Protecting against market downturn

by Stephen Butler

Gulp. I checked the total account balance of all my "investable assets" and saw that I lost about 2 percent a week ago. Ouch.

Most of what I have is in stock-oriented mutual funds, but I also own some blue chip stocks and one share of Berkshire Hathaway. I'm not losing sleep over 2 percent, but it did prompt me to think about whether I was sufficiently protected against the downside.

I recall the old Wall Street term, "selling down to the sleeping point." A similar brokerage-world axiom was always, "you can't lose money by taking profits." So, here we are after a terrific run-up in stock market values. At a typical 15 percent annual rate of return, the average portfolio has more than doubled during the past five years.

So where do we go from here?

The two cautionary quotes above have their roots in a world that represents the dinosaur of the financial services industry. That was a world where investing in stocks was done with full service brokerage firms at high commissions fixed by law. Sure it made sense to encourage people to pull out of the market -- and then get back in -- if you were the brokerage firm. It was called "churning," and it explained why 80 percent of all small investors lost money during any five-year period of time.

Today, it's a different world. We have mutual funds that offer a great job of downside protection, and we don't have to touch a thing. We can sleep like babies. A "buy and hold" investment strategy is far easier to pursue today if our inclination is to leave our portfolio on automatic pilot.

Where do we go for this prescription for financial Ambian? Balanced funds offer some great ports in a storm. Three that come to mind are Vanguard Wellington fund, Dodge and Cox Balanced and Fidelity Balanced. We will outline what they have accomplished, but first the basic fundamentals:

A portfolio with roughly one-third of its money in bonds has hit the "sweet spot" of a mix between stocks and bonds that maximizes the downside protection while costing the least in upside opportunity costs. We can generate more protection against the downside with a higher concentration of bonds, but then we begin to pay a price in total returns.

When we see a fund categorized as a successful "balanced" fund, without exception it will be a fund that has only a third of its money in bonds.

Vanguard Wellington, in the vortex of the worst market decline in 20 years, lost 6.9 percent in 2002. In the previous two years, while the Standard & Poor 500 index lost 44 percent, Wellington made 10.4 percent and 4.2 percent respectively. Dodge and Cox Balanced lost 2.94 percent in 2002 but made 15.1 percent and 10.05 percent in 2000 and 2001.

Fidelity Balanced lost 8.5 percent but had made 5.2 percent and 2.25 percent in the two earlier years.

Among these three funds, the following years were like the horse race between Sea Biscuit, War Admiral and that other horse.

From 2003 through September 2007, Wellington generated 20.75 percent, 11.18 percent, 6.82 percent, 14.97 percent and 9.3 percent.

In the same period, Dodge and Cox scored 24.44 percent, 13.3 percent, 6.59 percent, 13.86 percent and 4.68 percent. Fidelity weighed in at 28 percent, 11 percent, 10.7 percent, 11.6 percent and 10.6 percent.

These funds present a steady march of consistent gains far beyond what any money market or bond portfolio would have generated. All this was accomplished during one of the greatest market crashes of the past 100 years.

Wellington now has a little less money in cash (1.2 percent versus 6.5 percent) and a little more money in non-U.S. stocks. For our own edification purposes, (or, just so you know) the Dodge and Cox fund has invested its 28.4 percent allocation of bonds in a combination of Inflation protected treasuries (10.25 percent), high-yield bonds (14.3 percent) and International bonds (4.29 percent).

For the moment, Dodge and Cox is closed to new investors, but the other two funds would welcome you with open arms until such time as Dodge and Cox opens up again.

While all this was going on, I noticed that my single share of Berkshire Hathaway, in just one week, increased in value by about 9 percent, which helped to blunt the otherwise 2 percent downdraft.

The lesson here is that a prudent mix of bonds and value-oriented stocks can help maintain an even keel in what mariners call a "confused sea."

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