companies and the funds that owned them. The investor made his first move based on his new knowledge. He sold the value company fund and moved it to another large US company stock fund.  Very quickly, he was rewarded for doing so.  It was only half way through 1997, and these two mutual funds were up even further; he now had $140,000 in his total portfolio.

This caused him to cash in the small company fund as well as the international fund, trading both in for more large US companies.  But remembering that diversification is important, he chose funds by the name “high tech” and “medical tech.” They were all US large companies, but the “focus” of the mutual fund manager, the expertise in business analysis, was different in each fund.  He still felt diversified.

By the summer of 1998 he was rewarded again.  Everything was up now.  Well . . .  everything except for his bond fund.  By now he had over $190,000 in his total portfolio.  He had almost doubled his money since 1995.  The bonds were around $22,500 while all of his other funds were over or nearing twice their original value.

He sold the bond fund mid-year 1999.

“All in” now, rounding 1999 and heading for 2000, he had a portfolio valued at nearly $210,000.  It was all in US large-company stock, but of varying market sectors.  He still felt diversified and had already done the math on his $210,000 fund.  It might as well have been 2005, and his fund might as well have been $420,000.  He was confident that this was in his future, doubling money every 5 or 6 years.  He would be a millionaire by the end of 2012, he figured.  “Maybe I should buy the cottage now while prices are still relatively low,” he mused.

During early 2000, you would not have been able to hear a pin drop if you were a super hero with super hearing. But hear it or not, there was a pin, and it popped the villain and took the air out of it in short order.

You see, the villain in this story was a slowly growing bubble.  First it was one fund out of the five, then two out of five.  Then three and four, and finally, all five of our investor’s funds were in five essentially identical mutual funds.  The silent killer was a portfolio bubble.

Though the mutual fund managers named their funds differently, they all owned essentially the same companies.  GE and IBM for example fit the descriptions for almost every category named by mutual funds.  Apple found its way into almost every fund as well.  With the typical mutual fund holding between 200 and 300 of the most popular companies in its class, US large company mutual funds became so closely identical by holdings that when one moved, they all moved – in lock step.

When things were good they all went up. And when things were bad . . . well . . .


By the end of 2000 his account balance was $150,000.  He was not sure where to go.  Hold on for a bit – markets rebound, he said.

He goes to his adviser for a pep talk.  The adviser assures him that market corrections are normal and that markets rebound – he should stay put.  Gut confirmed.  Stay put.

So he stays put – he stops opening the statements for a few rotations.  At the end of 2001 he opens his statement and finds what he feared – a balance of $110,000.  He is dangerously close to his 1992 balance.  And ten years later! How could this be?  He starts to sell the large-company funds one at a time.

He goes into small-company funds in 2002 – why not? These funds did very well in 2000 and 2001.  He feels smart and decides that next time he’ll see it coming a little farther ahead and make the move sooner.  But not to worry.  He still has his $100,000, plus a little bit . . . and now he knows better.

Or does he?

Tune in again for the rest of this story.

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