DIVERSIFICATION, "AN IDEA WHOSE TIME HAS COME", AGAIN

     The very hallmark of suitability is diversification.  To uphold the fiduciary duty of implementing only suitable investments, the broker must avoid over-concentration at all costs in favor of a diversified portfolio.  The more aggressive the objectives of the investor, the more necessary it is to diversify the investor's assets to mitigate the risk (see Legal Duties of Stockbrokers - Duty to Diversify). 

     With the tremendous gains in the S&P 500 during the mid-90's, one would have been hard pressed to encourage investors to venture away form the rampaging stock market.  However, the technology crash in the NASDAQ and the recent two-year double digit downturn in the S&P 500 has caused investors once again to turn their attention to diversify their portfolios.  Investors now want to reduce their risk and lower their concentration in technology at all costs. 

     The above chart shows the compounded annual returns between 1981 and 2004 in five various portfolio mixes.  At first blush, one would feel justified for having ventured only into the S&P 500 for the last 24 years.  But take a closer look at the five asset class diversified portfolio in column five.  Compared to column one, there were 22 years of positive returns instead of only 19.  In other words, with the extra balance, the investor was able to sleep more comfortably for three more years.  During the four year period from 2000 through 2002, the investor in stocks only would have lost over 43% of invested capital.  However, during that same four year period, in the diversified portfolio, the account would have basically broken even!  This at a time when, according to Lipper, Inc, the average diversified stock mutual fund lost 34.3% between 2000 and 2002.  In terms of market loss and measured against the market's all time highs, the Dow Jones Industrials were down (32%), the S&P 500 had fallen 49%, while the NASDAQ was down a staggering 74%.  Between 2000 and 2003, the S&P 500 lost nearly 16% while the 5 diversified asset classes gained 21%!  The results speak for themselves.  In 2004, the 5 asset classes outperformed stocks alone because the low returns of bonds and cash were more than offset by international returns of 20.3% and returns in equity REITS of 31.6%.  

     Further, from the chart, you can see that the diversified portfolio over the entire 24 years under-performed the 100% stock portfolio by .29%.  Notice the level of risk by comparison.  The S&P 500 had a standard deviation of 16.24% over the period compared to only 7.44% for the diversified portfolio, less than half the level of risk. Standard deviation is a measure of volatility indicating the amount by which most of the returns varied around the average.  The higher the standard deviation, the greater the volatility and thus the greater the risk.  For example, a security with a standard deviation of 10% indicates that most (two-thirds) of the actual returns over a particular time period varied around the average return by plus or minus 10% - in other words, if the average return was 17%, most of the actual returns ranged from 7% to 27%.  Or, you could apply the concept of standard deviation to the market in general.  Over the last 3 years, the S&P 500 has had a standard deviation of approximately 20%.  If your return expectation was a 10% average annual return for the future, you could expect that return to fluctuate between a high of 30% and a low of -10%.  With the graying of America, investors are continually looking for returns and results that they can rely upon, on an ongoing basis.  A diversified portfolio in five non-overlapping asset classes, with reduced volatility, helps provide the probable assurance of verifiable consistency. 

     Finally, in the late 90's, investors strayed far away from the S&P 500 and implemented large positions in the tech-heavy NASDAQ to their detriment incurring losses well in excess of 50% from 2000 through 2002 with this concentration.  As has been previously indicated, the S&P 500, which is market-capitalization weighted, was down 23.4% in 2002 and 11.9% in 2001.  However, according to James B, Cloonan, Ph.D., Chairman of the American Association of Individual Investors, in the April, 2002 AAII Journal, "a portfolio of the same 500 stocks, equally weighted, would have been up 1.63% for the year.  The NASDAQ Composite Index, also market-capitalization weighted, was down 20.13% in 2001 alone, but those same 4,000 stocks bought in equal dollar amounts would have been up 63.86%!  This seems incredible, but recall almost all the losses on the NASDAQ were in the high-cap. technology stocks.  In contrast, micro-cap. stocks (companies whose market capitalization is below $250 million) had a banner year".  Further, according to the AAII Journal/November 2002, "Over the last 10 years the Wilshire 5000 index has had an average annual return (through September 30, 2002) of 8.69%.  However, the return of the Wilshire 5000 unweighted by market capitalization (in other words, the average stock in the Wilshire 5000), is 14.17% a year.  And to throw in another shocker:  The NASDAQ Composite index is down dramatically year to date, with a return of -39.26%, yet the average stock on the NASDAQ is up 30.54%, and the average stock has been up each year for the past three years".  Actually, 37% of all U.S. stocks had a positive return in the year 2002.  The average return of those stocks that did have a positive return was an astonishing 43.4%.  The point about market indexes is this.  Because of the dependence upon market capitalization weighting, the U.S. equity market as a whole is generally not performing as well, or as badly, as the major benchmarks indicate.  

     The S&P 500, on an equally weighted basis has performed well over time.  It is available as an ETF under the symbol RSP (Rydex S&P equal weighted ETF), and is traded on the ASE.  The symbol of the index itself is SPXEW.  During the period 2000 to 2005, it had a six-year annualized return of 8.96% compared with -1.13% for the S&P 500.  Over the 16 hear period from 1990 to 2005, SPXEW's annualized return of 12.42% was 187 basis points higher than the S&P 500.  Moreover, the volatility of the index as measured by standard deviation was 172 basis points lower than the S&P 500!  

     While the NASDAQ Composite Index was and is heavily weighted with large-cap technology & telecom stocks, the S&P 500 was far less concentrated.  Consider the S&P 500 concentration (by market capitalization) in tech/telecom at the following periods:

     9/99                  12/99                     6/00                  12/00                 6/01               12/01                 6/02            

       31%                   37%                     39%                   27%                 24%                 21%                 15%           

Note: The S&P 500, by number, currently has 26 telecom stocks, 19 software stocks and 15 computer related stocks, totaling 60 issues out of 500 for a total of 12% "technology & telecom"!  Since its high in June, 2000, the percentage of tech/telecom, in terms of market capitalization value, has steadily declined.  The technology/telecommunications concentration in the S&P 500 as reported in the Wall Street Journal on June 25, 2002 was only 15%, and 20% by 12-31-02. 

By contrast, the technology/telecom concentration in the NASDAQ Composite Index between 12/99 and 3/00 averaged 63% in terms of market capitalization value.  As of late 2002, the NASDAQ was still over 50% invested in tech/telecom.  And consider a comparison between the NASDAQ Composite Index and the Dow Jones Industrials as of March, 2000.  The NASDAQ was trading at 172.2 times the past years earnings of its 100 component stocks!  In June 2005, the current P/E ratio of the NASDAQ 100 is 30.  By contrast, the Dow Jones was trading at 22.5 times the past years earnings of its 30 component stocks as of March, 2000.  Currently, its P/E ratio is17.6.  

     The 12.89% average annual return in the S&P 500 for the entire 23 year period was only available for those investors who remained there during the technology boom.  Many strayed to the NASDAQ through their own greed along with that of their advisors (seeking the higher performance of dot-com and tech. issues) and they experienced necessarily a much lower compounded annual return through 2002.  They participated in this high risk technology concentration usually without any protection or exit strategy i.e. stop losses, protective puts or custom collars.  Further, rather than their brokers selling or cushioning the decline in value of this 100% concentrated stock portfolio, many brokers bought more or "averaged down" during the market decline.  At the end of last year, large-cap technology stocks (those in the top half of the Russell's index of the 1,000 biggest U.S. stocks, traded at 33 times the past year's earnings.  Technology stocks in the Russell 2000, an index of small-cap stocks, had a price-to-earnings ratio of 59.  This when earnings growth for both small and large technology companies were about the same over the past two years, suggesting that small-cap technology stocks don't deserve such high valuations compared with their larger peers.  

    Tech-heavy mutual funds joined the internet explosion in high risk NASDAQ issues as well.  In December 1998 there were a total of 48 technology equity funds (as defined by the Morningstar Principia Pro software).  By the end of 2000 there were 118 tech. funds - an increase of 146%.  The bulge in tech. portfolios took place between June 1996 and December 2000.  In the short space of 19 months, 70 new equity funds with a heavy weighting in technology were launched. These totals only consider distinct, surviving portfolios as of April, 2003.    

     As we observe the markets rebounding nicely in 2003 (the market overall was up over 40% according to the VAY index), we must remind ourselves of the valuable lesson history has taught us!  In the last 23 years the five asset class diversified portfolio has performed virtually equivalent to the growth stock portfolio, but with less than half the level of risk.  It will take all or our resolve to remember that historical truism.  No one can be sure that the market has bottomed out.  Historically, there have been 5 bear markets since the depression.  A bear market is defined as lasting more than 12 months in a period where stocks lost at least 20% of their value.  The bear markets were 1929-1932; 1940-1942; 1968-1970; 1973-1974 and 1980-1982.  More currently, the Wilshire 5000 total return index declined by 46% from its March, 2000 top to its October, 2002 low. Only diversification can sustain us through the unchartered waters of these uncertain times.    

     The point is this:  Sector sizzle will come and go just like it always has.  Conversely, investors planning for retirement want their retirement funds to grow consistently with the realistic probability of controlling risk levels.  A diversified portfolio does that. Once again, it is "an idea whose time has come".

                                    Historical Portfolio Returns: 1/79 – 12/02

             Stock %        Bond %        Ave. Annual Return            Standard Deviation*

                0%             100%                           9.6%                                   6.4%

               10%             90%                            9.8%                                   6.4%

               20%             80%                         10.0%                                    6.7%

               30%             70%                         10.2%                                    7.3%

               40%             60%                         10.3%                                    8.1%

               50%             50%                         10.4%                                    9.1%

               60%             40%                         10.4%                                  10.3%

               70%             30%                         10.5%                                  11.5%

               80%             20%                         10.5%                                  12.8%

               90%             10%                         10.4%                                  14.2%

              100%              0%                         10.4%                                  15.6%

Stocks:  Russell 3000

Bonds:  Lehman Aggregate Bond Index          

     Assuming 15% capital gains and dividend taxes and a 40% effective tax rate on current income the 

following results were achieved between 1-1-90 and 12-21-2003, on an after tax basis:

                                                                        ANNUALIZED                   ANNUALIZED 

                                 ASSET CLASS         AVERAGE RETURN       STANDARD DEVIATION

                                       Bonds                               4.64%                                 3.69%

                                International Equity                 1.43%                               16.20%

                                Emerging Market Equity          4.24%                               22.37%

                                Small-Cap Stocks                    8.28%                               18.15%

                                Large-Cap Stocks                    8.60%                                14.21%

                                Municipal Bonds                     6.37%                                  4.65%        

        Abandoning bonds is as foolish now as it was in 1999!  Investors should note that maintaining a 30% allocation in fixed income securities cuts portfolio volatility by one-third, but with negligible upside impairment.  Instead of trying to guess, we look for sound investment opportunities with low correlations to U.S. stocks and combine them in proportions most appropriate to each client's needs, objectives and risk/return profile.  For example, the correlations between emerging market stocks or real estate investment trusts and stocks is quite low.  And there's effectively no correlation between the returns on cash and the returns on U.S. stocks.  You can see that the dollar, too, moves without relation to the U.S. stock market, which adds to the diversified effect of investing abroad.  With the recent decline in interest rates, and the chance for increases from historic lows, one needs to be a bit more creative, utilizing inflation indexed bonds, convertible securities, mortgage backed securities or laddered Treasury Notes, for example.    Quality high yield non-rated bonds ("junk" but not "trash") should be considered when the issuer forgoes the cost of a bond rating in favor of increasing the yield to the investor.  Quality corporate bonds could also be considered.  However, one must always keep an eye on default potential.  According to Moody's, for companies started in 1970 to 1997, the mean five-year cumulative rate of default was 0.1% for those with a top Aaa rating.  The default rate climbed to 11.5% for speculative Ba-rated companies and to 30.8% for B- rated firms (See the following article on junk bonds).  The most compelling reason for including bonds in a portfolio is again, diversification.  Consider the 1970's, a decade when interest rates increased from 5% to 14%.  According to a recent Ibbotson study, an investor with a 30% allocation to bonds during this period captured 98% of the total return of stocks with only 73% of the price volatility.  If that statistic isn't convincing enough, consider the possibility of another market shock, be it a stock market crash a la 1987, or another terrorist attack on U.S. soil.  In the past, bonds acted as a shock absorber during such tumultuous events, cushioning the bruising performance of equities.  As interest rates begin to rise, regardless of economic conditions, bonds should be a part of every long-term investor's holdings.  It is prudent, however, to adjust duration and credit spread exposure as conditions change.  

                                                        Scorecard - Standard Deviation*

                                                               (1 = best - 9 = worst)

     Standard Deviation                                                                       Volatility Risk Rating

          up to 7.99                                                                                                   1

      8.00 - 10.99                                                                                                   2

     11.00 - 13.99                                                                                                  3

     14.00 - 16.99                                                                                                  4

     17.00 - 19.99                                                                                                  5

     20.00 - 22.99                                                                                                  6

     23.00 - 25.99                                                                                                  7

     26.00 - 28.99                                                                                                  8

     29.00 and up                                                                                                   9

                     THE BENEFITS OF DIVERSIFICATION (1970-1990)

                                                                                                                                                                                                                                                                                                                                                                                                                                                      Stocks     5 Asset

                                                                                      Bonds        Class      

                    100%          100%         60%Stocks          Cash      Diversified

Year              Stocks            Bonds            40%Bonds       (1/3 in each)    Portfolio*

1970                 4.0%               12.1%                  7.5%                      8.0%               4.7%

1971               14.3%               13.2%                14.1%                    10.8%             13.7%

1972               19.0%                 5.7%                13.5%                      9.4%             15.1%

1973             -14.7%                -1.1%                -9.1%                     -3.0%              -2.2%

1974             -26.4%                 4.4%              -14.9%                     -5.4%              -6.6% 

1975               37.2%                9.2%                25.7%                     17.0%             19.6%

1976               23.8%              16.8%                21.2%                     15.2%             11.5%

1977               -7.2%               -0.7%                -4.6%                      -0.9%               6.1%

1978                 6.6%              -1.2%                  3.7%                        4.4%             13.0%

1979               18.4%              -1.2%                10.8%                        9.1%             11.5%

1980               32.4%              -4.0%                17.5%                      13.2%             17.9%

1981               -4.9%                1.9%                -2.0%                        4.1%                6.4%

1982               21.4%             40.4%                29.0%                      24.0%              14.4%

1983               22.5%               0.7%                13.4%                      10.5%              15.4%

1984                 6.3%             15.4%                10.1%                      10.8%              10.4%

1985               32.2%             31.0%                31.9%                      23.4%              25.4%

1986               18.5%             24.4%                21.1%                      16.6%              23.3%

1987                 5.2%             -2.7%                  3.6%                         3.9%               8.6%

1988               16.8%               9.7%               14.0%                        11.0%            13.2%

1989               31.5%             18.1%               26.2%                        19.2%            14.3%

1990              - 3.2%               6.2%                 0.6%                          3.6%            - 1.4%

Compound      11.2%              8.7%               10.5%                          9.6%             11.2%

Annual Ret.

Standard Dev.

Risk Levels -   16.20%          11.80%               9.53%                        8.00%             7.75%        

Var. Portfol.

Mixes

# of Years         15                   14                    16                                17                  17

with Positive

Returns

Stocks:  S&P 500 Index, Bonds:  Lehman Agg. Bond Index, Cash:  180 day C.D.

*Diversified Portfolio:  20% S&P 500, 20% Lehman Aggregate Bond Index, 20% Equity REITS, 20% MSCI World Index (International), 20% Cash.                                                                                      Assumes annual rebalancing.

Sources:  Morningstar, Ibbotson, Thomson Fin'l, NAREIT & BB&K Index.

                                        HISTORICAL MARKET INDEX ANNUAL RETURNS

                                              DJIA                                  S & P 500                           NASDAQ

                                 ANNUAL RETURN (%) ANNUAL RETURN (%)   ANNUAL RETURN (%) 

2003                                      27.4                                       28.7                                     33.3

2002                                     -14.5                                      -23.4                                    -31.3  

2001                                     -  5.4                                      -11.9                                    -21.1

2000                                     -  4.7                                      -  9.1                                    -39.3                          

1999                                      27.0                                        21.0                                     85.6

1998                                      18.0                                        28.6                                     39.6

1997                                      24.8                                        33.4                                     21.6

1996                                      28.6                                        23.1                                     22.7

1995                                      36.5                                        37.4                                     39.9

1994                                        4.9                                          1.3                                    -  3.2

1993                                      16.7                                        10.0                                     14.7                

1992                                        7.4                                          7.7                                     15.4  

1991                                      23.9                                        30.6                                     56.8

1990                                     -   .6                                        -  3.2                                   -17.8

1989                                      31.7                                        31.5                                     19.3

1988                                      15.9                                        16.8                                     15.4

1987                                        6.0                                          5.2                                    -  5.3

1986                                      26.9                                        18.5                                       7.3

1985                                      32.8                                        32.2                                     31.5

1984                                        1.1                                          6.3                                    -11.2

1983                                      25.6                                        22.5                                     19.9

1982                                      25.8                                        21.4                                     18.7

1981                                     -  3.4                                       -  4.9                                    -  3.2                 

1980                                      21.4                                        32.4                                     33.9

1979                                      10.5                                        18.4                                     28.1

1978                                     -  3.2                                          6.6                                     12.3

1977                                     -17.3                                       -  7.2                                       7.3

1976                                      21.8                                         23.8                                     26.1

1975                                      45.4                                         37.2                                     29.8

1974                                     -23.1                                       -26.4                                    -35.1*                  

1973                                     -13.1                                       -14.7                                    

1972                                      14.6                                         19.0                                     

1971                                        9.8                                         14.3

1970                                        8.8                                           4.0

1969                                     -11.6                                       -  8.5

1968                                        7.7                                         11.1                                     

1967                                      15.2                                         24.0

1966                                     -18.9                                       -10.1

1965                                      14.2                                         12.5

1964                                      18.7                                         16.5       

1963                                      20.6                                         22.8

1962                                     -10.8                                        - 8.7

1961                                      18.7                                         26.9

1960                                     -  9.3                                           0.5

1959                                      16.4                                         12.0

1958                                      34.0                                         43.4

1957                                     -12.8                                       -10.8

1956                                        2.3                                           6.6

1955                                      20.8                                         31.6

1954                                      44.0                                         52.6

1953                                     -  3.8                                       -  1.0

1952                                        8.4                                         18.4

1951                                      14.4                                         24.0

1950                                      17.6                                         31.7

1949                                      12.9                                         18.8

1948                                     -  2.1                                           5.5

1947                                        2.2                                           5.7

1946                                     -  8.1                                        -  8.1

1945                                      26.7                                         36.4

1944                                      11.8                                         19.8

1943                                      14.1                                         25.9

1942                                        7.6                                         20.3

1941                                     -15.4                                       -11.6

1940                                     -12.7                                       -  9.8

1939                                     -  2.9                                       -  0.4

1938                                      28.1                                        31.1

1937                                     -32.8                                       -35.0

1936                                      24.8                                        33.9

1935                                      38.5                                        47.7

1934                                        4.1                                       -  1.4

1933                                      66.7                                        54.0

1932                                     -23.1                                      -  8.2

1931                                     -52.7                                      -43.3

1930                                     -33.8                                      -24.9

1929                                     -17.2                                      -  8.2

1928                                      49.5                                        43.6

    Average Annual Return    9.2%                                     12.1%                                13.7%

                                           (76 Years)                             (76 Years)                          (30 Years)              

     *  First year of NASDAQ Index.  

Sources:  Bloomberg (Dow Jones & NASDAQ)

                Ibbotson (S&P 500)     

                                      HIGH YIELD OR “JUNK’ BONDS, HAVEN OR HORROR

                                                                By Mason A. Dinehart III, RFC

     A high yield, or “junk” bond is a bond issued by a company that is considered to be a higher credit risk.  The credit rating of a high yield bond is considered “speculative” grade or below “investment grade”.  This means that th