Finding the right mix in a tumultuous market

Amid the stock market’s sharp losses and wild volatility in the first quarter, some investors may have discovered their true threshold for pain.

So what do you do if that threshold turned out to be a lot lower than you’d thought?

There are steps you can take to reduce your risk of serious portfolio losses should stocks be headed for something worse than what they’ve already experienced.

Of course, paring back on equities is a knee-jerk reaction many people have when prices fall. And when emotions rule investment decisions, the odds go up that you’re making the wrong decision for your long-term financial health.

For all anyone knows, the stock market already has hit bottom, ending a decline that began last fall.

Still, some investors may have legitimate reasons for wanting to lower the risk in their portfolios, given the uncertainty facing the economy and the markets.

If your tolerance for risk has changed, here are three strategies that could make your portfolio safer:

--

Cut your stock weighting

The easiest way to reduce your risk of loss is to cut back on stocks in favor of less risky assets, such as bonds or short-term cash accounts.

The average domestic stock fund fell 10.6% in the first quarter, according to Morningstar Inc. By contrast, the average government bond fund gained 2.8%, while long-term California municipal bond funds slipped 1.9%.

For anyone whose assets primarily are in a 401(k)-type retirement savings plan, shifting the mix is easy enough.

But think about the next 10 years, rather than the next 10 weeks, before making a move, financial advisors caution.

Norman Boone, head of Mosaic Financial Partners, a San Francisco-based advisory firm, says shifting your asset mix is justified only if your long-term goals or your life circumstances have changed -- for example, you will be retiring earlier than expected.

In either case you might decide that capital preservation has become more important than capital appreciation.

If you opt to shift money from stocks to high-quality bonds (such as government, corporate or municipal issues), you can expect to reduce your risk of serious loss. Compared with stocks, bonds are inherently less risky because they are interest-bearing IOUs.

Consider what happened in the last stock bear market: From March 31, 2000, to Sept. 30, 2002, a portfolio of 80% stocks and 20% bonds dropped 32.7% on average, according to data from Vanguard Group.

By contrast, a portfolio of 40% stocks and 60% bonds lost just 5.5% in the period.

The flip side, of course, is that cutting back on stocks and boosting bonds is likely to lower the long-term returns on your portfolio. And that may be particularly true this time, given the low yields now on government bonds.

From 1926 to 2007, a portfolio of 80% stocks and 20% bonds generated an average annualized return of 9.7%, according to Vanguard. The return on a 40% stocks-60% bonds portfolio was 7.9%.

That difference of 1.8 percentage points a year becomes huge over time.

“We design portfolios based on what the client needs to get in terms of returns the rest of their life, so they don’t run out of money,” Boone says. “If you go from 80% equities to 50%, you’re raising the probability of running out of money.”

But if the thought of losing a large chunk of your nest egg in the near term is too much to handle, then reducing stocks in favor of bonds or cash is an easy solution.

If you don’t want to manage the mix yourself, you can opt for portfolios, often known as balanced funds, that maintain set asset allocations.

“Plain old asset-allocation funds have appeal if you want to tone down the volatility” in a portfolio, says Russ Kinnel, director of fund research at Morningstar in Chicago.

The average fund in Morningstar’s “conservative allocation” category was down 3% in the first quarter. Conservative-allocation funds hold stocks and bonds but tilt more toward bonds. Morningstar’s favorite conservative allocation funds: T. Rowe Price Personal Strategy Income, Vanguard Tax-Managed Balanced and Vanguard Wellesley Income.

--

Shift your stock mix

If you’re worried about a deep economic slump, you could cut back on stock investments that might be most vulnerable under those circumstances.

The difficulty, of course, is in trying to predict which stock sectors might fall the most and which might fall the least.

Historically, shares of smaller companies have been riskier than those of large companies. And shares of companies in emerging markets overseas have been considered riskier than those of companies in the developed world.

Measured over the last year, smaller U.S. stocks have in fact fallen more sharply than bigger stocks. The average small-cap “growth” fund lost 10.7% in the 12 months ended March 31, compared with a mere 1.3% drop for the average large-cap growth fund.

And in the first quarter alone, emerging-market funds slid 11.3% on average, compared with a 10% decline for the average foreign fund.

But there’s no guarantee that those trends will continue even if markets overall take another dive.

There may, however, be a good reason for some investors to consider cutting back on smaller stocks and emerging-market issues: Both of those sectors have scored large gains over the last five years. If that means they’ve grown to be a larger share of your total portfolio than you’re comfortable with, that’s a reason to pare them back.

Foreign stocks, in particular, are “one area where someone’s portfolio could be out of balance,” says John Kleponis, a portfolio manager at Yosemite Capital Management in Tustin.

But if you sell foreign issues, consider moving that money into domestic stocks rather than into cash, Kleponis says. In the U.S. market, “we think most of the damage is already done.”

Another option for investors who are concerned about potential losses in an extended market decline: “Try to find those funds that have held up better in times like this,” says Giles Almond, head of Matrix Wealth Advisors in Charlotte, N.C. One such fund he uses for foreign-stock exposure is First Eagle Overseas. The portfolio lost a modest 1.9% in the first quarter.

Another idea: The FPA Crescent fund in Los Angeles, managed by Steven Romick at First Pacific Advisors. Crescent was down 1.2% in the first quarter and has earned 13.3% a year, on average, over the last five years. Romick manages an eclectic portfolio of stocks and bonds and isn’t afraid to hold a large chunk of cash when he can’t find bargains.

--

Add a portfolio ‘hedge’

Let’s say you’re generally happy with the long-term outlook for the stock funds you own, but you’d also like to have some “buffers” in your portfolio -- investments that stand a good chance of rising if the stock market slides further.

The first caveat: Just because Wall Street pitches an idea as a portfolio buffer doesn’t mean you should bite. You could pay high management fees for a fund that doesn’t do what it promises.

“Whenever we go through a downdraft in the market, these ideas come up,” says John Bagley at Strategic Wealth Advisors, a Scottsdale, Ariz.-based fee-only financial advisor.

“There’s a lot that is just about marketing,” he warns.

The bigger issue is whether a small hedge-type investment would really offset much of what you’d lose in a deep stock market decline.

What’s more, a hedge of some kind might allow you to sleep better at night, but in the long run it’s just a bet against the bulk of what you own, says Yosemite’s Kleponis.

In any case, he says, “The best time to [hedge] is after the market has gone up, and not after a severe drop.”

That said, if you’d still like to add a buffer, here’s a look at fund sectors that might offset overall stock market declines:

* Commodity funds. Precious-metal funds, which typically own shares of gold- and silver-mining companies, rose 4.9% in the first quarter, on average, as gold hit record highs.

Funds that track broad measures of commodity prices also did well in the quarter as investors favored “hard assets” over stocks. Pimco Commodity RealReturn, which is designed to replicate or beat the performance of a basket of commodities, surged 14.4%.

But natural-resource funds, which include commodity funds, lost 2.8% in the quarter, according to Morningstar. Many funds in the category are focused on energy stocks, which had a rough quarter despite record oil prices.

The argument against buying commodities now is that they’ve had a great run since 2002, and you’d be late to the party, if you got there at all.

Still, many advisors say they’ve become convinced that commodities belong in every portfolio, on a small scale, as a long-term holding.

Matrix’s Almond typically puts 2.5% of a client’s assets in the Pimco fund. “Even that has been enough to help” overall portfolio performance, he says.

Maybe the best advice if you want to add commodities at this point: Do so slowly over the next six months.

* Long-short funds. These portfolios can bet on stocks (go “long”) and also bet against stocks, by “shorting” them.

In a short sale a fund borrows shares, usually from a brokerage’s inventory, and sells them in the market. The bet is that the market price will drop.

If the bet is correct, the fund eventually can buy new shares at a lower price to replace the borrowed shares. The profit is the difference between the sale price and the repurchase price.

The risk with shorting is that the stock can rise instead of fall -- which means the bet is a loser.

In the first quarter the average long-short fund slipped 3%, according to Morningstar. So shorting stocks appeared to help the funds limit their overall loss compared with the average stock fund.

Some investment advisors doubt whether many long-short funds will be able to consistently deliver decent results.

“You need to have an active manager who is right on both long and short calls,” Mosaic’s Boone says. In his view, that’s easier said than done.

Still, some funds have had success with the strategy. Diamond Hill Long/Short fund, based in Columbus, Ohio, lost just 0.5% in the first quarter and earned an average of 17.7% a year over the last five years.

* Bear-market funds. Some mutual funds are designed for just one thing: making money when a market is falling.

Typically, that means these funds primarily or exclusively short the stock market, the bond market or some narrow segment of either.

Many of the funds are “inverse index” portfolios: They do their shorting using futures contracts tied to broad or narrow market indexes. So if an index falls 5%, an inverse index fund is supposed to rise 5%. The flip side also is true: If an index rises 5%, your inverse index fund should drop 5%.

Some bear-market funds juice their bets, so they move twice as fast as the market, in the opposite direction.

Patrick Smiekel says he has routinely used inverse-index funds to hedge his portfolio.

“A short fund should be part of a varied portfolio,” says the 62-year-old Montecito resident, calling the funds an “insurance policy” against serious losses.

But David Kathman, an analyst at Morningstar, says the funds have limited appeal -- mainly, he said in a recent report, to hedge large portfolio bets that you don’t want to sell.

But for most people, he said, “The best way to hedge risk is through old-fashioned portfolio construction,” meaning basic diversification.

--

tom.petruno@latimes.com

--

(BEGIN TEXT OF INFOBOX)

A couple of winners -- and a lot of losers

Treasuries

Funds that own long-term U.S. government bonds jumped 4.4% in the first quarter as fearful investors sought safety.

Commodities

Record prices for oil, gold and other raw materials helped boost many funds that own physical assets or the stocks of commodity-related companies.

Technology

Spooked investors sold many of last year’s highest fliers in the tech sector, including Google and Apple. The average tech-stock fund fell 16%.

Financial issues

The U.S. credit crunch hammered stocks of banks, brokerages and related firms. The average loss for funds that focus on those issues: 12.1%.

Asian stocks

Asian markets, big gainers last year, were hit hard by the global sell-off. The average Pacific-region stock fund dropped 10.8%.

Junk bonds

The typical junk-bond fund lost 3.6% as investors fretted that heavily indebted firms would have more trouble repaying their debts in a weakening economy.