Unlocking a safer, smarter portfolio

  @Money June 11, 2013: 11:53 AM ET
portfolio diversification

With a few tweaks to your portfolio, you can still hedge against the risks that really matter.

(Money Magazine)

RORO has made a mess of a lot of carefully designed portfolios.

RORO isn't what George Jetson's dog used to say. It's trader jargon for "risk on/risk off." Investors pile into risky assets -- especially stocks, both U.S. and foreign -- when the economic news is bright, and run for cover into Treasuries at the first whiff of trouble.

Even if you're a steady buy-and-holder, RORO has left its mark in two big ways:

First, diversification is harder. A classic way to reduce your volatility is to own different kinds of assets, so that when one part of the market falls, something else may be going up -- or at least falling less. RORO wrecks that. It first roared in the 2008 crisis, when not just U.S. stocks but foreign stocks, high-yield bonds, real estate, commodities, and you-name-it all crashed.

The HSBC RORO index, which tracks how closely assets correlate, or move together, kept rising from there. It stayed near historic highs through late 2012.

The mood-swing trade has tailed off this year, but that's because U.S. stocks boomed as Europe and emerging markets dragged. So spreading your bets with international stocks didn't help you in the crisis and isn't boosting your returns now.

Related: Tips on investing in stocks

In any case, it's too early to declare an end to RORO, says HSBC strategist Mark McDonald. With the global economy still vulnerable to crisis, a raised eyebrow from Ben Bernanke or a European finance minister may be enough to set off an undiscriminating tizzy. "Any market hiccup can cause correlations to spike again," says McDonald.

Second, safety is getting risky. One investment that has smoothed your ride is the safe haven everyone runs to at "risk on" time: Treasuries. They're now so popular that the yield on a 10-year note is down to less than 1.8% (When bond prices rise, their yield falls.)

That creates some problems: Yields have little room to go anywhere but up from here, which means you could experience sharp losses when interest rates, and thus yields, start to rise again. What's more, holding bonds at these rates means you risk seeing your investment's value eroded by even a moderate amount of inflation.

How, then, in this twitchy environment, do you build a portfolio safe enough to let you sleep at night, with returns that get you to your goals? MONEY dove into the best research on diversification and talked to some of the sharpest advisers. The big takeaway: With only a few twists, you can still hedge against the risks that really matter.

What follows are five key ideas to guide a long-term investor through a market where everything turns on the latest news flash.

KEY IDEA NO. 1

Forget the short-term, protect against generational risk

The idea that other countries' markets will move out of step with the U.S. is an important part of the pitch for international mutual funds and ETFs. ("Diversification" is literally the first word on T. Rowe Price's "International Investing Explained" web page.) This has become a harder case to make, however.

Consider the relationship between U.S. equities and an index of developed markets. A 100% correlation means markets always move together; zero is no relationship at all. Since the '70s, correlations have shot up from 37% to 88%.

What happened? Globalization. "As the world becomes increasingly interconnected, macroeconomic events are more often driving market movements," says Tyler Shumway of the University of Michigan business school. Companies in Europe or Asia do much of their business here, and vice versa.

Foreign stocks: Safe for retirement?

Even the fact that you can easily diversify abroad with a mutual fund makes it harder, ironically, to reap the benefits of diversification. The anxieties of investors in Florida can feed through to stock prices in Frankfurt.

Related: Oakmark Fund searches the globe for value

Step back from the short term, though, and diversification still looks powerful. William Bernstein, a Portland, Ore., investment adviser, says it protects against risks that play out over decades -- like a slump long enough to blow out the gains of a generation of investors. That happened to Japanese investors after 1989.

To be blunt: Owning overseas is a hedge against the unlikely but real possibility that you'll someday find yourself living in the next Japan. Research from AQR Capital Management shows that while countries often fall together in the short term, long slumps are something nations often do on their own.

In a decade in which Japan fell 40%, in fact, a global portfolio rose 130%. "Global exposure helps you cut out the risks of investing in a single country," says Gregg Fisher of advisory firm Gerstein Fisher. And that includes your own country.

How to retool: Over five years foreign equities have lost an annualized 1.4%, vs. a 4.9% gain for the S&P 500. If disappointing performance led you to lighten up on foreign shares or to stay out, this year's divergent markets may offer a window to get in. The stocks in Fidelity Spartan International (FSIIX) look relatively inexpensive, trading at about 13 times next year's expected earnings, compared with 14.3 for the S&P. "Smart investors go fishing in troubled waters," says Bernstein.

How much do you want to own? A third of your stocks is a baseline. Though the short-term diversification benefits of going abroad have declined, they haven't disappeared. A report by Vanguard found you get most of that advantage with a 30% allocation.

The same report also revealed something surprising: "Emerging markets are almost as correlated with the U.S. as is the rest of the developed world," says Vanguard's Christopher Philips. These riskier markets might be attractive for their return potential, but there's no need to add a lot just to be diversified.

A broad international fund with around 15% in such countries, like MONEY 70 picks Dodge & Cox International Stock (DODFX) or Vanguard Total International Stock (VGTSX) gives you plenty of exposure.

Key Idea No. 2: Some stocks beat others

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