Challenging Conditions Ahead Call for Portfolio Review

Last year should have scared some sense into the average investor.

For the first time in years, diversification worked, and greed didn’t. Cautious investors triumphed, and those who believed that “things are different this time” learned otherwise.

Even if you survived last year intact, however, this is no time to rest on your laurels. Challenging conditions ahead and the unpredictable nature of markets make periodic reviews a necessity.

If you took some heavy hits, there’s even more reason to reassess your strategy.

Here’s what to think about when reviewing your portfolio:

* Prepare for the worst . . .

Interest rate cuts by the Federal Reserve could stave off a recession--or not. The market could recover lost ground quickly--or not. The happiest investors in the worst-case scenarios will be those who hedged their bets.

To reduce risk, most investors need to keep part of every portfolio in cash and bonds, which, as 2000 showed, tend to do better when stocks falter.

Real estate and natural resources stocks can also diversify a portfolio, said Upland financial planner Nancy Langdon Jones, who likes to keep 15% of her clients’ portfolios in real estate investment trusts and mutual funds that specialize in timber, oil and metals. After years of lagging returns, both sectors took off in 2000, with REITs up 26.2% on average and natural resources up 30.4%.

“Our clients were complaining about both of these [investments] until last year,” Jones said.

If you’re already in retirement, your need to reduce risk may be especially acute. Unlike working investors, you don’t have years of wages ahead of you to make up for any investment mistakes you make.

Although retirees may find that one year of flat or negative returns does not require any belt-tightening, a string of poor returns could seriously increase the risk of running out of money.

If you’re still saving for retirement, you might want to recalculate your savings assumptions using more conservative investment return figures. Some planners say an 8% or 9% annual return for a diversified portfolio may be more realistic in years to come than the double-digit gains the market gave us in the late 1990s.

Consider reviewing your estate plans, especially if they involve charitable or personal gifts aimed at reducing the size of your taxable holdings.

Estate planners typically encourage affluent older people to take advantage of gifting rules by giving away $10,000 per recipient annually to leave less to Uncle Sam. But make sure you can survive an extended market downturn before you give that money away.

Finally, consider taking any non-retirement investment money and using it to pay off credit cards and other consumer debt. That provides a guaranteed return that may beat anything the stock market has to offer this year.

* . . . but hope for the best.

There’s a downside to preparing for the worst: You can miss out on some of the benefits if the opposite happens instead.

That’s why it’s important to keep in mind that stocks historically have provided better long-term returns than any other class of investment. Planners say most investors need to keep at least 50% of their portfolios in stocks and stock mutual funds to beat inflation and achieve real growth.

Besides, if you’re completely out of the market, you can miss outstanding rallies such as Wednesday’s, when a surprise Fed rate cut catapulted Nasdaq upward by a record-breaking 14% in one day.

“I don’t think anyone could have predicted that,” said Robert Wacker, a San Luis Obispo financial planner.

Wacker tells his clients that they need to keep their money in the stock market so they can benefit from these sudden updrafts, as well as from the long-term returns stocks tend to offer. He also takes some comfort from the fact that the stock market historically has done well after the Fed trims rates, although he cautions against too much optimism.

“On the one hand, the market tends to go up significantly after a rate cut. On the other, [the Fed] sees a real specter of recession out there,” he said.

* Take a good, hard look at your portfolio . . .

Clinging to an investment that has lost significant ground could be the smartest, or the most foolish, thing you can do right now.

If the investment is the stock of a company with bleak prospects or a mutual fund that consistently trails its peers, there is little sense in hanging on to it until it “comes back.”

Many investors feel obligated to try to break even on their investments, even when it exposes them to the risk of losing even more money, said Terrance Odean, an expert in investor behavior and a professor at UC Davis.

On the other hand, many stocks, mutual funds and market sectors fell precipitously last year, and selling out now could just prevent you from participating in some future rally.

How to tell the difference? Sometimes it’s tough, but you can get a clue from remembering why you bought the investment in the first place and how it’s performing relative to its peers.

If you decided last year that your portfolio needed more technology stocks and you bought a diversified tech fund at the peak of the market, it could be smart to hang on, particularly if the fund did no worse than its peers. After all, most financial advisors believe in technology’s long-term prospects, even if the short-term outlook is a bit dicey.

But if you bought technology stocks without regard to how they fit into your overall portfolio, and many plunged well beyond Nasdaq’s 39% loss last year, it’s time for a stock-by-stock review and pruning.

Investors “should have some level of knowledge” about the stocks they own, Wacker said. Decisions about buying or keeping a stock, for example, should be based on the company’s earnings and competitive situation, not on stock tips picked up in chat rooms or overheard at a party, he said.

Investing tools available on many Web sites, such as the portfolio manager at https://www.morningstar.com, can help you review and compare your funds and stocks.

* . . . but know when enough is enough.

Many investors don’t have the time, skills or inclination to manage a portfolio of stocks and bonds. That’s why many planners recommend the professional management and diversification available through mutual funds. Mutual fund investors can tweak their portfolios once or twice a year, whereas stock investors often find they must constantly monitor their holdings.

“You can’t go on vacation and not check your [stock] portfolio for weeks--that’s too long,” said Seattle financial planner Karen Ramsey, author of “Everything You Know About Money Is Wrong” (Regan Books, 1999).

Even if you have time to research and track your holdings, many planners recommend sticking to mutual funds unless you have a relatively large portfolio.

“If you don’t have more than $200,000 to $300,000, I don’t think you can get diversified enough” buying individual stocks, Ramsey said.

Keeping it simple also applies to the type of investments you choose. The average individual investor can live without exotic trappings such as hedge funds and elaborate stock option strategies. Sticking to plain-vanilla investments can help keep you from getting blindsided by risks you didn’t anticipate.

Just one recent example: Thousands of investors who borrowed money to buy stocks faced margin calls in 2000--requirements from their brokerages that the money be repaid or the account liquidated as the stocks bought on margin plummeted in value.

Ramsey recommends her clients--most of whom have a million-dollar-plus net worth--eschew exotic investments and techniques.

“Most people don’t really understand” the risks of many investment strategies, Ramsey said. “If you don’t understand how it works, you shouldn’t invest in it.”

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Liz Pulliam Weston is a personal finance columnist for The Times.