Time for a New Hand?

By JOSH FRIEDMAN and TOM PETRUNO

Oct. 9, 2000 12 AM PT

TIMES STAFF WRITERS

When Duke Energy shares are whipping Cisco Systems and the three main U.S. stock indexes are in the red for the year, you know you’re in a brand-new market game.

A new game often means learning to play by different rules. And that may be the key challenge for many investors in a market where neither the bulls nor the bears seem to have a convincing hand.

Consider: If you had known at the start of this year that the Dow Jones industrial average would be down 6.3% through the third quarter and the Nasdaq composite index would be down nearly 10%, you might have figured it would be a good year to stay out of stocks altogether.

Yet the average domestic equity mutual fund was up 6.3% through the third quarter, according to fund tracker Morningstar Inc. And returns in many market sectors--including mid-size stocks, health care, natural resources and utilities--have been more than generous.

If this is a bear market, plenty of investors must be happy to be a part of it.

For others, however, 2000 has marked the end of a spectacular winning streak that began in 1995. The blue-chip Standard & Poor’s 500 index is down this year after five straight years of 20%-plus total returns.

And a big reason for the S&P;’s slump is the slide in giant technology stocks that had ruled the market in the late ‘90s. Those shares plummeted again last week on growing worries about their sales and earnings prospects, reducing the average technology stock mutual fund’s year-to-date return from a positive 3.0% at the end of the third quarter to a negative 5.7% by Friday, according to Morningstar.

Aggressive technology investors who early this year mocked the idea of keeping some of their money in something as pedestrian as a municipal bond mutual fund may be reconsidering now: The average California long-term muni bond fund has produced a return of 8.1% so far this year, which beats most stock funds.

The general idea of portfolio diversification isn’t novel, of course. But it may be so for people who coasted along in recent years without focusing on how their investment mix was being changed by the market’s moves.

Jeremy Siegel, a finance professor at the University of Pennsylvania’s Wharton School, said that, although the ‘80s and ‘90s explosion in mutual funds has, by definition, brought about more diversification for investors, “The trend in the last five years has been toward more concentration--perhaps too much--thanks to the big ride in technology and a reluctance to realize taxable gains.”

Abiding by basic diversification rules can raise the odds that you’ll always have some element of your portfolio making money, and lower the odds of a catastrophic loss of capital.

Yet many small investors understandably find it boring to think in terms of classic diversification strategies--30% in this stock sector, 20% in that sector, 10% in this one, etc.

For some, there is still a feeling that diversification dilutes returns too much in exchange for supposed stability.

“I look at diversification with a bit of a jaundiced eye,” said Mel Brocklehurst, a 70-year-old retiree in the High Desert community of Pinon Hills. “Technology has created a new paradigm, so it’s hard to argue with those stocks” despite their volatility, he said.

One survey last year found that only 44% of 401(k) retirement-plan investors had any kind of asset allocation program.

The ‘D’ Word

Burned by the failure of some textbook diversification rules in the 1990s--such as the argument for owning foreign stocks--even some professionals have junked the old formulas.

“A lot of other financial planners are throwing out asset-allocation altogether,” said planner LauraTarbox of Tarbox Equity in Newport Beach.

Still, planners say some investors have become more receptive to the idea of diversification this year, as forgotten market sectors have suddenly zoomed while recent stars have tumbled.

“In the past few years people were saying, ‘Just give me that tech.’ But the blood on the streets following Nasdaq’s March peak has made the most compelling case for diversification we’ve seen in quite awhile,” said Victoria Collins, a planner with Keller Group Investment Management in Irvine.

“Investors have been hurt, and pain always causes a little better listening,” she said.

The good news, at least so far, is that some money that has come out of tech stocks and blue chips has looked for a home in non-tech stocks and smaller stocks--rather than fleeing the market entirely. That has helped produce this mixed stock market.

“It’s a broadening market, and more than likely these trends will continue, so it’s time to throttle back, to add a little more non-tech” to one’s portfolio, said Marshall Acuff, equity strategist at brokerage Salomon Smith Barney.

“Once the Internet bubble burst, people started thinking about the prices they are paying [for stocks],” he said. Still, “I wouldn’t rush out and buy steel stocks,” Acuff said. “I’d still look for growth stocks, but growth at a reasonable price.”

Barring an economic recession, many Wall Street pros can’t see a reason the market should fall into a full-fledged bear phase, which traditionally means a decline of more than 20% in such major indexes as the S&P; 500 from their peaks. (Though tech-heavy Nasdaq is down 33% from its record high set in March, the S&P; 500 is down just 7.7% from its record, also set in March.)

In a true bear market, investors tend to sell out of everything. That hasn’t happened this year. Many investors are simply looking for new ideas.

“We may see a shift toward ‘value’ stocks--or at least more of a mixed market--for the next couple of years,” said Stuart Freeman, strategist at brokerage A.G. Edwards & Sons. “Many people forget, if they ever knew, that there have been long periods in the past when value has outperformed growth.”

Mixing ‘Old’ and ‘New’

Indeed, the search for relative value--stocks selling for much lower price-to-earnings ratios than the tech sector’s giants--has helped pump up long-ignored medium-size and smaller stocks since spring.

There is no guarantee that those sectors wouldn’t collapse in a true bear market. But because the small-cap and mid-cap sectors often move out of step with blue-chip stocks, many financial advisors suggest that investors keep some portion of their portfolios in those sectors.

An investor with a portfolio now exclusively blue-chip stocks, for example, could consider moving 10% of the total into a small-cap fund and 10% into a mid-cap fund. Or you can change the contributions in your 401(k) plan to begin adding to those types of funds, if offered.

Collins, however, said her firm generally doesn’t adhere to a strict diversification matrix based on modern portfolio theory--with precise percentages in large, medium and small stocks, value and growth, U.S. and international, etc.

“Instead, we look at the industries with the most potential,” she said, “and we use a mix of those as well as assets such as bonds to tone down a portfolio’s volatility.”

Many advisors and investors appear to be thinking in terms of “old economy” and “new economy” these days, rather than a traditional diversification model.

Collins, for example, said she might set up a portfolio including names such as Nortel Networks, Texas Instruments and software giant Oracle along with financial stocks such as Chase Manhattan, utilities such as Williams Cos. and retailers such as Target.

As she put it, “Here’s diversification by looking at the trends going forward.”

Pat Morgan, a 69-year-old retiree in Westlake Village, likes having stakes in the old and new economies. Her portfolio combines names such as biotech giant Amgen, wireless phone leader Nokia and computer-chip firm Conexant Systems with Coca-Cola, McDonald’s and Home Depot.

She doesn’t feel compelled to add smaller stocks to her mix of technology and blue-chip names, in part because she worries about their liquidity. “I always look at the trading volume to see if there is a good market, so that probably keeps me away from the smaller and riskier stocks,” she said.

Tarbox said her firm recommends a small-stock weighting of 12% of assets for its model portfolios.

“That’s not as much as we’d like, but we’ve had people question why we’re in [small stocks] at all,” she said. Compromise and negotiation can be part of the planning process.

Americans’ overall mutual fund investment mix shows how dominant big-stock funds are in people’s portfolios: Large-capitalization-stock funds hold 59% of total diversified U.S. stock fund assets, according to Lipper Inc.

An additional 30% is in funds that can invest in any size stock. Just 11% of diversified fund assets are in funds that specifically focus on either small- or mid-cap stocks.

For some investors, the process of diversification itself carries risks.

“Some people own 20 mutual funds, often without realizing that most of them have the same stock holdings,” said Joel Framson, a planner with Glowacki Framson Financial Advisors in West Los Angeles.

Investor Tommy Mayton, 70, of Columbus, Ga., said he has more than 50 mutual funds. “I know the experts would say I have too much overlap, but this method has worked pretty well for me,” he said.

Investors who build portfolios of individual stocks can achieve good diversification with less than two dozen stocks, some experts say.

“Twenty stocks is basically enough if they are chosen properly,” said Robert Sheard, author of “Money for Life” (HarperBusiness, 2000). “After that you’re watering down your best ideas.”

Taking Inventory

Meanwhile, in a year when bonds are providing decent returns overall, investors who own them are perhaps appreciating them more as a capital-preservation tool--especially with many technology stocks down 60% or more from their peaks.

Patti Ogden, a Los Angeles teacher in her 50s, said she’s glad she bought the Janus Balanced fund, which mixes bonds and stocks, several years ago when designing her portfolio.

“Although it can wobble a bit, that fund has held up nicely during most of these market downturns,” she said.

Some investors have turned to other traditional value investments in recent months, including real estate investment trust shares, which typically pay high cash dividend yields.

“In the past, that was often a difficult discussion, but with REITs doing so well this year it’s a lot easier to explain the benefits” of that asset class, Framson said.

Of course, a few months of hefty returns from REITs and other previously lagging market sectors don’t necessarily mean they’ll keep the lead. But Wall Street is keenly aware of its own cycles. Big-name growth stocks for the most part trounced everything else from 1994 through 1999, and big-name technology stocks were generally the best of the best performers.

When the market, like a supertanker, begins to move in a new direction, it can be carried along by its own weight.

Investors who dislike the idea of formal diversification plans still would be wise to take inventory of what they own: What percentage of your stock fund assets, for example, are in big-cap growth stocks? What else do you own that might offset your big-cap stake if its returns disappoint for an extended period?

“Even people who were properly allocated five years ago may now be in a position where they need to be taking from the part of the portfolio that makes them feel so good and putting it into what has made them feel so bad,” said Paul Merriman, president of Merriman Capital Management in Seattle.

Though it requires discipline and there may be tax consequences to consider, portfolio rebalancing can force you to buy low and sell high--a feat otherwise often difficult to achieve.

Don Roth, 64, of Northridge, said he cut his stock exposure to 6% of assets from 20% a few years ago after retiring, with the balance in lower-risk assets.

“Somebody in their 20s might have 50 years to make it up if the market tanks. But I have a lot to lose,” he said. “This way, my risk is that if the market takes off again, I get left behind. I can live with that.”

Times staff writer Josh Friedman can be reached at josh.friedman@latimes.com.

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Where the Money Is, by Fund Sector

The bulk of the dollars invested in diversified U.S. stock funds are in large-capitalization-stock funds. Small-cap and mid-cap funds hold about 12% of that total pie.

Large-cap funds*: $1,774 billion

Multi-cap funds**: $905 billion

Mid-cap funds: $186 billion

Small-cap funds: $156 billion

* Includes large-cap funds, S&P; 500 index fund and equity-income funds

** Can invest across the entire spectrum of stocks

Source: Lipper Inc.

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New Millennium, Different Leaders?

Mutual fund sector returns through the third quarter of this year:

They’re Hot

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