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By Jason Stipp | 06-13-2011 12:20 PM

Concrete Tips for Volatile Markets

Morningstar's Christine Benz says crafting a long-term investment policy statement, double-checking your cash stake, and gauging your holdings' volatility and ballast can help investors ride out a rough patch.

Jason Stipp: I'm Jason Stipp from Morningstar. We've hit a rough patch here in late spring with some volatility in the market caused by some weak economic numbers. A lot of you've probably been checking your portfolios in this time of market certainty, but should you make any changes? Here with me to offer some concrete tips for managing your portfolio amid volatility is Morningstar's Christine Benz, director of personal finance.

Christine, thanks for joining me.

Christine Benz: Jason, great to be here.

Stipp: So, there are some things that you should keep in mind during times of volatility, and then there is some actual concrete steps that we should take. Before we get to the concrete steps, what would you say to someone who is just really, really worried right now with the market ups and downs? I think we are down pretty much across the board over the trailing month. What do you say to them first of all?

Benz: Well, probably first thing is to try to tune out the noise and the near-term news flow to the extent that you possibly can because one thing that we see again and again when we look at investor behavior is that investors respond to their emotions and respond to the fear that they feel during times like this. And seeing these headlines, many of which are pretty negative about the broad economy and the market, many of them are pretty negative, and that kind of fear can prompt you to make ill-timed decisions. I personally am close too obsessed with what we call our investor return data that look at when investors time their purchases and sales of their mutual funds. What we see is that investors consistently undermine their own returns by buying and selling at poor times, and times like this are when they make those mental mistakes.

Stipp: The fact of that matter is even though we've had hit a rough patch no one knows if it will continue or get worse or if it will turnaround and maybe improve itself?

Benz: Well, that's a thing, but I do also think that's important to keep blips like this in perspective. Maybe it will be the start of something that will be bad for a while, but think back to a year ago, Jason, we were sitting here kind of talking about same thing, how to manage volatility right after that Flash Crash. And there were a few bad months, but stocks went on to have a pretty nice year in 2010. So, you really just don't know.

Stipp: So, Christine, I know it's important to keep things in perspective, but certainly investors are taking a close look at their portfolios and probably want to do right thing--they don't want to the wrong thing. But they want to make sure that they don't need to take action, or if they do take action, they want to be sure of what kind they should take. What are some concrete steps? Where should you start when you are thinking about making sure that your portfolio is ready for a good time or a bad time?

Benz: I think the first step would be to make sure that you have an investment policy statement. This can be complicated; it can be short. But basically it's just a statement that basically says, "Look, here is what I'm trying to achieve with this portfolio. Here are the general asset-allocation parameters that I'm trying to stick to. How often I'll adjust them when things get out of whack as well as what I'm looking for in an individual security." So, if I'm a mutual fund investor, I want expenses below X level. I want a manager tenure of at least five years. Set your parameters for a security selection. Certainly, if you are an individual stock investor you need to lavish even more time on that piece.

And also importantly this investment policy statement would lay out how often you'll revisit your portfolio. So, it will help you decide ,"Well with these market inflection points, maybe it's not the right time for me to be looking at my portfolio." The investment policy statement might say you'll revisit and possibly rebalance your portfolio at very specific intervals, and that will serve as a check against making big changes at times like right now.

Stipp: So one of the other things that that policy statement could do is remind you of what time period you are looking to invest over, so that you are not going to worry necessarily about what happens over the next few months but you'll be able to stay focused on what your portfolio needs to do over that longer time period?

Benz: Right. Exactly.

Stipp: So, a question about the investment policy statement and what it includes: I would assume asset allocation is going to be in there including the cash stake. So it seems like a cash stake in more conservative investments will be important to take a look at really for any market environment, especially for one where things might get a little volatile and we might see a down market.

Benz: That's absolutely true. So you want to assess your liquidity needs as well as what you have in liquid cash reserves, so you're comparing those two because that's really a key point, Jason. The key to being able to ride out volatility with the stock portion of your portfolio is making sure that you do have money set aside in very stable investments to help meet near-term cash needs. So definitely spend time thinking about what is an adequate liquidity reserve for me given where I am in my life. What I often say is retired people probably want about two years in cash or maybe cash surrogates, such as very short-term, high-quality bond funds or two years' worth of living expenses. For people who are still working like you and me, they probably want to think in the range of something like three to six months' worth of highly liquid investments.

Stipp: So having those investments will ensure that you'll have the money to cover your short-term needs. It could also have a mental effect that you know you have those covered, so you're less likely to panic and sell something that's down over a short period of time.

Benz: Right, that's the other key benefit, and that's why that is such a key part of having that well-laid asset-allocation framework that does declare how much you need to set aside in cash.

Stipp: So, Christine, assuming that I have the investment policy statement and I have that cash stake set out, how would I go about checking the vital stats of my portfolio and comparing it to that investment policy statement, to prepare it for an uncertain time ahead?

Benz: Well, I really like Morningstar's Instant X-Ray tool or any of our X-Ray functionality if you've got a portfolio already saved on the website, you can X-ray it and see what is my asset allocation and you can also check up on whether you have any inadvertent style or sector bets happening in your portfolio. You'll be able to see your portfolio's investment-style exposure compared to that of the S&P 500 and its sector exposure, as well.

One thing I would say is for investors who haven't been paying close attention, there is a good potential that may be they've got a little bit more in small- and mid-caps than they intended because of those parts of the market have enjoyed such robust gains until this recent market weakness. So that X-Ray tool can really provide a good quick check on your portfolio's vital signs, and then you can compare that to the parameters that you've laid out in this investments policy statement.

Stipp: So one thing that you might look at as you're looking at your portfolio holding by holding, you could look at the funds and could you get a sense on fund by fund, such as how volatile this fund could be if we hit a rough patch, because certainly some funds will lose more than others.

Benz: Right. So absolutely, that's a key step in terms of setting your own expectations about what to expect from your portfolio. So maybe you see a fund like Fairholme flagging right now. Well, maybe if you would spend time thinking about it beforehand and assessing the big-sector concentrations going on in that portfolio, you would have been prepared for the fact that it hasn't behaved particularly well recently. So you want to spend time certainly looking at the backward-looking risk statistics of each of your holdings, such as focusing on beta and standard deviation. Our colleague, Esther Pak, has recently written some great pieces that detail how to use those backward-looking risk statistics. You also want to spend some time asking certain questions, such as "While on a forward-looking basis, which of my holdings should I expect the most volatility from? Which are concentrated in sectors? Which are very concentrated in individuals positions?" So you want to spend some time thinking about forward-looking risk measures, as well.

Stipp: So before we hit a really big rough patch, You need to know which investments are going to require the most patience from you in order to ride that out?

Benz: Right, and make sure you have a balance. So if you got some of those things in your portfolio, make sure that you have ballast to help counteract some of those very volatile investments.

Stipp: Another thing the X-Ray can tell you is that it gives you a sense of your fees. And obviously fees are important at anytime, but especially when you might not see great performance out of your investments is especially critical.

Benz: Right, and I think this is a great exercise to go through if you have some nervous energy or you've been concerned about how your portfolio has performed recently, it's a really easy way to feel like you're taking back some control. So compare your funds with other funds or exchange-traded funds that invest in a similar space, but just make sure that you are not paying more than you need to for an investment that does a specific thing.

We've now got a tool on Morningstar.com or a data point that shows you whether your funds fees are above- or below-average relative to other funds within that same share class. I think that that's a good check, and if you see a lot of the above-average or high expense ratios, then shop around for other investments maybe within our fund Analysts Picks list that can do essentially the same thing at a lower cost.

Stipp: It's not always the case, but it can be the fact that a fund with a higher expense ratio might take on more risk to overcome that expense ratio, which could mean that that's the kind of fund that could be most at risk if we see a downdraft.

Benz: Absolutely, and that's something I would say particularly in the realm of fixed income, where the margins between winners and losers are so narrow that if you got a high-cost investment, that really is a strong incentive to the fund manager to take on more and more risk to help offset that built-in impediment, so you want to be particularly scrupulous about costs in the bond fund realm.

Stipp: So lastly Christine, I know that you had mentioned the investor returns can give you a sense of how well investors broadly have used funds if they bought them at opportune times or if they bought them at bad times and sold them at good or bad times. How can you get a sense of how well you've done and using your investments, and if you in the past have behaved well so to speak during a market downdraft?

Benz: Well, it's a good question Jason, and I do think that times like this are a great time rather than looking outward and surveying all the scary economic data. Spend a little time looking inward and survey your own performance as an investor. So for people who have a portfolio saved in our Portfolio Manager tool, they can see, if they have a transaction portfolio, how they've done, how their actual performance has done for that total portfolio since they've been managing it, and they can see maybe where they've added or subtracted value. So you could go holding-by-holding and say, how did I do on security selection, good or bad, and if you did well on security selection, how did you do on the timing piece, good or bad? So just spending a little time evaluating your own skills as an investor and trying to take some lessons from how you've done, you might find ways that you can do better in the future and learn from the way that you've been managing your own portfolio.

Stipp: So hopefully Christine, we won't have to worry about a highly volatile market coming up, there's certainly some uncertainty, but thanks for the tips on actual concrete steps you can take to prepare for what could be a bumpy time ahead.

Benz: Thank you, Jason.

Stipp: From Morningstar, I am Jason Stipp. Thanks for watching.

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