Tom Orecchio, CFA, CFP, ChFC, CLU, AIF
Tom Orecchio, CFA, CFP, ChFC, CLU, AIF
Tom Orecchio examines the principles of wealth management and financial planning-from portfolio and tax management to alternative investments and estate planning-to help physicians achieve financial success.

Diversifying Your Portfolio, Even in “Good Times”

According to recent headlines, markets are rallying and a sense of optimism has returned. The first quarter of 2011 ended strongly -- in spite of the many geopolitical events that occurred over the last few months -- and with the recent news of higher profits and projections from tech and manufacturing companies in the U.S., the momentum seems to be continuing.  

Before we all break open the champagne bottles and start putting all of our money back into equities, however, it’s worth stepping back and remembering the lessons learned over the last couple of years. The end of 2008 was the wake-up call for many investors. Ever since then, even in more optimistic times such as these, it’s critical to make sure that your portfolio has a clear investment strategy and is adequately diversified. Individual investors also may want to take a closer look at other alternative assets to protect the downside during times of extreme volatility.

The start to any portfolio-protection strategy begins with a long-term investment horizon and a disciplined plan. Short-term, emotional decision-making is the enemy of successful investing. The complement of the asset-allocation decision is diversification: arming one’s portfolio with investments that tend to “zig” when others “zag.” For example, one may diversify a traditional 60% to 40% portfolio mix by adding international stocks and bonds, emerging markets, Treasury inflation-protected securities, commodities and real estate.  

In addition to these more common asset classes, are there other ways to reduce downside risk and volatility, while still seeking to deliver a desired rate of return? There are, in fact, many strategies that propose to do just that -- but they are not without risk and shortcomings.

Fixed income exposure, the greater use of trading strategies, equity-indexed products (such as annuities), structured notes and inverse products may provide downside protection benefits that many investors desire; however, there also can be some major drawbacks, including:

•    Cost -- many of these products are layered with fees;
•    “Black boxes” -- minimal transparency into the actual operations of the strategy;
•    Illiquidity -- resulting from extended lock-up periods;
•    Counterparty risk -- default risk associated with the institutions involved;
•    Greatly reduced upside return potential;
•    Inconsistency of the product behaving as advertised; and
•    Implementation challenges -- some have requirements limiting client participation, while others have significant operational hurdles.

Other strategies, such as an “option overlay” strategy seem to have fewer disadvantages and more potential to protect against the downside. At its core, this approach uses puts, calls and other options techniques to create a floor beneath which the portfolio’s value cannot fall. These option strategies often are associated with protective measures applied to individual stocks, especially when one is faced with high exposure to a company while retaining a very low cost basis.

The take-away is that long-term investing and diversification among asset classes that don’t move in lock step should remain the foundation of your investment strategy -- even now when the temptation may be to jump fully into U.S. equities given its recent performance. And, while another October 2008 may not be right around the corner, it may be worth investigating other opportunities to further reduce portfolio volatility, as long as you proceed with some caution and due diligence.

Tom Orecchio is a principal and wealth manager with Modera Wealth Management, LLC (“Modera”). Nothing contained in this blog should be construed as personalized investment, financial planning or other advice, and there is no guarantee that the views and opinions expressed herein will come to pass. Investing in the stock and bond markets involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be construed as a solicitation to buy or sell any security or engage in any particular investment strategy.

Modera is a registered investment adviser with the U.S. Securities and Exchange Commission. For more information about Modera, including our registration status, fees and services, please refer to the Investment Adviser Public Disclosure website, visit our website, or contact us at (201) 768-4600 to obtain a copy of our Disclosure Brochure.