Recession-resistant funds may scoop up lots of holdings
Sometimes, the questions we "don't "ask are more important than the ones we do.
Had someone asked, for example, "Can he hit?" the Red Sox might never have traded pitcher Babe Ruth to the Yankees. Had Socrates asked, "What's this drink called?" we might have a different Philosophy 101 course.
One question every investor needs to ask is, "How much money can I lose?" It's a particularly urgent question in uncertain economic times - now, for example. So for the second column in our series on dealing with stormy financial markets, we're going to talk about how to make your portfolio as recession-proof as possible.
Let's start with the proposition that the more narrowly focused your portfolio, the larger the potential gains or losses. Suppose, for example, you had invested in the Hey, Boy & Howdy Fund, which owned five stocks. If one of its stocks had been Google, then you would have made a great deal of money. But if one of those stocks had been Enron, then you'd be sitting on some big losses.
Highly concentrated funds, particularly those that focus on one sector, enjoy the biggest potential for outsize losses and gains. If you're worried about a downturn, you should look for funds with many holdings. You'll give up the chance for a 100 percent gain in one year, but you probably won't lose 70 percent, either.
One easy choice would be Vanguard Total Stock Market Index, which holds 3,685 stocks and tracks the MSCI US Broad Market Index. (Vanguard's rival, Fidelity, offers the Fidelity Spartan Total Market fund, which has 3,411 holdings and tracks the Dow Jones Wilshire 5000 index.)
These funds will protect you somewhat if one stock, or even one whole sector, takes a bruising. Keep in mind, though, that they're still stock funds and will follow the stock market faithfully - even if it walks off a cliff. If you want further protection, you have to invest in something that might not move in lockstep with the broad stock market.
You can use two statistical measures to determine how closely one type of fund tracks another. The first is a fund's statistical correlation with another fund or a broad index. A 100 percent correlation is a perfect match; a 0 percent correlation means the two funds' movements are unrelated. A negative correlation means the two move in opposite directions.
Consider, for example, the Lipper large-cap core fund index, which measures the performance of the largest funds in that category. The index has a 98.9 percent correlation with funds that track the Standard & Poor's 500 stock index. If you own an S&P 500 fund and a large-company core fund, you're not getting much diversification from owning the two funds.
Another measure, called r-squared, shows how much one fund's movements can be traced to the movements of a benchmark, such as the S&P 500. The closer the r-squared is to 100, the more the returns from the fund are attributable to the returns from the benchmark. The Lipper equity-income fund index, for example, has an r-squared of 95.4 percent with Lipper's index of S&P 500 index funds. Again, pairing the two types of funds in your portfolio won't give you a great deal of added benefit.
You can find both these statistical measurements at www.morningstar.com, and many funds' Web sites provide the information, as well.
What types of funds don't correlate with the S&P 500? International funds have only a 75 percent correlation with S&P 500 index funds. Still, you should remember that when the U.S. stock market melts down, foreign markets melt right alongside us. Among sector funds, the lowest correlations with the S&P 500 have been among gold funds, natural resources funds and Japan funds.
But you get better diversification if you mix in funds that invest in different asset classes, such as money market securities or bonds. Over the past three years, funds that invest in Inflation Protected Securities, or TIPS, have had a negative correlation with S&P 500 index funds. So have government securities funds. Municipal bond funds also have a very low or negative correlation with S&P 500 index funds.
Some experts also consider real estate funds to be a separate asset class. In the past three years, real estate funds have had a 53 percent correlation with S&P 500 funds.
If we were to construct a Cowardly Portfolio, then, we might consider a 20 percent allocation each to a mix of U.S. stocks, international stocks, real estate, bonds and money market funds. In broad terms, this gives us 60 percent in stocks, 20 percent in bonds and 20 percent in money market securities, or cash.
For ease of calculation, we used Vanguard funds for a low-cost model portfolio. You can create your own cowardly portfolio with funds from different managers, if you like.
The portfolio performs brilliantly in down markets and reasonably well in up markets. Had you invested, for example, in the Vanguard Total Stock fund on Dec. 31, 1999 - the eve of the 2000-2002 bear market - you'd have gained about 21 percent through the end of November. By contrast, the Cowardly Portfolio would have gained 86 percent, thanks to gains in its other holdings, particularly real estate. The past 12 months, however, the Cowardly portfolio has lagged the Vanguard Total Stock portfolio.
You can adjust the degree of cowardice in the portfolio by adjusting the proportions of your total portfolio that you hold in the different funds. You can also improve your returns by rebalancing periodically. The best method: Rebalance the entire portfolio if one holding rises to 30 percent of your holdings, or falls to 10 percent.
If you have a long-term outlook (20 years or more) then you probably shouldn't build a portfolio based on short-term gloom. In the long term, stocks will fare best. But if the question you're worried about is, "How much will I lose?" then consider a Cowardly Portfolio.
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