In the first two parts of this series, I reviewed mutual funds, stocks and arbitrage. This month, I conclude with an overview of hedge funds, diversification and portfolio balancing.

Hedge funds
Benjamin Graham, the godfather of value investing, started the first hedge fund in 1923. While most investors choose securities that are likely to increase in value, hedge fund managers predict the direction and degree of price increases or decreases, enabling them to be profitable regardless of market conditions—if their predictions are correct.

Hedge funds have been exempt from regulations that governed other investments, allowing aggressive strategies such as short selling and the use of derivatives. These private partnerships required a high initial investment, limited the number of clients and often restricted withdrawals, ensuring a client base of institutions and wealthy individuals. While the institutional investor’s prospectus defined the types of securities it might purchase and limited the percentage of ownership in a single company’s stock, hedge fund managers were free to make their own rules.

Fees of 2 percent of managed assets plus retention of 20 percent of earnings made hedge fund managers rich and revered during the late 20th century. When the market tanked, most of the damage was sustained by hedge funds that borrowed large amounts of cash to trade debt and the “quants” that used computer modeling to make buy/sell decisions. The most successful hedge fund managers were the contrarians who, like construction apprentices, had learned the craft from mentors, developing the judgment to win a zero-sum game where a loss balances every win.

Hedge fund managers are gutsy contrarians, swimming against the tide. A basic assumption is that stock market returns and interest rates are “mean reverting,” which is a fancy way of saying, when markets go off track, they always revert back to long-term average performance. Riding out the waves of gain and loss is a daunting process—even the most gifted investors are right less than 60 percent of the time, and most are lucky to achieve 30–40 percent. As economist John Maynard Keynes said, “The problem, of course, is that markets can remain irrational longer than the rational investor can remain solvent.”

Around the turn of the century, hedge fund managers were influenced by the influx of pension fund money into the mix, reducing risk tolerance since pension fund managers sacrifice higher profits for steadier returns. The best managers rely on humility and the ability to admit mistakes to provide perspective when the patterns change and stay alert for data that contradicts their decisions, asking if they are wrong or just too early, committed to the right course, or just stubborn.

Diversification
Diversifying your investment portfolio reduces risk by averaging out gains and losses across a range of asset types. Purchasing as few as eight different randomly selected stocks provides some diversification. Adding other classes of assets such as bonds, real estate, commodities such as gold, or geographic diversification into foreign markets further reduces risk.

Theoretically, you could achieve maximum diversification (“buying the market portfolio”) by predicting the market value of each available asset and purchasing a weighted share of each. This is the idea behind index funds. Or, you might use “risk parity,” assigning weights that are inversely proportional to the perceived risk of each investment, if you believe that future risk is easier to forecast than market value.

The diversification concept becomes clear if you think of it in corporate terms. A company diversifies vertically by acquiring more components of the supply or distribution chain, such as subcontractors or suppliers. Horizontal diversification occurs through expanding product lines or acquiring related companies or competitors.

Portfolio balancing
Establish an allocation formula based on your risk tolerance and projected retirement age. You can start by subtracting your age from 110 to establish the percentage of stocks in your portfolio. Then determine what else to include. As you near retirement, you generally increase the percentage of bonds and reduce stocks, but the overall intent is risk reduction to preserve your capital.

Researching target-date funds—a professionally managed portfolio that becomes more conservative with time—can help you establish an allocation formula. If you plan to retire in 10 years, find out how target funds set for 2022 are allocated, and use those parameters to guide your own investments.

Online tools, such as Morningstar’s Instant X-Ray, allow you to analyze your own portfolio, and TRowePrice.com allows you to retain your data on file without buying a premium membership with Morningstar. Each year, shifts in value alter the percentages for each asset class. For example, your stocks have gained value and make up 70 percent of the portfolio, but your target is 60 percent. You sell stocks and buy other assets to restore the targeted percentages.

Monitoring your portfolio won’t prevent all losses, but it will indicate how well you are meeting your financial goals.

NORBERG-JOHNSON is a former subcontractor and past president of two national construction associations. She may be reached at [email protected].