Have the Rules Changed?

Bert Whitehead, M.B.A., J.D. © 2009

We are experiencing the worst economic crisis since the Great Depression, and we are likely to see further erosion. It’s a perfect storm brought on simultaneously by a financial crash, a real estate crash, and an economic crash. Investors who have always ‘played by the rules’ by diversifying their portfolios are confronted by the reality that all asset classes are collapsing, except for long-term Treasuries and perhaps gold. Small businesses are closing, real estate across the nation has tanked, and even the safety of banks and insurance companies are questionable.

So have the rules changed? Many investment strategies which have long been considered sacred don’t work anymore. The basic principles which we use in Functional Asset Allocation, however, are sound. That means that investment portfolios should be based on ‘endogenous’ factors that reflect the client’s individual circumstances.

Most investment strategies have been based on Modern Portfolio Theory. This assumes that the correlations of investment performance should be the dominant consideration in constructing and managing a portfolio. Investment managers all promised they could ‘time the market’ to take advantage of the next asset class which would out-perform the market.

Those strategies are always based on ‘exogenous’ factors such as interest rates, historical performance of stocks, oil prices, etc. Long-term US Treasuries have never been considered as the core of a portfolio, because brokers don’t make any money on Treasury bonds unless they are constantly being traded.

For our clients, we are re-evaluating the appropriate investment risk exposure based on each individual situation. The ‘invisible hand of the market’ has radically rebalanced our portfolios so that most are now heavily weighted in bonds and cash vs. stocks. We do not slavishly sell out bond ladders to boost the client’s exposure to stocks.

The current economic cycle has magnified the risks clients are exposed to. Job security is questionable, real estate values have plummeted, and businesses across the board are faltering. In reviewing clients’ portfolios we take we consider three primary risk factors:

1) How much risk does a client need to take to achieve financial independence, i.e. how much is enough? If you already have enough to survive this financial cycle, we will recommend that you take less risk in your portfolio than previously.
2) How much risk are you already taking? If you have your own business, or are subject to being laid off, or are concerned about becoming disabled, it is appropriate certainly to take less risk in your portfolio since these risks are greater now than last year.
3) How much risk is appropriate for your situation? If you have dependents, kids to send to college, too much leveraged real estate, etc. your portfolio should be more conservative. If you are single with a good job and in good health, you may want to be more aggressive. Note that this has nothing to do with ‘risk tolerance’ which is an unreliable and irrelevant factor when balancing a portfolio.




We generally try not to reduce clients’ exposure to market risk by selling off stocks and equity mutual funds despite market drops. This cycle will pass eventually and maintaining a position in the market is critical to rebuilding your portfolio. Clearly younger clients have a once-in-a-lifetime opportunity to achieve financial independence by dollar cost averaging in the market now through their 401-K’s and other pension options.

When extra cash is available, we want to reinforce or add to clients’ bond ladders where appropriate. And in today’s markets, a heavy cash position is often appropriate. We are also cognizant that the government stimulus, which is being funded with a flood of Treasury debt, will likely cause serious inflation down the road.

The problem is that the current deflationary cycle may last 1-2 more years, or possibly 5-10 more years. Rather than selling Treasuries, we are positioning clients for inflation by increasing their cash cushion (which will earn higher interest in inflationary cycles) and urging clients to remortgage their homes with 30 year mortgages if they can do so for a rate that is 1.0% or more less than their current rate.

We are monitoring the investments which are held by our clients, and may make short-term suggestions during your tax appointment or by email. After tax season we will be reviewing your portfolio with you in depth to identify the appropriate amount of risk we suggest in your circumstances and the corresponding rebalancing required in your portfolio. The market is so volatile and unstable currently that we are avoiding unnecessary market moves.

Occasional market rebounds, as we recently have seen, don’t indicate that this economy has turned around. A single swallow doesn’t mean spring is here. While most polls indicate that the general public is optimistic about the federal government stimulus and other bold intervention, the overwhelming consensus of the business and financial communities is very negative. Market reaction has exacerbated fear and panic among investors.

The concern is that government reaction to the crisis is not focused on the central problems: financial institutions and housing. It is the uncertainty whether massive splintered federal spending, knee-jerk regulation, and laws targeted to special interests is doing more long-term harm with little to show in short term gain. This recession is world wide with most countries even worse than we are, and international markets are now increasingly concerned about the stability of Treasury debt.

As a result we really don’t know which way the market and the economy is headed. Many government economists are confident that the recovery will begin this year, though more stimulus spending may be needed. Wall Street is generally more pessimistic, expecting this downhill slide to last 5 years or more. That would mean even lower interest rates, further stock market drops, and real estate stagnation. It is not prudent to guess at this point which way the economy will go over the next 3-6 months and make major shift in portfolios.

No matter what happens, we want to take whatever steps are needed to protect you financially. The rules of Functional Asset Allocation haven’t changed, but it is likely that your world is changing and we will make sure your portfolio is adjusted accordingly.