The 30% That's Missing From Your Portfolio

If your equity portfolio is 100% invested in individual stocks or stock mutual funds, you should be aware that it's at risk. First, let me explain why, and then I'll suggest some strategies to mitigate this risk.

Stocks: The bedrock of a portfolio
There's nothing wrong with owning a portfolio that is heavily tilted toward individual stocks or stock mutual funds. Equities have proven themselves as the asset class with the greatest potential for wealth creation over long periods of time. However, in an overheated market, even talented, value-conscious stock pickers are exposed to valuation risk.

In 2008, for example, the S&P 500 lost 38.5% of its value (on a price basis, i.e., before dividends). Would a classic value strategy have protected you from such horrific losses? No. In fact, the S&P 500 Pure Value index significantly underperformed its parent index during that bear market, losing half its value. That's not exceptional: Last year, the market fell 16% from April 23 to July 2. Meanwhile, the S&P 500 Pure Value Index declined 20%. This suggests that investors can't rely on a strategy of buying cheap stocks for protection during a market correction.

What no broker will tell you: The market's overpriced
None of this would matter if there were no reason to anticipate a correction. Unfortunately, with stocks overvalued, there is ample justification to fear a pullback. Yes, investors are being bombarded with the message that stocks are cheap right now, but that just doesn't add up. It might look that way to observers who look only at the market's multiple of 2011 earnings, but that isn't reliable.

If we look at two more stable indicators of long-term value, Tobin's q ratio and the Shiller P/E ratio, which is based on average inflation-adjusted earnings over the prior 10-year period, stocks look markedly expensive right now. The S&P 500 could decline more than 20% to 1,000 tomorrow and it wouldn't be undervalued. How would you expect your portfolio to fare in that scenario?

In that regard, owning the SPDR S&P 500 ETF (NYSE: SPY  ) looks like a risky proposition right now. When it comes to broad U.S. stock exchange-traded funds, I much prefer the Vanguard Dividend Appreciation ETF (NYSE: VIG  ) , with its tilt toward megacap, high-quality stocks -- a segment that looks better priced than the broad market.

2 strategies to reduce portfolio volatility
Thankfully, there are strategies that can reduce the volatility of your stock portfolio. Lower volatility gives investors the resolve to ride out market corrections and allow their stock picks the time to work out. These are two of those strategies:

Covered calls
Income-producing option strategies reduce portfolio volatility. Take Motley Fool Pro, which has written covered calls on consumer products company Procter & Gamble (NYSE: PG  ) . A covered-call strategy involves selling call options on a stock you own. The options have a strike price above the market price of the stock. If the stock achieves the strike price, you may be forced to sell some of the shares you own at that price. But keep in mind that you can set the strike price at the outset of the trade, so you can choose a price at which you are comfortable selling your shares.

If the stock does not achieve the strike price by expiration, the options expire worthless and you will have pocketed the entire sum you received on selling the options. The option income contributes positively to portfolio returns and dampens the magnitude of dips in a correction. Procter & Gamble is a good candidate for this strategy because it is a very stable business and relatively easy to value. Other stocks that would do the trick nicely: Johnson & Johnson (NYSE: JNJ  ) or McDonald's (NYSE: MCD  )

ETFs
ETFs enable investors to take on -- or hedge -- exposure at the stock sector or asset class level with the same convenience as buying a single stock. As I mentioned above, the broad market looks overvalued, and that is even truer for the small-cap segment, which the Russell 2000 index tracks. In a downturn, these stocks could be particularly vulnerable. As such, I think a short position in the iShares Russell 2000 Index ETF (NYSE: IWM  ) is an excellent way of hedging stock holdings.

Investors can also use ETFs to make "positive" wagers. For example, Motley Fool Pro began buying the Vanguard Energy ETF (NYSE: VDE  ) in February 2009, ultimately building a 3% core position with an average cost below $66 per share and an expected holding period of three to five years. In less than two years, the position has generated a 50% return, yet Pro continues to rate this ETF a buy. With oil looking set to breach $100 per barrel, that looks far from unreasonable.

The missing 30%
Motley Fool Pro aims to have 70% of its$1.4 million real-money portfolio in individual stocks and the remaining 30% in stock-related strategies, including ETFs, options, and short positions. That's the 30% I alluded to in the title, the 30% that could protect your stock portfolio during periods of market stress and enhance returns with exposure to specific stock sectors or other asset classes.

Completing your portfolio
If you're interested in finding out more about putting that 30% to work for your portfolio in 2011, simply enter your email address in the box below. In return, Pro advisor Jeff Fischer will send you his free report, 5 Pro Strategies for 2011, along with an individual invitation to join Pro, which has reopened to new members for a short time.

Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. Johnson & Johnson and Procter & Gamble are Motley Fool Income Investor selections. The Fool owns shares of and has written covered calls on Procter & Gamble. Motley Fool Alpha has opened a short position on iShares Russell 2000 Index. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of Johnson & Johnson and Vanguard Energy ETF. Motley Fool Alpha owns shares of Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (14) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 20, 2011, at 4:11 PM, pondee619 wrote:

    "If your equity portfolio is 100% invested in individual stocks or stock mutual funds, you should be aware that it's at risk"

    "...to have 70% of its$...portfolio in individual stocks and the remaining 30% in stock-related strategies, including ETFs, options, and short positions."

    A 100% stock or stock mutual fund portfolio is at risk. So, I should have 70% in stocks and 30% in "stock-related strategies"? A "stock-related strategy" is different from a stock or stock mutual fund? Shouldn't there be bonds, commodities, REITS, etc.? I don't see how a 100% stock/stock fund portfilio is different from a 70% stock/30% "stock-related strategies" portfolio.

  • Report this Comment On January 20, 2011, at 4:20 PM, TMFAleph1 wrote:

    "Shouldn't there be bonds, commodities, REITS, etc.?"

    Yes, but you are referring to one's entire asset allocation. I am only referring to the equity component of the asset allocation. Note that I wrote:

    "If your EQUITY portfolio is 100% invested in individual stocks or stock mutual funds, you should be aware that it's at risk"

    Alex Dumortier

  • Report this Comment On January 20, 2011, at 6:56 PM, globalsailor wrote:

    This sounds like it's getting too complicated. If you need to play all of these games it is because you don't have enough confidence in your stocks. Furthermore, having a fixed income section of at least 20% can help you market time.

  • Report this Comment On January 20, 2011, at 7:24 PM, TMFAleph1 wrote:

    @globalsailor

    I don't disagree with you; unfortunately, the reality is that most investors don't have enough confidence in their stock investments and are easily "shaken out" by a little bit of volatility. By reducing the overall volatility of the portfolio, the strategies I refer to help bolster investors' resolve and enable them to go on to earn acceptable long-term returns.

    Alex Dumortier

  • Report this Comment On January 20, 2011, at 7:31 PM, globalsailor wrote:

    If you can't handle the volatility don't buy it. What sounds to me is that investors seek diversification over information. If investors bought 12 stocks rather than 30 they would be better informed and earn higher returns.

  • Report this Comment On January 20, 2011, at 7:32 PM, globalsailor wrote:

    By the way, how many stocks does Buffet buy in a year? I can't imagine it being more than 10 and he does this stuff all day.

  • Report this Comment On January 20, 2011, at 8:12 PM, TMFAleph1 wrote:

    @globalsailor

    It's a different game for Buffett now, due to size/ capacity. He was MUCH more active when he was managing his investment partnerships.

    The article isn't advocating diversification per se. In fact, the additional strategies could all relate to the stocks you already own. I don't see why "If you can't handle the volatility, don't buy it" would be a superior approach to low-cost hedges/ insurance.

    Alex Dumortier

  • Report this Comment On January 20, 2011, at 11:00 PM, ikkyu2 wrote:

    Information asymmetry - the bane of the retail investor to whom this article is directed - is nowhere more pronounced than the equity options markets. No one who can't explain Black-Scholes, on a whiteboard, without a crib sheet, defining every term in its theoretical basis and also explaining the pros and cons of real-world proxies used to estimate those terms, has any business buying or selling any kind of option, because they do not understand how those options are priced.

    If you guys are really stuck for things to talk about, how about corporate debt and convertibles? I've made a killing in each of these over the last 3 years and you don't have to understand bizarre options pricing to do so.

  • Report this Comment On January 21, 2011, at 2:50 AM, TMFAleph1 wrote:

    @ikkyu2

    Your objection appears totally inconsistent with one of your two follow-on recommendations; indeed, pricing a convertible bond is quite a bit trickier than pricing an equity option.

    Alex Dumortier

  • Report this Comment On January 21, 2011, at 11:26 AM, pondee619 wrote:

    Equity portfolio, bond portfolio, real estate potfolio, commoditiy portfolio etc...MY PORTFOLIO. Stop the pocket accounting and talk about the whole. Your team's offence may be great but if the D sucks you still don't win. Until you consider all of your investments you are just whistling in the wind. But then, which subscription would you hawk?

  • Report this Comment On January 21, 2011, at 12:20 PM, TMFAleph1 wrote:

    An asset allocation newsletter?

  • Report this Comment On January 21, 2011, at 1:55 PM, pondee619 wrote:

    "An asset allocation newsletter?" Do these fools have one? Is there one newsletter that these fools sell that would cover a person's entire investment portfolio? Give guidance to someone regarding a complete investment package? Supply a diversified game plan of investments under one cover? Do these fools have such a subscription, or is it peicemeal, requiring someone to buy several subscriptions to get a complete picture?

  • Report this Comment On January 21, 2011, at 2:49 PM, TMFAleph1 wrote:

    The closest thing to an asset allocation product is probably Rule Your Retirement, although a couple of the other products (Motley Fool Pro, Motley Fool Alpha) also incorporate some elements of asset allocation in their approach.

    Alex Dumortier

  • Report this Comment On January 24, 2011, at 11:34 AM, pondee619 wrote:

    "The closest thing to an asset allocation product is probably..."

    "incorporate some elements of asset allocation "

    So, these fools don't have an asset allocation product. Only something that probably comes close. And there is nothing offered that provides a complete picture in fooldom?

    "On January 21, 2011, at 12:20 PM, TMFMarathonMan wrote:

    An asset allocation newsletter?"

    I should go elsewhere in search of one? Why should these fools offer a complete newsletter when there remains the chance of selling someone several.

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