How to Stay Afloat

You just might need to adjust your portfolio quarterly, in not monthly

Tempted to move everything to bonds or cash because you're getting whipsawed by Wall Street? Don't do it. The average money-market account is yielding less than 1% and the 10-year Treasury bond less than 4%, so abandoning equities would be a mistake. And when interest rates rise again, bond prices will fall.

It's time for Plan B. Investors need to rethink some of the formulas for meeting their financial goals by reducing the volatility of their portfolios. How do you do that? Diversification among different asset classes--stocks, bonds, and cash--is still essential, but now you may need to add some more specialized assets to the mix such as gold, commodities, and real estate investment trusts. In the past, they've proved to be effective hedges against rough times on Wall Street because they don't move in lockstep with the stock market. You also may need to invest in a hedge fund or hedged mutual fund, which aims to profit whether the market is moving up, down, or sideways.

The more volatile stock market will demand not only more diversification but also more of your time. While you don't want to be a market-timer, shifting your money in and out of stocks with the latest news flash on cable TV, you may need to become more tactical--changing your asset allocations to take advantage of important market or sector developments. Buying and holding won't work in a market that may be swinging rapidly even as it remains locked in a trading range over time.

While few investors have the time or skill to react to daily or weekly developments, adjusting your portfolio once a month or once a quarter could add to your returns. "What's going to make a comeback is the importance of tactical asset allocation," says James W. Paulsen, chief investment officer of Wells Capital Management. "The way value will be added going forward will be to overweight stocks, catch a two-year rally, and then overweight bonds. Then overweight stocks again." The same strategy applies to other asset classes such as REITs, commodities, or gold.

This can be risky. After a downturn, those who underinvest in stocks are left flat-footed when the market recovers. So don't just try to guess which way the herd is going--add some stocks or stock sectors that the herd is ignoring. Anyone with homebuilder, defense, or insurance stocks, for instance, has enjoyed healthy gains in the past three years. Some concentrated funds such as Longleaf Partners Fund and Clipper Fund, which hold large positions in a few market-bucking stocks such as FedEx (FDX ) and Philip Morris (MO ), have delivered strong three-year average annual returns of 10.5% and 12.7%, respectively.

The arsenal for coping with volatility also holds more sophisticated weapons. Options, for example, can be an effective hedge: They can lock in gains, though they do limit your upside. One possibility is to sell call options--contracts that give buyers the right to purchase a stock at a predetermined price within a specific period--on the stocks in your portfolio. These so-called covered calls provide extra income during downturns.

What's more, since volatility is a factor in option pricing, the rockier the market, the more the buyer pays you for the option, and the higher your income. "When I sell calls today, I'm getting a yield in the 26% to 30% per year range," says Walter Sall, founder of Gateway Fund, a mutual fund that sells covered calls on the stocks in the Standard & Poor's 500-stock index. To limit losses, he uses some of the fund's income to buy put options, contracts that rise in value when the market falls. The fund has earned 9.3% a year since its 1988 inception and has never lost more than 5% in a year. Other leading covered-call funds include Bridgeway Balanced Fund, which returned -3.5% in 2002, its first full year, and Analytic Defensive Equity Fund, which has averaged 10.1% since it began in 1978. However, leave "naked" options--the selling of call options on stocks you don't own--to the pros.

A long-short strategy--betting for and against different stocks--may be a good way to deploy at least part of your money. Hedge funds that do this require that investors be "accredited," with a net worth of at least $1 million or a salary above $200,000. But a number of mutual funds, such as AXA Rosenberg Value Long/Short Equity, Phoenix-Capital West Market Neutral, and James Market Neutral also use this strategy, and you can invest in them for as little as $500. Such funds tend to be volatile, so they shouldn't be more than a small part of your portfolio--say, 10%. But they can be useful diversifiers because their movement differs from that of the stock market. Last year, AXA Rosenberg's fund, which shorts stocks with high price-earnings ratios and goes long on cheap stocks, gained 28%. But in 1999, when tech stocks soared, it lost 12%. AXA and the two market-neutral funds are always 50% short. Others, such as Franklin U.S. Long-Short, GAM Gabelli Long-Short, and Icon Long/Short, vary their positions. Franklin, the oldest of the three, has an 11.2% three-year average annualized return.

Other hedging strategies provide more stable, albeit lower, returns. Merger-arbitrage funds such as Merger Fund and Arbitrage Fund have rarely had a down year. They profit by capturing the difference between an acquisition target's current share price and the price bid for it by its would-be acquirer. Merger Fund sports a 9.3% average annual return over the past 10 years, though it fell 5.7% in 2002--its first down year. The Arbitrage Fund, started in September, 2000, had a 9% return in 2001 and 9.3% in 2002.

Call options, hedged mutual funds, long-short strategiesIf your head is spinning, the answer may be an asset-allocation fund, which does it all for you. Such funds as Leuthold Core Investment, UBS Global Allocation, and Evergreen Asset Allocation shift their weightings between every asset class to suit market conditions. All three have respectable annual returns over the past three years--they were -0.5%, 1.7%, and 3.8%, respectively--in a terrible market. This way, if the market has you scared, you can let someone else do the worrying.

By Lewis Braham in New York

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