The Well-Stocked Portfolio

Technical analysis. Modern Portfolio Theory. Put and call options. Forget these fancy words.  What most people want to know is simply, "What do I do with my money?" 

My answer? Diversify.

Look at it this way: diversification is like having the right clothes for every occasion.

Simply put, a well-stocked portfolio is like a well-stocked closet. In a well-stocked closet, you have clothes for different occasions and for changes in the weather. You paid the right price for everything, and perhaps even bought some on sale. You are a careful buyer, so you checked the seams, noted the workmanship -- quality is important.

After going to all the work of finding (and paying for) these nice things, you don't throw them out after a few months and buy different ones. You hold them for the long term unless they fall apart or go hopelessly out of style. Then you admit your mistakes and give them to the Goodwill.

Likewise, a well-stocked portfolio should have stocks and bonds of high quality that are right for tough times like this and good times, too. You should do the research before buying, pay the right price, and hold onto them for the long term.

So the first thing to do with your money is to check on what you already have -- check for the well-stocked portfolio. That's diversification. In my next column, I'll move on to talk about how to determine the "right price," how long the "long term" is, and what is meant by "high quality."

But first, I want to tell you about the Four Season Portfolio Plan. It is an asset allocation model to help you organize your investment so that you have something for every occasion, every change of weather.  

Invest in the classics

The first thing to know about the Four Season Portfolio Plan is that it's a portfolio of classics that are not to be traded. It's a challenge to find good companies in which to invest -- it's fun, but not easy. Don't go tossing your finds out like yesterday's fashions just because they lose -- or even make -- a few bucks. Remember, a great investment is like an expensive suit, meant to be around for a long time.

It seems to me that there are four identifiable kinds of economic "weather" that can help or hurt our investments, and they correspond rather nicely to the four seasons of the year: spring, summer, autumn, and winter. Here's what I mean:

Spring: a time for growth

Spring is notable for encouraging things to grow. With warm days, cool nights, and soft rains, buds appear and flower, grass turns green, and trees begin to leaf. The economic climate that I correspond to spring is when businesses are encouraged to bud, flower, and grow. Think of warm days, cool nights, and soft rains as low interest rates, low inflation, and high consumer confidence and optimism. 

All of these conditions make companies feel good about the future, so they begin to spend money and to make capital investments. Then their suppliers make money. Companies' profits begin to grow and people want to invest in them by buying their common stocks. Growth in a company's profits always means growth in the price of its common stock. In general, growth companies put their earnings to work on future growth, rather than paying a large percentage out in dividends.

In order to benefit from the spring economic season, you should own growth stocks. These are stocks of companies whose profits grow consistently, who make more money year after year. 
But not all stocks are growth stocks. Some companies don't make money year after year. They only earn money when the business cycle is gearing up, after a recession or a long, boring economic slowdown.

These are the companies that make the big stuff: cement, heavy machinery, things businesses would buy if they were happy about the future and ready to put some money into it, by, say, building more factories, or adding more equipment. Companies whose profits only increase at the outset of a business cycle are called "cyclical" companies, and their stocks don't belong in the Four Season Portfolio Plan because they won't be "in style" year after year.

Summer: travel the world

Things don't bloom all at the same time during the summer, and the economies of the world don't usually bloom all at the same time, either. So economic "summer" is the season for taking advantage of good times in other countries. The well-stocked portfolio will hold international growth stocks. This can include international mutual funds, or "exchange-traded funds" (ETFs) of foreign countries (which are index funds of the largest companies in a particular country) or stocks in those American companies that do international business and, of course, whose earnings are growing consistently year after year after year.

There's still another way to buy foreign countries' companies: A lot of foreign companies sell shares on our U.S. exchanges. They're called American Depository Receipts or ADRs. However, it's often difficult to get good information about them on a regular and timely basis.

Aside from enabling U.S. investors to participate in robust foreign economies, international investments bring in non-dollar denominated earnings. That means that if the dollar is weakening, foreign earnings buy more dollars and earnings seem higher. (Conversely, if the dollar is strengthening, they are worth less.)

You can follow ADRs of large companies and ETFs in the stock tables of major newspapers; international mutual funds -- usually "closed-end" funds -- are also listed in the stock tables.

When the Four Season Portfolio is suited up with stocks that cover both the spring and summer-type economic climates, it benefits through the consistent growth in the earnings -- which almost always eventually translates into growth in the price of the stock. And that's what stock is supposed to do.

Now we've got growth seasons covered. Let's move on to the harvest ... 

Autumn: uncertainty abounds

I try never to say the word "fall" when referring to the capital markets -- call me superstitious.

So autumn is the time of year when you don't know what the weather is going to do. You can get heat, cold, rain, sleet, hail ... anything can show up in autumn. In an economic autumn, no one knows if interest rates are going up or down, if we're in or out of a recession, if inflation will increase or decrease.

To defend your portfolio against this season of uncertainty, the Four Season Portfolio holds high quality hybrid-types of investments like Real Estate Investment Trusts (REITs) and Convertible Bonds. 
REITs are companies that purchase and manage real estate. They offer the opportunity to invest in a wide range of business sectors, such as shopping malls, hotel chains, restaurant chains, office parks, healthcare facilities, and apartment complexes.

Income earned from the underlying businesses is passed through and taxed to the shareholder. If the underlying business is robust and profitable, these dividends can grow over the years and offer an excellent hedge against inflation. In my opinion, the most desirable REITs are "equity" REITs (versus the "mortgage" REITs), because they actually own the properties and not the mortgages on the properties.

Convertible bonds of a company are loans that pay the investor interest semi-annually and the principal of the loan upon maturity, but also enable the bondholder to convert the bond into a fixed number of shares of the company's common stock. The interest rate on a convertible bond is lower than the company's regular bonds because of this "equity-kicker." If the value of the company's common stock rises, so will the value of the convertible bond.  If it doesn't, the bondholder still gets the interest payments and principal repayment at maturity.

Both REITs and convertible bonds pay decent income, which should ease the pain of bad markets. But they also have the potential for growth to take advantage of good markets -- just what you need to help you deal with uncertainty and unease when it strikes.

Winter: no growth

Winter means hard times. Things are dormant. Nothing grows. 
During an economic "winter," nothing good is happening in the stock market, in the growth side of your portfolio. To be prepared for no growth, recession, and other unpleasantries, the Four Season Portfolio can still look to the interest paid on high-quality, fixed-income securities (bonds) for at least some contribution to your portfolio. Not exciting, but reliable.

Bondholders are loaners to an entity, not owners, like shareholders. Prices of bonds are determined by their length to maturity, their quality, and their interest rate. They come in a variety of styles.

• AAA-rated Treasury bonds offer the highest degree of assurance that both interest and principal will be paid, but they are subject to federal (although not state or local) income tax.
• Municipal bonds are issued by a city, county, state, or other political entity, and most of them are exempt from federal (often state and local, as well) income tax. Therefore, municipals are most useful for investors in high tax brackets. 
• Corporate bonds are issued by corporations and are fully taxable.
• Zero-coupon bonds are issued by the Treasury, municipalities, and corporations. They are bought at prices discounted to face values; interest is not paid but is reinvested and compounded until maturity date. For example, at this writing in late October, a $10,000, 10-year zero coupon Treasury bond is priced at $6,467.

The prices of all bonds, if sold before maturity date, are sensitive to current interest rates. If prevailing interest rates are higher when the bond must be sold than when it was purchased, the market price will be at a discount to its face value. Conversely, if rates are lower, the market price will be higher than face value.

Because quality is a large determinant of price and, of course, safety, the wise investor buys only investment grade (rated "BBB-plus" or higher) quality bonds. If the interest and principal repayment is insured, all types of bonds will receive a AAA-rating, regardless of their original status. 

So that's a summary of the Four Season Portfolio Plan -- what the well-stocked portfolio should hold. This approach has worked for me and my clients for decades. Remember to look for my next column for a discussion about how to assess the quality and price of your stocks and bonds, and what is meant by the "long term."

Susan Laubach, MEd, PhD, registered investment advisor and former institutional stockbroker/branch manager of a major NYSE firm, has given seminars on portfolio management for over 20 years. She has been featured on CNN-FN, CNBC, WETA's "In the Prime" series, and is the author of "The Whole Kitt & Caboodle: A Painless Journey to Investment Enlightenment." She can be reached at
susanlaubach@comcast.net or via editor@physicianspractice.com.

This article priginally appeared in the January/February 2003 issue of Physicians Practice.