Controlling Risk in Portfolios
- By Milt x_Zall
- Feb 07, 2002
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
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 protected]