It is said that when the British surrendered to the Colonial Army at Yorktown the band played a tune titled “The World Turned Upside Down.” True or not, it is a fitting sound track to a seemingly improbable situation: The defeat of a well-trained army and navy of the most powerful empire in the world by an under-funded, out-numbered and ill-equipped army of colonials. It was as if the Sun, Earth and stars had become unhitched leaving navigators without their usual bearings.
In much the same way, the Great Recession has shattered our views on what is ‘safe’ and what it means to be ‘conservative’ or ‘aggressive.’ Looking to preserve capital and produce income? Invest in government bonds and maybe real estate. Young and looking to score big on the potential upside of stocks? Go for small company stocks or overseas because if there’s a bust you’ll have time to recover. At least that was the conventional thinking. Everything that was traditionally considered to be ‘safe’ and dull turned out to be dangerous and ‘risky.’
There’s nothing scarier than conventional thinking in a changing market. And what has evolved after the near melt down of the US financial system – indeed the global financial system – in the Fall of 2008 is certainly a changed market.
Household names including the bluest of the Blue Chips have entered and come out of bankruptcy. The foundation for wealth for most people – real estate – has crumbled and is a long way from recovery to previous levels. Government debt of developed countries considered at one time to be nearly risk-less have been to the precipice as Greece neared default and threatened the entire Euro zone. Now, it’s not even beyond the pale to consider a future downgrade of the credit rating of the US Government.
Having an understanding of risk is important not just for investors but for the advisers trying to guide them. In the past, an adviser (or your company’s 401k web site) would have you fill out a questionnaire. Those eight to 12 questions would identify the type of investor you were and lead to an asset allocation reasonably appropriate for an investor’s Risk Profile, Time Horizon and Goals. This was sometimes considered a “set and forget” type of thing.
But commonsense and our experience tell us that things change. Take the weather: Some days it’s sunny and other times it’s rainy or cold. What you wear on one day or even part of a day may not be right when the weather changes. That’s just like investing. A risk profile and asset allocation determined at one point might not be right for another.
So risk profiles are not static things either. Invariably, they change based on how we feel. Hey, we’re only human. You need to reconsider your risk appetite regularly and now is a good time. And it should be more than a few multiple choice questions.
After the run-ups in the markets in the late 90’s, people would tend to see things going up perpetually and say they would be more comfortable with risk. On the other hand, after the two major meltdowns this past decade, the pendulum has swung the other way. Too far, in fact.
Faced with our own emotions and the vagaries of a global economic system, one might consider it to be less risky to sit on the sidelines. Or maybe it’s safe to put all your chips on what you know – like your company stock. Or just cash it all out and leave it parked in a money market or bank.
At first glance these strategies may be considered low risk but in reality – even the reality of today’s changed world – they are not. Your company stock? Consider Enron or Lucent and ask their employees how their retirement accounts held up. Cash? At the minuscule rates banks are offering, you’re already behind the eight ball with taxes and inflation.
There’s more to risk than the volatile nature of an asset’s price. And what should matter most is not which assets are owned but how well they perform on the upside and downside.
If you’re hungry, your goal is to not be hungry. You say you like to eat steak and always eat steak. Well, that’s great but the risk of heart disease may catch up to you. So what you ate before may not be right for you now. Maybe it’s time to substitute more fish and add more vegetables.
That’s the essence of remodeling your portfolio now. Government bonds still have a place in your portfolio – just like that steak – but it’s time to scale back on the developed nations of Europe with their risks of default and the US where another bubble is brewing and add those from emerging markets. If you own gold or want to buy it because it’s a “safe haven” for inflationary times and you don’t want to miss the boat, consider other more usable commodities like potash. (As the world adds nearly 75 million people a year, there’s a growing demand for cultivating food for them and potash is a staple needed for fertilizers). After seeing a huge multi-national like BP get hammered for its lackadaisical approach to employee and environmental safety, it may be time to add more small companies to the mix which have less bureaucracy and may be faster to respond to opportunities and troubles.
The risky stuff may actually be more safe than the traditional stuff.