I write the Portfolio Manager's Toolbox column to address big picture, as opposed to stock-specific, investment issues. On this anniversary of the column, let's review the major themes of the year.
Sector Diversification
In 1999, investors wanted all tech, all the time. By June of this year, investors wanted anything but technology stocks in their portfolios. Neither extreme is ideal. In general, the technology sector is the fastest growing of the 11 major stock market sectors, but it's also the most volatile.
I wrote Making the Most of Your Sector Plays to describe the definitions of the major sectors and resources for tracking them. How to Make the Right Sector Calls described risk factors associated with each sector. And my pieces How to Choose the Right Sectors for this Economy and Picking the Best Sectors for the Coming Months discussed how different sectors perform during different parts of the economic cycle.
I generally expect that the technology, health care and financial sectors, as the fastest growing parts of the economy, will have the greatest chance of outperforming the S&P 500 for the years to come. I generally keep 25% of my clients' assets in each of these three sectors, keeping the remainder in what I call "slow but steady" stocks, which include energy stocks, real estate investment trusts and consumer noncyclicals. I rebalance annually back to a 25% allocation.
In as challenging an environment as we've seen over the past two years, I find that this allocation forces me to sell high and buy low. For example, by the end of 1999, I had 40% in tech, 15% in financial services and 11% in health care. To rebalance, I sold 15% of the tech positions in January 2000, reinvesting the proceeds in health care and financial services stocks.
Health care did great in 2000 as investors fled to safe stocks, and financial services outperformed well in anticipation of rate cuts by the Fed. This shift resulted in positive returns for my clients in 2000.
In August 2001, I began rebalancing away from health care and back to tech and other economically sensitive stocks. I was temporarily derailed by the Sept. 11 attacks, but the performance of these stocks since Sept. 30 is consistent with an economic recovery in 2002.
Risk Management
I also wrote several articles in 2001 describing how to evaluate the risk of your investments, as well as their potential for returns. Diversification Raises Returns, Lowers Risk -- Here's Proof offered a mathematical analysis of the benefits of sector diversification, as described above.
Take Your Portfolio's Temperature With This Risk Thermometer discussed stock-specific risk parameters, while Rebalance Your 401(k) With This Annual Checkup, Part 1 and Part 2 described how to optimize your choice of mutual funds in your retirement plans.
The recent collapse of Enron
(ENE)
reminded me that whenever a single stock accounts for more than 10% of your assets, the riskiness of your portfolio goes way up. One of my rules is that I automatically sell half of a position whenever it exceeds 10% of a portfolio. I spend a lot of time convincing prospective clients that they should diversify away from single-stock situations -- where most of their wealth is tied to a single company through stock or stock options. If you find yourself in that situation, you have some work to do.
Stock Models Revisited: Lessons From the Internet Era updated tools I had previously described for evaluating companies, while Trading Rules to Live By outlined specific steps I take to minimize risk in my clients' portfolios.
Market Valuation
Knowing history gets you through crises. I would say that quite a few inexperienced investors liquidated their portfolios during the week of September 17th and are now wondering whether they should jump back now that the S&P 500 has gained 20% and the Nasdaq 40%. A recent article, Lessons From the Bear's Bite outlined how the most recent bear market unfolded.
The Mostly Efficient Market Hypothesis, Part 1 and Part 2 and Stock Market Valuations: Too High, Too Low or Just Right? described tools for evaluating the overall state of the stock market. I always say that 50% of a portfolio's performance is attributable to the overall stock market, 30% to sector selection and only 20% to individual stocks. So developing a sense of what drives the overall market will get you better results from your stock picks.
Outlook for 2002
The recent rally merely erased the Sept. 11 effect, leaving the S&P 500 fully valued at current levels. In my view, the single biggest drag on the stock market next year will be rising interest rates. And the single biggest boost to the stock market will be a return to growth in corporate earnings. My expectation, therefore, is that the S&P 500 will gain only 8%-10% in 2002. In a low growth environment, you need to be extra vigilant with your stock picks, since losses will be tough to recover.
I appreciated your feedback over this past year, and I look forward to your suggestions for future topics.
David Edwards is a portfolio manager and president of Heron Capital Management, a New York management firm. At the time of publication, his firm held no positions in any
securities mentioned in this column, although holdings can change at any
time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Edwards appreciates your feedback and invites you to send it to David Edwards.
