The worst decision investors can make is to bail from stocks at the bottom, so knowing your tolerance for pain when setting asset allocations is the key, financial planners say
When looking at an equity market that's already lost 20% of its value from its highs last October, it's a little late to be thinking of defensive measures for your portfolio's asset allocation, says Paul Baumbach, wealth manager at Mallard Advisors in Newark, Del.
The best time to bulletproof your portfolio, he says, is during times of average or overpriced stock valuations. At this stage of the game, a more productive move by investors would be to take time to assess their actual exposure to further market declines. By getting a handle on their true exposure, investors can avoid getting overly emotional and pulling out of an asset when it's at or near bottom.
"Being human is the worst disadvantage we have as investors because the heart is telling you to do things that the head says not to do," Baumbach says.
Down times such as these can also be instructive for making allocation decisions in better times ahead, he adds. He might urge clients to write down how they're feeling about their portfolios now, put the paper in a sealed envelope, and revisit it two years from now once the market has rebounded and they're feeling more confident about aggressive investment vehicles.
"If any investor is saying, 'I want to pull money out of stocks,' he's also saying he had too much invested in stocks to begin with," Baumbach says. He tells clients to identify their panic point—the maximum exposure to U.S. stocks they feel they can stomach in a falling market—and then structure a portfolio to stop short of that threshold.
Too Much Company Stock
The single biggest mistake investors make is over-reliance on their own company's stock, according to Mark Congdon, a retirement specialist and senior partner at the Horizon Group in West Henrietta, N.Y.
Congdon says he read the riot act to a 55-year-old client who accepted a buyout package from a big manufacturing firm and had more than two-thirds of his net worth tied up in company stock. "No more than 5% of your portfolio should be in your company stock," he says.
Jeffrey Camarda, chief executive of Camarda Financial Advisors in Fleming Island, Fla., cites a woman who inherited $800,000 worth of Merck (MRK) stock. When he told her to sell it down, she resisted, only to have to dispose of it later for just $100,000 after the shares had been pummeled by a deluge of bad news involving its painkiller Vioxx.
Generally speaking, Mallard's Baumbach suggests two-thirds of your equities exposure be in U.S. shares and one-third in foreign stocks, but says that allocation should shift more toward non-U.S. assets over time as China, India, and other countries become bigger contributors to the global economy and America's role diminishes.
Of the U.S. portion, roughly 65% should be in large caps, 10% to 15% in small caps, and the remainder in midcaps. The balance among value, growth, and blends of the two should be based on what's occurring in the markets at any given time, Baumbach says.
Asset Allocation Strategies
Zero or low correlation between various asset classes is the hallmark of a defensive asset allocation strategy. That's not as easy to achieve using foreign stocks as it was before globalization started pulling all developed markets in roughly the same direction. While non-U.S.-based multinationals such as Unilever (UL) have a place in global stock funds, Baumbach prefers international small-cap names that would be unknown to most U.S. investors and are much less vulnerable to an economic downturn in the U.S. He gets these through the Artisan International Small-Cap Fund (ARTJX), which was down 22.4% year-to-date as of July 30 and is closed to new investors. He recommends holding no more than 10% of a portfolio in this type of fund.
European equities, however, have had their own problems. In view of their weakness year-to-date, Tim Schick, director of portfolio management at Camarda Financial Advisors, is pointing clients more toward emerging markets, which need to be assessed case-by-case, since many have been battling severe inflation on the back of surging commodity prices. Schick likes India for its diverse economy, vast foreign exchange reserves, and high level of government spending on infrastructure projects.
He uses the Eaton Vance Greater India Fund (ETGIX) but generally cautions clients about single-country funds, which tend to be overly concentrated in the top 10 holdings and deserve no more than a 4% to 5% weight in an investor's portfolio. Although the Greater India Fund was down 40.55% year-to-date as of July 31—it returned 55% in 2007—Schick sees the 20 times p-e multiple of the Indian stock market as a whole as great value relative to the 8% annual growth rate of the Indian economy.
For more diversified non-U.S. equities exposure, he likes the Threadneedle Emerging Markets Fund (IDEAX)—down 15.93% year-to-date vs. a 16.36% loss in the Morgan Stanley Country Index for Emerging Markets, the benchmark stock market index of emerging-market stocks. He sees the Threadneedle fund as more of a pure play on less developed markets because of the much larger position it takes in frontier markets, such as those in Africa and the Middle East, and its lower weighting in developed markets.
The outlook for foreign currency values should also figure in deciding how much exposure to have in non-U.S. stocks, says Kay Conheady, a financial advisor at Apropos Financial Planning in Rochester, N.Y. With the dollar likely poised for recovery against other currencies after an eight-year slide, she urges clients to hold less than 15% of their portfolios in non-U.S. stocks whose performance will be eroded by a rising greenback.
Conheady favors international index funds such as the Vanguard Total International Stock Index Fund (VGTSX) and the Vanguard Emerging Markets Stock Index Fund (VEIEX). She thinks expense ratios should be under 1% of an investor's holdings, and tries to keep the fees her clients pay for index funds below 0.5% of their holdings.
To protect yourself from the slowing economy and a volatile stock market, Conheady suggests scaling back on all stocks, especially growth stocks, which have further to fall than value stocks when the economy hits a rough patch. She thinks the S&P 500 index, at 24 times trailing 10-year earnings, is still overpriced compared with historic levels, even after a nine-month slide. (Some pros like Conheady regard the 10-year p-e ratio as a more accurate measure of valuation than one-year calculations.)
Horizon Group's Congdon says that when you're assembling an asset allocation strategy, a shaky stock market can be your friend by providing lower entry points for buying stocks. "You can use dollar-cost averaging to get into balance," he says. "Instead of rebalancing all at once, you can rebalance over time" by taking profits on stocks that have gained the most and using the proceeds to buy ones that have been hit the hardest.
Historically, government bonds have been a safe haven for investors when equity markets turn turbulent. But with the Fed funds rate slashed to 2%, bond yields are dreary and can't even compensate investors for inflation. Consequently, most financial planners recommend lower portfolio weightings in bonds than they would normally.
A better hedge against rising inflation risks: floating-rate instruments such as the senior secured term loans that companies secure from banks, says Camarda's Schick. These notes are reset quarterly based on market interest rates, pushing investors' coupon rates higher when rates are rising.
Not only do senior secured bank loans currently yield several hundred basis points more than Treasuries, but investors don't have to tie up their money for long periods to get those higher yields, since the term loans are usually paid off within a year, says Schick. These loans also tend to increase in value because, unlike Treasuries, supply is limited amid stricter lending standards. One sticking point is that the credit ratings of the companies are generally not high and may even be below investment grade. But, as the most secured senior part of a company's capital structure, the term loans are the first to be paid off and are at risk only if a company files for bankruptcy, he says. While these notes are now trading near 90¢ on the dollar, the default rate is much lower than that would imply, around 4%, he says.
Term loans are available in bundled form through mutual funds and closed-end funds. Eaton Vance, the biggest buyer of bank loans, offers the Eaton Vance Floating-Rate Fund (EABLX), which is down 2.48% year-to-date as of July 29, vs. a 3.18% loss in the benchmark Lehman Brothers Aggregate Bond Total Return Index.
Conheady recommends having a 5% allocation in a real estate investment trust (REIT) index such as the Vanguard REIT Fund or a fund holding Treasury inflation-protected securities (TIPS), both of which are more diversified than owning individual TIPS and feature low expense ratios that won't eat up any inflation benefit you're getting.
But with banks tightening credit and takeover and new building activity in the doldrums, the times don't favor a bull market for REIT shares, says David Darst, a managing director at Morgan Stanley (MS) and author of the forthcoming book, The Little Book That Saves Your Assets. Instead, he prefers the iShares Lehman TIPS Bond Fund (TIP) as an inflation hedge and uses State Street Global Advisors' SPDR Deutsche Bank International Government Bond Fund (WIP) to protect portfolios from rising inflation worldwide. Given his view that the dollar has already lost nearly 90% of the value it's going to lose, he suggests that 75% of what investors allocate as an inflation hedge be put into the Lehman ETF and 25% into the SPDR fund.
Financial planners don't recommend complex alternative asset strategies such as long/short funds or other hedge funds to clients with less than $1 million because of the high minimum investments and premium-priced fees. But for high net worth investors with $1 million to $20 million saved, a hedge fund such as a 130/30 fund, which uses proceeds from a borrowed short position to buy an additional 30% in long bets on stocks, can help diversify a portfolio, says Darst.
The golden rule for investors is to be patient and to avoid reacting emotionally, says Congdon. "A good allocation strategy will do that—it takes the emotion out of it. At any given time, there will be positions in your portfolio that you will dislike if it's being done correctly."
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