Batten Down the Hatches for the Dog Days

This could be a stormy summer. Like the mortgage debt crisis three years ago that blew up and froze the financial markets, there's a nontrivial chance the government debt crisis could do the same this summer. Government debt, normally the investment of last resort, is starting to look hinky. With respect to the federal debt ceiling, some Republicans in Congress seem intent on provoking a default in August. Biting the hands that feed us--i.e., stiffing investors in U.S. Treasury securities--hardly seems like a good idea for a debtor nation. But "smart politician" is virtually an oxymoron these days.

More than America, the Euro bloc lurches inexorably toward default. For the moment, Greece is the only nation that is likely to formally default. However, all Euro bloc members have pretty much assumed de facto responsibility for all the sovereign debt and bank debt of all member nations. So a default by Greece is, in effect, a default by the entire Euro bloc. Such a development would not be well-received in the financial markets. But Euro bloc leaders are divided about what to do, and progress toward true resolution is seen about as often as the ivory-billed woodpecker.

Although another financial crisis is a low probability event, the simultaneous dysfunction in Washington and Europe could make things go haywire in the dog days of this summer. After all, nothing has been done since the last credit crunch that would preclude another one this year. What to do?

Love cash. Have a cash lovefest. Build up your emergency fund and put it in a bank (making sure it's 100% covered by FDIC insurance). Avoid non-essential big purchases for the next few months to increase cash on hand.

Be cautious with money market funds. If U.S. Treasury securities actually default, money market funds might have to break the buck. A sudden spike in interest rates could reduce the value of their T-bills and impose losses on the funds. Although the extent of such losses is likely to be comparatively small, given the very short maturities that money market funds are supposed to hold, it's not impossible that a freeze-up in the Treasury securities market could result in money market losses and perhaps momentarily limit access to your account. This is a low probability event, and fund management companies would probably go to great lengths to avoid breaking the buck. But it happened once in 2008. If you are likely to need funds in a money market account in the near future, consider moving the necessary amount into a federally insured bank account in July if the debt ceiling mess remains unresolved.

Invest defensively. Now's not the best time to take a flier, except if you have mad money you can easily afford to lose. Note how the Nasdaq market has, in recent days, been falling proportionately faster than the Dow and the S&P 500. Many risk assets are falling, literally, out of favor. Be careful about diving into emerging markets. China's economy is slowing, and India's and Brazil's governmental yield curves are inverting (seen by some as a sign of impending recession).

Avoid unnecessary financial commitments. If you're thinking of making a major financial commitment, like buying an annuity or a whole life insurance policy, consider stepping back and waiting to see how things play out over the next few months. If, for example, you buy an annuity now, and Treasury yields rise sharply later this year because of a U.S. government default, you may effectively have lost money because you would have bought at today's low interest rates.

Line up credit lines now. Credit could evaporate if things go gonzo. While borrowing is to be avoided if at all possible during a financial crisis, there sometimes are pressing reasons to go into hock. Line up any loans you'll need. Since it's even possible a bank might terminate the unused portion of a line of credit if the sky falls, you may want to draw down on credit lines now if you are absolutely sure you'll need the money and have no other way to get it. Make damn sure you can repay what you draw down. And keep the loan funds in a bank account, not a money market fund.

All this may sound on par with suggestions to stock freeze dried food and bottled water, and to start a garden in your back yard. But we haven't had to rely on subsistence farming in more than a century. Just three years ago, credit was crunched and the financial system almost failed. As far as money goes, take nothing for granted.

Investing in Discouraging Times Can Be the Essence of Simplicity

Some financial advisers have been moving away from traditional diversified asset allocations and recommending strategies involving structured products, computerized trading models, hedge funds, commodities, and other alternative investments. While these types of investments used to comprise, perhaps, 10% or 15% of an investor's portfolio, some advisers now recommend a much higher level, even up to 100%.

There are a variety of problems with these alternative products. They can be expensive (in terms of fees and trading expenses), opaque (in terms of what they actually involve) and unpredictable. Worst of all, they can be significantly more complex than traditional stocks, bonds and cash equivalents like money market funds.

Complexity is biggest problem of all. If there's a single reason why Wall Street crashed and we're now in the worse recession since the Great Depression, it's that Wall Street got so entangled in complex financial products that even many of its most sophisticated financial engineers and most seasoned executives couldn't figure out how bad things would get. If these people can't handle complexity, how would an ordinary investor deal with it?

Another problem with these complex approaches is that they can mask a fundamental truth: you can't get something for nothing. By now, one would think that's clear. After all, the entire game with derivatives was that somehow risk could be shifted in some magical way to stabilize the financial markets. The joke was on everyone who actually believed that. These new, alternative investment strategies appear to rest on the implication that there is a way to attain portfolio stability while still getting good returns. The last year and a half should have taught investors that there is no easy money in the financial markets.

When you can't stand the ups and downs of the financial markets, reduce your risks by simplifying your portfolio. Decrease the percentages of stocks and bonds you hold and increase the amount of cash and cash equivalents. Two years ago, many investors might have 60%, 70% or more of their portfolios in stocks, 15% or 20% in bonds, and 0 to 10% in cash. Today, if you've developed a heightened appreciation for prudence and stability, put 30% or 20% or even less of your portfolio in stocks and much more in bonds and cash. If you really can't stand volatility, put everything in cash. The great advantage of this approach is that you have a comparatively easy time figuring out what your risks are, and you can easily adjust your risk levels to whatever you're comfortable with. The costs of this approach can be modest, especially if you use low cost index funds.

Keep things simple. There's no need to follow the smart money. The smart money brought us the current financial and economic mess. Investors who think for themselves are the most likely to do well.

Stock Market Basics

For readers who are just starting out in the world of saving and investing, here are the basics of the U.S. stock and bond markets. (The financial markets of other nations can be quite different, so research them separately.) There’s much more to learn if you want to become an active investor. But you can get an idea of the concepts here.

1. The corporation is an organization. It sells pieces of itself, called “stock,” in order to raise money to conduct business. (In other words, it takes money to make money, for corporations as well as people.) People who buy stock become owners (collectively with all the other stockholders) of the corporation.

2. Stock. When you buy a share of stock, you own a tiny portion of the corporation. The stock will increase in value if the corporation does well, and it will decrease in value if the corporation does poorly. Many people refer to stock as “shares” (as in shares of stock). If you want to invest in a particular stock, research it carefully.

3. Bonds. A bond is a way that corporations and governments borrow money. An investor lends them a fixed amount of money (e.g., $10,000), which is called the “principal.” They pay interest on the bond for a stated amount of time (e.g., 10 years), and then, if all goes well, they repay the principal (i.e., the money originally invested in the bond). Corporate bonds have “credit risk,” meaning the risk that the corporation might be unable to pay them. Government bonds are less likely to have this problem if they are issued by the governments of wealthy nations. But government bonds of less well-off nations can have significant credit risk. The riskier a bond, the higher the interest rate it will have. Be careful investing in bonds that offer a high return—the return reflects a higher risk that you won’t be repaid.

4. Mutual Funds. Mutual funds are a type of corporation used for investment purposes. Their business consists of investing in stocks and/or bonds. When you invest in a mutual fund, you are buying shares of the mutual fund. That gives you an interest in the fund’s holdings of stocks and/or bonds. The value of your mutual fund shares is based on the values of the fund’s holdings of stocks and/or bonds, and will increase or decrease as they increase or decrease in value. Most mutual fund shares are bought or sold at prices based on the values of their holdings of stocks and/or bonds at the close of the financial markets for the day. You usually buy or sell mutual fund shares by directly contacting the company that manages the fund.

Mutual funds can be index funds or actively managed funds. Index funds invest in a way that copies, or mimics, a financial market index, like the Standard & Poor’s 500 or the Nasdaq 100. Index funds have low costs and fees because they don’t have to pay professional money managers to strategize for them. Actively managed funds hire professional money managers to select stocks and/or bonds for them to invest in. These funds have higher costs and fees, because the professionals have to be paid to do the investment strategizing. Some actively managed funds are quite successful. But most do no better, or even worse, than index funds. An investor who is just starting out has relatively little, or nothing, to gain by investing in an actively managed mutual fund,

An exchange traded fund (ETF) is a special kind of mutual fund that can be bought or sold during the hours the stock market is open, at a price that normally reflects the most recent prices for its holdings of stocks and/or bonds. ETFs are bought or sold through stockbrokers.

5. The stock market and bond market are the principal financial markets for investors. They are open for normal trading from 9:30 a.m. to 4:00 p.m., East Coast Time. You can buy or sell stocks, bonds or exchange traded funds during these times. It is possible to buy or sell some U.S. stocks and bonds in other markets at other times. But the prices you get may be less favorable.

6. Stockbrokers are people and firms that serve as intermediaries in the process of buying and selling stocks. You can’t personally call or e-mail a stock market to buy or sell. You have to go through a stockbroker. (However, you can directly invest in or sell mutual funds--except ETFs--by contacting the company that manages the fund.) Stockbrokers charge commissions and/or other fees for their services.

7. Risks. You’ll probably have very little trouble getting information about the potential rewards offered by investments. You’ll probably have a harder time getting information about the risks (because people selling you investments tend not to emphasize their bad points). However, risk and reward walk hand-in-hand down Wall Street. The greater the potential reward, the greater the risk of loss. If you’re getting a glowing story about how great an investment is, but very little detail about the risk of loss, you will be at an informational disadvantage. You might be tempted to invest because you don’t know how bad the investment could be. Go back to cigarette ads from the early 1960’s. They’ll tell you that it’s enjoyable and sophisticated to smoke. But they’re rather short on information about heart disease, cancer and emphysema. Makes it tempting to light up—and that’s the idea. Make sure you know how an investment can go wrong before investing.

8. Investment Strategies. There are about eight and one-half zillion investment strategies. The large majority of them are (a) inconsequential (i.e., they won’t give you much of an advantage, or any, in the long term), (b) expensive (i.e., they require you to buy and sell investments often, which means large transaction costs that can significantly reduce your returns), (c) bunk (i.e., stupid, also referred to as dumb), or (d) fraudulent (i.e., a way to steal your money). Are there investment strategies that will prove superior in the future? Possibly, but you’ll have a hard time separating them from (a) through (d) above. Most professional money managers do not get returns higher than the stock markets as a whole and some do worse. That’s why investing for a return around stock market averages is a rational strategy. In general, most investors should stick to a simple strategy of investing on a diversified basis for the long term. See our recent blog on why the investor who does average is likely to do well. http://blogger.uncleleosden.com/2007/06/why-average-investor-does-well.html.


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