If one of your New Year's resolutions is to review your investment portfolio, be aware that diversification will help protect you against a possible downdraft in the hot computer-technology stocks.
Investment advisers usually diversify mutual fund portfolios along two lines, based on the stocks they hold: small-company stocks vs. large-company stocks, and growth stocks vs. value stocks.
Growth stocks generally are defined as companies with above-average rates of growth in sales or earnings whose share prices tend to be high compared with their recent earnings per share. Value stocks typically have less-robust growth rates and sell at prices more in line with their recent earnings per share.
A simple form of diversification suggests owning large-capitalization value stocks to balance the greater risk of small-cap growth stocks.
But the distinction between growth and value may be losing its usefulness. For one thing, managers of so-called value funds often chase hot technology stocks and, in the process, erode the purity of their investment styles.
Looking at large-cap stocks, fund managers at OakBrook Investments in Lisle, Ill., say that dividing funds according to the volatility of their returns over time produces a more pronounced distinction than the value-growth duality.
Peter Jankovskis and Janna Sampson observed that their AmSouth Select Equity Fund, which buys major companies in leadership positions in their industries, performed differently than other large-cap growth funds.
"It tended to have very good defensive properties and tended to trail during booming growth markets," Jankovskis said. The distinctive characteristic of the Select Equity Fund has been the stability of returns over time for its component stocks.
"Back in the 1970s and '80s, [portfolio analysts] focused on value and growth characteristics," Jankovskis said. "Our focus on stable and variable returns is actually a much sharper differential. Over the last year, everybody has focused on growth stocks and how growth stocks have done so well and value stocks have done poorly. Looking at the world as we do, the key driver has not been growth, but volatility. That's true not only of growth stocks but also value stocks."
Using an index of growth and value stocks published by California-based Barra Inc., Sampson said returns by the two groups differed by 15 percentage points over the past year, in favor of growth stocks. But "if you look at our stable and variable [categories], they differ by 36 percent."
Within the growth group, variable growth stocks outperform stable growth stocks by 45 percentage points, she added.
If the OakBrook analysis stands the test of time, a diversification seeker would do far better by pairing some variable funds against stable funds instead of growth against value funds.
The mutual fund industry has not yet tackled this alternative framework, although Chicago-based fund tracker Morningstar Inc. considers portfolio return variability in assigning its popular star rankings.
The variable-stable spectrum reveals useful information about seemingly similar funds. For example, OakBrook found that the growth and income funds sold by Janus Funds and Vanguard Group are variable funds, whereas the Scudder Growth and Income Fund tracks with stable value funds.
Most value funds are stable. An exception, said Jankovskis, is Vanguard Windsor, which he classifies as a variable value fund.
Stable growth is out of favor, he said.
"Most people don't expect a growth fund to have a stable characteristic."
Stable growth stocks in the AmSouth Select Equity Fund include Sysco Corp. (the food distributor, not Cisco Systems Inc., the computer networking company), trading with a price earnings ratio of 33, vs. 175 for Cisco; Pitney Bowes Inc., the postal system developer, with a P/E of 21; and two newspaper stocks--Gannett Co., with a P/E of 25, and The Washington Post Co., with a P/E of 24.
Investors interested in ranking their funds according to variability instead of P/E should look for a statistic called beta, available in many mutual fund research reports.
The beta of a fund measures the variability of returns compared with the variability of the market, typically Standard & Poor's 500-stock index. Variable funds usually have higher betas.
Investors looking to add stability to their large-cap portfolio should add one or more funds with betas of less than 1.
"We think the returns you've seen in the variable world, the variable growth world in particular, are representative of a bubble," Sampson said. But you don't have to flee the stock market to protect yourself, she said.
"There are a lot of stocks that didn't participate in this run-up. All you have to do is step into some of those other stock categories and you should do better over the long run than if you step into cash or bonds."
The first step, using the beta measure as a proxy for variable and stable categories, is to classify the funds you already have. If you have a growth and value fund, but they both have betas of greater than 1, you need to diversify.