Keeping the Right Portfolio Balance in Unsteady Markets

Last Updated Jan 17, 2010 4:52 PM EST

Financial advisors promote the virtues of building a diversified, balanced portfolio. When it's done right, it can reduce volatility, and therefore risk, without appreciably sacrificing returns.

But as a recent article in the Wall Street Journal makes clear, doing it right is no small feat. The piece highlighted the wretched performance during the bear market of target-date funds, which are supposed to shift their mix of assets away from stocks and toward safer instruments, such as Treasury bonds, as the date nears when their shareholders are presumed to be retiring.

It turns out that these funds maintained high allocations to stocks, providing little protection for their aging investors. One product that was singled out, DWS LifeCompass Income, was supposed to be the next best thing in funds aimed at this clientele. It wasn't.

The fund, offered by a unit of Deutsche Bank, was designed to provide income to investors and guarantee a partial return of capital, but LifeCompass lost its way, you might say. When the stock market dropped out of sight last year, the managers were forced to sell stocks and buy bonds to meet their commitments. As stocks became cheaper, sales rose, as did the purchase of increasingly expensive bonds.

Hmmmm. Buy high, sell low. Doesn't sound quite right, does it?

Many target-date funds failed to sufficiently take account of their shareholders' imminent need for income, and the high proportion of stocks left the portfolios with excessive risk for that sort of investor. An added shortcoming of the DWS fund, which was closed earlier this year, is that it was structured in a way that failed to permit proper rebalancing to ensure that the right assets were bought at the right prices.

Louis Stanasolovich, president of Legend Financial Advisors in Pittsburgh, is not surprised by the dismal performance of funds like these. A portfolio comprising only stocks and bonds won't cut it in a climate in which stocks are volatile and prone to nosedives and miserly interest rates give bonds little hope of providing the income that investors, especially elderly ones, need.

He proposes a far more diversified, kitchen sink portfolio containing six funds in greatly diverse asset classes:

Hussman Strategic Growth, a safety-conscious capital-appreciation stock fund.

Leuthold Core Investment, which holds stocks, bonds and cash and seeks income as well as capital appreciation.

Caldwell and Orkin Market Opportunity, a portfolio of long and short stock positions. The fund generally has a positive bias on the market, but being able to sell short allows the managers to benefit from anticipated declines in overvalued companies or bet on a broad market decline in extreme situations.

First Eagle Global, which can invest in U.S. and foreign stocks and also hold debt instruments.

Franklin Adjustable U.S. Government Securities, a portfolio mostly of government-backed adjustable-rate mortgages.

Rydex/SGI Managed Futures Strategy, a fund offering access to alternative asset classes like commodities and financial derivatives.

Stanasolovich finds that this mix provides solid returns and, thanks to the broad diversification, minimal volatility, which is essential for investors who are middle aged or older. Since 2000, he said, a portfolio built from equal weightings in each fund has returned 6.5 percent a year on average, compared to an annual loss of 3 percent in the Standard & Poor's 500-stock index.

To generate such returns, he emphasized, it's important to rebalance the portfolio every year; he does it in January, but any date should work as well as any other. He sells enough of whatever has been outperforming and buys enough of the laggards to restore the equal weightings.

"That forces you to harvest your winners," Stanasolovich said. To put it another way, his strategy instills the discipline necessary to buy low and sell high.

Other combinations of funds are likely to provide long-run returns that are as good as his or better. But many, many more are likely to do worse. If you're worried about a renewed decline in stocks and worried just as much about running out of money even if you play it safe, then Stanasolovich's approach stands an excellent chance of beating the typical target-date fund.