Will Fortune Smile on Your 2006 Stock Portfolio?

To "take stock" is a popular expression that means to think carefully about something so that you can forman opinion about it. For example, you should take stockof all your options when purchasing a home or whenlooking into trading in your old vehicle for a newermodel. Similarly, physician-investors should "takestock"when it comes to purchasing stock.

"It's difficult investing for yourself even if you knowwhat you're doing because emotions get involved,"explains Jason Papier, managing partner of PW JohnsonWealth Management. "Emotions are the reason why80% of investors don't beat the market. It's a strongmotivator, like fear and greed, and it tends to make peopledo the wrong thing at the wrong time."Papier saysthat despite being a financial advisor, he doesn't investhis own money. Instead, he has his partner do all hisfinancial planning, and vice versa. "Because the emotionsare a lot stronger when the money's your own,"Papier explains. Separating that emotion from reason isone of the keys to successful stock investing.

Take Stock of Yourself

Do you know what type of physician-investor youare? What's your tolerance to risk, as well as your timehorizon? Having an understanding of those factors iseven more important than analyzing a stock's price-to-earningsratio. Unfortunately, many physician-investorsoverestimate how much risk they can handle. Dr. WaltWoerheide, professor of investments at The AmericanCollege, says that understanding an investor's risk toleranceis critical when it comes to setting up a portfolioand determining an investment strategy.

"One of the tradeoffs is consumption today vs consumptionduring retirement," Woerheide says. "Somepeople choose to live a life of poverty today so they canenjoy their retirement. Others care about enjoying lifetoday. Once a financial planner establishes what thevalue of a physician-investor's portfolio needs to be onthe day they retire, then they have to look at risk toleranceand rates of return that are available in the marketplaceand see if there's a fit."

Sometimes, in the case of a conservative investor whoneeds to earn a 12% rate of return, there isn't a fit. Ifthat's the case, they have to choose between learninghow to live with more risk, living less luxuriously today,or deferring retirement. "Something has to give whenyou can't get a match between the rates of return necessaryto achieve the goals the client wants and the risktolerance of that client," Woerheide explains.

Another scenario is when investors indicate thatthey want to be able to retire with $250,000 a year inretirement money, but the biggest asset they have istheir home. The latter is what Merrill Lynch financialadvisor Mary Lou Zangerle calls a nonworkingasset. "Working assets are stocks, bonds, and cash,"Zangerle says. "When an investor has $800,000wrapped up in a house and wants us to provide themwith $250,000 a year in retirement money, we have toget them to understand that it won't happen unlessthey put a certain amount of money into a retirementplan going forward." That's where developing theright investment strategy is critical.

Take Stock of Diversification

Papier agrees that understanding your own goalsand risk tolerance is important when it comes to stockinvesting. However, he believes it's even more importantfor physician-investors to understand diversification.Papier says diversification in stock investing takeson a broad definition. It means diversifying amonglarge, mid, and small cap stocks, as well as diversifyingamong styles like growth and value. Diversificationalso has a regional connotation, such as domestic vsinternational stocks, as well as a sector aspect. Thelatter, Papier says, is a mistake many investors make."People tend to invest in what they know, which isa good thing," Papier explains. "But you still needto be diversified."

There are some advisors who believe that aninvestor can be properly diversified by owning 10stocks in their portfolio. Many other advisors, however,suggest the number of stocks needs to be in the 100range. "My general rule of thumb is that the morestocks you have in your portfolio, the better off youare," Woerheide says, and offers the following illustration.Imagine you own 100 different stocks withroughly the same amount of money in each stock.Suddenly one of your stocks becomes an Enron andthe value collapses to zero overnight. What are yougoing to lose? If you own 100 stocks, your portfolio isdown 1%. Now imagine that you own only 10 stockswith your investments evenly distributed among them.If one stock goes under, you've now lost 10% of yourportfolio, and that can be a painful loss.

"Diversifying out as many stocks as possible minimizesthe damage when a company goes under,"Woerheide explains. "And I guarantee that no matterhow sophisticated you are and how carefully youselect, sooner or later you're going to buy a companywhose bottom suddenly falls out." The opposite,however, is also true. Woerheide says that by diversifyinginto more stocks, sooner or later you're likely tohit the next Microsoft or Home Depot—a stock thatseems to do nothing but rise.

In some cases, diversifying is not always easy. Papiersuggests that it's much more difficult to be diversifiedin small company stock than in large caps, or in internationalstocks vs domestic. The reason, he says, is thelack of available information. "There's a lot less informationabout small cap and international stocks,"Papier explains. "As a result, a lot of investors useboth mutual funds and stocks. They may invest inindividual large cap value stocks, and use mutualfunds for their small cap and international investmentsbecause it's a little easier to get diversification andresearch on those latter companies."

Merrill Lynch's Zangerle is a big proponent of assetallocation, and says that sector allocation is actuallymore important than individual stock picking. Thereason, she explains, is that investors should be in sectorsthat are growing. "The oil industry is a sector thathas been very good," Zangerle says. "You could havepretty much thrown a dart and picked any stock in theoil industry and you would have been okay."

Don't Forget Asset Allocation

Papier echoes those thoughts, and stresses that evenwithin a sector, it's important to diversify amongregions and companies. "You've got to be diversifiedregionally so you don't have natural disasters wipingout your entire investment," Papier says. "I would alsoprefer that investors consider more than one companyin a sector, because single-company risk is very real."

Zangerle cautions that just because you own individualstocks, mutual funds, and bonds doesn't meanyou're well diversified. There are bond mutual fundsand stock mutual funds, and if you also own individualstocks and bonds, you may not be as diversified as youthink. Similarly, it's important to revisit your investmentstrategy to make certain you stay properly diversified."Let's say you have a $1-million portfolio, withhalf in stocks and half in bonds," Zangerle says. "Themarket has been very good, and now your portfoliohas grown to $800,000 in stocks and still $500,000 inbonds. Your portfolio is out of whack, and you have tobring it back to that 50/50 split. But it's very difficult toconvince people who thought their risk tolerance was a50/50 split to take that frosting off the cake."

In contrast, if that split turned into $200,000 instocks and $550,000 in bonds, it's important to sellsome of the bonds and move the funds over to thestock side of the portfolio to maintain the balance.Woerheide suggests it's also important to understandwhat is meant by being either an aggressive or conservativeinvestor from an asset allocation perspective. "Ifa person is aggressive, it doesn't necessarily mean youbuy really aggressive stocks," Woerheide notes. "Whatit means is you put a greater percentage of your portfolioin stocks. If a person is conservative, it doesn'tmean you just buy high-dividend-paying utilities. Youput a greater percentage of your portfolio into bonds,maybe a little more into money market instruments,and a smaller percentage in stocks."

Remember Rules of Thumb

There are some key bits of advice that experts havefor selecting a stock to purchase, and they don'trequire becoming an expert overnight. Woerheideexplains that even though he has a PhD in finance, heusually spends just 10 minutes examining a stock forinvestment purposes. The reason he feels comfortabledoing that, he says, is because he believes the market isfairly efficient. That means that at any point in time,securities are fairly priced to reflect all publicly knowableinformation about that company.

Wall Street Journal

"There's no trick I can tell you that would enable youto open the tomorrow and immediatelyknow that 2 days from now a certain stock's priceis going to jump $3," Woerheide says. "But if you justdo a little bit of research, you can figure out which arethe superior stocks." That "little bit of research"includes examining a corporate management team tosee how long the team has been together and how successfulit has been. It's also important to look at a company'sprice-to-earnings ratio, says Darrell Canby ofCanby Financial Advisors, to see if the company is overvalued,undervalued, or valued just right.

"Back in the heyday of the dot-com era, when price-to-earnings ratios were ignored, that was certainly a redflag to be careful," Canby says. "Today we're lookingat ratios that are much more reasonable. Some companieshave a very low ratio, which would suggest thatthey might have some value and would be a good buy."

Research, however, does not mean putting too muchstock in a hot tip. Papier explains that corporateemployees who are privy to inside information guard itclosely. They're the top people in the company, andthose in the second tier think they have inside information,but often it's inaccurate. "I'll see doctors who havebought stock because of what a patient told them andit hasn't done well," Papier says. "[The doctors] getcaught up in the excitement of having information thatothers don't. But really, it's a gamble, and it's illegal." Ithighlights the importance of not only doing your ownresearch, but working with an investment professional.

"Everyone has their place in life, and I'm not goingto do my own dentistry," Zangerle says. "And if aphysician comes in and says that something is the best,I don't want to buy it because in 2 years when thestock goes from 28 to 3, who's going to get blamed forit?" Canby echoes, "If I wanted to get some adviceabout the pain in my arm, I wouldn't go to my neighbor.I'd go to a doctor."