| BUSINESSWEEK ONLINE : JUNE 26, 2000 ISSUE | ||||||||
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| COVER STORY
Diversification Is the Best Revenge The key to a sound portfolio remains balance Asset allocation and diversification, the foundation concepts of modern investment theory, have seemed like one more idea rendered obsolete by the New Economy. In recent years, despite the grumbling of grizzled Wall Street veterans, many individual investors earned astonishing returns by putting the bulk of their investment dollars in one asset--high-tech stocks. Says Clay Singleton, a vice-president at Ibbotson Associates, a Chicago firm specializing in asset allocation: ''It's hard to resist the siren song of tech stocks.'' Until now. The stock market's extreme volatility and the meltdown in tech stocks are reminders that putting all your investment eggs in one basket is a risky, stomach-churning strategy. Sure, high-tech companies are transforming the way we live and work. Yet history shows a long line of sure bets that disappointed their owners for years to come. A $10,000 investment divided equally among three glamour stocks of 1969--Eastman Kodak (EK), Xerox (XRX), and Polaroid (PRD)--would be worth only $58,000 today. The same investment in the highly diversified Standard & Poor's 500-stock index would now be $413,000, according to John J. Brennan, chief executive of the Vanguard Group. Says Scott L. Lummer, chief investment officer at Mpower, an online investment advisory service: ''The only way of making sure you don't get completely blown out is to diversify.'' These days, the watchword on Wall Street is balance. Yes, in the New Economy, technology should make up a healthy portion of the average investor's portfolio, perhaps as much as a third considering the sector's share of the overall market and economy. But other sectors of the equity market, such as finance and health care, shouldn't be neglected. Indeed, the U.S. equity market seems poised for a broad-based rebound. That's because signs are mounting that the Federal Reserve's six interest-rate hikes are slowing down the economy. It's particularly good to be in the stock market at the end of a string of interest-rate hikes. Following the final rate hike by the Fed in each of the past three tightening cycles, the equity markets were up an average of 14% six months later and 23% a year later, according to economists at Merrill Lynch & Co. And the story is not just the U.S. stock market. International equities are enticing with the world economy picking up at a rapid pace. Yields in the U.S. corporate bond market may have peaked, too. ''No one wants to be bearish,'' says David Bowers, chief investment strategist at Merrill Lynch & Co., ''but people do want to be more defensive and cautious.'' RISKS AND REWARDS. Despite the hours most individuals spend scouring stock tables and mutual-fund rankings, academic research shows that how investors allocate their assets is the primary determinant of their long-term returns. In other words, the decision to invest in stocks over bonds or cash has more impact on your returns than whether you chose Cisco Systems (CSCO) instead of Intel (INTC) or a Janus mutual fund over one from Fidelity. So, if U.S. stocks are not always the best-performing asset, why not just move all the money into bonds at the appropriate time? Later, you can switch around to other assets, such as cash or international stocks, or even back to U.S. stocks. That's allocating, but the investor who does it is trying to time the market. Sure, anyone can make a shrewd move now and then, but history shows that market-timers rarely beat buy-and-hold investors over long periods. True allocation means the portfolio has a mix of assets, and not all are necessarily doing well at the same time. But neither will they all do poorly at once. ''The reality is, with an asset-allocation approach you will never do as well as the best-performing class or as poorly as the worst-performing asset class,'' says Ross Levin, a certified financial planner and president of Accredited Investors Inc. in Edina, Minn. ''But you will do well over time.'' The essential insight behind asset allocation is that different investments carry distinct risks and rewards. For instance, stocks are far riskier than U.S. Treasury bills. After all, the former represent the uncertain returns on entrepreneurship, while the latter is merely a short-term loan to an extremely creditworthy borrower. But investors are paid well for the risks of equity investing: The real long-term return on stocks has bested T-bills by more than six percentage points--the reward for taking greater risk. There's another risk here. While you can be confident that stocks will pay off in 20 or 30 years, you have no idea what they will be worth in six years or even six months. Recent market behavior demonstrates just how volatile stocks can be: So far this year, the Nasdaq has whiplashed investors with four one-day plunges greater than 7%. The remedy: a long-term financial goal with a portfolio that can back it up. A key question in designing a portfolio is ''how much financial risk can I stomach?'' For example, can you withstand a 40% drop in your stock market portfolio, or is 10% your limit? Making that decision will be easier if you have a long-term time horizon. An investor with 30 years to retirement can bear greater volatility than one who's winding up a career. Time and risk are two sides of the same asset-allocation coin. Look at the accompanying table (page 206). Take, for instance, the 52-year-old middle manager earning $150,000 a year. He would like to count on 80% of his salary (a standard assumption in retirement planning) when he retires at age 62, or $120,000 a year. He already has a nest egg of $1 million targeted for retirement, thanks to some savvy tech-stock investments over the past few years. Tech, in fact, now constitutes 80% of his portfolio, and he recognizes--especially after the past few months--that's way off base. The only sop to safety is his 20% allocation to bonds. What should he do? We asked that question of Financial Engines Inc., an online financial advisory firm founded by William F. Sharpe, a Nobel laureate in economics. The firm uses thousands of simulations to assess the odds that your portfolio will meet your goals. Staying with current tech-heavy allocation, the investor has only a 63% chance of achieving his goal by age 67. That's not good enough for most people. And there's only a 42% chance of reaching the goal by age 62. In the interim, the portfolio will remain a volatile one, about 70% more volatile than a benchmark portfolio of stocks, bonds, and cash that mirrors the aggregate holdings of U.S. investors. DAMAGE CONTROL. To fix this situation, Financial Engines suggests dropping the tech-heavy approach. It recommends 25% in large-cap stocks, 10% in small-cap, and 18% in international stocks. The firm suggests building the bond portion up to 25% and putting 22% of the money in such cash investments as Treasury bills or money-market funds. The bottom line is a portfolio with lower risk, 75% of the benchmark's volatility, and a greater chance, 84%, of reaching the investor's goal by age 67. The odds of an exit at age 62 are not improved. Financial Engines also ran simulations for investors aged 32 and 42 with the same tech-heavy portfolios. In all three cases, diversification lowers risk and improves the odds of reaching the investor's goal. In fact, for the younger two, the odds for early retirement are greatly enhanced. These simulations do not assume the 25% a year returns of the late '90s, nor the 86% gain in the Nasdaq in 1999. Such returns are far above the norm, and should moderate. ''It's reasonable to say returns will average in the mid-to-high single digits over the next five years,'' says Mark M. Zandi, chief economist at RFA/Dismal Sciences Inc. Don't worry, though. There are other money-making opportunities, such as international equities. Europe, in particular, is garnering greater interest as Continental companies embrace corporate restructuring and mergers in a bid for world-class efficiency. Asia looks enticing, too, especially with the entry of China into the World Trade Organization. That could be as big a boost for the regional economy as it is for China itself. The U.S. bond market could also offer nifty returns. True, the long-term Treasury bond market has rallied this year as the government reduced long-term debt. Yields are still relatively high for 2- to 10-year notes. Corporate bonds offer even higher yields, with little incremental credit risk. The inflation-adjusted yield on investment-grade corporates is 5%. For junk bonds, where the credit risk is higher, there is still a 7% premium over the inflation rate. Investors face plenty of uncertainty. The Fed may have come down too hard on the economy. The recoveries in Asia and Latin America are still fragile. But that's the point of asset allocation--building a sturdy financial structure that can withstand the occasional storm and protect your long-term investments. By CHRISTOPHER FARRELL _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP |
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