|BUSINESSWEEK ONLINE : JULY 17, 2000 ISSUE|
Time to Reshape Your Portfolio
The bull market has made America a nation of lapsed diversifiers
Retire rich. If that's your goal, thank your lucky stars for the stock market of the 1990s. Wall Street's remarkable five-year run, lifting the Standard & Poor's 500-stock index 220%, showered undreamed-of rewards on retirement savers and created more 401(k) millionaires than Regis Philbin could ever imagine. But now the miracle market is looking shaky: Tech stocks haven't fully recovered from their two-day April plunge, and the broader market has gone nowhere all year. Maybe you've started to wonder: How can I protect the paper wealth for my retirement and keep it growing for 10, 20, or 30 years--until I leave the working world, and beyond?
The answer, experts say, is asset allocation. Dozens of investment studies show that one basic decision--how you divide funds among such broad asset classes as large- and small-company stocks, domestic and foreign shares, corporate and government bonds, and cash--will determine, on average, 90% of your success as money manager. The impact of a diversified-asset mix swamps the effects of hot stock picks or great calls on market turns.
Younger investors, with a long time to ride out market swings, can invest more heavily in stocks, even volatile sectors such as technology and small caps. Older savers need to start locking up funds in safer securities such as bonds. But investors of all ages, even those who are already retired, can benefit from mixing asset classes. Diversification can both cut their risks and boost returns, as gains in overseas markets, for example, offset the inevitable occasional losses in U.S. stocks.
RISKY TERRAIN. Yet the bull market has turned America into a nation of lapsed diversifiers. Thanks to strong stock gains, investors who started 1995 with wealth split evenly between stocks and bonds would have entered 2000 with 71% of their portfolios in stocks. Even 401(k) investors--long criticized for being too cautious--had 72.5% of their funds in equities at the end of 1998, the latest data available. ''If you asked our investors what they think is the right mix, they'd say between 40% and 60% stocks,'' says Jim Norris, who oversees 401(k)s at Vanguard Group, a mutual-fund manager. ''But in fact, they're closer to 80%.'' When the market drops, millions of investors are going to discover that their ride on the bull has taken them into far riskier territory than they ever intended.
For a growing number of workers, that risk is keyed to an enormous bet in shares of their employers' stocks. Workers whose plans offer company shares have tied up more than 30% of their 401(k) money in that option. Employee stock-purchase plans and stock options boost the concentration. Take Bob Levy of Salt Lake City, a self-described ''very aggressive investor,'' whose stock portfolio was well-diversified until three years ago. That's when the stock of Sun Microsystems, Levy's employer since 1987, blasted off, gaining 866% from mid-1997 to today. Now, the 60-year-old sales manager and his wife, Suellen, a 58-year-old teacher, are Sun millionaires--and watched nervously as the stock dropped from 106 3/4 in March to 72 in May, before rebounding to 90 at the beginning of July.
With retirement just three years away, Levy is exercising Sun options and selling the shares to diversify into the Old Economy--utilities, oils, chemicals--as well as small companies, international stocks, and bonds. His goal: ''I want a buffer of steady income so I'll never have to sell into a down market.''
For younger investors, such thinking is so 1990. In their experience, investors who sold stocks to maintain a balanced portfolio have been left in the dust. ''We have thousands of accidental millionaires whose fortunes were made because they didn't fuss with rebalancing,'' says Joanne Bickel, who develops advice and tools for participants in TIAA-CREF's retirement plans. Today's prevailing message: Stocks, despite their short-term swings, deliver bigger long-term rewards than other investments.
For investors such as Anne Strusz, that means every market dip offers a chance to buy. When the Nasdaq fell 790 points in April, ''I called my planner and said: 'Let's find a way to take advantage of this,''' says Strusz, national sales manager at Verizon Information Systems, a Dallas company formed by the recent merger of GTE and Bell Atlantic. So Strusz, 49, started putting an extra $100 a month into a tech-dominated fund recommended by her American Express Financial Advisors planner. As a single woman hoping to retire by age 58, Strusz figures she needs to invest for rapid growth. ''I'm a risk-taker in many ways,'' she says.
OVERCONFIDENT. To money manager Roger Gibson, such talk smacks of the bravado a Japanese investor might have expressed in 1989. ''Why would they diversify out of the Nikkei when Japanese companies were buying up the world?'' asks Gibson, president of Gibson Capital Management in Pittsburgh. Those overconfident Japanese took a big hit--and still haven't recovered. The Nikkei today is 55.4% below its 1989 peak.
Asset allocation, with periodic rebalancing, can give you the discipline to avoid such irrational exuberance. Rebalancing forces you to sell high, unloading the assets that have gained the most, and buy low. That locks in gains and reduces your exposure to market drops. A diversified portfolio also positions you to catch the next great winner. ''For years, my clients were saying: 'You're killing us--these REITs are dogs!''' says Stephen Barnes, who blends balanced portfolios for Barnes Investment Advisory in Phoenix. ''But every dog has its day''--and real estate investment trusts are 2000's top performers, posting 15% returns in the first half.
Of course, diversifying requires a dispassionate view of your investments. That can be especially tough for entrepreneurs. Since 1981, Timothy Murray and Laurence Purcell have poured most of their earnings back into their firm, Purcell Murray Co., a Brisbane (Calif.) distributor of high-end appliances. In 1998, as California's boom drove up demand for designer kitchens, the partners anticipated skyrocketing growth. This year's sales should double 1999's $100 million-plus, they say. But Purcell, now 58, and Murray, 57, needed a strategy to start pulling wealth out of the business and diversify.
Their solution: Reorganize the firm as a Subchapter S corporation, which combines a corporation's limited liability with a partnership's simpler taxes. Purcell and Murray are now paying themselves dividends--payouts they had avoided, since dividends from regular corporations are taxed twice. The company can also now provide richer pension and savings plans for the owners and their 56 employees. Murray and Purcell are pouring up to 70% of their newly freed cash into stocks. ''These are healthy guys who plan to be running their business another 10 or 15 years. They can take that risk,'' says their planner, Stewart Viets of Lincoln Financial Advisors.
LESS HAZARD. Most savers don't need a corporate reorganization to rebalance. Their challenge is to assess how they feel about the three R's--risk, return, and retirement. ''If you've got retirement goals, you look for the return you need to meet them,'' explains Harold Evensky of planners Evensky Brown & Katz in Boca Raton, Fla. ''Then see whether you can stomach the risk to make that return. If not, you have to decide: Do you want to eat better or to sleep better?''
Answering that requires you to understand your own style and risk tolerance. Darryl Haysbert of Atlanta just decided he could take more chances. An investor since he was 16, the 33-year-old mortgage broker says he's selling bonds to buy more blue-chip stocks--an added risk that is offset, he says, by keeping half his wealth invested in rental homes in high-quality neighborhoods. ''I'm looking for greater return, and I have time to recover any losses,'' Haysbert says.
Diversifying reduces hazards in two ways: By blending in low-risk assets, such as cash or short-term bonds, a balanced fund gives an investor a secure base of money with a steady--though small--payoff. And diversifying combines investments that behave differently, so that the upswings of one will offset the drops of another.
The goal is to mix assets to achieve a targeted return with the least possible risk. Academics and investment pros fill books with dense mathematical arguments over how to find that ''efficient frontier.'' If you want a scientifically optimized portfolio, find a private money manager who's steeped in the subject and who will--for a minimum investment of $500,000 and fees up to 3% a year--invest your funds accordingly.
Most investors, however, can get 90% of the benefit of asset allocation with 1% of the effort. Some 401(k) managers will, if you elect, automatically rebalance your account every quarter or year. But for most people, the simplest way to maintain a diversified portfolio is to buy a balanced fund or a fund of funds tuned to your age or conservative, moderate, or aggressive style (page 108).
If you want more control, you'll find a wealth of calculators, risk questionnaires, and sample portfolios on the Internet sites of mutual-fund companies and financial advisers. (For mixes prepared by Standard & Poor's Personal Wealth, see page 106.) Most rely on the standard asset types offered by brokers or 401(k) plans: U.S. stocks, international stocks, real estate limited partnerships and REITs, corporate and government bonds, and cash.
LOTS OF BUZZ. Finding pure plays in all these groups can be tricky. Fortunately, index funds--mutual funds that track the performance of a market index, such as the Russell 2000 for small-cap stocks--have proliferated, making it easier to diversify inexpensively. The latest wrinkle is exchange-traded funds (ETFs), index-based instruments that can be traded all day long like stocks. In many cases, they're even cheaper and more tax-efficient than comparable index funds. But while ETFs are getting a lot of buzz, they offer little advantage to retirement savers, who tend to be buy-and-hold investors using tax-deferred accounts such as IRAs or 401(k)s.
Not everyone can buy index funds: 401(k) investors are limited to a menu of investments selected by their employer. Matching those choices to asset classes isn't easy--especially with mutual funds, which don't always stick to their stated style and objective (page 110). Two Web-based services--FinancialEngines.com ($54.95 per year) and Morningstar's free Portfolio X-Ray--delve into funds' holdings to give you a picture of how your investments meet or miss your planned mix. Fidelity Investments offers a similar planner for its 401(k) clients. TeamVest, a Charlotte (N.C.) firm that provides investment advice for Quicken.com, offers a $400-per-year service to analyze your 401(k) holdings and alert you when your mix shifts out of balance.
Setting up your asset mix is just the first step. You must also review and rebalance your portfolio periodically. You don't want to rebalance too often. If you sell off fast-rising stocks to buy more bonds every month, you'll lose much of the advantage of holding stocks. ''You've got to let your best-performing assets run,'' says El Cajon (Calif.) money manager William Bengen. Many experts recommend an annual review. Another approach: Rebalance when your portfolio strays more than some set amount, such as five or seven percentage points, from your preferred mix. If, for example, you want large-cap U.S. stocks to account for 40% of your portfolio, you would rebalance if their share fell below 33% or rose above 47%.
Most 401(k)s allow frequent, even daily, adjustments, and you don't have to worry about the tax impact of gains or losses. If you have both a 401(k) and a taxable account, you can do most of your rebalancing in the tax-deferred account. But at some point you'll probably have to face the bite of selling taxable assets. Just remember: ''Unless you're going to die holding the stock, you're going to pay that tax eventually,'' says Evensky. Besides, a 20% tax on your capital gain could be dwarfed by the damage that a 25%, 30%, or 40% drop in stocks could wreak.
Perhaps this sounds like too much trouble--especially after five years in which U.S. stock investors made money with such ease. If so, make a stop at the Bear's Cave (www.401kafe.com/education/bears/bears_calc.html). Plug in your portfolio to see how you would have fared in the 40% drop of the 1973-74 bear market. That might be just the wake-up call you need to get the message: Protecting your retirement account through diversification is well worth the effort.
By MIKE McNAMEE
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Time to Reshape Your Portfolio
COVER IMAGE: How to Retire
TABLE: Don't Dump Those Stocks
CHART: Out of Balance in a Bear Market
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