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Subject:  Portfolio Strategy in a Global Down Draft Date:  9/14/2008  8:20 PM
Author:  WatchingTheHerd Number:  251847 of 504761

(also posted at: )

The number and size of the recent failures in the financial industry (from Bear Stearns, IndyMac, Fannie and Freddie and now, apparently, Lehman Brothers and Merrill Lynch) are causing millions of investors to review their investments and try to find a way to protect their assets from future turmoil and losses. A lot of the thinking likely began during the first credit freeze-up in August of 2007 but the worldwide nature of the problem requires rethinking many truisms of portfolio management that might have been useful in the past but may have limited value in the current situation.

A Triangle Model of Investments

Traditional strategies for investing are based upon long-observed patterns of performance with assets in three key categories. Each category can exhibit movement (and hence, provide opportunity for making / losing money) independently of what happens in the others but they also frequently move in patterns related to each other which have encouraged certain strategies by investors based upon their goals (growth versus safety) and horizon (long term versus near term).

Stocks -- Investments in stocks are based upon obtaining mid- to long-term gains in the price of the stocks based upon long term growth in a company's earnings or based upon speculation of short-term mistakes in other investors' current valuation of the company. The truism with stocks is that over a long term period (NOT just one or two business cycles), a well-diversified portfolio managed to proactively cull out losers will outperform virtually any other category of investment. Another truism is that stocks should be avoided by investors with capital preservation goals over a short time horizon, especially when economic growth slows or declines outright since slow/no growth cuts earnings and drives stock prices down.

Bonds -- Investments in bonds produce profit directly for the bondholder by interest paid back to the bondholder by the issuer at maturity. Because the actual value of promises of future, fixed payments of principle and interest are DIRECTLY dependent upon changes in real (or imagined) interest rates, the price of bonds at any given moment not only reflect the credit worthiness of the borrower but reflect larger estimates of changes in interest rates over the life of the bonds. One key truism with bonds is that accurately rated bonds pose significantly less risk over short periods than stocks and are therefore a more suitable investment vehicle for investors with short term horizons whose tolerance for risk is lower than those investing with a 15-20 year horizon.

Commodities -- Commodities act as the raw materials to higher level products and services and provide two avenues by which investors can profit. By their nature, many commodities such as wheat, rice, pork bellies, oil, natural gas, etc. can have regular, seasonal fluctuations in their supply, demand or both, requiring producers and consumers to constantly make bets on those numbers and their impact on their ability to fill next week's orders of widgets. This short term speculation is virtually required in a modern economy and has profit potential for those with nerves of steel. Because of commodities' perceived role as required inputs for an economy (albeit with some seasonal fluctuation), investors often use commodity investments as a hedge against currency concerns. The idea behind this is that no matter what a government may do to devalue its currency through monetary policy, a barrel of oil or a bushel of wheat is "worth" what we get out of a barrel of oil or bushel of wheat and therefore, in theory, if a currency declines in value by half, any commodity position denominated in that currency will double, protecting the investment. The key truism for commodities is that overall demand for commodities may fluctuate week to week or month to month but is predictable and steady over many months / years. In other words, demand for commodities is nearly independent of the long term performance of one or both of the other investment categories.

Trade-offs In the Triangle

Much of the established wisdom of portfolio management for individuals and institutions revolves around correctly understanding why each of these corners of the triangle traditionally behaves the way it does and how problems with one corner affect the other two. For example,

1) fears in the stock market will lead many short-term investors to shift funds to lower-yield but higher-safety bonds, raising prices in the bond market, lowering interest rates
2) fears of weak economic growth or actual reductions in economic output often lead the Federal Reserve to lower interest rates to reduce the cost of borrowing to spur the economy, raising bond prices
3) signs of stable earnings growth increase valuations on stocks, attracting more investors into stocks and lowering demand for bonds, reducing their price and causing borrowers who DO need to borrow money to pay higher interest rates to attract lenders
4) volatility in credit markets combined with weak growth or losses in equities can trigger increases in commodities prices as investors assume steady demand for commodities will protect against currency declines result