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Wealth Extractions: Taking inventory of your investments

Jan. 3, 2011
By J. Haden Werhan, CPA/PFSEven the best-run dental practice can benefit from a periodic inventory to confirm that what you think you’ve got is in the same ballpark as what you actually do hold in storage. Similarly, your personal investments can benefit from an “inventory,” or what we in the business call a portfolio analysis. One of the main purposes of a portfolio analysis is to determine whether your wealth is well diversified. In other words, does your portfolio contain a truly wide range of holdings within each part of the market in which you’ve chosen to invest? Diversification is a good thing. It helps protect you from the risk of any one of your holdings going belly-up and causing you serious damage — while still enabling you to efficiently capture the returns that are available from the market. It’s about as close as it gets in this world to enjoying a free lunch. Unfortunately, if there’s a common theme during portfolio analysis, it’s that people often think their holdings are a lot more diversified than they actually are. Compare that to how many of your patients talk about brushing and flossing regularly, but when you shine your light on the subject, it becomes pretty clear who’s really walking the walk. So, how do you tell if your portfolio is truly diversified? When we conduct a portfolio analysis for a new client, we often find that the quantity of holdings may seem impressive, but when we poke and prod at things a bit, the façade crumbles and what’s underneath can reveal a dearth of true quality. Instead of holding a wide range of different kinds of companies’ stocks across a wide range of markets, we’ll find:• Enormous, risky investments in one small corner of the market and in only a few kinds of companies (most often big, popular company stocks, known in financial lingo as large-cap growth). • High expenses for the “privilege” of holding on to their undiversified little corner of the universe. With that in mind, here are some of the items we typically check for during portfolio analysis:
Equity (stock) diversification —
We find a significant portion of investor assets are often allocated to individual stocks. Using individual securities to build a truly diversified equity portfolio is typically not the most efficient or cost-effective way. For example, you could need several hundred individual stocks to achieve meaningful diversification just in the U.S. large-cap growth asset class. Individual stock selection also exposes you to accompanying risks that can be avoided by building a diversified portfolio with low-cost mutual funds that are dedicated to achieving true diversification.
Domestic versus international —
Investors’ stock holdings are often significantly concentrated in U.S. equities with a minimal percentage invested internationally. Thus, their overall equity allocation lacks global diversification and the related risk-reducing benefits that it can bring to a portfolio. Equity risk premiums — As mentioned above, investors’ portfolios are often heavily tilted toward large-cap growth stocks. Large-cap and growth are generally considered less risky than small-cap and/or value stocks, and thus they carry lower expected returns. We typically advocate a more balanced exposure to the three risk factors of equity (stock in general), small-cap (small company stock), and value (struggling company stock) — depending on unique financial goals and risk tolerances.
Cash reserves —
Particularly during scary markets, a relatively large percentage of a portfolio might be held in money market funds/cash. We typically recommend holding small portions in cash for your rainy-day needs, but keeping the remainder fully invested throughout all markets, to help you achieve your desired investment goals.
Tax-efficient asset location —
Sometimes, portfolio assets aren’t efficiently located to minimize the impact of taxes. All else being equal, we recommend locating your most tax-inefficient holdings within your tax-sheltered accounts. Bond (fixed income) holdings — The fixed income portion of a portfolio also can be scrutinized. Because fixed income is supposed to function as a portfolio’s stabilizing force, we look here for signs that the investor is taking on too much risk in the form of longer-term or lower-quality bonds. In my last Wealth Extractions column, “After the Earning is Over,” I encouraged you to gather your financial statements and make a list of the holdings you’ve currently got. If you’ve completed that step, it’s going to come in handy now. But don’t worry if you haven’t; this information will still be plenty useful. Today’s call to action is to use what you’ve just learned to read a few paragraphs more about diversification from CBS Moneywatch columnist Larry Swedroe. That way, you don’t have to take my word for it.
J. Haden Werhan, CPA/PFS, says, “Serving the dental community has been core to what I do throughout my career. I tell people it’s in my blood. After growing tired of transacting commission-based real estate sales, I looked for better ways to support practices. I found what I was seeking at Thomas, Wirig & Doll, just as we were setting up Capital Performance Advisors. I’ve never looked back.”Haden has been a member of our affiliated firms since 1998, providing wealth management, accounting, and tax services to successful practitioners. He came to the firm following a lengthy career managing, consulting, and providing accounting services to dental practices ranging from start-ups to acquisitions to large group settings. He has regularly lectured and provided seminars on tax, financial planning, practice management, and practice evaluations at the University of California, San Francisco; the University of the Pacific School of Dentistry; and various dental societies.He can be reached by e-mail at [email protected].