Giving Risk Its Proper Allocation of Respect
The experts routinely urge you to diversify your investment portfolio--but the road to riches in recent years seems to have been traveled best by ignoring that advice.
Those who put all of their money into large U.S. growth stock funds--while largely avoiding volatile small-cap funds, foreign funds and even bonds--ended 1998 with more money than those who did the “right” thing by diversifying their portfolios for safety.
Smart move, right? Not necessarily.
While it’s true that these investors ended the year with more money, they didn’t necessarily have more money throughout the year. The late-summer downturn illustrates the risk they took.
For instance, an investor who put $10,000 into a well-diversified portfolio (as described in the accompanying chart) at the beginning of last year would have “lost” just $34 by Aug. 31, on average, when the stock market cratered.
Investors who put $10,000 in an all large-cap stock fund at the beginning of the year would have lost 10 times as much by that date. Luckily for them, the market recovered.
Indeed, three short months ago, most of us were looking at losses in our portfolios, following a violent third-quarter correction in the stock market that took large-company stocks to the precipice of a bear market.
But thanks to a rapid-fire fourth-quarter recovery, the average large-cap growth fund ended the year up 36.5%.
“Think of this as a car crash that you were almost in, and you weren’t wearing a seat belt,” said John Rekenthaler, director of research for mutual fund tracker Morningstar Inc. Count your blessings and try a safe (or safer) approach from now on.
Why? Consistent above-average returns in large U.S. stocks, those found in the benchmark Standard & Poor’s 500 index, “is a likely indicator of lower-than-average returns going forward, not higher,” said Stanford professor William Sharpe, a Nobel laureate who has spent his career measuring risk and reward in the market.
Plus, the S&P;, judged by traditional valuation measures such as price-to-earnings ratios, is as frothy as it’s ever been.
“People forget that investing is a risk-reward trade-off,” Sharpe said. “If you forget half of the equation--risk--you miss the point.”
Added Bruce Veaco, co-manager of the Clipper fund, managed by Pacific Financial Research in Beverly Hills: “We’ve been cautioning our clients for some time now to look at returns in context of risk.”
An easy way investors can factor risk back into their portfolios in 1999 is by examining their mix. The way you allocate your assets (in other words, how much you decide to invest in stocks versus bonds versus cash, and the kinds of stocks and bonds you choose) in 1999 may affect your portfolio more than the specific mutual funds you choose.
Financial planners and market strategists offer the following advice:
* Recognize that there are two types of risk. There’s the risk of being too aggressive, perhaps by loading up in one risky asset class.
And there’s the risk of playing it too safe, notes Laura Tarbox, head of Tarbox Equity, a financial-planning and asset-management firm in Newport Beach. “We’re seeing people who are still scared and who want to stay all in cash,” she said. “What they don’t realize is that they run the risk of not being able to meet their long-term retirement goals.”
* Bring your small-cap allocation back to a “market weighting.” That means consider putting 20% of your U.S. equity allocation in stocks with market capitalizations of $1 billion or less, notes Hal Reynolds, chief investment officer with Wilshire Asset Management in Santa Monica.
Historically, small-cap stocks have outperformed the S&P.; But this hasn’t been the case in recent years. Indeed, not since the Bush administration have small-company shares led the market. So a small-cap rally is long overdue, analysts say.
Also, based on valuation measures such as price-to-earnings ratios, “small-cap stocks are cheaper now than they’ve ever been” relative to the S&P;, argues Dan Coker, emerging-growth strategist for Schroder & Co. in New York.
But Sheldon Jacobs, editor of the No-Load Fund Investor newsletter, cautions against loading up on small-cap stocks in 1999--that is, earmarking more than 20% of your domestic stock allocation.
While small caps look attractive, it’s unclear that investors can be weaned off the largest and most liquid stocks this year. Also, small-cap exposure doesn’t provide downside protection.
In fact, small caps tend to fall more than large caps when the market is going down, as they did this summer.
The role small caps play is really to protect against the second type of risk: being too conservative and failing to meet your long-term goals, argues Coker. So err on the side of caution when it comes to small caps, analysts say.
* Consider increasing your foreign stake. Seventy-one percent of mutual fund investors don’t have any exposure to foreign stocks, according to a 1997 survey by Scudder. And toward the end of 1998, investors were net sellers of foreign funds as the global financial crisis unfolded.
“The lesson investors should take away from the collapse in Asia last year isn’t to avoid international investing altogether, it’s to do it in a very broad, diversified way,” said Alan Skrainka, chief market strategist at Edward Jones & Co. in St. Louis.
He notes, for instance, that the typical Europe fund gained 20.1% last year. The typical foreign stock fund was up a respectable 12.4%.
Edward Jones recommends that investors consider putting 10% to 12% of their equity stake in foreign stocks in 1999, versus the current average of just 4.5%.
* Don’t shortchange value. In recent years, “growth stock” funds (those that invest in companies with rapidly growing earnings) have trounced “value stock” funds (those that invest in companies whose shares are considered undervalued relative to their assets or earnings).
Yet over the last 15 years, these fund categories have delivered roughly the same returns. The average growth fund has generated annualized returns of 13.2% over the last 15 years, compared with 13.3% for the average value fund, according to Morningstar.
“These investment styles tend to run in sine waves,” said Luke Collins, director of KPMG Peat Marwick’s investment consulting practice in Chicago. “There are times when growth is in favor, and there are times when value outperforms.”
It’s impossible to tell when growth or value will lead the market. The solution? Have equal exposure to both at all times, planners say.
However, investors who haven’t re-balanced their portfolios recently may find that, given the phenomenal rise in growth stocks recently, their growth allocation may now be significantly higher than their value allocation. Plus, if you did any tax-loss selling this year--that is, if you sold losers to offset capital gains in your portfolio--chances are you dumped a value fund.
* Don’t turn your back on bond funds. The S&P; 500 is hitting record highs for yet another year, but that doesn’t mean the trend will continue and that you should put all your money back in the market.
Morgan Stanley Dean Witter investment strategist Peter Canelo says about 20% of one’s holdings still belong in bonds (though investors with short time horizons may want to have considerably more).
Another good reason to think of bonds: Canelo believes that concerns over the year 2000 computer bug could grow toward the latter half of 1999.
“If that happens,” he said, “you’re going to see a return to the safe-haven mentality we saw [in 1998], which means bonds could have a strong finish.”
Paul J. Lim can be reached at paul.lim@latimes.com.
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All in the Mix
An investor did best in 1998 simply holding a portfolio of large-capitalization stocks (i.e. blue chips). But such a portfolio fell much more sharply by the market’s late-August lows than did diversified portfolios. Here’s a look at four hypothetical portfolios that began the year with $10,000-and their net gains and losses on specific dates:
Portfolio A: 100% large-cap stocks
Portfolio B: 50% large-cap stocks; 50% taxable bonds
Portfolio B: 50% large-cap stocks; 50% taxable bonds
Portfolio D: 25% large-cap stocks; 20% foreign stocks; 5% small-cap stocks; 50% taxable bonds
Portfolio A
$10,000 investment: Loss at Aug. 31: -$372
Portfolio B
$10,000 investment: Loss at Aug. 31: -$24
Portfolio C
$10,000 investment: Loss at Aug. 31: -$328
Portfolio D
$10,000 investment: Loss at Aug. 31: -$34
Source: Morningstar Inc.
