News Room
Manage portfolio actively
By Brenda Wenning/Local columnist
GateHouse News Service
Posted Oct 27, 2008

In poker, if you have a bad hand, you "fold." In investing, the commonly accepted philosophy is to "buy and hold," even during a bear market.

So which of the two is really gambling - poker or buy-and-hold investing?

Today’s market, which is putting the buy-and-hold investment approach to its biggest test since the Great Depression, may provide the answer.

When the Dow Jones Industrial Average dropped 500 points on Sept. 15, even the least informed investor likely saw trouble ahead. Yet the prevailing advice was to stay put. The Dow dropped another 777 points on Sept. 29 - and, again, the prevailing advice was to stay put. In October the market was more volatile than at any time in its history - and dropped nearly 2,500 points at one point.

While the market has gone up as well as down, does it really make sense to leave your investments where they are when you know that financial institutions hold trillions of dollars worth of bad debt?

The stock market has seen 14 bear markets since the Great Depression. Market fundamentals and common sense dictate that we should be prepared for number 15.

During the last bear market, which began in September 2000 and lasted until March 2003, the S&P 500 lost 49 percent of its value. If all of your money were invested in the S&P 500 stocks, as of today you still would not be at the breakeven point.
And now your money is invested in a market that’s being compared to the Great Depression. While that may be journalistic hyperbole, consider that if your money were invested in the S&P 500 stocks during the Great Depression, it would have lost 86.7 percent of its value from September 1929 through June 1932 - and it would have taken you 25.2 years just to break even.

While it’s true that bear markets are historically followed by bull markets, does it make sense to keep all of your hard-earned money invested in the stock market when the market is likely to lose at least 20 percent of its value?

Managing risk to increase rewards

Those who advocate a buy-and-hold strategy will tell you that you need to stay invested, because you can’t "time the market." They’re correct.

No one knows how the market will perform tomorrow, next month or next year. But historically, changes in factors such as corporate profits, interest rates, inflation, unemployment and other variables have provided strong indications of when we were entering a bear market and when we were entering a bull market.

Active management uses sophisticated technology and economic data to identity the impact of these variables. Using proprietary models based on these factors, active investment managers can determine whether investors should be heavily invested in the market or whether they should temporarily pull money out of the market.

Models are not foolproof, of course. You may miss days when the market makes significant gains, but it is even more important to miss days when the market suffers significant losses. If your portfolio were to fall in value by 50 percent, for example, you would need a 100 percent gain just to break even.

Models used by active investment managers generate "alerts," which tell them when it is time to buy a specific investment and "stops," that tell them when it is time to sell. A stop-loss point is established whenever a new investment is made. If the investment appreciates in value, the stop is moved up to protect the gain. If the investment declines in value past the stop-loss point, the investment is automatically sold.

Active management does not prevent losses, of course. Losses are a fact of life, no matter what investment strategy is used. However, the use of stops alone can prevent major, portfolio-draining losses, such as those experienced by investors in technology stocks in 2000 or financial stocks last year and this year.

Unlike active managers, buy-and-hold managers do not react to changing economic conditions, because they believe a diversified portfolio can withstand any market conditions. They recommend allocating your investments to stocks, bonds and cash equivalents based on set percentages. Investments within each group are further diversified - for example, stock holdings may be split between growth and value stocks; small-cap, mid-cap and large-cap stocks; foreign and domestic stocks.

In theory, if your portfolio is properly diversified, losses in one area should be offset by gains in other areas. Today, though, it is difficult at best to achieve the negative correlation between investments that is needed for diversification to sufficiently manage risk. In today’s global economy, markets around the world are in sync with the U.S. stock market. When the U.S. market tanks, other stock markets generally do as well.

Active managers may also advocate diversification, with assets allocated based on set percentages, but it is only one tool for reducing risk. Along with stops and alerts, active managers may use other tools, such as hedging and setting price targets.
Hedging is used to reduce the risk that an investment will decrease in value by investing in an offsetting position in a related security, such as an options contract. An options contract obligates the buyer to purchase the stock or other asset at a predetermined price at a future date.

Price targets, like stops, determine when an investment should be sold. If, for example, a stock increases in value and reaches an expected target value, the manager sells all or a portion of shares in the stock, guaranteeing the gain. Price targets are obtained through a careful analysis of the stock, including a review of its trading history, its price-to-earnings ratio and many other factors.

While past performance does not guarantee future results, these tools historically have helped investors to significantly reduce their investment risk and increase your long-term gains. Like any investment strategy, active management cannot guarantee gains - but it sure beats gambling.

Brenda P. Wenning is president of Wenning Investments LLC of Newton. She can be reached at Brenda@WenningInvestments.com or 617-965-0680.