Tactically Reduce Stock Portfolio Risk

Physician's Money DigestDecember15 2003
Volume 10
Issue 23

A diversified portfolio and fixedincome allocation is not enoughfor today's investor. To preservecapital and reduce the impact of marketvolatility, investors need to actively managerisk. Following are 5 key strategiesthat can help long-term investors achievedesired exposure to company-specific riskand reduce exposure to market risk:

• Avoid stocks that look undervaluedsimply because they have fallengreatly in price. Unfortunately, tech-bubbleinvestors learned this lesson too late.Overvalued stocks have farther to fall.Tech-bubble investors experienced howfar down "down" is. On the other hand,stocks whose prices are undervaluedcompared to the company's intrinsicworth and market proxy, such as the S&P500, behave differently.

• Buy stocks whose earnings characteristicsbeat their peers and the S&P500. Once story stocks (ie, those withcomplex values and features) run theircourse, the marketplace returns to stockswith solid earnings.

• Look for stocks with strong fundamentals.Strong fundamentals improve astock's ability to sustain and grow earnings,a requisite for successful long-terminvestors. Is a company's present earningslevel a one-time event, or is it sustainable?In-depth, fundamental analysiscan help determine the answer.

• Selectively hedge to reduce thepotential negative impact of market andsector risk. Plans to preserve capital canget lost in the riptides of market andsector risk. There are two types of marketplaceevents that can increase downsidevolatility in a stock portfolio: the unpredictableand the foreseeable. Unpredictableevents in the marketplace,such as rising energy prices, inflation,significant interest rate movement, amarket bubble or crash, and deflation,can cause a stock portfolio's value todrop like a stone.

You can't foresee when such eventswill impact your stock portfolio, but youcan see whether the market or sectorsare overvalued. Hedging by shorting theexchange-traded funds of overvaluedstock market indexes and sectors (pluscash holdings) can increase your potentialto lower downside volatility fromrisk that is not company-specific in yourstock portfolio.

• Look for opportunities in unpopularstock cap sizes and sectors. Don't getcaught putting all your eggs in the currentlypopular baskets, no matter whatthe top performing sector and stock capsize is at the moment. That's market timing,or worse, it's momentum trading.Neither approach is a good long-terminvestment strategy. As the stock markethas reminded investors over the past fewyears, the less equity risk managementdiscipline you have, the more vulnerableyou are to volatile markets.

The results:

In the past few decades, equity portfolioshave endured stock markets roiledby periods of high energy prices, inflation,and interest rates. The1974 bear market, the 1987 marketcrash, the late 1990's tech bubble, andtoday's bear market ensued. What willthe next few decades bring for investors?While no one can predict the future, youcan increase your potential to preservemore of your portfolio's gains. Yourequity portfolio manager needs toactively manage downside risk.

Walter F. Harrison III is the lead manager at Granum Value Fundmutual fund. Fund shares are distributed by Mercer Allied Company, LP, and GranumSecurities, LLC, and are offered and sold through the currently available prospectus.For a prospectus containing information, including charges, fees, expenses, and risks, call888-547-2686 or visit www.granumfunds.com.

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