Most high net-worth investors understand the virtues of strategic asset allocation. This process involves setting specific target ranges for general asset classes (stocks, bonds, and cash equivalents). Then, as market movement pushes sector exposure beyond target limits, sector exposure is either trimmed back or increased.
Doing so effectively reallocates the portfolio, so that sector exposure once again matches pre-set asset allocation targets determined by investor objectives and risk tolerance. If one adheres to this strategy over the long term he or she will, by definition, "buy low" and "sell high," over and over again. This is a simple, yet effective strategy.
The same principle can be applied to sub-sectors within the equity, or common stock, portion of the portfolio. A disciplined strategy of setting equity sub-sector target ranges - - and reallocating exposure to them periodically - - results in effective risk management within the equity sector. It also allows one the opportunity to build a portfolio with a more attractive risk/return profile.
Risk is reduced for each given level of expected return through exposure to additional risky asset classes whose returns have a low correlation with one another. By exposing one's portfolio to additional equity sub-sectors (foreign stocks, emerging markets, small capitalized companies, etc.) that do not necessarily walk in lock step with one another (having a low correlation with each other), portfolio diversification is increased, reducing relative risk.
If your current stock portfolio consists of exclusively, or predominantly, large U.S. traded companies (as represented by the S&P 500 index), augmenting it with targeted positions in various equity sub-sectors can be quite beneficial. During periods of weakness or stagnation in the domestic large cap stock market, foreign or emerging markets may be reacting to a completely different set of circumstances. For instance, explosive growth in China, the opening of an emerging market economy to increased foreign investment, or new tax legislation improving the landscape for very small companies domestically could have far- reaching effects on the relative performance of a sub-sector even though the S&P 500 might remain largely unaffected.
The first step in this process is to determine appropriate target percentages for each sub-sector you intend to utilize. These choices should be based upon careful research examining sector volatility, correlation of returns, your current holdings, and individual risk tolerance, to name but a few. Statistical modeling software can be very helpful in this area. There is sophisticated software available that can look at various combinations of equity sub-classifications and determine, based upon historical and/or predictive data, what combination of sectors has the most advantageous risk/return profile. Once target ranges for each sub-sector are set, within the context of your overall asset allocation (your target mix of total stocks, bonds and cash equivalents), the portfolio can then be reallocated so as to bring it in line with target percentages.
Once the portfolio is allocated according to targets, it then needs to be rebalanced periodically, as market conditions dictate. As certain sectors outperform others, and target exposure ranges are either exceeded or become under-weighted, the portfolio needs to be brought back in line with predetermined targets. Target ranges themselves, on both the portfolio and the sub-sector levels, also need to be revisited periodically. Obviously, this should be done before any rebalancing prompted by market movement, to limit trading costs associated with rebalancing.
As investors come to grips with the realization that we may be in store for a prolonged period of higher volatility and below-trend equity returns in the domestic markets, at least by recent historical standards, more and more investors will embrace the wisdom of diversifying one's equity portfolio across the spectrum of equity sub-sectors, both globally and domestically.
For more information about the way we manage portfolios at Marc J. Lane Investment Management, Inc., please call us at (312) 372-1040. We'll be delighted to help you in any way we can.
J. Brad Strom is a Senior Vice President and a Portfolio Manager of Marc J. Lane Investment Management, Inc., the registered investment advisory affiliate of The Law Offices of Marc J. Lane, a Professional Corporation. Mr. Strom earned his Master's degree in Finance from DePaul University's Graduate School of Business in 1993 and his Chartered Financial Analyst designation in 1994. He is a member of the Investment Analysts Society of Chicago and the Association for Investment Management and Research.
The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright © 2007 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.