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Forget Gains, Best to Avoid Losses

Forget Gains, Best to Avoid Losses

It used to be, hold on for the long-term. These days, there is a new refrain: Avoid losing days to win.

For years, advisors told clients to hold for the long term. This standard thinking led many investors to embrace buy-and-hold portfolios with 60 percent of assets in stocks and 40 percent in bonds. That classic mix worked — until last year when markets crumbled. A decade of returns was lost.

Now many financial advisors and portfolio managers are beginning to question the traditional thinking. They are emphasizing new kinds of diversification. “We are trying to dispel the idea that just participating in the stock market will lead to success,” says David Gluch, director of U.S. product management for Invesco Aim. “The old thinking has caused many clients to suffer serious losses and lose confidence in advisors.”

Seeking new approaches, Invesco Aim has turned some old advice on its head. In the past, advocates of buy-and-hold investing often said that if you miss just a few of the market's best days, you are doomed to mediocre performance. Now Aim says that instead of thinking about the best days, investors should focus on the worst. The goal of advisors should be to avoid unacceptable losses — not to strive for double-digit returns.

The Importance Of Being Defensive

To demonstrate the importance of protecting against losses, Gluch cites a study of the market's best and worst days. An investor who put $1 into stocks in January 1928 would have $45.18 by March 2009. If the investor missed the ten best days, the ending value would be $14.99. But if the investor missed the 10 worst days, he would have $143.47. From that, Gluch concludes it is more important to protect against the worst days than it is to be in the market for the best times.

Simple arithmetic explains the outsized impact of the bad days, he says. If investors lose 50 percent — as many did last year — then the portfolios must achieve a 100 percent gain in order to recoup all the losses. After one bad downturn, it can take years to recover, and many investors don't have that much time to spare.

To help investors protect against disastrous losses, Invesco Aim recently introduced Aim Balanced-Risk Allocation (ABRZX), a fund that represents a departure from classic 60-40 portfolios. For more security, the Aim managers hold three asset classes: commodities, government bonds, and stocks. Such a mixed portfolio could avoid bad losses in variety of economic conditions, including recessions and periods of high inflation.

While the Aim managers adjust their holdings as market conditions change, the portfolio normally has most of its assets in bonds. To appreciate why the managers favor fixed income, consider that the S&P 500 has a standard deviation of 19, and many commodities post standard deviations of more than 20. In contrast, the Barclays Aggregate bond index has a figure of 5. Because stocks and commodities are so volatile, they should typically account for only a small portion of the portfolio. That way, stocks and commodities cannot swamp a portfolio, the Aim managers say.

The managers concede that their portfolio will lag during roaring bull markets. But they argue that the fund is likely to avoid huge losses at any time, enabling shareholders to obtain competitive long-term results.

The Aim fund began operating in June, and the company has been promoting it to advisors. While the new fund represents a radical departure from traditional strategies, advisors have been open to considering it, says portfolio manager Scott Wolle. “We have been through two savage bear markets in the past decade,” he says. “Advisors are looking for different ways to approach diversification.“

Diversify, Of Course

Another outspoken critic of traditional portfolios is Robert Arnott, chairman of Research Affiliates and portfolio manager of PIMCO All Asset (PASAX). Arnott says that a 60-40 portfolio typically captures 60 percent of the stock-market downside. So if the market drops by 10 percent, the portfolio would fall by 6 percent. That sort of loss could destroy a retiree's nest egg.

Arnott says that instead of depending so heavily on stocks, investors should hold a wide range of assets, including high-yield bonds, emerging market bonds, and commodities. By diversifying broadly, investors can achieve some growth while facing limited downside risk.

Arnott notes that a 60-40 portfolio would have lost 11.0 percent during the period from June 2008 through September 2009. An investor would have only lost 3.4 percent with a portfolio that held equal weights of 16 different asset classes, including real estate and commodities, as well as U.S. and foreign stocks and bonds. An active manager, Arnott does not advocate holding equal weights of various asset classes. But he contends that investors can achieve sound results by avoiding overpriced assets and diversifying broadly. “If you hold a portfolio of uncorrelated assets, you can outperform equities while taking less risk,” he says.

Instead of blindly holding blue-chips, investors should take a flexible approach, says Louis Stanasolovich, president of Legend Financial Advisors, a registered investment advisor in Pittsburgh. “Investors in S&P 500 index funds haven't made money in more than 10 years, but other asset classes have done well,” he says.

Convinced that the economy could remain sluggish for years, Stanasolovich is currently wary of blue-chip stocks. Instead he is emphasizing commodities and emerging market stocks. A favorite holding is SPDR Gold Shares (GLD), an ETF. The value of gold rises when the dollar falls, and Stanasolovich figures that the dollar will keep sinking for the next five years. “We have the biggest budget deficit and the biggest trade deficit in the world,” he says. “That will hurt the dollar for a long time.

Stanasolovich has up to 75 percent of his conservative portfolios in bond funds. A favorite holding is Loomis Sayles Bond (LSBDX). Because that fund holds a wide mix of investment-grade and high-yield bonds, it should produce healthy results under a variety of market conditions.

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