Portfolio Advice: Diversify to Survive

Obsessive love affairs are destined to end badly.

So it goes with technology stocks — who could blame you for falling in love? Those triple-digit returns you were getting from tech stocks and tech-filled mutual funds were so hard to resist. You blew off other sectors — which seemed boring in comparison. And when the tech bubble deflated, you just couldn't let go.

Now look at you: Stuck with a sagging portfolio that's still overweight in technology, and trying to figure out how to get things back in order.

You might feel like you're alone, but financial planners across the country say they are seeing this scenario every day. Although the tech crash has knocked down investors' tech allocation a bit, that may not have done enough. At the end of January, the National Association of Investors Corporation top 100 index of most widely held stocks showed a tech weighting of almost 34 percent, compared with the S&P 500's 24 percent weighting in tech at that time.

Letting Go Is Hard To Do

"What we've been seeing is many investors that think they're diversified and they own seven or eight large-cap growth funds; or four large-cap growth funds, one mid-cap growth funds and an S&P 500 fund," says Lou Stanasolovich, a certified financial planner with Legend Financial Advisors in Pittsburgh. "That's when they want to evaluate what they have."

The most difficult part of the diversification process is letting go, say planners. Before investors sell their beaten-down tech stocks or mutual funds, they need to come to terms with the fact that what once made them rich, if only on paper, is now worth a fraction of what it once was. That's why many investors are often reluctant to sell their tech holdings, because they cling to fond memories of the past.

For that reason, many planners say investors should not go on the rebound. Most recommend dollar cost averaging, or selling your investments little by little over a period of time, as the best way to wean yourself off of losing stocks. That way, investors can not only come to grips psychologically with selling off their losers, but also decrease the risk of selling a stock or a fund at too low of a price.

"I would avoid doing anything dramatic or selling it all right away, just for the purpose of dollar cost averaging," says Matthew Reading, a certified financial planner with Austin Asset Management in Austin, Texas. "No matter what, you don't know what's going to happen to a stock. That's true on the upside as well as the downside."

Reading also suggests that investors place a limit order to sell at a certain price that is good till cancel. That means you place an order to sell a stock only when it reaches, say, $25 or higher. That way, you decrease the risk of selling a stock at a really low price. The downside is, if the stock never reaches that $25, your sell order won't get fulfilled. If that happens, you may need to place another order to sell the stock at a lower price.

Move Quickly to Diversify

But not everyone agrees you should divest gradually. Some, like Roger Gibson, president of Gibson Capital Management in Pittsburgh, argue that the longer your portfolio is undiversifed, the worse it's going to be for you in the long run.

When he is counseling someone to diversify, Gibson tells clients to imagine that they were starting from scratch and devise an optimal portfolio from there. Once that's determined, Gibson says he moves as quickly as possible to get their portfolio there. "I would say bite the bullet and let's move," says Gibson.

Figuring out what to sell is another difficult step. Stock picking is hard for professionals, let alone amateur investors, and there are no hard and fast rules about which stocks to sell. Most planners say investors should take a hard look at their stocks' fundamentals, outlook and earnings and determine whether or not they still believe in the company's future. If not, it could be time to sell.

One of the biggest hurdles for investors selling stocks is the psychological factor. It is difficult to unload a stock after you've watched it soar to lofty heights and plunge to bottomless depths because you're still probably thinking that it could go up again.

Though selling losing stocks is indeed painful, the good news is you can use those losses to offset any capital gains you might make during the year, a process called tax-loss selling.

Planners say one of the biggest mistakes investors made during the bull market is that they were afraid to sell stocks at the top not only because they were greedy, but because they were afraid of paying the capital gains taxes. Investors need to be careful not to let any potential tax burdens get in the way of prudent investment decisions.

The Right Asset Allocation

What investors should do, say planners, is re-evaluate their portfolios every one or two years, take profits on those stocks that have had a good run and get rid of those losing stocks that seemed to have lost their will to live.

"People have to remember that at the end of the day, if you're paying taxes, that's a good thing because that means you made money," says Bryan Olson, vice president at the Schwab Center for Investment Research.

Figuring out the optimum asset allocation for you is another complicated task that should be determined taking into account your age, income, risk tolerance and time horizon. But many planners say a simple way to balance your portfolio is to get your sector weightings in line with the broader market, namely, the S&P 500. That way, when one sector is out of favor in the stock market, investors will be somewhat shielded by the diversification.

"Use the market," says Olson. "Obviously if you have strong feelings one way or the other, slightly overweight or slightly underweight that sector. But to go to any extreme, you're making a very conscious bet and exposing yourself to added risk."

The caveat there is that the sector weightings in the S&P 500 fluctuate according to what the market has a mania for, so investors should be mindful of that.

Legend Financial's Stanasolovich has a different view, recommending that investors have an equal weighting of different sectors or asset classes in their portfolios. So, your large growth allocation is equal to your small value stake and so on. The planner says this strategy will serve investors well in most market environments.

To figure out if you're having an unhealthy relationship with technology, Stanasolovich recommends looking at both your individual stocks and all of the holdings in your mutual funds (information that should be available on most mutual fund companies' Web sites or on fund tracker Morningstar's site).

After you've determined out how much you have in what, then you need to figure out what kind of asset allocation you want to achieve and decide how quickly you can handle getting there. Breaking up with your tech stocks might be hard to do, but it might be the only way to get your life back together again.