FSO Editorials: Adding Volatile Sectors to a Stable Portfolio by Robert B. Gordon 03/02/2004

Adding Volatile Sectors to a Stable Portfolio
~ Best for Experienced Investors ~
by Robert B. Gordon, Sc. D.
March 2, 2004

This is a very important message for all readers. We are very close to starting the next big leg down in this bear market. It could come without warning at any time. The general public is bullish, the advisors are bullish. I urge you to get your financial house in good shape. With over 60 years of market experience, I am a strong believer in diversification of assets provided the criteria for selecting them are very stringent. After a long search, we finally chose 10 stable assets for an ultra conservative bear market portfolio published in our last essay.

We did not stress the need for buying all 10 asset classes to get the tremendous advantage of their diversity - their ability to react differently to various market forces. We are doing that now in this new essay. The reason is very simply that we expect this bear market to be very vicious and investors will need excellent diversity to help preserve their assets.

From our reader e-mail we note that many investors are picking one or two funds from a larger portfolio. We have no control over this practice and feel it not to be a wise action. With current low fund purchase prices in tax-free accounts, we hope to convince more investors to buy the full complement of funds to improve the diversity and performance of their portfolio.

Another very important point about the 10-fund stable portfolio, and the larger portfolio recommended below, is that we consider them to be essentially "permanent." Since there now is a 30-year old Permanent Portfolio fund, we are unable to use the name. The best we can do is to include this unique fund in both of our recommended portfolios. The permanence of our two portfolios depends on the investor doing the required rebalancing at appropriate intervals. However, management time for the stable portfolio is very modest and more a joy than a chore in the stable/volatile portfolio. In my experience, there is little or no difference in the time required to manage 5 or 10 funds as it is very low in each case.

This essay will bring together previous writings on this subject with the goal of building a growth portfolio for the very long term, say twenty years. To be successful and have long life it will almost certainly need active management by an experienced investor. But let me add that many of our readers could start with the stable portion and add the volatile funds as their market experience builds over time. The knowledge and understanding does not come from any books, but simply by observing market actions over a time period which the investor can control.

We will first describe the most important 2/3 of stable assets needed for long-term survival and then address the selection and addition of a diversified group of volatile asset classes. This part of the portfolio will provide an important growth potential from (1) the separate price actions of the individual volatile classes and (2) profit opportunities resulting from well-timed portfolio rebalancing steps. When a volatile asset is low in price, rebalancing transfers assets from the stable assets to the volatile asset, thereby building future profits to be taken when the volatile asset goes to the top of its price range.

There are many types of securities we leave to professional traders and managers. We are concerned primarily with stocks, bonds and no-load mutual funds. But there are major types of stocks and bonds we could define as separate sub-asset classes. And, there are dozens of types of mutual funds with new ones still being conceived.

Because we are in the early years of a long and severe bear market, we are primarily interested in very stable asset classes, most of them funds holding bonds of the right type and maturity, well managed and with excellent performance records. In our previous essay we selected ten such stable funds, five of them with unique portfolios or management styles. The other five were more traditional income funds in government bonds or holding 2/3 bonds and 1/3 stocks. At this time I am unaware of any other types of stable assets and would be happy to receive any suggestions for additions from our readers. Remember that the asset class is determined by the type of assets held, not the name given to it by the management company.

Unlike the limited number of stable assets now available, there may be more choices for the volatile asset classes if we count the many stocks and mutual funds in areas like precious metals, short and reverse index funds and natural resources like oil and gas. However we would classify them as being three major volatile classes, each having a variety of sub asset classes.

Please note well that every asset class selected for a bear market portfolio must display one most important characteristic - the probability that it possesses a long-term price up trend. Of course, the stable classes need this same requirement, but do not display the same degree of volatility. The 3 major volatile asset classes are expected to have long-term price up trends, but with various degrees of short-term volatility. The short fund class gains in each market down trend and loses in each up trend in the general market and is thus certain to be volatile. Experts consider the precious metal class to be in a long term up-trend with intermittent sharp price corrections one of which may be starting now. The oil and gas industry predominates in the natural resource asset class and is reasonably assured of a favorable price trend due to the expected depletion in the world reserves.

So, to summarize where things stand, we have previously defined 10 stable assets in 5 major asset classes. We will select from that group for our new stable/volatile portfolio and then will proceed to select 8 volatile asset classes from the 3 major groups mentioned above.

I have quite recently discovered a very promising stable U.S. Treasury bond fund managed by PIMCO, a large firm specializing in bonds. Four years old, it buys Inflation Protected U.S. Treasury bond futures on margin and then reinvests their cash remainder to further increase their income stream. They have grown to 9 billion dollars in assets. On my FastTrack screen, PRRDX (no load version) shows a steadily rising chart that has gained 11.31% annually thru 2/13/04. If it did not have 4 years of expert Pimco management behind it plus 5 stars from Morningstar, I would feel somewhat hesitant in recommending it to others. I am a recent owner and plan to insert it into our Stable Asset Portfolio in place of a much poorer performing treasury bond fund. Readers are free to do their own checking on this attractive new fund.

Adding volatile asset classes for a long bear market portfolio is definitely not for everyone. It brings added risks and management attention. But it also brings welcome added profit potential for those to whom it is well suited. We have already published on FSO numerous stable/volatile portfolios. Some of them have as few as 3 highly selected funds and can be used as a learning vehicle with limited amounts of investor assets at risk.

The big advantage of the volatile assets, when properly selected and managed, is first the potential increase in portfolio growth from the volatile assets themselves and, second, the possible increased gains from portfolio rebalancing. Please read earlier essays to learn how rebalancing, done at the right time, can convert "paper" profits into real profits.

We have long advocated that the stable portion of a stable/volatile portfolio be at least 50% of the total dollars. In our own portfolios we have some as low as 55% but, for use by an unknown group of investors, we will suggest a ratio of 2/3 stable and 1/3 volatile. Individual investors can set the ratio where they feel most comfortable.

I have never, in over six decades of investing, felt the need for diversity as much as I do right now. The reason is very simple. The future of the financial markets has never been as uncertain as it is right now. I make this warning now because I have never seen a reader e-mail that shows anything close to over diversity. The only positive statement I can make to all readers is this: clear out the losers and the misfits and keep or add every promising asset class you can find. If any reader has any questions about this, please write for help.

Regardless of how stable and permanent any single fund may appear to be, very unexpected events can happen in a volatile twenty-year period. The Hussman funds, favorites of many readers, could be affected by the loss of Dr. Hussman’s services for any reason. Even the Permanent Portfolio fund could lose its long profitable record in severe market conditions it has not yet had to face.

I know that many readers understand what diversity means within an individual asset class like precious metals where they may own a dozen or more stocks. I am also sure that there are millions of families in the U.S. with all of their assets in the equity in their house. I offer them my sympathy, but there is no way I can help them. So, I continue to focus my efforts on helping as many of my readers as possible to achieve a well balanced portfolio.

I have yet to get a reader e-mail indicating ownership of too many different classes, but I get quite a few that do not have enough in my view. More common is a reader’s portfolio with considerable duplication in a few asset classes. It is possible to count as many as twenty important stable and volatile classes, although some of them are more important than others.

The ingenuity of fund managers is increasing the number of available asset classes as in the example of the two Hussman Funds, each quite unique. Of course, the number of major stable and volatile classes that can perform well in a major bear market is surely limited.

Early in my writing career, in an essay on diversification, I used the term "marching to the beat of different drummers" to emphasize real diversity. To be meaningful in uncertain markets, it is important to choose all of the major asset classes as well as some important sub classes.

The idea of recommending a 20-asset portfolio would shock most of our readers, but it would be easy for me to suggest a good one. One of my own stable/volatile portfolios has now reached 17 quite distinctive funds, all performing as intended. I hope that many readers will take a critical look at their current holdings for any duplication, whose elimination would be beneficial.

The reason why I am using many selected asset classes is that the future of our financial markets is now almost completely unpredictable. So we need as many "life savers" as we can jam into out little savings "life boat."

And we add to the above title, neither are good, productive bear market portfolios. I am managing my personal portfolios at 3 different on-line brokers, each different in size and holdings. None of them have less than 10 funds. My current list of funds and stocks, either owned or under study is 31.This is because in my retirement years, investing has been my principal avocation. I have been building them slowly as ideas come to me in preparing my essays. It is nice to see an alphabetic listing of my holdings on my broker report screen, but I then split them into stable and volatile sub-lists for analysis.

Any decisions on when to rebalance a portfolio are made using price charts on my computer screen. You can do the same thing using the charts readily available at www.bigcharts.com. It is easy to locate the sharp price peaks in the volatile funds and far less important with the stable funds which normally have much smoother charts. But, remember, in a portfolio rebalancing, all of the funds are returned to their original percentages. This job should never become a chore; but should represent a happy task of adding up the portfolio gains and resetting it for more in the future.

Importance to the investor does not mean that the assets need to be large in either dollars or percentage of assets but means that it is of serious importance to your gaining investment skills and to your happiness now and later. Let's consider, first, the ten fund stable asset portfolio described recently. Those ten different assets need not be purchased in a short time period because their volatilities are all fairly low. I see no reason why they could not be purchased one a month in the following approximate order: Treasury bond, foreign bond, Treasury bond, foreign bond, Treasury bond, Permanent Portfolio, Hussman Income, Hussman Growth, Merger fund, Bond/stock fund. I am really making trivial differences here. It would be reasonable for some readers to buy these ten funds at the fund companies if there are advantages to the investor in so doing. Depending on the dollar amounts involved it would be feasible to do a biennial rebalancing with the assets held at the funds. Portfolios of moderate to large size would be better handled at a firm like Scottrade which has great tools to help mutual fund buyers and no purchase/redemption cost if funds are held for three months. Go to their web page and check it out.

Now, let’s discuss the really important procedure for building a stable/volatile portfolio such as we present below. Most important, all of the stable items should be owned first to protect the volatile components. Once they are in place, the volatile components could be added as quickly or as slowly as the investor desires. The natural resource group will be the least volatile and the short funds and precious metals will be either up or down depending on where they are in their quite volatile price swings.

Rather than shocking our readers with an 18-fund portfolio, adding eight volatile asset classes to the ten stable funds, we made some hard choices and eliminated three very fine stable funds. Then, to reach the desired dollar ratio of 2/3 stable and 1/3 volatile, we made some alterations in the dollar amounts of several funds to the levels given below. It was not easy to make the cuts. We may very well build the larger portfolio as our best idea to date.

PLEASE NOTE - If any readers prefer to build the full 18-asset portfolio, write me and I will be happy to assist them in any way with my best wishes for their success.

      1. U.S. Treasury bonds in different maturities
      2. Selected Foreign Government bonds, one holding gold.
      3. Conservative funds with unique styles successful over long periods.
      4. A unique diversified stock fund using options for growth and hedging

		Annualized Performance 01-02-2002 to 02-17-2004
	Percent Allocation	Actual	Weighted
US Treasury Bond
PRRDX	10%	10.90%	1.09%
Target 2015	10%	8.57%	0.86%
Foreign Gov't. Bond
No Load Fund	10%	15.53%	1.55%
PSAFX	10%	14.92%	1.49%
Unusual Portfolio Funds
MERFX	7%	15.40%	1.08%
PRPFX	7%	13.39%	0.94%
Hedged Stock Fund
HSGFX	12%	17.71%	2.13%
TOTAL	66%		9.14%

      1. Short and reverse index funds
      2. Precious Metals, stocks and funds
      3. Oil and Gas stocks and funds

		Annualized Performance 01-02-2002 to 02-17-2004
	Percent Allocation	Actual	Weighted
Short/Reverse Index Funds
Fully Managed BEARX	5%	13.82%	0.69%
Short Nasdaq	4%	- 4.17%	- 0.17%
Short Bonds RYJUX	4%	- 6.31%	- 0.25%
Precious Metals
No Load Gold Fund	5%	53.28%	2.66%
Closed End Fund ASA	4%	43.62%	1.74%
Closed End Fund CEF	4%	20.57%	0.82%
Oil & Gas Resources
Large Energy Fund	4%	10.40%	0.42%
Oil & Gas Income Trust	4%	44.48%	1.78%
TOTAL	34%		7.86%%


GRAND TOTAL	100%		17.00%

Please note from the weighted performance data that the volatile assets produced nearly the same gain with only half the dollars of the stable assets. Note that the short funds category holds 3 different types of short funds, the gold category holds 3 quite differing types and the energy category holds a large fund and a small Income Trust.

We rebalanced this portfolio on four dates where peak prices occurred in volatile funds such as precious metals or short funds. We give the portfolio values at the initial, ending and two intermediate dates below for your study. Rebalancing did achieve a modest gain from 17.0% to 18.4% annualized and we did prevent any serious change in the initial percentage of each asset.

		Fund Values After 4 Rebalancings
ASSET	Initial 1-2002	05-28-2002	02-04-2003	02-17-2003
PRRDX	$5,000	$5,475	$7,209	$8,483
Target 2015	$5,000	$5,475	$7,209	$8,483
Foreign Gov't Bond	$5,000	$5,475	$7,209	$8,483
PSAFX	$5,000	$5,475	$7,209	$8,483
MERFX	$3,500	$4,352	$5,046	$5,938
PRPFX	$3,500	$4,352	$5,046	$5,938
HSGFX	$6,000	$7,770	$8,651	$10,180

BEARX	$2,500	$3,237	$3,605	$4,242
Reverse Nasdaq	$2,000	$2,590	$2,884	$3,393
RYJUX	$2,000	$2,590	$2,884	$3,393
Gold Fund	$2,500	$3,237	$3,605	$4,242
ASA (NYSE)	$2,000	$2,590	$2,884	$3,393
CEF (Amex)	$2,000	$2,590	$2,884	$3,393
Large Energy Fund	$2,000	$2,590	$2,884	$3,393
Energy Income Trust	$2,000	$2,590	$2,884	$3,393
TOTAL	$50,000	$62,749	$72,090	$84,833

There may have been one time in a lifetime when an investor could bet everything on a sure winner, but right now is not that time. Although only a tiny minority of our nation’s people know what lies ahead, our readers should consider themselves fortunate to have been warned in advance. AAA bonds did well in the 1929 crash if they kept their top rating, but only a very few still held their AAA rating at the end. Many stocks and bonds and trusts (funds) went out of business and I expect this will happen again.

If any reader would like to build our fifteen-asset class portfolio gradually over a period of time, here is the order in which I would do it for maximum safety and peace of mind: Buy the seven stable classes: Treasury bond, foreign bond, treasury bond, foreign bond, PRPFX, MERFX, HSGFX. Buy the eight volatile classes: major energy fund, BEARX, CEF, RYJUX, ASA, ERF, gold fund, reverse NASDAQ short fund. They can most easily be acquired in one of several discount brokerages with minimum purchases of only $1,000 in tax free accounts. However, most important, to retain the 2/3 of stable assets, it will be necessary to purchase $2,000 x 7 = $14,000 of stable assets and $1,000 x 8 = $8,000 of volatile assets. I see nothing wrong in acquiring this portfolio gradually if done safely as suggested above.

Unlike the stable portfolio presented last week which needed occasional rebalancing about every two years, this portfolio will require more frequent rebalancing to capture fleeting gains from the volatile components. Experience over the years will teach what is the best frequency. I urge all readers to give this portfolio a chance to demonstrate its value over the long run. Rebalance as needed and permit each asset class to make its best contribution to the portfolio ‘s success. I will be happy to answer your general questions.