WHETHER YOU’RE RUNNING a trust account worth billions or a bank account worth considerably less, there are times when you just want to play it safe. Maybe you’ve grown less tolerant of risk. Maybe you’ve got a major expense coming up or are just sick of seeing your account balance drop.
Whatever the reason, it’s okay to downshift your risk from time to time — as long as you do it right. For most people, “playing it safe” means selling their entire portfolio and stuffing their assets into a seemingly risk-free investment — most likely a CD or money-market or savings account. But even leaving aside the tax bite that comes with selling long-term positions, stuffing your money in the proverbial mattress is a losing move.
There’s no such thing as a free ride. Savings accounts and CDs are insured, but you’re paying for every bit of that safety in the form of mediocre returns. Even uninsured money-market funds are paying a record low 1.35% interest. The return becomes even more depressing after taxes.
It’s human instinct to go to extremes, but the best portfolios aren’t black or white, but shades of gray. There are ways an equity investor can tone down risk without abandoning it altogether. With an eye toward minimizing transaction costs, taxes and stress, here are a few ideas to bring your portfolio down a notch:
Keep in mind that “playing it safe” isn’t necessarily about what you buy, but rather how you trade. And a defensive portfolio shouldn’t be devoid of all stocks, but all big positions. We can never say it enough: Size matters. When someone tells me they lost money in stocks, chances are it was because of their position size, not stock selection.
So start by trimming your exposure, not killing it altogether. If a position takes up 10% of your portfolio, cut it to 5%. If it makes up 4%, cut it to 3%. In short, take some money off the table, but don’t leave the casino. By reducing the size of your positions rather than eliminating them outright, you aren’t turning off the music, just lowering the volume.
For those stock positions you do keep, a series of protective stop-loss orders can automatically lessen your risk if the market doesn’t go your way. So if you’ve got 1,000 shares of XYZ at $50, sell a third off the top and place orders to sell another third if the stock trades below $44. Sell the final third should the stock trade under $40.
Not only have you defined your downside, but you’ve protected your upside as well. If XYZ moves higher, you’ve sold only one-third of your position and are still poised to participate in the move. The best part about the technique is that with the exception of that initial sell, it’s the market that’s determining when you get out, not your own emotions. You can take the money and run without running away entirely.
Selling stock generates cash, and although the returns on cash are dismal, it does serve as useful drag on an overall portfolio when you’re looking to reduce risk. It’s one of a few common hedges we talked about a few months back.
Like a weight belt or flat tire, a cash allocation immediately lowers a portfolio’s overall volatility while still allowing you to take reasonable risk on more speculative plays. In short, instead of putting $10,000 into a portfolio of “safe” stocks, I’d keep 80% in cash and put 20% on some promising growth names — even in highly volatile areas like emerging markets or small-cap stocks.
In addition to selling stock, another way to create a cash drag in your portfolio is to simply add new cash, effectively diluting the potency of your holdings.
In addition to paychecks and other noninvestment income, you can also create a cash drag by directing your mutual funds to pay interest, dividends and capital gains in cash, rather than reinvesting them directly. Although the idea is pooh-poohed by financial planners in it for the “long haul,” it’s one way to gradually begin increasing your liquidity while decreasing your overall portfolio risk.
A final strategy would be to focus new purchases primarily on fixed-income and income-oriented stocks. Although most investors have been weaned on growth stocks with no dividends, a large part of the market’s long-term return has actually come from dividend yield, not price appreciation, as we pointed out a few months back. Say you bought the Dow in 1975, when the last bear market was finally starting to bottom out and the dividend yield was 6%. Based on price appreciation alone, the index would’ve returned 1,526%. Not bad. But factor in the dividends and that number jumps to 4,198%.
So instead of hiding in a money market, you might consider diversifying a portion of your assets among a number of the most attractive dividend plays.
You might also consider other income-oriented investments. We first started talking about bonds last summer, and although I’m cautious on U.S. Treasurys here, I do believe emerging-market bonds still offer serious upside despite their recent run. We’ve highlighted a few emerging-market bond funds in recent weeks, including Templeton Global Income Fund (GIM), Templeton Emerging Markets Income Fund (TEI) and Morgan Stanley Global Opportunity Bond Fund (MGB).
Among equities, there are several income-oriented sectors worthy of consideration at current levels. Real estate investment trusts (REITS), which we first covered in depth last fall, continue to march higher, and this is one of the few sectors that I believe deserve a place in every portfolio.
Although there are a number of exchange-traded funds (ETFs) that track REIT shares, investors should consider supplementing an ETF allocation with some small-cap names. The real estate ETFs (and actively managed REIT mutual funds for that matter) tend to be overweight in both Equity Office Properties Trust (EOP) and Equity Residential Properties Trust (EQR), the industry’s two largest players. Some of my favorite smaller-cap plays include One Liberty Properties (OLP), Entertainment Properties Trust (EPR) and Sovran Self Storage (SSS).
Financials are another income-oriented sector that presents opportunities at current levels. As with most stocks these days, I think the biggest bang will come from the smallest stocks. After all, Citigroup (C) trades at 18 times earnings and four times sales. It sports a dividend yield of only 1.29%, pretty puny compared with those of some of the regional banks or small S&L’s.
Toning down the volatility of your portfolio from time to time is a necessary if frustrating evil. In the great game of the market, sometimes you just have to play defense.
– Originally on Mar 18, 2002 by Jonathan Hoenig
