How to avoid portfolio pain
Certain risk-reduction techniques could have eased the pain the bear market has inflicted on so many investors.
The Turtle and the Hare
A favorite technique employed by Phil Holt, president of Holt Portfolio Services, Fairfax, Va., involves regulating the "beta" of the mutual funds in portfolios. Beta is a measure comparing a security's volatility to an index such as the S&P 500. Typically, some stocks, such as General Mills Inc., fluctuate less than the S&P 500 Index while others, such as Intel Corp., fluctuate more.
Mutual funds that own more of the Intel-type stocks will fluctuate more than mutual funds that own the General Mills-type. For example, one large-value fund, the Dodge & Cox Stock Fund, has a beta of 0.60, while another fund in the category, Legg Mason Value Trust, has a beta of 1.15. We can expect the Legg Mason fund to rise or fall, in relationship to the market, nearly twice as much as the Dodge & Cox fund.
When Holt develops and maintains portfolios, he takes into account each mutual fund's probable fluctuations (beta) as a method of controlling risks relative to returns. He believes that adjusting the average beta of the mutual funds in a portfolio is a powerful strategy. It avoids the major disappointments that can occur from incorrectly predicting market tops and bottoms.
By adjusting portfolios' average betas, you only have to be generally correct about market excesses in order to add value to portfolios, Holt said. And it is much more realistic to think you can be generally correct rather than exactly correct when it comes to timing securities markets.
Spreading Eggs Among Baskets
All securities do not go up or down at the same time. Sometimes stocks do well when bonds are struggling and vice versa. Sometimes international stocks do well when U.S. stocks are struggling and vice versa.
Nobel prize-winning research is available to suggest the optimal mix of these and other asset classes to obtain the best returns with the least risk (www.ibbotson.com/research). But these mixes are based on the historical performance of the asset classes, and there's no guarantee that the future will exactly repeat the past. Nevertheless, Holt uses available research on mixing asset classes to guide the development of his clients' portfolios.
But what about the future? Holt monitors key economic forecasts and the asset class mixes of some of the largest public pension funds. Watching these funds is a good idea because in the course of allocating billions of dollars, they acquire some of the best information available about probable future economic scenarios and the correspondingly appropriate asset allocations. Holt uses asset class diversification as a technique to control risks and improve returns in client portfolios.
What About Market Timing?
Holt believes market timing has a place in the inventory of risk-control techniques. Much maligned and misunderstood, market timing does not attempt to gaze into the future. Rather, market timing properly done entails techniques designed to avoid erosion of your capital by enabling you to avoiding severe market declines.
Holt's article in the June 1996 issue of Technical Analysis of Stocks and Commodities magazine described a superior technique using an index's price and volume relationship over time. Other investors have relied for decades on the 39-week price moving average of a mutual fund as well as a related index to provide buy and sell signals.
Market timing may not be suitable for every portfolio because of the emotional impact the technique may have on some investors. It is a long-term approach. Every market-timing action may not be profitable, and several unprofitable transactions in a row are possible.
Nevertheless, the potential ability of market timing to avoid occasional catastrophic declines is significant, Holt says, and justifies including market timing as an additional risk-control technique.
Zall is a retired federal employee who since 1987 has written the Bureaucratus column for Federal Computer Week. He can be reached at email@example.com.
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