Fine-Tuning a Portfolio to Make Money and Still Sleep Soundly
April 04, 2011
Amid the recent market turmoil, maybe you are wondering whether you really have the right mix of investments. Here are a few thoughts to keep in mind: Taking Stock If you are a bond investor who is petrified of stocks, the wild price swings of the past few weeks have probably confirmed all of your worst suspicions. But the truth is, adding stocks to your bond portfolio could bolster your returns, without boosting your portfolio's overall gyrations. How can that be? While stocks and bonds often move up and down in tandem, this isn't always the case, and sometimes stocks rise when bonds are tumbling. That happened in this year's first six months, when U.S. stock-mutual funds soared 10.8%, while taxable bond funds slipped 0.3%, according to Lipper Analytical Services. Indeed, Chicago researchers Ibbotson Associates figures a portfolio that's 100% in longer-term government bonds has the same risk profile as a mix that includes 83% in longer-term government bonds and 17% in the blue-chip stocks that constitute the Standard & Poor's 500-stock index. But while the risk level is similar, the bond-stock mix had better returns over the past 25 years, gaining 10.2% a year, compared with 9.6% for longer-term government bonds alone. The bottom line? Everybody should own some stocks. Even cowards. Same Great Taste, Even More Filling All right, you will buy a few stocks. But you are sticking strictly with blue chips. A good move? Here's another fun fact from Ibbotson Associates. The Chicago firm calculates that a portfolio that's 100% in the S&P 500 is about as risky as a mix that includes 73% S&P 500, 6% smaller-company stocks and 21% foreign stocks. But the globally diversified portfolio was more rewarding over the past 25 years, climbing 12.9% a year, compared with 12.2% for the S&P 500. If you're going to own stocks, it clearly pays to diversify. Padding the Mattress On the other hand, maybe you're a committed stock-market investor, but you would like to add a calming influence to your portfolio. What's your best bet? You've got a bunch of choices, but none of them is great. Some investments, like gold and Treasury bills, really help to damp a stock portfolio's ups and downs, but their recent returns haven't been anything to rave about. Other choices, such as bonds and real-estate investment trusts, don't crimp returns too much, but they also don't provide a lot of downside protection. What should you do? When investors look to mellow their stock portfolios, they usually turn to bonds. Indeed, the traditional balanced portfolio, which typically includes 60% stocks and 40% bonds, remains a firm favorite with many investment experts. A balanced portfolio isn't a bad bet. But if you want to calm your stock portfolio, I would skip bonds and instead add cash investments such as Treasury bills and money-market funds. Ibbotson calculates that, over the past 25 years, a mix of 75% stocks and 25% Treasury bills would have performed about as well as a mix of 60% stocks and 40% longer-term government bonds, and with a similar level of portfolio price gyrations. So why do I favor the stock-cash mix? A couple of reasons. First, the stock-cash mix offers more certainty, because you know that even if your stocks fall in value, your cash never will. By contrast, both the stocks and bonds in a balanced portfolio can get hammered at the same time. Second, a mix of stocks and cash should offer fewer tax hassles. That's partly because a stock-cash combination will kick off less in total interest and dividend income each year than a traditional balanced portfolio, so the stock-cash mix should be more tax efficient. In addition, you can dip into your cash investments without realizing a capital gain, so there's less accounting headaches at tax time. That's not the case with stocks or bonds, where a sale usually results in a capital gain or loss that then has to be reported to the Internal Revenue Service. Patience Has Its Rewards, Sometimes Stocks are capable of generating miserable short-run results. During the past 50 years, the worst five-calendar-year stretch for stocks left investors with an annualized loss of 2.4%. Sound grim? In fact, even conservative investments can generate disappointing results over shorter periods. Longer-term government bonds, in their worst five-year stretch during the past 50 years, lost 2.1% a year, while Treasury bills gained just 0.8% a year in their toughest five-year spell. But while any investment can disappoint in the short run, stocks do at least sparkle over the long haul. As a long-term investor, your goal is to fend off the dual threats of inflation and taxes and make your money grow. And on that score, stocks are supreme. According to Ibbotson Associates, over the past 50 years, stocks gained 5.5% a year after inflation and an assumed 28% tax rate. By contrast, longer-term government bonds waddled along at just 0.8% a year and Treasury bills returned a mere 0.3%.
