Picking Your Shots

There comes a scene in countless old crime movies when the cop shouts to the barricaded criminal: “Listen buddy, we can do this the easy way, or we can do it the hard way!” At which point the criminal usually chooses the hard way, and gets gunned down.

For many individual investors today, the choice of an investment strategy also comes down to the easy way or the hard way.

You can make things easy on yourself by focusing on the few big decisions that really matter. In other words, you can pick your best shots.

Or you can take the complicated approach, expending--often wasting--energy on a slew of individually less important decisions.

It’s what Vanguard Group founder John Bogle describes as the “clash of two cultures in investing: complexity and simplicity.”

Not surprisingly, in an age when anyone can trade shares of Amazon.com via a home computer between hands of video poker, many people wittingly or unwittingly choose the hard way.

With more than 13,000 mutual funds to pick from, not to mention tens of thousands of stocks, bonds, options and derivatives--and with hundreds of magazines, infomercials, cable shows, Web sites and newsletters chiming in with advice--the pressure to do something is maddening.

“There is so much noise in the marketplace when it comes to investment advice, it’s no wonder people are having difficulty blocking it out,” said Robert Williams, who manages the Irvine office for St. Louis-based brokerage Edward Jones.

Granted, some of us over-complicate our portfolios because, like Vegas, it’s fun.

For instance, no one put a gun to Ralph Stevens’ head and told him he had to invest in 52 mutual funds. Admits the 67-year-old Tucson retiree, who has since pared his fund portfolio to 31: “It’s like my hobby.”

But most of us complicate our financial strategy because we mistakenly think we must. We assume that unless we listen to every bit of advice, every “whisper number” that pops up on the Internet--and act on it--our children won’t have money for college. Or our mortgages won’t get paid off. Or our retirement won’t happen.

Yet there’s just as good a chance--if not better--of accomplishing all those things by simplifying your strategy.

“My judgment and my long experience have persuaded me that complex investment strategies are, finally, doomed to failure,” Bogle said in a recent speech. “Investment success, it turns out, lies in simplicity as basic as the virtues of thrift, independence of thought, financial discipline, realistic expectations and common sense.”

Indeed, there are really only four portfolio decisions that are key. In order of descending importance, and simplicity, they are:

* Asset allocation, or determining what percentage of your portfolio will be in stocks versus bonds versus cash--and, within each asset class, what portion will be held in different styles of stocks and bonds (or stock funds and bond funds).

* Timing decisions to fine-tune your asset allocation strategy. For instance, if you think bonds will outperform stocks next year, you might decide to rebalance your portfolio slightly to reflect that belief.

* Mutual fund selection.

* Individual security selection.

“Each decision [in this list] takes on lesser importance” for your long-term returns, said Roger Ibbotson, finance professor at Yale University’s School of Management.

And yet, the further down you go on this list, the more individual decisions you’ll have to make. That’s where the time-wasting can become extreme.

For instance, “your overall asset allocation decision probably won’t change that much,” notes Mark Riepe, director of the Schwab Center for Investment Research in San Francisco, a research arm of discount brokerage Charles Schwab.

“Once you set the policy in motion, you don’t need to be looking at it every single day” or month or quarter, or even year, he said.

But deciding which fund managers to pick takes more work. After all, you’ll probably want to monitor your funds with more frequency than you do your asset allocation decision--perhaps semiannually, quarterly, even monthly.

And if you own individual stocks, you’ll probably want to monitor them even more closely.

That makes sense. Yet, in the long run, that effort actually deserves less attention than your most crucial decision: your overall asset allocation.

Asset Allocation

Whether you’re aiming for long-term growth in your portfolio (with an asset mix that consists of, say, 75% stocks, 20% bonds and 5% cash), or whether you’re more interested in preserving capital (40% stocks, 40% bonds, 20% cash), this single decision is likely to have more impact on your returns than the individual stocks or stock funds you select.

Notes Hal Reynolds, chief investment officer of Wilshire Asset Management in Santa Monica: “For individuals, asset allocation is critical. It becomes the framework for the entire portfolio.”

In recent years, there has been much debate as to how important allocation really is.

Yale’s Ibbotson set out to determine what portion of a fund’s returns, on average, could be explained by the fund manager’s asset allocation strategy--as opposed to his or her timing and rebalancing decisions, or even individual stock selection.

Ibbotson studied the performance of 94 “balanced” mutual funds (those that invest in a mix of stocks and bonds) with at least a 10-year track record as of March 31, 1998.

Amazingly, his research shows that nearly 100% of a typical fund’s returns over 10 years can be explained by its asset allocation. In other words, on average, the funds Ibbotson studied were “not adding value ... . . [with] their combination of timing, security selection, and management and fees and expenses,” Ibbotson wrote.

That’s not to say that fund managers can’t help or hurt their returns in the short term with specific stock picks. After all, Bill Miller’s decision to hold onto America Online when other so-called value managers didn’t helped propel his Legg Mason Value fund to the top spot among its peers recently.

Ibbotson, digging deeper in his research, found that about 40% of the differences of returns between funds could be explained by asset allocation. The other 60%, presumably, could be explained by myriad timing and stock selection decisions made by the individual managers, as well as by fund expenses.

But over time, as Ibbotson’s research seems to illustrate, better-than-average stock picks are often offset by bad picks in a portfolio. What really counts, on average, is the general type of stock you’re in, not the individual issues.

Perhaps a reason for the dominance of allocation over stock picking in the long run is that funds of similar styles so often hold the same stocks. Large value funds like Legg Mason Value tend to invest in overlooked or beaten-down stocks such as Philip Morris, while large growth stock funds focus on shares of companies with rapidly expanding earnings, such as Merck or Dell Computer.

The good news is, once you make your asset allocation decision, you don’t need to do much else, many experts say.

“If you really want to simplify things, once you know what you want in stocks versus bonds, you can fall back on index funds,” Wilshire’s Reynolds said.

For instance, say you have $100,000 to invest and you decide to allocate 50% of that to domestic stocks, 25% to foreign stocks and 25% to bonds. If you want, you can simply put $50,000 into a “total stock market” fund, such as one that tracks the all-encompassing Wilshire 5,000 index of domestic stocks; $25,000 into an index fund that tracks the Morgan Stanley capital international Europe/Australasia/Far East index; and the remaining $25,000 into a bond fund that tracks the Lehman Bros. aggregate index.

That’s in essence what Pat Strier and her husband, both college professors, do.

With a few exceptions, including a small position in an Internet-related stock mutual fund, the Southland couple’s portfolio is constructed entirely with index funds.

“We took this path after [actively] managed funds were not keeping up with the indexes--and we were paying management fees,” Strier said.

Over the last decade, index funds that mirror the benchmark Standard & Poor’s 500 index of blue-chip stocks have returned, on average, 17.7% a year. By comparison, actively managed funds that invest in similar types of stocks have returned 15.4%, according to fund tracker Morningstar.

As for bonds, bond index funds that track the Lehman Bros. aggregate index have delivered total returns (yield plus or minus any principal change) of 8.7% a year, on average, versus 8% for their actively managed counterparts over the same period.

Rebalancing and Timing

Once you have mapped your overall asset allocation, the next issue is when to recalibrate the mix.

There are two basic ways to rebalance your portfolio.

One way is to do it strategically. In other words, periodically predict which asset classes will outperform and which will underperform in the near term--then gently shift assets into the groups you favor.

That’s more or less what William Lindstrom, 69, does.

The Banning resident tries to keep things as simple as he can. He sticks with funds and fund managers with solid reputations and impressive track records. And he invests in only about seven funds at a time, a manageable number for him to track.

Earlier this year, Lindstrom shifted some money from the Weitz Value fund, a small-stock fund, into Janus Twenty, a large-growth-stock fund that has since closed to new investors. Janus Twenty gained more than four times as much as Weitz Value in the 12 months ended in March.

It’s not that Weitz Value disappointed Lindstrom that much. In fact, the fund has been one of the few bright spots in what has been an otherwise dreary small-stock universe. Rather, the large growth stocks that Janus Twenty invests in are “where I think the growth is going to continue to be for a while,” Lindstrom said.

Of course, it’s often impossible to predict which sectors are going to be hot. Consider the mid-April surge in value stocks that caught growth investors off-guard.

Plus, this kind of timing forces investors to pay constant attention to their portfolios.

This is why Wilshire’s Reynolds suggests investors stick with an even simpler approach, what he calls “passive rebalancing.”

Here, rather than making short-term market calls, you adhere to your long-term asset allocation decision.

As your mix grows unbalanced--for instance, if your large growth stocks have been doing so well relative to small stocks that they now represent 75% of your holdings, not the 65% that you had intended--you periodically bring your portfolio back in line.

In the short term, this may seem counterproductive. And it can be psychologically difficult, because it means selling your big winners to buy laggards.

But passive rebalancing can help assure that you buy low and sell high, rather than the opposite.

Larry Kroll, an engineer who lives in Irvine, recently had just 20.3% of his portfolio in large stocks, 18.5% in small and medium-sized stocks, and 11.2% in foreign equities (with the balance in bonds and cash).

He realizes that he would have fared much better in recent years with a bigger allocation to large stocks.

But now Kroll, 37, fears that with large growth stocks trading at historically high valuations, they’re bound to suffer a major pullback.

And he doesn’t want to go through that again: He recalls that in the 1987 market crash, his funds lost, on average, 30% of their value in a single day.

“I remember being at work that day, hearing the news, walking down the hall and selling my mutual funds,” he said.

Kroll said the experience drove him to pull out of the market until the early ‘90s. As a result, “I totally missed the start of this bull market,” he said.

That’s why Kroll said he’d rather stick to his long-term allocation plan and not try to time the market.

Thus, Kroll is content to pick his shots through asset allocation and fund manager selection.

And in the end, financial planners say, Kroll has taken another step to simplify his strategy--by understanding his true investing temperament.

He knows that in the event of short-term market trouble, any effort he’d spend on trying to time the market may end up unraveling his long-term investing plan.

Selecting Actively Managed Mutual Funds

Using all index funds to satisfy your asset allocation plan is the simplest strategy, but that may not be interesting enough for many investors.

Mitchell Freedman, a Sherman Oaks financial advisor who chairs the personal financial planning committee for the California Society of CPAs, suggests using a mix of index funds and actively managed portfolios to fill your asset slots.

Your goal with an actively managed fund, of course, is to increase your returns over time--in other words, to beat the market.

It’s difficult, but some funds do it. What should you look for in selecting a fund?

* The fund manager’s level of experience. If simplicity is what you’re after, go with an experienced manager you can trust, analysts say. This way you won’t feel as compelled to constantly check up on the fund.

* The fund’s performance during the current manager’s tenure. Be wary of picking funds based on five- or 10-year performance if the current manager has been running the fund for only part of that time.

* Style drift. Because your biggest decision will be asset allocation, you should pick funds that stay true to their investment styles.

A fund manager with a tendency to stray--sometimes investing in large stocks, for example, sometimes in small ones--may end up undoing your asset allocation plan.

Obviously, these aren’t the only things to consider. You’ll also want to study the level of risk your fund manager takes and the fees the fund charges.

Selecting Individual Securities

Bogle’s advice notwithstanding, some investors may not be satisfied with just picking mutual funds. Many increasingly want to select individual securities to own.

That’s fine, said Edward Jones’ Williams, “if you have the time, temperament and the talent to do it on your own.”

And if you don’t? Then you may want to follow Jim Rapp’s lead, experts say.

Rapp, 42, who lives in Alexandria, Va., used to invest entirely through mutual funds. But starting in 1996, he began shifting a greater portion of his portfolio into individual stocks.

Rapp, who runs his own Internet and technology consulting firm, CyberStrategies, said picking his own stocks “is kind of like exploration.”

But rather than micromanaging his entire portfolio, Rapp set some prudent boundaries.

First, he realized that he had neither the time nor the expertise to research and trade individual foreign securities. So he kept his foreign stock allocation in mutual funds. Among his recent holdings: Janus Worldwide, one of the top-rated global funds of the ‘90s, and Vanguard European Stock Index fund.

Recently, he also maintained a core holding in USAA S&P; 500 Index fund to ensure that his portfolio has long-term exposure to large value stocks. (By definition, a “neutral” index like the S&P; 500 will include both growth and value stocks.)

This gives him time to focus his attention on choosing tech stocks, where his interest and expertise reside. In other words, he can pick his best shots here.

“I just feel more comfortable with this sector,” said Rapp, whose holdings include industry leaders such as Microsoft and Cisco Systems.

“That’s a perfectly viable approach, to concentrate on that part of your portfolio where you have the temperament,” said Williams.

By taking this relatively simple approach, Rapp is, in effect, following former Fidelity Magellan manager Peter Lynch’s oft-quoted advice: “Invest in what you know.”

He’s also adhering to the advice of Edward Jones chief investment strategist Alan Skrainka, who argues that one of the simplest ways to invest is to identify those sectors with the best potential for consistent, above-average growth (of which technology is one), then stick with companies with leadership roles in those industries.

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Paul J. Lim, who covers the mutual fund industry and other investing topics for The Times, can be reached at paul.lim@latimes.com.