When Markets Turn Ugly, a Diversified Portfolio Is Your Best Friend

A few rules, followed strictly, can save you a lot of pain during a week like this.
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This is the kind of week where friends and relatives slide up shyly and ask, "Are you OK?" They've seen the news coverage of the market swoon, heard about a friend of a friend who got wiped out daytrading, and want to know if your firm is still going to be in business next week.

We're actually in a state of serene calm because the tech correction we've been expecting for months is finally here. Meanwhile, our diversification rules kept our clients out of hot water. At mid-morning on Tuesday, when the

Nasdaq

was down 19.4% on the quarter and down 3.4% on the year, our clients were down 5.4% for the quarter, still up 4% on the year. By Thursday's close, the average client was down just 1.2% on the quarter and up 8.6% on the year.

How is this possible? Our accounts, after all, have a pretty substantial technology stock allocation, as this is the sector we believe has the greatest chance of outperforming the

S&P 500

.

The answer is that we adhere to simple mechanical diversification rules. These rules can be summarized as:

Invest no more than 2.5% of a portfolio in any one stock.

We like to think we're as smart as anyone when researching companies and selecting investments. But experience has taught us that we have a 60% success rate in picking stocks whose returns over the following year exceed that of the S&P 500. By starting each portfolio with 40 stocks, we set up a situation where a stock that doubles will increase the value of the portfolio by 2.5% while a stock that falls 50% will subtract 1.25%. Over time, we find that the majority of stocks in the portfolio track the S&P 500 (the base hits). The occasional 100% gainers (the home runs) boost the portfolio's return in excess of the S&P 500, and the occasional 50% losers (the strikeouts) have no material impact on the overall performance.

Also, we don't "fall in love" with any particular company because no position accounts for more than 3% of all our portfolios. So we don't have any psychological need to hang onto a company that has not performed as expected. We take the tax loss and move on.

Invest no more than 25% of a portfolio in any major sector (e.g. technology, health care, financial services.)

Sector concentration can work for you or against you. For example, if you bought

TheStreet.Com Internet Sector

index last August at the low, you would have seen a 170% gain by March 10. Since then, you would have experienced a 30% loss. If you bought the index on margin, you probably got sold out earlier this week at a 100% loss.

We can't take that kind of risk for our clients. However, we have observed that the major sectors move in different cycles. The technology sector has doubled over the last year, while health care services have been flat and financial services have been flat to lower. In 1994, health care services were strong while technology stocks took a big stumble. By maintaining 25% exposure to each of these three major sectors, we give up some of the upside in return for minimizing the down side.

In the fourth quarter of last year, technology stocks surged while banks stocks fell. At quarter-end, we had 40% in tech, 11% in financial services. In the first quarter of this year, we sold enough of our tech stocks to bring the allocation back to 25% and invested the proceeds in bank stocks. This move didn't do much for us in January and February, but it worked out great for us in March and the first week of April. In our portfolios,

Yahoo!

(YHOO)

fell 32.5% peak to trough, while

Fleet Boston Financial

(FBF)

surged 36.1% in the same time frame.

Invest 25% of a portfolio in what we call "slow but steady" stocks. Typically, these are value stocks with low volatility and high dividends or stocks that are uncorrelated or negatively correlated (Beta less than 0.40) with the S&P 500 -- oil companies for example.

If you're a pure "value" manager, it's been a pretty grim two years. Underperformance by this style has caused investors to pull out of value funds and fire their value managers. Liquidation in this sector has further depressed stock prices. But when markets are crazy, there's nothing like high-dividend-paying stocks with positive operating cash flow, low price-to-earnings and price-to-sales ratios and a solid balance sheet to anchor your portfolio. In the current environment, companies like

FedEx

(FDX) - Get Report

,

SunTrust Bank

(STI) - Get Report

,

Ford

(F) - Get Report

,

Exxon Mobil

(XOM) - Get Report

,

Crescent Real Estate Equities

(CEI) - Get Report

and

Suburban Propane Partners

(SPH) - Get Report

are gaining relative to the tech stocks and boosting overall returns with dividend income. (Remember dividends?)

Invest a portion of the portfolio in fixed-income assets sufficient to cover minimum return requirements. This might range from 0% for a 35-year-old focused on maximum capital growth to 40% for a retired 70-year-old.

It's a lot easier to view a market slide like last Tuesday's if you know your fixed-income assets (government, corporate, high yield and municipal bonds) are generating income no matter what. We like all our clients to have a year's living expenses tucked away in a money market account. A 35-year-old with no dependents and a high income doesn't need much in the way of minimum return. A retired 70-year-old needs to know that his or her portfolio will generate at least 5% a year, and preferably 8% a year. Eight percent a year is the most a client can draw out of a portfolio without risking a gradual depletion of the assets. A client who draws down 5% a year is pretty assured, based on historical returns, of never running out of money.

Monitor carefully any stock that grows to more than 5% of a portfolio; automatically sell half of any stock which exceeds 10% of a portfolio.

Our big score this year was

Incyte Pharmaceuticals

(INCY) - Get Report

, which we bought last summer in the low 30s and watched it appreciate to 60 by year end. The stock took off in the first quarter, especially after a positive write up on the front page of

The Wall Street Journal

in February.

As the stock surged towards the ultimate high of 289 we noted that this position accounted for as much as 22% of some of our accounts. We sold three quarters of our total position at an average of 264, bringing this stock back to 5% of our clients' individual portfolios. Three weeks later, an offhand remark by

President Clinton

and British

Prime Minister Blair

knocked biotechs for a loop. Incyte bottomed at around 80, was last at 109, and we're cheerfully buying more. Meanwhile, the proceeds from the February sale were diversified into other companies that have continued to move up.

Another example: If we held onto every share of

Dell Computer

(DELL) - Get Report

we have bought since January 1994, this company would have grown to 35% of our total portfolios by January 1999 -- fine when Dell stock was moving up, not so good in the last year when Dell swooned a couple of times on earnings concerns.

Bottom line: In a properly diversified portfolio, if you manage the risks, the returns take care of themselves.

David Edwards is a portfolio manager and president of

Heron Capital Management, a New York investment management firm. At the time of publication, his firm was long Yahoo!, Fleet Boston Financial, FedEx, SunTrust Bank, Ford, Exxon Mobil, Crescent Real Estate, Suburban Propane, Incyte Pharmaceuticals and Dell, though positions may 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 at

DavidEdwards@HeronCapital.com.