Finance

Risky Business

2012 portfolio resolutions

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In January 2011, we picked up our glasses and saw a rosy tint to the future. The prescription was a good one (or so we thought) as we gazed out months into the future. The US economy was on a slow mend and large cap businesses were generally flush with cash and profits. “Stocks could do well this year,” we believed.

As 2011 progressed, the tint of our glasses changed, first by events abroad – the Arab Spring, surging oil prices, twin Japanese disasters, and an ubiquitous Euro zone credit crisis – and then by our own political paralysis resulting in a debt downgrade and brinksmanship gone awry. We longed for a time when economic fundamentals ruled and people didn’t.

Yet the US markets made it through the year relatively unscathed. The S&P ended 2011 unchanged, while the Dow rose 5.5%, helped by fewer financial stocks in its index and a predominance of mega stocks – the investment of choice in 2011. Not surprisingly, overseas markets did not fare as well. Using the 2011 Dow Jones Global Total Stock Market Indexes (Wall Street Journal), the World Emerging Markets were down (-22.37%) and the World Developed (ex-US) Markets were off (-15.34%).

Bond markets also ended positive, contrary to the outlook at the start of the year. Winners included muni bonds (which entered 2011 in disrepute) and treasuries that benefitted from the ‘riskoff’ trade. The speed and unpredictable nature of international headlines meant bonds became a relatively safe place to park your money.

As investors entered 2012, the risks of volatility and policy mishap remained. Although encouraged by signs that the US economy is gaining traction, investors viewed Europe’s path to recovery as halting and uncertain. And with China’s economy balancing at a tipping point between a hard and soft landing, global finance became too fragile to predict.

The good news is that you don’t have to be all-prescient to be a successful investor. There are winners and losers in every market environment: you simply want more good holdings than bad.

Underperformance is often tied to being in the right space with the wrong fund or investing in the right fund, but the wrong space. Of course you could always say, “I’ll just invest in the broad indices.” That means as the market goes, so do you. That works if policy continues to reign. But, if the markets go back to performing based on fundamentals (the traditional explanation for the ups and downs of particular holdings), then you could suffer the opportunity costs of being too broadly invested. If overall market performance parallels the economy, you could be in for a middling, muddling year; finding even a few sectors that beat the indices could enhance your portfolio returns.

Risk diversification can help you define those areas of outperformance. It assigns asset classes different risk parameters and then emphasizes or de-emphasizes the holdings based on the outlook for the economy.

It is not as hard as you might think. You probably already have views on whether or not we’ll see inflation this year, whether Europe can get its act together sufficiently to avoid a Lehman-like event or whether certain companies are poised to do well. And you probably have an opinion on whether you would prefer to bet on growth (a good year for stocks) or rely on income for your portfolio returns.

If you missed making a New Year’s resolution for your portfolio, it’s not too late. Here is what you can do now:

Step 1: Review

Create a list of your economic beliefs for the coming year. Then check your portfolio to make sure you have some holdings that match those beliefs. Still worried about a Euro zone collapse? Focus on the US. Think that the housing and the labor markets will cease to be a drag on our economy? Expand into small caps and select sectors you feel can outperform. Unsure about the future? Hang onto your bond positions so that you can tolerate the bumpy ride.

Step 2: Protect

Add some securities that protect you in case you are wrong. Even the best manager cannot predict all the factors that could influence a portfolio. But, while diversification is a form of insurance, limit the range. A majority of your holdings should still follow your thesis as outlined in Step 1.

Step 3: Clean house

Almost every portfolio also has a dud or two. Don’t be afraid to replace these.

Review each holding and how it performed in relationship to its peers. Why has it lagged? If you still like the space it occupies (such as high-yield or the technology sector) don’t be afraid to sell the laggard and purchase a similar fund whose investment outlook you prefer.

Step 4: Learn from your mistakes

As investors, we tend to repeat the error of our ways over and over, without being aware of the patterns of our behavior. Set up a check list of questions to ask yourself about each holding on a regular basis. Try to be factual, not emotional, in order to avoid impulsive tendencies.

The key is to be diligent, disciplined and most of all humble. If you can admit that you can be wrong, you may be on your way to being right more often than not.

Betsey Purinton, CFP® is Managing Director and Chief Investment Officer at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail her at bpurinton@strategicpoint.com.