Unlocking a safer, smarter portfolio (pg. 2)

  @Money June 11, 2013: 11:53 AM ET

KEY IDEA NO. 2

Markets may move in sync, but some stocks beat others

The demise of easy stock diversification (at least in the short run) means there's one less obvious strategic edge available to individual investors. A bulwark against disaster is good -- but is there any way to actually capture a better return along the way?

Research into the history of financial markets has found few strategies that offer a long-term advantage. Two that might: owning small-company and value stocks, or shares that trade at a deep discount to earnings or business value. Small-caps beat blue chips by an annualized two percentage points since 1927, according to Morningstar data; large value beat pricier large growth stocks by about as much. Stocks that are small and cheap won even bigger.

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The idea of tilting your portfolio toward some corners of the market pushes against the idea of spreading yours bets as widely as possible.

However, Larry Swedroe of Buckingham Asset Management says you can use tilt as part of a strategy to lower your overall exposure to risky assets. He's found that since 1970, a portfolio with 50% in bonds and the rest split evenly between an S&P 500 index fund and a U.S. portfolio of small value stocks would have matched the long-run return of a fund with all of its assets in the S&P, with less volatility.

Two big caveats: First, the future might not look like the past. Second, this approach takes guts, even with a bigger bond stake. The reason small caps deliver better performance is that they clearly are risky. And although value investing is often thought of as conservative, stocks are often cheap when the market sees trouble ahead.

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Besides, when bull markets take hold and "go-go" growth stocks soar, being a value investor can make you feel like a chump. "Way more important than your specific mix of assets is your commitment to keep your money invested through thick and thin," says investment adviser Rick Ferri of Portfolio Solutions.

Sticking to a tilted portfolio, which is bound to be out of step at times, requires extra commitment.

How to retool: You don't have to go whole hog on this strategy. Adding even a style-focused ETF like Vanguard Small Cap Value (VBR) gets you some tilt. Or, says Daniel Solin, also a Buckingham adviser, you could add the value and small-cap factors separately, with Vanguard Value Index (VIVAX) and Vanguard Small Cap Index (NAESX).

If more than 50% of your overall stock mix is in value, and more than 10% is in small caps, you're tilted. A similar strategy can also be applied to your foreign holdings using iShares MSCI EAFE Value (EFV) and iShares MSCI EAFE Small Cap (SCZ).

KEY IDEA NO. 3

Bonds are your frenemy

While correlations within the stock market have risen over the years, Treasuries, the core of many bond portfolios, are now negatively correlated with equities -- they often move in the opposite direction. That would be great, if their sub-2% yields didn't make them such unappealing investments.

"You're not necessarily being compensated enough for the interest rate risk looming around the corner," says Peter Palfrey of Loomis Sayles Core Plus Bond Fund, putting it mildly. The duration, or interest rate sensitivity, of a 10-year Treasury is 8.8 years, meaning a one percentage point spike in rates would cut its price 8.8%.

The lack of yield is a big enough worry that veteran investment adviser Charley Ellis, a longtime advocate of a passive buy-and-hold approach to investing, told MONEY in an interview last month that his best advice is to not own bonds.

The tough question is, What would you do instead? Adding a lot of equities can't be the answer. As the Cyprus crisis earlier this year showed, the global economy is hardly out of the woods yet; bonds will probably still be a cushion in future stock shocks. Cash or CDs are an option for safety, but that means living with yields from barely over zero to 1%.

How to retool: Although not as safe from a rate spike as cash, Treasuries with durations below three years still offer a reasonable amount of protection from a rate turn.

Wealth manager Chris Cordaro of RegentAtlantic Capital also suggests that you diversify with some highly rated corporate bonds. They don't add much risk of default, and the higher yields they pay give you an extra cushion against an interest rate move. Vanguard Short Term Bond (BSV), a low-cost ETF, is mostly Treasuries, but keeps about 20% of its portfolio in high-grade corporate bonds.

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Also look beyond the U.S. "Foreign bonds give you good value today, with better yields than Treasuries for income and protection against interest rate risk," says Bohemia, N.Y., financial planner Ronald Rogé. He suggests that you make foreign bonds about 10% of your bond stake. Pimco Foreign Bond (PFOAX) is a solid choice that employs hedges against currency risk -- the possibility that falling foreign currency knocks out some return.

Finally, if going shorter leaves you hungry for income, consider a change on the stock side of your portfolio. "Many good-quality stocks can get you 3% or 4% yields right now," Rogé says. SPDR S&P Dividend (SDY), an ETF, currently yields 2.8%; the Vanguard Value Index Fund's yield is 2.5%.

KEY IDEA NO. 4

Inflation is worth fighting

Shortening-up addresses the interest rate risk in your bond portfolio. Another risk remains on the table: inflation.

Rising prices haven't been much of an issue in this slow-growth economy -- and many economic experts say they may not be for some time -- but a diversified portfolio isn't about protecting against what's likely to happen. It is insurance against painful shocks.

Boston University economist Zvi Bodie notes that the long-run forecast for inflation is about 2.5% a year. "But I am highly uncertain," he adds. "I would not be very surprised if it turns out to be 4% or 5%."

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The good news is that the U.S. Treasury sells really effective insurance against inflation in the form of bonds called TIPS, which adjust their principal value in line with rising consumer prices. The bad news is that the yields on them are really lousy -- in fact, they are now -0.64%. In other words, you are guaranteed to lose a bit of money on them if you hold to maturity.

Who'd take the government up on an offer like that? You might, once you know that -0.64% represents the real, or after-inflation, yield. Buy a normal 10-year bond yielding 1.73% and you will lose just as much if inflation runs a moderate 2.37%. If it's higher, you'll lose more. Although TIPS can't fix the fact that yields on all kinds of Treasuries are low, they do deliver truth in advertising and probably better real yields than savings accounts or CDs.

How to retool: TIPS are as vulnerable to interest rate risk as any Treasury, so for the most part short is the way to go. Pick the low-cost Vanguard Short-Term Inflation Protected Securities (VTIP) or buy short-maturity TIPS directly at TreasuryDirect.gov.

As for how much you need to hold in TIPS, consider your life stage. "The average person might have half TIPS and half Treasuries," says Swedroe. (So if you have a bond fund that's mostly regular Treasuries, you'd dial back that investment to add a TIPS fund.) He adds that older people will want a bit more, since inflation poses the most serious threat to those dependent on investments for income. Younger people still in the workforce need fewer TIPS.

Unlike with regular Treasuries, there's a case for owning longer TIPS, but individually, not in a fund. If you need to protect money with no chance of a surprise loss, a TIPS bond protects purchasing power (minus that negative yield). That's provided, of course, you know for sure you will hold until maturity.

KEY IDEA NO. 5

The new diversification tools Wall Street sells are already rusty

Wall Street's response to high correlations and lousy bond yields has been to sell "alternatives" -- a mixed bag of everything from commodity futures to hedge fund strategies. Avoid these often expensive funds.

The diversification and return potential of alternatives is overstated, argues William Bernstein in the e-book Skating Where the Puck Was.

Commodities futures, for example, had amazing records a decade ago. They beat bonds and stocks, and correlated with neither. But new indexes, funds, and ETFs now mean that anyone can pile into futures -- and they have. As the market has become crowded, returns have been lower, and correlations have risen too. When investors were running for the exits in 2008 and 2009, they dumped their futures bets along with their stocks. "The moment you securitize an asset, you begin to destroy its diversification benefits," says Bernstein.

The same applies to hedge-fund-like strategies such as "absolute return" and "market neutral." By the time such strategies get to retail, they may be too well-known to work.

There's no magic combination of assets that will make you a winner every year. Cover the big dangers -- a long slump, a rate turn, and inflation -- and leave RORO worries to Wall Street's hyperactive set. To top of page

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