Markets were up slightly in the leafy month of June. The S&P 500, Nasdaq, and Dow all rose between 1% - 2% for the month. Bonds were weaker, with the long term U.S. government bond index down 1.58%. It seems bonds have finally risen as far as they are going to, which means interest rates are not going to fall further. In fact, in early July rates have risen quite sharply.

All of our model portfolios are up since we launched them at the beginning of April 2002 save one, the Daredevil portfolio (our most risky) which is down 1.2%. We’re satisfied with this performance as the Dow, S&P 500, and NASDAQ are still down 12.42%, 13.4%, and 12.47% respectively in the same period. Our portfolios include the Safety, Conservative, Moderate, Growth, Aggressive Growth, Daredevil, and Starter (low minimum). Since April 2002 these portfolios have returned respectively: 9.96%, 9.32%, 1%, .3%, 8.62%, -1.2%, and 2.19%. 

These are all diversified portfolios investing in stocks and bonds, so we would expect them to beat these stock indexes in down markets. It’s worth noting though that we have not underperformed the market on the way up either. Our Growth and Aggressive growth portfolios are up 18.2% and 20.65% over the last three months, while the Dow, S&P 500, and NASDAQ are up 13.12%, 15.38%, and 20.1%. Our performance is more impressive when you consider that the cost of ownership of the funds in our portfolios is factored into our return, while the indices have no ownership fees. 

A more accurate comparison is against the world of fund of funds – mutual funds that literally own other funds much like our model portfolios. The average fund of fund was up 1.07% over the last 12 months, our lowest performing portfolio over the last year was up 4.08% (Starter) All of our portfolios would be in the top 20% of these fund of funds and our Aggressive Growth Portfolio would have been the number one stock and bond fund of fund by performance.

The goal of our portfolios is to deliver good risk adjusted returns – to try to capture most of the upside of the stock market while minimizing risk. One way we try to accomplish this goal is by diversifying into areas of the market we find attractive via superior funds. 

Our overriding investment strategy, which for lack of a better phrase can be described as managed asset allocation, goes something like this: In our opinion there are two ways to manage a portfolio. For both you have to first determine your risk profile – how much time you have to invest your money combined with your personal tolerance for risk and volatility. The next step is to determine your broad stock/bond/cash allocation. Next you want to buy funds in these broad categories that are more or less uncorrelated to each other. This means if you need 60% stocks, 30% bonds and 10% cash, you don’t put all 60% of your portfolio's stock allocation into, say, U.S. large cap growth stocks, or have your entire bond allocation in junk (high-yield) bonds.

If you want to build a truly simple and easy to mange portfolio you need go no further than Vanguard and buy a total stock market index fund (or even better an index fund that owns stocks around the world) for whatever your stock allocation is, a total bond market fund for your bond allocation, and a money market for your cash allocation. Then you need to asses your portfolio every quarter or so – did your risk profile change or did one asset class go up in price so much that your allocations are out of whack? With this method you do not make decisions on what the market is doing, or what area you want to be in, or other active strategy decisions. This simple strategy is low cost and easy to manage. It also works. 

If you managed your investment portfolio in this way, you’d be better off than 95% of individual investors out there today. We take a more active approach with our own model portfolios and our privately managed accounts - an approach we use in hopes of beating the other 5% of investors.

We start with the same broad asset class decisions, or target allocations - say 60% stocks, 30% bonds, 10% cash. But we also make slight shifts from the target allocation based on our outlook for stocks and bonds in general. So if an investor’s risk profile calls for a base allocation of 60% stocks, we may go up to 65% or even 70% if we think market conditions are right for a stock surge. 

Next we determine what areas we think have the most opportunity for the next 1 – 3 years. Generally these are out of favor areas with reasonable valuations, but not always. We also look at categories that lower overall risk because they move with less correlation to the rest of the portfolio. We may find small cap growth more promising and weight a client's overall stock allocation accordingly.

An example is one of the shifts we made in our more aggressive portfolios last year. At the end of June 2002 we felt stocks were weakened enough to offer some buying opportunities, and that cash was yielding so little as to make it an unattractive investment. We had a 10% cash allocation in our Aggressive Growth portfolio, which we shifted equally into a Japan fund and a Global Telecom fund. Both promptly fell as the market continued to soften. In recent months these areas have been strong, and this position is now worth more than if we remained in cash. The entire portfolio, however, is a bit riskier as we are fully invested.

There were two separate moves here – increasing overall stock allocation and choosing certain specific types of stocks to invest in. This leaves us with two areas of potential trouble – misgauging the value of stocks, or incorrectly identifying those categories of stocks will outperform going forward.

We don’t shift the risk level substantially up or down off the “target” allocation based on our market outlooks. Just because we think Japan stocks offer opportunities doesn’t mean we put a large allocation of Japan funds into the low-risk Safety portfolio. What we are doing is making minor shifts in risk level based on the areas of the market we want to be in. This is primarily how we have beaten the market, adjusting for risk, since we started these portfolios.

What we are not doing, and you shouldn’t either, is making massive bets on short term predictions. Again, we make only small shifts in our basic allocations – and we maintain those allocations for months, if not years (not days or weeks). Predicting the market’s short-term direction is a fool’s game, although it makes for exciting banter on financial television shows that need daily commentary on markets. The internet and mail are full of promises from gurus who can pick the next hot stocks or market moves. Take our word for it, if anyone could do this with high degree of accuracy, they wouldn’t be telling you how. Besides the difficulty predicting anything in the market, big changes to your portfolio can cost money in fees, taxes, and transaction costs. For more on that issue please read last month’s lead article. 

These two methods are equally legitimate and appropriate for different types of investors. Other ways of investing – putting money into whatever area has been the hottest, making big market timing bets on the direction of stocks, frantically switching between funds - will simply not work over the long haul.

We’re bringing this up because in the very near future we will likely be easing back a little in some of our portfolios. Bonds and stocks have been hot and both need some cooling off. The economy is simply not strong enough to warrant continued growth in stock prices like we’ve seen in recent months. The fact that we could be wrong in our analysis is why our moves will be small and cautious. We don't know enough about the future to do it any other way (and neither does anyone else.