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How to protect your money

By Barbara Whelehan ·
Friday, May 7, 2010
Posted: 5 pm ET

The 900-plus point drop in the Dow forces us to think about how best to protect our investment portfolios from market mayhem.

The timing of Thursday's financial Armageddon couldn't have been better -- for the purpose of this blog post, anyway. In my latest blog, I cited a study that found flaws with modern portfolio theory, or MPT. I then promised to tackle the topic of how to protect your investment portfolio.

First a quick recap: MPT involves constructing a portfolio that maximizes return for a given level of risk. In other words, it's about risk management. The study by authors Meghan P. Elwell and Alexander Pekker points out that MPT has drawbacks. One problem is that correlations between asset classes change all the time.

Because of these drawbacks, investors can lose their shirts.

I asked the authors of the study how investors can protect themselves, and this was their answer:

"Investors need to realize that all assets are accumulated for some purpose (such as retirement, college education, bequests, etc.), with each purpose having unique cash flow requirements, risk profile and time horizon. Rather than adopting a 'one size fits all' MPT portfolio (such as a variant of the traditional 60/40 equity/fixed-income portfolio), assets need to be allocated in accordance with their intended purposes.

"For example, a retiree should allocate assets designated to fund living expenses in a cash-flow-certain, low-volatility, inflation-protected portfolio, while putting assets designated to fund grandkids' college education in a more growth-oriented portfolio. Within each portfolio MPT may be utilized, but the overarching purpose-based asset allocation can help protect the investor from the various risks inherent in MPT."

Let's face it, we've never been more aware of risk, having lived through two bear markets in the last decade, not to mention that drop in the Dow of nearly 1,000 points. But to these experts, I pointed out that a lot of other financial experts advocate that retirees allocate 50 percent or more of their portfolio to stocks. "What do you say to that?" I asked.

The authors replied (in an e-mail) that retirees could have as much as 40 percent devoted to equities and other risky assets if they're drawing their income mainly from Social Security and a pension. But if they're drawing income mainly from their own assets, then they need to have lesser exposure, 20 percent to 30 percent, so they can meet their income needs.

That means retirees need to have a pretty big nest egg to accommodate decades' worth of living expenses from a moderately positioned portfolio.

Recommendation: To gain an in-depth understanding of MPT, read author James Picerno's book, "Dynamic Asset Allocation: Modern Portfolio Theory Updated for Smart Investors." He describes the evolution of MPT and explains how to optimize your portfolio according to varying market conditions.

In the meantime, let's look at how two portfolios have performed over the past one, five and 10 years. The "Gone Fishin' Portfolio," which I purloined from a book of the same name by Alexander Green, invests in many asset classes (though I had to improvise because one fund, Vanguard Inflation Protected Securities, did not have a 10-year track record). The 60/40 portfolio invests in only two asset classes -- the S&P 500 and a broad bond index.

As shown, even though the Gone Fishin' Portfolio took a worse beating during the two bear market periods of 2000-2002 and 2007-2009, it fared better than the less diversified portfolio over one, five and 10 years.

Why diversification matters: returns of two portfolios
  1-year 5-year 10-year March 2000
- Oct. 2002
Oct. 2007
- March 2009
Gone Fishin' portfolio 38.82% 6.46% 5.59% -9.97% -34.81%
Domestic 60/40 portfolio 26.63% 3.73% 2.45% -8.86% -23.76%
Source: 2010 Morningstar, Inc.
Trailing returns through 4/30/2010. Returns greater than one year are annualized.
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