How to cure a sickly, volatile investment portfolio

If the stock market's recent roller-coaster ride has you feeling a bit queasy about your investments, maybe it's time you considered this question: How healthy is your portfolio?

That's the question Richard Coppa poses to investors these days. Coppa is Managing Director of Wealth Health LLC, a Roseland, NJ financial advisory firm. His clients are typically in their 50s or 60s, with investable assets between $2 million and $10 million.

Maybe you don't have millions of dollars sitting in your accounts (not yet, anyway). But if you have any money at all invested – via a 401(k) plan, your kids' college funds or anyplace else – you've almost certainly noticed the crazy volatility on Wall Street lately.

On Thursday alone, the Dow Jones Industrial Average fell 376 points, or 3.6%, to close at 10,068.01. Meanwhile, the Standard & Poor's 500 Index on Thursday gave up 43.46 points, or 3.9%, to finish at 1,071.59.

It was only back on April 26 when the Dow and the S&P 500 both hit their 2010 highs. Now, less than a month later, both benchmarks are officially in "correction" territory, having lost more than 10% of their value.

Such wild market swings are nerve-wracking for Wall Street pros and individuals investors alike. It's never any fun to watch your hard-earned money go down the tubes.

Yet, Coppa thinks that during turbulent times investors at all levels get far too bogged down on a single number – their rate of return – without proper consideration of risk, much less their overall financial health. "I always hear people comparing their returns to what the S&P 500 did," says Coppa. "But you're not the S&P, so that's comparing apples to oranges."

What investors and their advisers really should be measuring, Coppa says, is risk-adjusted returns to gauge financial well-being. To assess risk, Coppa is a big fan of using the Sharpe ratio, even if many clients don't exactly get it.

The Sharpe ratio shows how much risk is in an investment (or portfolio), and whether or not an investor was adequately compensated for taking on additional risk. The formula for calculating the Sharpe ratio is a bit complex – which may explain why even well-to-do investors would rather focus on a simple number like their annual return.

But Coppa likens the single-minded emphasis on "rate of return" to using risky methods to lose weight – and then focusing solely on the number that pops up on a bathroom scale. "You can certainly lose weight by only drinking liquids or going on any fad diet for two weeks," he notes. "But what good is it to drop 10 pounds if you mainly lose muscle, or your cholesterol and blood pressure are too high?" he asks.




Using Technical Measures and Common Sense

Janice Wan, CFP and founder of Sierra Pacific Financial Advisors in Newark, Calif., finds that the single biggest risk facing her clients – the bulk of whom are 40 and 50-something doctors and Silicon Valley executives – is being overly concentrated in one or a few stocks. Her fix: divest of those highly-concentrated positions through forward sales. "Then we create a new portfolio based on the financial plan we do for them," Wan says.

Lew Altfest, president of Altfest Personal Wealth Management in New York, says he uses "technical and practical" strategies to assess a portfolio's health.

A surefire way to know if someone's portfolio is off kilter, Altfest says, is to do a quick check of the beta – or volatility level – of their investments.

According to modern portfolio theory, a stock with a beta of 1 has the same risk as a benchmark index, typically the S&P 500. So a stock or fund with a beta or 1.40 will be 40% more volatile than the index. Conversely, an investment with a beta of .80 will be 20% less volatile than the index, a concept easily understood by investors.

The "practical" technique Altfest uses, particularly with would-be clients, is to start off by describing "average risk tolerance" as being 65% invested in stocks and 35% in bonds. "Then I'll just ask: Where do you stand relative to that?'"

If an investor says he or she is more aggressive or more conservative, Altfest will recommend adjusting the mix of stocks and bonds accordingly.

"Next, I'll look at their portfolios and see if their asset allocation actually matches the risk tolerance they described. And you'd be surprised at how many times they don't even come close," Altfest notes. "The client simply might not be aware of it or they really haven't looked at the specifics of their portfolio for years."

No financial adviser in his or her right mind would approve of a client tuning out the specifics of their portfolio for years. But on ultra-volatile days like we've seen lately in the stock market, you could hardly be blamed for wanting to tune out -- at least temporarily -- what seems like an endless stream of negative news from Wall Street.



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