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FINE-TUNING THE PORTFOLIO: THE OLD RULES STILL APPLYConsider your personal time frame and appetite for risk. Then hedge accordingly
Letting 1998 be your only guide, you might conclude that the S&P 500 is the only game in town--and that small-cap stocks, emerging-market stocks, and high-yield bonds are financial sinkholes. You might think that diversification doesn't reduce risk, because in this past year, investments that were supposedly independent of each other fell in sync. And you might also decide that bear markets are nothing to worry about because when prices plunged this fall, they snapped back within weeks. Wrong, wrong, wrong. Experts on asset allocation say that investors should resist the temptation to base their decisions on one crazy year or to chase after the latest hot ticket. Instead of speculating on what's going to do well in 1999, rely on some time-tested principles of investing. First, divide your money among a variety of assets, including ones that have bombed lately but might snap back, like small-cap stocks. Second, unless your outlook is resolutely long-term, put some money in safer holdings like government bonds--contrary to recent experience, bear markets can last an agonizingly long time. COMFORT ZONE. Putting every penny of your 401(k) money into large-cap stocks tempts a lot of people. The company names are reassuringly familiar, and the returns have been excellent in recent years. ''Every adviser I talk to has trouble getting people into things like small-cap and foreign,'' says Jeffrey B. Schwartz, senior consultant for Chicago-based Ibbotson Associates, which provides investment software and consulting. No wonder: For the 12 months ended Nov. 30, the total return on the Standard & Poor's 500-stock index was 23.7%, vs. 16.8% for a Morgan Stanley Dean Witter index of developed-economy stocks, -11.1% for an Ibbotson index of small stocks, and a lousy -19.7% on an International Finance Corp. emerging-markets composite index (table). But 20-year return differences aren't nearly so stark. And by going whole-hog into large caps, says Mark W. Riepe, vice-president in charge of Charles Schwab & Co.'s Center for Investment Research, ''in essence, you're forecasting that the recent past will continue into the future.'' As Riepe notes, ''large-cap stocks have not always ruled the universe. In the late '70s, small caps were the place to be. Throughout much of the '80s, international stocks were the place to be.'' FRIGHT TEST. Diversification hedges your bets. When one asset class does poorly, another usually will be doing well. At first glance, the planetwide meltdown in 1998's third quarter seems to disprove that principle. Investors such as Long-Term Capital Management, the Greenwich (Conn.) hedge fund, spread their bets among various countries and asset classes, only to have all of them lose value at once. Most of the time, though, the major asset classes don't move in lockstep like that for long. Even during this past year's turmoil, the most typical diversification strategy was still a big winner: Investors who put some of their money in U.S. Treasury bonds did very well on them, offsetting losses elsewhere. As you think about allocating assets for the new year, consider your tolerance for risk. Think back to when the Dow Jones industrial average was around 7,500. If you sold stock during the downdraft or even thought hard about it, it's evidence that the ratio of stocks in your portfolio is too high for comfort, says Scott Lummer, chief investment officer of San Francisco's 401(k) Forum Inc., which advises retirement-plan participants. Many people were saved from selling in 1998 only by the brevity of the downturn. The next time could be different. Says Ibbotson's Schwartz: ''People have made so much in the past five years that chances are, as soon as we have a prolonged bear market, we're going to see a massive outflow. They'll say, 'I've made so much. I'm not prepared to lose it.''' Whether you bail out or not has a lot to do with the second key factor in asset allocation: how soon you'll need the money. It's easy for a 30-year-old to be brave when her retirement account is down because there's plenty of time for it to recover. Not so for a 60-year-old. Investment advisers say that if you will need your money in less than five years, you probably shouldn't have more than 60% of it in stocks. Here again, though, the experience of 1998 could lead some investors in the wrong direction. The rapid rebound of this past fall may persuade people that diversifying away from stocks would be foolish--akin to passing up free money. The people most at risk of making such a mistake and overcommitting to stocks are those who feel they can't achieve their investment goals without getting the very highest returns. Says 401(k) Forum's Lummer: ''You deny the fact that there's actually risk in the market. When that risk reveals itself, fear takes over. You sell, and lock in your losses.'' Another reason to diversify into bonds is that their returns are actually quite respectable. Over the past 20 years, long-term U.S. corporates and intermediate Treasuries have both provided roughly 10% annual returns (table). If you do decide to move more of your money into fixed income, remember that not all debt is created equal. Junk bonds, for instance, may have attractive yields, but they are at least as volatile as stocks. If safety is the goal, think of short-term bonds or even money-market funds, which invest in safe, low-yield securities like Treasury bills. FOREIGN ADVENTURE? There are a few points on which asset-allocation experts disagree. One is whether emerging markets belong in a balanced portfolio. Skeptics say that it's not clear whether they add meaningfully to a portfolio's diversity. However, Lou Rowan, national sales director for Tacoma (Wash.)-based adviser Frank Russell Co., says: ''The emerging markets are roughly analogous to late 19th century America. That would have been a very good investment, wouldn't it?'' Whatever their disagreements heading into 1999, asset-allocation experts share a view that the worst thing investors can do is pour all their money into the latest investing fad. Yet many do exactly that. Says Rowan: ''The individual investor is missing out on what pension-fund managers learned painfully in the late '60s and early '70s: setting long-term goals and implementing them in a well-diversified fashion.'' That's not a brand new idea, perhaps. But with 1998's roller-coaster ride still fresh in our minds, it's as timely now as ever.
By Peter Coy in New York RELATED ITEMS
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Updated Dec. 17, 1998 by bwwebmaster
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