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Hedging Against Market Losses
st Quarter, 1997 performance results proved to be a wake-up call for
investors believing that they could profit as spectacularly as they had in 1995
and 1996. The wake-up call comes at an inopportune time for Wall Street, because
it is IRA season -- a time when securities firms especially encourage investors
to open, and to additionally fund, retirement accounts.
How optimistic were investors before these performance results? According to
a survey of mutual fund investors by Montgomery Asset Management, investors
expected to earn more than 16% return on their mutual funds this year, and an
even better 22% annual return in each of the next ten years.
How disappointed were fund investors in the first quarter? Extremely. Rather
than return a handsome profit, the average stock fund lost 1.98%, and the
average bond fund lost 0.29 (source: Wall Street Journal). More particularly:
| Capital Appreciation: |
-3.70% |
| Growth: |
-1.25% |
| Small Cap Stock: |
-6.97% |
| Mid Cap Stock: |
-5.89% |
| Growth and Income |
1.37% |
| Equity Income |
1.81% |
| Global |
0.51% |
| International (non-U.S.) |
2.34% |
| Stock/Bond Blend |
0.17% |
| Short Term Debt |
0.51% |
| Intermed. Corp Debt |
-0.54% |
| Short Term U.S. Gov't. |
0.33% |
| Long Term U.S. Gov't. |
-1.35% |
| Long Term Corp. |
-0.79% |
| High Yield Taxable |
0.60% |
| General Taxable Bond |
-0.43% |
| Mortgage Bond |
0.26% |
| World Income |
-1.87% |
| General Long Term Muni. |
-0.43% |
| Insured Muni. |
-0.84% |
| Single State Muni. Debt |
-0.38% |
Overall, not a positive quarter, especially compared with the money market
yields for the same quarter of better than 5% (the highest yielding money market
fund last quarter was Strong Heritage Money Fund, yielding 5.48%).
Critically, these market declines can be characterized only as routine. Last
summer's 7.4% decline in the Dow Jones Industrial Average and the current 7.4%
decline do not even qualify as a "correction" (10% decline, none in
six years), nor as a "severe correction" (15% or more) nor as a
"Bear Market" (20% or more; last one in 1990).
In this market environment, advisors urge caution and diversification. In
upcoming articles, I will discuss how investors can exercise caution in making
investment decisions.
Diversification continues to be an effective hedge against risk of loss,
though the degree of protection varies. In discussing diversification, advisors
sometimes use the term "correlation", or "correlation
coefficient". This means the statistical measure of the degree to which the
movements of two variables (asset classes) are related. Based upon correlation,
one can create a portfolio and compare performance.
Recently, Ned Davis Research/T. Rowe Price did just that. The
"diversified portfolio" contained 30% large cap stocks, 15% small cap
stocks, 15% foreign stocks, 30% intermediate term treasury bonds and 10%
treasury bills.
The performance results are striking. For example, consider how well hedged
the diversified portfolio was during these three periods of market decline:
Cumulative Total Returns During Market Decline, 5/24/96 - 7/24/96:
| Diversified Portfolio: |
-5.2% |
| Large Cap Stocks: |
-7.3% |
| Small Cap Stocks: |
-15.6% |
| Foreign Stocks: |
-3.2% |
| Intermed. Treasury Bonds: |
-0.4% |
| Treasury Bills: |
0.8% |
Cumulative Total Returns During Market Decline, 8/25/87 - 12/4/87:
| Diversified Portfolio: |
-18.0% |
| Large Cap Stocks: |
-32.9% |
| Small Cap Stocks: |
-38.8% |
| Foreign Stocks: |
-15.6% |
| Intermed. Treasury Bonds: |
1.5% |
| Treasury Bills: |
1.7% |
Cumulative Total Returns During Market Decline, 4/28/71 - 8/9/71:
| Diversified Portfolio: |
-4.6% |
| Large Cap Stocks: |
-7.1% |
| Small Cap Stocks: |
-16.5% |
| Foreign Stocks: |
6.9% |
| Intermed. Treasury Bonds: |
-3.5% |
| Treasury Bills: |
1.4% |
The diversified portfolio also performed well over various five year periods:
1/4/71 - 12/31/75:
| Diversified Portfolio: |
25.1% |
| Large Cap Stocks: |
17.5% |
| Small Cap Stocks: |
-27.6% |
| Foreign Stocks: |
50.4% |
| Intermed. Treasury Bonds: |
34.2% |
| Treasury Bills: |
33.8% |
1/2/87 - 12/31/91:
| Diversified Portfolio: |
71.2% |
| Large Cap Stocks: |
99.2% |
| Small Cap Stocks: |
39.4% |
| Foreign Stocks: |
49.8% |
| Intermed. Treasury Bonds: |
65.4% |
| Treasury Bills: |
39.8% |
1/2/90 - 12/31/94:
| Diversified Portfolio: |
42.7% |
| Large Cap Stocks: |
48.3% |
| Small Cap Stocks: |
47.3% |
| Foreign Stocks: |
7.6% |
| Intermed. Treasury Bonds: |
53.1% |
| Treasury Bills: |
26.6% |
The message is clear: diversification, into asset classes with low
correlation, is a proven way to reduce risk. Investors should not forget this as
they consider opening, and additionally funding, retirement accounts in this
declining market.
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Sponsored by James J. Eccleston. This Web site contains material of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
Always consult an attorney and/or investment adviser when building and protecting your wealth.
All content Copyright © 2010 Advocate Compliance Partners, Inc. except where noted. All rights reserved.
One North Franklin Street, Suite 2620, Chicago, IL 60606
Telephone 312-332-0000 | Fax 312-332-0003
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