Model portfolios offer new investors the wrong strategy for long term investment success.
There are a number of difficulties with recommending model portfolios for all investors. The main one is that each individual has different objectives, acceptable risk levels and so on.
For example, conservative or income-seeking investors may want to emphasize utilities and banks for their high and generally secure dividends. More aggressive investors might want to increase their portfolio weightings in resources or manufacturing stocks.
As well, model portfolios would need to be continually monitored and updated as individual stocks rise and fall in value and as a percentage of the total.
In addition, different investors may be more comfortable holding a larger or smaller number of stocks, real-estate investment trusts (REITs) or exchange-traded funds (ETFs) in their portfolios. So it’s hard to set any specific number of stocks in a model portfolio.
Watch out for broker “model portfolios”
These days, some of the most misleading ads you’ll see concern so-called “model portfolios.” All too many brokers use these model portfolios to build their businesses.
The big problem with these model portfolios is that as the ads explains in the fine print, these calculations don’t reflect trading that actually happened. Nobody turned $100,000 into $1.7 million. Instead, the fine print explains that the results show "hypothetical or simulated performance" and are "not meant to represent actual performance results."
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The main problem with hypothetical model portfolios is that they rarely, if ever, produce results that you can achieve in the real world. Here are three reasons why:
- Overly aggressive hypothetical management can inflate model portfolio results: Of course, it’s safe to manage hypothetical model portfolios much more aggressively than real-life investing in the stock market. That gives the hypothetical account great returns when it succeeds, but it runs up much steeper losses when it fails. However, the losses are only hypothetical, so they can be easily disposed of.
When the losses reach embarrassing levels, the broker can simply forget the old hypothetical account. It can then start a new hypothetical account that may do better.
Brokers may start up several hypothetical accounts, and eliminate all but the top performers over a period of years until they are left with just one hypothetical account that makes them look brilliant. Mutual-fund companies do the same. Fund company employees refer to the start-ups as “incubator funds.” These funds have little money in them, so it’s inexpensive to treat them in such a way that they build a great record. It’s even easier for a broker to build a top performance record for a hypothetical account where there’s no money involved.
- “Front running” can also have a big impact on model portfolio results: Unlike a real-money account, a hypothetical account can legally profit from front-running. When a broker’s research department plans to issue a strong buy recommendation and a thick research report in a rising market, it will generally add the stock to the model portfolio and issue the report simultaneously. That means the model portfolio will “buy” the stock instantly, but the firm’s brokers will need time to scan the report and call their clients.
Over the course of a week, a $10 stock can rise to $10.50 or even $11 in a situation like that. These near risk-free 5% to 10% gains can have an enormous impact on the model portfolio’s hypothetical profit, especially when they compound over 10 or 15 years.
- Some model portfolio results are based on the previous day’s trading: Some model portfolios have an even more blatant advantage over real world investing: buys and sells in the portfolio are calculated as if they took place at the closing price of the previous day. This alone gives you the magic wand you need to claim extraordinary results without any investment analysis.
All you need to do is simply check the market just before the close every day for stocks that have risen 5% or more since the previous day. Then you “buy” the ones that went up, and “sell” any you own that went down, in each case at the closing price of the previous day.
That way, you can claim credit for as many risk-free 5% gains as you need, and create whatever hypothetical profits you dare to advertise.
Model portfolios and practice accounts only distract you from a long-term investment strategy
Model portfolios and practice accounts have a lot in common. They both distract investors from long-term investing goals. Practice-account and model portfolios don’t teach you anything about a long term conservative strategy. They instead focus your attention on the making fast profits with quick stock market gains. Rather than an educational experience, practice accounts and model portfolios are a little like play-money sessions at Las Vegas, where gambling novices can learn to play casino games without risking any real cash.
In the casino, players are learning how to play the game. But they aren’t learning how to win, because that’s not possible. In the end, they can’t overcome the statistical advantage built into casino games that gives the house an edge. They’re really learning how to avoid losing their money any quicker than they choose to.
Using an online broker practice account can teach you how to enter an order to sell or buy stocks online; how to double-check your order before submitting it, so you avoid obvious but common mistakes, like buying 10,000 shares when you only meant to buy 1,000; and so on.
In doing so, you can choose what stocks to buy, but the only feedback you’ll get on your choices is the price changes they go through after you buy.
However, there is a large random element in short-term stock market results. Model portfolios are marketed to only show you the gains you could make. In reality, it will take months or years before you know if your choices are likely to provide attractive long-term returns. In fact, the real test will come only when you see how you do in the next bear market.
Have you used model portfolios in the past? Have they inspired you to trade? Have those trades been profitable? Share your experience with us in the comments.