A Rebound-Ready Portfolio

12/15/2008 12:01 am EST

Focus: GLOBAL

Chris Gilchrist

Editor, The IRS Report

Chris Gilchrist, editorial director of EveryInvestor, tells investors how they should protect themselves, diversify, and position their portfolios for a rebound.

Q. Chris, in an interview at the recent World Money Show in London, you discussed the failure of the most widely used diversification strategies during the current global market declines. Why did it happen?

A. There are two major reasons. First, current portfolio planning techniques are based on portfolio theory, which systematically underestimates the frequency of extreme events as well as the size of potential losses. ‘Standard deviation’ is a false measure of risk because investment returns are not ‘normally distributed’. Inadequate recognition of risk meant advisers recommended too high a proportion of capital be invested in equities.

Second, finance theorists hold that the excess annual return on equities above risk-free bonds should be no more than 2% to 3% as against a historical 5% to 7%, but this, too, is contrary to what we know about investors. It assumes investors are indifferent between loss and gain, when we know investors are about twice as risk-averse as they are gain-seeking and that this systematically skews their behavior.

Nevertheless, if you follow the theory, you end up putting more capital into risky assets in order to achieve your target rate of return. So, the failure arose not from diversification itself—though that, too, has been problematic—but from putting too high a proportion of assets into riskier assets.

Q. What diversification strategy do you recommend for most individual investors?

A. There is still merit in the concept of diversification, but you must seek out truly different asset classes. For example, there is lot of evidence that private equity and forestry are two assets which don’t correlate with listed equities, plus they both have superior long-run rates of return. Adding these to a standard equity-and-bond portfolio is much better than adding, say, small-cap equities, which don’t actually give you much diversification benefit at all.

And I think most investors should plan to hold more in cash over a market cycle. They should set levels at which they’ll switch some of that cash into and out of risk assets, and stick to their rules.  

Q. Many advisors and investment newsletters are now touting a ‘return to dividends’, and recommending high dividend-paying equities. Do you agree?

A. I do agree that safe dividends will be prized by investors in coming years, but determining whose dividend is safe is a really tough call. I prefer to focus on dividend- paying potential rather than actual dividends. For example, both Barclays (NYSE: BCS) and Rio Tinto (NYSE: RTP) are financially strong and have good cash flows, which they are using to rebuild capital and pay off debt over the next two years. After that, they’ll have a lot of cash they could hand to shareholders. I prefer stocks like these to safer utilities where there’s lower scope for dividend increases in future.

Q. Do you have any favorite dividend-paying stocks that you are currently buying?

A. A couple are GlaxoSmithKline (NYSE: GSK) and BT Group (NYSE: BT). GSK is one of the strongest of the Big Pharmas, and BT has big debts, but can easily pay them down from cash flow from its recession-proof land-line telecom business.

Q. Looking back over the past months of huge global losses for almost all investors, are you still an advocate of steady investing over time?

A. Regular investing is a fail-safe strategy that always works if you give it enough time, but the minimum period for it to really work is ten years. I started to invest regularly recently in high-volatility areas like emerging markets and natural resources, because falling markets are perfect for regular investing. I want prices to stay low for several years, so I can accumulate a lot of stock at low prices. I’m happy for the next boom to be a few years off. 

But I do regret not selling my bank stocks!

Q. Do you believe the commodity super-cycle is over?

A. When China, India, and Brazil put growth in reverse, the commodity boom will be over, but not until then. We’re just having a pause, but just as we had hysterical over-promotion in the boom, we’re now getting hysterical doom-mongering in the slump. Anyone who seriously thinks oil will be $40 a barrel in three years time needs a mental check-up. Big oil stocks like BP and Royal Dutch Shell (NYSE: RDS-B) are a steal. 

Q. Which, if any, commodities do you currently favor?

A. I like gold, but personally hold gold mining stocks. That’s been a mistake over the past year, when gold stocks have hugely underperformed bullion, but I think gold stocks are now ready for a major bull run. The supply position is tight and we’re just at the point when demand will probably pick up. We had a classic drop off in jewelry demand (mainly India) after the price went from $600 to $800. History shows this is normal and demand resumes after a time lag of about a year.  Millions of people getting a bit more money in India and China will want to own a bit of gold.

Q. Are there any other markets or sectors you favor now?

A. European investment-grade corporate bonds seem to me insanely cheap. A diversified fund will pay a running yield of 7.5% and have a redemption yield of 10% or more. I’m expecting to make returns of 10% a year over the next two to three years. One fund manager recently described the opportunity to me as “equity-style returns without equity-style risk.”

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