Wednesday, April 29, 2009

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.

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