Harvard Management Co. had almost 40% of its "in house" portfolio in iShares MSCI Emerging Market ( EEM) and a total of 72% in various emerging market ETFs and individual stocks, according to a recent SEC filing. That portfolio, while small, is the most transparent part of the endowment. The heavier the weighting to emerging markets, the more volatility. This can work for or against you, depending on the direction of the market. For this decade, it has helped. But in 2008, it was a drag, as iShares MSCI Emerging Market fell by half versus 38% for the S&P 500. Harvard's allocation to emerging markets isn't right for individual investors. The "right" amount is subjective, though this point gets to a crucial aspect of managing your portfolio -- or, more correctly, your portfolio's volatility. There are industries that offer a greater chance of going up a lot, such as emerging markets, agriculture and technology. And there are categories that offer little chance of going up a lot, like utilities, Ma Bell telecoms and mega-cap health care. The key is striking a balance between the two categories to create a portfolio that offers sufficient long-term growth but still allow for sleeping at night. This is the hard part. So let's look at numbers that can help begin to solve the problem. Over long periods, the stock market has averaged an annual return of 10%. Keep in mind that number includes booms and busts. For people who save properly, that's enough for retirement.
In thinking about 10%, where does that return come from, where can we get that 10%? Some of it will come from dividends. The S&P 500 has averaged about a 2% dividend yield this decade. It wouldn't take much to increase the yield of the portfolio by 50 basis points by overweighting sectors like utilities and telecom, which usually pay bigger dividends, and adding a higher-yielding name or two, like Altria ( MO). There are plenty of places to look for yield to enhance this dynamic. At this point in our hypothetical example, we have 250 basis points out of the target 1,000 basis points derived from dividends. A portfolio weighting of 10% in emerging markets, agriculture and technology or similar segments could provide a disproportionately large chunk of the 1,000 basis points. The next time there is a bull market, some stocks from those groups could easily rise 25% to 50% in a year. In 2007, iShares MSCI Brazil ( EWA) surged 73% and Potash of Saskatchewan ( POT) tripled. In 2008, they each dropped by half, so they are live-by-the-sword, die-by-the-sword holdings. Allocating 10% across a few volatile stocks or funds in a bull market year could deliver 25% returns to this little segment of the portfolio, or 250 more basis points to the overall return of the portfolio. I don't mean to imply that picking a stock that returns 25% in a year is easy, but you do know where to look for stocks, or funds, with that kind of potential. As another example, the Claymore/MAC Global Solar Energy Index ETF ( TAN) is down 80% since its inception last spring. Would it take much persuading to think it could rocket higher at some point? Knowing when to buy into the solar area wouldn't be easy but, here again, the odds of it going much higher at some point are pretty good.
At this point, we have 500 out of 1,000 basis points targeted by increasing the yield slightly and putting 10% into some volatile areas of the market -- again, this exercise assumes a bull market. In going with the example, the other 90% of the portfolio only needs to grow by 5.5% to get a 10% return for the entire portfolio. By having most of the portfolio in slower-growth names, the overall volatility could be much less than the market. This sort of composition could help offset some of the decline of a short move down, as happened during 2006's second quarter. For some people, putting 10% into hot-potato stocks is too much and, for others, not enough, but the more that goes into volatile stocks, the greater the chance for losses during a correction. Attention to this type of detail can help weather future cycles with less volatility.