Makeover for a Bear-Mauled Portfolio: How to Create a Winning Game Plan

    by Vern C. Hayden

    Makeover For A Bear Mauled Portfolio: How To Create A Winning Game Plan Splash image

    Like a desert mirage, the stock market shimmered its way through the dream merchants of Wall Street to investors all over America. For example, on March 10, 2000, Merrill Lynch introduced, with great fanfare, their brand new Internet fund—joining the tech feeding frenzy the day the Nasdaq hit a peak of 5028 and started to crash. It gives new meaning to the old cliché “timing is everything.”

    In January of 2002, Herb and Jocelyn Edwards (fictitious names, but real circumstances) walked into my office with what was left of a portfolio of mutual funds. They had bought into the hype of the times, and then suffered as the bear market started to trash their lifetime of savings. Their experience has a number of important lessons that other investors can readily learn from.

    Their original investment was about $450,000 when they went to a stockbroker for advice on investing their assets. But when they walked into my office, the then-current value was about $210,000, for a loss of about 53%.

    Keep in mind that to recover from a 53% loss, an investor has to make 114% just to get back to even again.

    One look at their portfolio, and you could see it was a ticking time-bomb, ready to blow up the moment the market turned south—which it did.

    Figure 1.
    The Edwards' Original Portfolio

    The Edwards’ portfolio is shown in Table 1, but it is also depicted in the graph in Figure 1, giving a much better “picture” of their portfolio. Figure 1 is a “scatterplot,” which reflects various pieces of information over, in this instance, a three-year period.

    The horizontal (x) axis represents “standard deviation.” This is a measure of the risk of any portfolio—an individual mutual fund, or an entire portfolio of mutual funds. Standard deviation measures volatility, and the higher the number, the higher the risk. So, if you go from left to right across the chart, you are going from lower risk to higher risk.

    Table 1. The Edwards’ Original Mutual Fund Portfolio
    Fund Category Portfolio Allocation 3-Year
    ($) (%)
    Firsthand Tech Value Tech 30,000 14.29 –77.89
    Dreyfus Premier Tech Growth B Tech 50,000 23.81 –71.66
    Putnam Int’l Capital Opp B Growth 40,000 19.05 –45.00
    Seligman Henderson Gl Tech B Tech 30,000 14.29 –63.37
    Alliance Bernstein Premier Gr B Growth 20,000 9.52 –58.78
    Calamos Growth Growth 25,000 11.9 –1.69
    MFS Mid Cap Growth Growth 15,000 7.14 –54.73

    The vertical (y) axis of the chart indicates return—the numbers range from lower returns at the bottom to higher returns at the top. The square box in the middle of the scatterplot represents the benchmark portfolio, in this instance the S&P 500 (this isn’t necessarily the perfect index for an entire portfolio, but I’m using it as a convenience for this article). As you can see, the index has a standard deviation of about 17.26 and the return has averaged -8.29% annually over the last three years through October 2003.

    If you draw vertical and horizontal lines through the benchmark, you create four sections of the scatterplot, indicating:

    • Upper left: Higher return and lower risk relative to the benchmark;
    • Lower left: Lower return and lower risk relative to the benchmark;
    • Upper right: Higher return and higher risk relative to the benchmark; and
    • Lower right: Lower return and higher risk relative to the benchmark.
    The most desirable sector to be in is the upper left because it indicates your portfolio had higher returns with lower risk relative to the market. I like to use scatterplots because they graphically depict how the various elements of a portfolio are working together. It is possible, for example, in even a conservative portfolio, to have some holdings that are much higher risk—located on the right-hand side of the scatterplot—as long as they are balanced by less risky holdings, with the overall portfolio in the upper-left section of the scatterplot. Of course, it is important to remember that this is a snapshot of how the portfolio operated in the past, and there is no guarantee performance will be repeated in the future. But looking at how a portfolio performed historically is a good way to get your bearings.

    In the Edwards’ scatterplot in Figure 1, the clear round circles represent their individual fund holdings; the solid black dot is their overall portfolio of mutual funds. (Various portfolio software programs can perform this kind of function; I use Morningstar Principia software.) You can see that the Edwards’ portfolio at that time was in the lower right-hand corner, the least desirable section of the scatterplot—it took on more risk than the S&P 500, yet it produced a lower return. The risk factor (standard deviation) of the portfolio is about 29.09, significantly more than the S&P 500. The return of the portfolio was in the lower right at -16.94% for each of the three years—it had significantly more loss than the S&P 500 index.

    Obviously, this wasn’t a desirable portfolio, and the scatterplot emphasized that from a quantitative standpoint.

    What Went Wrong?

    Before beginning the makeover of the Edwards’ portfolio, there are important lessons to be learned from what went wrong:

    1. The Edwards didn’t have a game plan that was based on their long-term investor profile.

      Lesson: Make sure your game plan is based on your investor profile. Your profile consists of at least three important ingredients: What is your timeframe (how much time do you have before you will need the money)? What are your financial goals? And, how much risk can you live with? If you know how much money it will take to achieve a goal and you know your investment timeframe, then you can figure out what kind of return you need to achieve your goals and whether that return is achievable given your tolerance for risk. Next, you need to determine if the return you need is reasonable. For most planning purposes, I use a 7% to 8% rate of return as a reasonable maximum for long-term stock investing.

    2. They did not correctly analyze their risk tolerance. With most of their portfolio in aggressive growth, their game plan can best be described as only having an “offense.” You can’t win any game with pure “offense.” Boxed below are two hypothetical portfolios. Most people would have pulled out of the offensive portfolio after it was down around 50% and suffered a significant loss. They would probably also lose some sleep over it. However, a portfolio with an offense and defense and even 10% annual returns would let the investor sleep at night. Such an investor would probably stay in the market and have almost the same gain in their portfolio as an extremely volatile one.

        Portfolio Game Plan:
      Mostly Offense Offense & Defense
      Initial Investment: $100,000 $100,000
      Year 1 80% 10%
      Year 2 -50% 10%
      Year 3 +50% 10%
      Final Value 135,000 $133,100

      Lesson: Start with a portfolio allocation that takes into consideration your risk tolerance and leads to providing a good offense and defense.

    3. With the price-earnings ratio of the portfolio at about 60 in 1999, they ignored the time-proven valuations of the market. Yet, one of the red flags of a charging bull market is the overvaluation of stock. The buzz of the hyper bull market was: “Things are different now” and “we’re in a new economy—if it goes down, it will come back up!” Yardsticks like the price-earnings ratio, price-to-book ratio, and dividend yield all went out the window.

      Lesson: Don’t let time-proven traditions based on proven fundamentals get swallowed up during “unfashionable” moments. The S&P 500 index is overvalued by traditional measures when its price-earnings ratio is over 15 to 18; the price-to-book value “safe” number is considered to be around 2.5. Currently, the S&P 500’s price-earnings ratio is over 20, and its price-to-book is now over 4. So, even today, we are in an overvalued situation, which means you have to keep an eye on the fundamentals. In other words, just because we have had a great nine months, keep your defense in good shape.

    4. Their portfolio was heavily weighted in technology—it was an “emotional” portfolio: Back in 1999, if you weren’t in technology you had no status at cocktail parties—everybody was on board the tech bandwagon. The smartest people’s minds were left at the door of the fervent greed-driven market.

      Lesson: Leave your emotions at the door, listen to your mind and use it to balance against greed and fear.

    5. They thought it was easy: All you had to do was throw your money at tech.

      Lesson: It is NEVER easy; in fact it’s hard work. You either need to spend a lot of time doing it yourself (and you can) or spend some money to find a good advisor to do it for you.

    The Makeover Game Plan

    In general, I divide investors into three basic profiles: conservative, moderate, and aggressive—with characteristics that are summarized in Table 2.

    Table 2. Investor Profiles
      Conservative Moderate Aggressive
    Risk Quiz Score* 5 to 7 8 to 12 13 to 15
    Goals home, car, retirement college/retirement retirement
    Time Needed 4 to 5 years 5 to 7 years more than 7 years
    Risk low: risk averse medium: risk steady high: risk seeker
    Expected Return 5% to 6% 7% to 8% 9% plus

    To makeover the Edwards’ portfolio, we went through a discovery process to determine their investor profile. The process included goal-setting, timeframe analysis and risk tolerance analysis.

    The basic objective was to meet a retirement goal in 15 years, since the kids’ education was already taken care of.

    Risk tolerance analysis included extensive discussions and tests to determine the Edwards’ risk profile. Examples of the kinds of questions that need to be considered in any risk analysis are presented in the Risk Quiz.

    After testing and discussion of risk tolerance, we agreed that a portfolio with moderate risk would be appropriate.

    The Edwards most closely fit into the moderate investor profile. Although they had a retirement goal that was 15 years down the road, they clearly did not have the staying power to ride out the volatility inherent in an aggressive portfolio.

    While the moderate portfolio was our target, we didn’t immediately implement it. The Edwards were severely bruised and losing sleep, so we declared a “time out.” The first thing we did for the Edwards was sell everything and park the entire sum of money in money market and bond funds. There were no taxes because there were losses rather than gains. In fact, they have losses to carry forward. And there were no commissions. There were some fees that totalled roughly $300.

    The typical “game plan” (allocation) that I use for moderate allocations has an “offense” that uses stock for 65% of the portfolio; the remaining 35% of the portfolio is the “defense,” with 25% in bond funds and 10% in a money market fund. Of the 65% in stock funds, the majority is placed with value or blend managers.

    A value manager is one who assesses the intrinsic value of a company and will buy the stock only when it is 30% to 50% discounted from that value; a growth manager pays more attention to the expected growth of the stock, and if they sense momentum in the price, they may buy it. A blend manager combines the best of both worlds.

    Player Criteria

    Now it’s time to pick the players for the Edwards’ portfolio—the individual mutual funds. Here are some guidelines for picking a suitable fund:

    Try to vary the style, since value and growth perform differently during various time periods. The value managers are generally safer during weak markets. Growth managers generally will do better in up markets.


    • The first thing to look for in performance figures is how a fund fared during bad years. Check out 1987, 1990, 1994, 2000, 2001, and 2002 (use I like to see a fund that doesn’t go down as much as the market during those bad periods.

    • Determine the appropriate benchmark for each fund you are considering. For instance, let’s say the benchmark is the Russell 2000 for small-company stocks. I want to see the fund outperform its benchmark two out of three years, but also cumulatively over three years. In addition, it should outperform its benchmark three out of five years and cumulatively over five years. In other words, I allow a manager to miss the benchmark in one year or two, but not overall.

    • The ideal, but seldom accomplished, goal is to find a manager whose fund doesn’t go down as much as the market but who does better than the market on the upside.
    To keep this task manageable let’s use just two measurements: price-earnings ratio and price-to-book ratio. will give you this information.
    • Price-earnings ratios: 20 or less is good; over 20, be very cautious.

    • Price-to-book value: 3 or less is good; over 3, be very careful.
    There are several numbers to look for when determining risk. Combine the riskiness of the fund with its performance in down years and you’ll have a good idea how risky the fund is overall. The most common risk measurements are:
    • Standard deviation: This simply measures how widely the returns varied over a certain period of time. If a fund has large variations, it is considered volatile and therefore more risky. The lower the number, the better, but generally below 18 is best.

    • Beta: This addresses the volatility of a fund relative to its appropriate benchmark. It’s a measure of a fund’s sensitivity to market movements. For instance, the S&P has a beta of 1.00; if a fund has a beta of 1.10, this implies that the fund has performed 10% better than its benchmark index in up markets and 10% worse in down markets. The lower the number the less risky, but 1.00 or below is a good starting point.
    Fund Structure and Company
    • Don’t use funds that employ rapid timing, after-hours trading or other scams that have been publicized recently.

    • Character counts—you want to invest only with managers and companies that have excellent character.

    • At least half of the fund’s board members should be true independents. It’s preferable that the chairman be an independent.

    • It is best if board members are paid in shares of their fund. They should also hold investments in their fund.

    • If fund performance takes a “pop” up at the end of a month, quarter or year, watch for “portfolio pumping.” That occurs when a manager uses some of the cash to buy stocks he already owns to drive the price up at the end of a reporting period.

    • I like managers with 10 to 15 years of experience under their belts.
    That gives you an overview of some of the things to look for when picking a fund. The Edwards had $210,000 left to invest. Table 3 shows how I would eventually invest it.

    Table 3. The Edwards’ Makeover Portfolio
    Fund Portfolio Allocation
    ($) (%)
    First Eagle Global 31,500 15.0%
    Dodge & Cox Stock 21,000 10.0%
    FPA Crescent 21,000 10.0%
    Hussman Strategic Growth 21,000 10.0%
    Royce Low Price Stock 21,000 10.0%
    Oakmark Equity & Income 21,000 10.0%
    Subtotal 136,500 65.0%
    Dodge & Cox Income 27,500 13.1%
    Vanguard Short Term Corp 25,000 11.9%
    Money Market Fund 21,000 10.0%
    Subtotal 73,500 35.0%
    Total 210,000 100.0%

    The information matrix in Table 4 gives you a significant amount of data from Morningstar for each of the funds in the makeover—these are all exceptional numbers. So far all have escaped scandal, and all of the funds have passed the criteria I mention here.


    Once you have made the overall allocation decision, you are still not finished. You must examine how these players work as a team. And for that, we go back to the scatterplot.

    Figure 2.
    The Edwards' Makeover Portfolio

    Figure 2 shows the scatterplot for the makeover portfolio—it is now in the most desirable quadrant, the upper-left corner, with lower risk (a standard deviation of 8.87) than the overall benchmark, and a higher return over the last few years through October 2003.

    In summary, by properly understanding your objectives, timeframe and risk tolerance, you have the basic necessities for creating a winning game plan—a portfolio that will work better for you in both up and down markets.

    Vern Hayden, CFP, is president of Hayden Financial Group, a fee-only financial planning firm based in Westport, CT, 203/454-3377. Mr. Hayden is author of “Getting an Investment Game Plan,” published by John Wiley & Sons and available for $29.95 in bookstores and through at a 30% discount.

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