Wednesday, January 18, 2012

Portfolio Protection, Step 3: Don’t Put All your Eggs in One Basket

In my recent article 5 Steps to Protect Your Portfolio | InvestorPlace, the third step I discussed was diversifying your investments to reduce the volatility and risk of your portfolio.

You can think of diversification simply as this, “Don’t put all of your eggs in one basket”. Instead, create a portfolio that has a variety of non-correlating assets, essentially, assets whose prices move in opposite directions. That way, if one stock or sector or style of investing underperforms, you have a fighting chance that some of your other assets will rise, ultimately reducing your losses.

Many investors pay no attention to diversification. Instead, they find a sector or industry they like and invest their entire portfolios in one place. That’s great if all of those stocks just keep going up. But the laws of nature—and the stock market—never work that way for long. Consequently, those investors eventually lose their shirts because even the very best sectors don’t rule the market for ever.

The bottom line is this: By adequately diversifying your portfolio, you reduce the risk that all of your assets will decrease in value simultaneously.

Having said that, you should know that there is no perfect selection of non-correlating assets. Like all aspects of investing, the correlation of assets is subject to change over time, through different economic and investment cycles.

As a result, you should think of your portfolio diversification as a moving target. You will need to monitor it regularly so that you can move investments in and out, as cycles change. Fortunately, the major economic cycles are generally years-long.

Broadly speaking, there are three major long-term economic cycles:

·       Recession ends and expansion begins, the early cycle when the stock market generally makes the most impressive gains, and more cyclical and high-growth stocks (such as small caps) typically do well.
·       The Fed raises interest rates as the economy heats up. About three months prior to this, and continuing for about nine months after, we enter a mid-cycle, when returns continue to be better than average, but not as good as in the early phase. Attractive stocks begin shifting to the cyclical, high-yield investments.
·       An expansion ends and a recession begins. For about a six-month period prior to the recession, stocks begin to turn flat, then begin to decline during the recession, with investors flocking to less economically-sensitive, more defensive stocks.

We have had a tremendous run (the early cycle) since March 2009 when the Dow Jones Industrial Average bottomed out at 6,547. Yesterday’s close is almost doubled that—12,482. But Europe’s troubles have created tremendous volatility and slowed down the cycles. Consequently, I think we are now somewhere between the early- and mid-cycles.

Historically speaking, that means that financials, consumer discretionary, technology and industrials should have been the biggest beneficiaries of the early cycle. Let’s see how that worked out.

According to Morningstar, the best sectors in the last three years were:

·       Consumer cyclical (discretionary), 34.8%
·       Technology, 29.3%
·       Real estate, 26.2%
·       Basic materials, 25.6%
·       Industrials, 23.1%

That mostly followed history, but where were the financials? They gained about 14.2%, third from the bottom of all sectors. Not bad, but it gets worse. The one-year return for the financial sector was -13.9%.

The financial sector hasn’t yet recovered from the huge credit debacle that almost drove us over the edge. But it is making progress. Consequently, I think we’ll see the financials begin to improve pretty soon, along with the other sectors that should do well in this cycle, namely the technology, industrials, energy and materials sectors.

So let’s talk about diversifying for this early-mid-cycle.

First of all, I think just about every investor would benefit by having the following investments in their portfolios:

·       Small-cap companies, with market caps between $300 million and $2 billion
·       Mid-cap companies, with market caps between $2 billion and $10 billion
·       Large-cap companies, with market caps more than $10 billion
·       International stocks
·       Growth stocks
·       Value stocks
·       Dividend-paying stocks
·       Fixed-income investments

The percentage devoted to each of these investments will greatly depend on your personal investment style and risk profile. But during this cycle, investors may want to focus on moving a larger percentage of their portfolios into mid- and large-cap stocks, adding a few dividend payers and more value stocks.

Of course, I believe there is always a place for small-caps, growth stocks and international companies. Most investors can easily get international exposure via multinationals, but you should also be ready to test the waters of emerging markets when we see the tide change—not just yet, though.

Some investors will want to purchase individual stocks or bonds, and others will be happier with exchange-traded funds that offer a basket of investments in any of the above categories.

In my article on ETFs 5 ETFs to Buy for Growth in 2012 | InvestorPlace, I gave you a selection of basic exchange-traded funds that cover these sectors. Today, I’ve run my screens on individual equities, looking foremost at technical indicators that appear promising in the short-term, followed by a selection of fundamental parameters. I was thrilled to see dozens of companies that looked very interesting. Here are a few for your consideration:

American Capital, Ltd. (ACAS) & Area Capital Corporation (ARCC), which are both private equity or business development companies. I had ARCC in my Buried Treasures portfolio at one time, and we saw a return of 82% in just eight months. I don’t see quite that stellar of a return in the stock in the next few months, but I think you could still gain double-digits. I believe both companies will benefit from an improvement in the credit markets.

For dividends, you might consider Duke Realty (DRE), an industrial, office and retail Real Estate Investment Trust, currently paying a 5.4% dividend, or Huntington Bancshares (HBAN), a regional bank with a 2.7% yield.

As you might expect, this is the sector in which I found scores of potentially good investments, but I’ll limit my recommendations to just a few.

Although Steve Jobs has departed, I feel that Apple Inc. (AAPL) still has plenty of momentum left. The tremendous innovation goes on, and most analysts expect the shares to reach more than $500 in the next year.

If the price of AAPL’s shares are a little too rich for your pocketbook, you might consider Agilent Technologies (A), a company that makes bio-analytical and electronic measuring systems, or that old stalwart, Cisco Systems (CSCO)—a business that has not performed very well recently, but looks more promising as the recovery continues.

Familiar household names like Boeing Co. (BA), Deere & Company (DE) and Caterpillar Inc. (CAT) would nicely fill out your portfolio in this sector. They are all trading at very reasonable price-equity ratios; each pays close to a 2% dividend, and they should continue to benefit as the global recovery strengthens.

If you are feeling ready to speculate a bit, you might also think about adding home builders, such as Lennar Corp. (LEN) and Toll Brothers Inc. (TOL) to your portfolio, to take advantage of the coming real estate recovery.

Energy and materials
Many of the companies in these sectors still seem undervalued, but I particularly like Agrium Inc. (AGU), an agricultural nutrient business, and BP plc, (BP), a company that is recovering from the disastrous oil spill, and looks interesting for days ahead.

These are just a few companies to help you transition your portfolio for the next sub-cycle. Of course, you should do your own homework and make sure that the stocks you select match your personal needs and goals. Happy Investing!

1 comment:

  1. Nancy,why can't we use SDS as a hedge to offset the market risk?