Defensive Investing

"The best offense is a good defense" 

In my opinion, the old adage applies to investing as well. 

Why is defense so important?  Because investors can only spend compounded returns, not average returns.  Average returns are meaningless.  Most investors do not fully appreciate the implications.  For example, according to Crestmont Research, while the Dow Jones Industrial Average averaged 7.3% return per year from 1900-2005, excluding dividends, the compounded annual return has averaged only 4.9%, almost one-third less.  The reason is that compounded returns are adversely affected by negative years and the volatility of those returns.  I will have much more to say on this topic in the sections below.

This hypothetical chart illustrates the difference between average returns and compounded returns for investors.  Simple annual returns can be calculated, in this example, by adding or subtracting each year's return and dividing by the total number of years.  Compounded returns, on the other hand, take into consideration that, in reality, you may have more or less money to grow at the beginning of each year depending on the prior year's performance.  By comparing the average with the compounded returns for hypothetical Investors A, B and C, you can see in how negative returns and the volatility of returns can impact a portfolio.  This may devastate the actual returns realized by investors.  Investor C is accumulating retirement assets at less than half the rate as Investor A even through the average returns are identical.

Any one who lost a considerable amount of money in the 2000-2002 bear market would appreciate this point.  Many of those portfolios are just getting back to breakeven or showing only modest gains after all these years.  A pro-active defensive investment strategy to try to minimize losses during that bear market might have been extremely valuable. 

Because negative returns generally have an adverse impact on the achievement of a client's long-term financial goals, I have made it a priority to try to minimize losses in the pursuit of gains.  I employ a Defensive Investing^TM approach to help clients grow and protect their retirement assets.  The goal of Defensive Investing^TM is to make money and keep it!   I attempt to combine solid offensive and defensive investment strategies to capture gains in rising markets and to preserve those gains when markets decline.  Although there are no guarantees, I believe that key to long-term financial success may depend more on the skillful management of investment risk than on trying to maximize gains.  The section below on "Why Try to Minimize Investment Losses?" powerfully illustrates that point.

To implement the Defensive Investing^TM approach I employ a mix of Asset Allocation strategies, Absolute Return strategies and Guaranteed Return strategies depending on the client's goals, needs, and tolerance for risk.  For more information on these approaches, click on Primary Investment Strategies.

The emphasis on risk management also is a result of the observation that we may have entered into a secular (long-term) bear market when the market peaked in March 2000.  Secular bull markets (upward trends) and secular bear markets (downward or sideways trends) occur regularly in stock market history.  During such bear market trends stock prices generally move sideways with great volatility for an extended number of years, usually a decade or more, and end up making only modest gains.  Historically, secular bear markets do not preclude periods of strong stock market rallies, such as the recent gain from 2003 to present.  However, they also include periods of substantial market declines, such as from 2000-2002.  Usually there are multiple up and down cycles within a long-term secular trend.  See Long-Term Market Outlook and Stock Market Headwinds   Investors accumulating assets for retirement or retiring during  a secular bear market face an especially daunting challenge of managing their money wisely.   

 
1.  Simple Math.  First is the simple math.  Losses, on a percentage basis, have a much greater proportionate effect on portfolio values, than do gains.   What goes down requires more to come back up!

How much of a gain and and how many years would it take to recover the original investment?  The answer as show in the table is that it would take a 45% return in year five to get back to breakeven, 21% per year for two years, 13% per year for three years, etc.  Keep in mind that these gains are just to get the portfolio back to even, not to make up for any planned returns that are needed for retirement.

For example, if the client’s initial withdrawal rate is 4% and he experienced a portfolio loss of 20% in one year, then the portfolio would have to grow a total of 42% over the next three years to get back on track.  In this example, not only does the client need to recover market losses, but also needs to recover the planned growth in the portfolio.  With that dynamic in mind, back-to-back years of market losses may make it almost impossible to ever recover, and a permanent adjustment in lifestyle and retirement spending may be necessary.

If the market declines in the first few years of retirement, the portfolio will run out of money by year 19.  But if the returns are reversed – that is, the positive years occur at the beginning of the retirement and the negative returns at the end – substantial assets still remain after 30 years.  It is interesting to note that the 30-year annualized return is the same in both scenarios. 

For example, assume a retiree age 65 has a $1,000,000 portfolio and requires $50,000, or an initial 5% withdrawal rate, adjusted for inflation at 4%, to maintain a certain lifestyle.  At the beginning of year one he withdraws $50,000, at the beginning of year two $52,000, at the beginning of year three $54,080, and so forth.  However, due to unfavorable market conditions, the portfolio value drops in year one and again in year two.  The ending value of his retirement portfolio in year two is $676,000.  The withdrawal of $54,080 at the beginning of year three would represent a “then-current” withdrawal rate of 8%.  Such a high withdrawal rate may significantly shorten the life of his portfolio and put his entire retirement in jeopardy. 

• For one, market volatility may be turned into an advantage with the proper investment strategies. 
• For another, alternative or non-traditional investments may thrive in bear markets. 
• Moreover, different strategies may be used or emphasized at different times. 
• And finally, history shows that secular bear markets generally include a series of strong stock market rallies.  As a result, substantial gains may be realized.

Secondly, the reported budget deficit ignores the cost of promised future obligations, like entitlement spending.  Politicians knowingly run up the Federal “credit card” with “off balance sheet” promises that future generations will never be able to keep.  There is no fiscal discipline by either party.  

The consequences of such budgetary deception may restrict the government's flexibility to generate  new spending programs, cut taxes, and lower interest rates in order to stimulate the economy during the next recession.  As a result, the next recession, or the one after that, could be more prolonged and deeper than necessary and affect the markets accordingly.  

According to an article written by The Concord Coalition, " A Fiscal Wake Up Call", "Our nation is about to undergo an unprecedented demographic transformation - with no idea of how to pay for it.  The coming age wave is not a temporary challenge that will recede once the baby boom generation passes away.  The boomers' retirement is ushering in a permanent transformation to an older population - and a permanent rise in the cost of programs such as Social Security, Medicare and Medicaid, which already comprise 42 percent of the federal government spending."

"It may seem that there is no immediate crisis, yet a broad bipartisan consensus exists that current fiscal policy is on an unsustainable path.  No one can say exactly when a crisis will hit, but by the time it does we will have likely burdened the economy with a debilitating amount of debt; leaving painful benefit cuts and steep tax increases as the only solutions.  Doing nothing to avoid such a gut-wrenching outcome, knowing full well that it could occur, would be an act of fiscal and generational irresponsibility".  Click on the following link if you are interested in reading the complete article http://www.concordcoalition.org/events/fiscal-wake-up/fiscal-wake-up-call.htm

A recent study by economist Lawrence Kotlikoff shows that the U.S. is responsible for $80 trillion in future entitlement promises, which is a figure six times larger than the U.S. economy.  To make good on those promises, future workers would have to pay tax rates ranging from 55% to 80% of their incomes!  David Walker, the Comptroller General of the U.S., remarked recently that the current fiscal policy is unsustainable. 

Record Trade Deficit.  The record high trade deficit is due to consumer spending on foreign-made goods, many of which are not made in the U.S. anymore, and on imported oil for which there is no viable substitute.  As a result, there appears to be no practicable way to reduce the defects without economic disruption.  Historically, such imbalances were resolved through currency devaluation.  If the dollar were to decline substantially, that could create inflation, higher interest rates, a world-wide recession and a host of other problems.  Such ramifications would certainly adversely impact the financial markets.  Rising interest rates are the single biggest influence that depress stock prices.  

Record Current Account Deficit. Record current account deficit which takes into account the trade in goods (the trade deficit) and trade in services (the money flow from investments).  In 2006 for the first time in many decades, foreigners earned more interest from their U.S. investments than the U.S. investors earned on foreign investments.  When foreigners buy American assets (such as Treasury securities, government agency and corporate bonds, stocks, real estate), the U.S. loses not only those valuable assets but also the future income from those assets.  That means more and more interest and dividends are being paid to foreign owners and not recycled in the U.S. for productive purposes.  With the huge need to borrow from abroad to support our public and private spending habits, the trend seems to be overwhelming and irreversible.  The fastest-growing expense of the federal government is the ballooning cost of interest, a large part of which goes to foreign owners.

Potential Dollar Crisis.  A potential dollar crisis could be the result of the massive foreign borrowing to finance our Federal budget and trade deficits.  Foreign central banks now own about 50% of all outstanding U.S. Treasury securities which gives them great power to potentially influence the U.S. economy.

Record Consumer Debt.  Record high consumer credit card and mortgage debt has resulted in a negative consumer savings rate, last seen during the Depression Era.  How durable is economic prosperity if it relies on borrowing beyond our ability to save?  Are the foundations of wealth now built on payment affordability and cash-flow management rather than on savings and investing?

Dependence on Foreign Lending.  There is a growing dependence on unreliable foreign central banks, such as China, to finance our public and private debt.  Such foreign financing has kept U.S. interest rates artificially low which has stimulated greater borrowing and spending.  The concern is that such central banks have their own domestic and political agendas that may not always be compatible with U.S. interests in the future.

High Oil Prices.  The high cost of oil and the geopolitical uncertainties with major producers in the Middle East and Venezuela makes the U.S. economy vulnerable.  There is a massive transfer of wealth from the West in the form of perto-dollars to countries that are influenced by growing anti-American sentiments. 

Housing Price Decline.  Consumers have been using their homes as an ATM machines, pumping billions of dollars into the economy beyond their income through mortgage equity extractions.  A decline or slowdown in home price appreciation will likely slow these equity withdrawals and consumer spending in return.  A recent study by Merrill Lynch indicated that the housing industry and all of its related activities have accounted 50% of the economic growth in the current cyclical expansion. 

Globalization.  The emergence of the internet and of a low-cost global labor markets in manufacturing and services sends employment overseas, keeps downward pressure on domestic wages and salaries, and affects our future standard of living.  U.S. businesses that want to expand their operations, expand overseas.  America is losing good-paying manufacturing and service industry jobs that have been the backbone of our middle class.  

In addition, our educational system is failing to produce high quality graduates that can compete with their global counterparts.  Comparisons of academic competence usually show American students scoring surprisingly low and falling further behind other countries.  Businesses can hire high quality brainpower elsewhere in the world at a fraction of the salary and benefit costs of a U.S. worker.  The trend towards low-cost global labor markets is irreversible. 

Derivatives.  One of the big unknown risks is that of the derivatives market.  The magnitude of this arcane market is astounding.  Derivative holdings (many of whose transactions are still not properly accounted for) recently had a notional value that was six times the size of world gross domestic product.  Many of these securities have not been around long enough to have been tested in a market crisis, so there is no assurance what would happen.  

Geopolitical Issues 

Geopolitically, the risks to the world are the greatest since the height of the Cold War.  Here are some of issues:

War on Terror.  The War on Terror, which it is euphemistically called so as not to offend anyone, is really a war against Islamic extremists bent on the destruction of the U.S. and Western civilization and imposition of their autocratic rule and intolerant ideology.  To consider it otherwise is dangerous and naive.  It is a conflict with no precedent in modern history.  Most political leaders and the media in the western world lack the courage to acknowledge the obvious and to confront the mortal danger that it represents.   Misguided notions of tolerance, diversity, moral relativism, political correctness, and the fear of reprisal have replaced common sense analysis and moral certitude. 

Islamic extremist have taken advantage of the civil liberties in western democracies to set up radical groups at universities and prisions, and to establlish radical mosques in an effort to recruit followers and develop anti-western hatred and fervor.  These efforts are funded primarily by the enormous wealth of petro-dollars from Saudia Arabia.  This is clearly seen all over Europe and is happening in the U.S. as well.  The West which prizes civil liberty and religious freedom has no countermeasures to confront this insidious threat because it is religious-based.  Many experts believe that it may be only a matter of time that these groups obtain nuclear, radiological, biological or chemical weapons and threaten the country from within.

Radical Islamists see the world and events as divided not between "good" and "evil", or "right" and "wrong".  Those are western notions.  Radical Islamists see the world divided solely between "believers" and "nonbelievers", and they will use whatever means, however horrific, to justify the spread and insure the domination of Islam. 

Particularly disheartening are the silence voices and lack of protest and outrage by the vast majority of Muslims in the US and around the world against the ruthless, barbaric atrocities carried out in the name of their religion.  Where are the voices of the moderate Muslims?  I can only interpret that their silence is a result of intimidation or acquiescence.  Neither of which bodes well.

Iran Nuclear Threat.  The antagonistic and confrontational leader of Iran has stated that he believes it is his calling to destroy Israel and bring about an Armageddon to resurrect the Islamic Caliphate.  It is also obvious that the development of Iranian nuclear technology for peaceful purposes is a ruse to acquire nuclear weapons which may be use in this war to end the world as we know it.  

Iranian Domination of the Persian Gulf. The growing threat of Iranian domination throughout the vital Persian Golf region and throughout the Middle East, and the resultant instability of neighboring countries.

Iraq.  The deteriorating military and political situation in Iraq with the potential of Iraq becoming a dangerous totalitarian Islamic state with access to the vast oil wealth and the enormous influence and power that wealth will buy.

Spread of Nuclear Technology.  The spread of nuclear and biochemical technology to fanatical groups hostile to the West by North Korea, Iran and others.

Pakistan. The precarious position of Pakistan which could easily become an Islamic nuclear state if the leadership should change suddenly.

Anti-Americanism.  The growing anti-Americanism around the world and the deliberate efforts of Russia, China, France, Venezuela and others to keep America on the defensive and diminish its influence in the world.

Corrupt United Nations.  A corrupt, incompetent, and totally impotent United Nations which is unable to deal with any global security issues.

Illegal Immigration.  The massive illegal immigration into the United States and the balkanization of American society.  The vast majority of illegal immigrants are poor, uneducated, and unskilled with the potential of creating a permanent underclass and putting a severe strain on social support services.  From an economic and societal point-of-view, this immense wave of illegal immigration is an unprecedented social experiment with unknown consequences that will to burden society with escalating costs, and lead to a deterioration in the quality of social support, educational, and health care services for everyone.

In Summary

Many of these trends have no historical precedent and others have very deep historical roots.  In any case, there appears to be no clear, easy, or quick answers.  How these issues will play out over the next 10-30 years is completely uncertain.  However, there is one thing that is certain: Baby Boomers will be right in the middle of their retirement when all of these concerns need to be handled. 

Optimistically, over the near-term, these economic and geopolitical trends may continue without causing too much disruption.  Many have gone on for a long time without disrupting the economy and the markets, and perhaps they can continue to do so.  However, economically, I believe that the U.S. cannot continue to borrow and spend its way into economic prosperity.  Geopolitically, I believe the resolution or lack of resolution of these issues will have a profound effect on world history. 

As a result, I believe that we have entered a period of time of unknown duration; one that will be characterized by increasing economic, financial and political uncertainty, and this will have a profound affect on the financial markets for the foreseeable future.  Furthermore, I believe that these issues and the attendant risks will affect the Baby Boomer generation throughout their entire retirement. 

I believe that the common financial disclosure you see that “Past performance is not a guarantee of future results”, means just that.  We can look to the past for guidance as to how financial markets behaved under certain circumstances, but considering the uniqueness and gravity of the issues discussed above, we cannot bet our entire financial future that market behavior will be similar going forward.  We have to spread our financial bets among different investments and different investment strategies to increase our chances of a successful outcome.  Furthermore, I believe it is foolish not to take these issues into consideration when planning for retirement.  I believe that a good “defense” will be as important, if not more important, than a good “offense” in assuring and enjoying a successful retirement.

The opinions expressed in this commentary are my alone and do not represent the views or opinions of ASC or APIA.

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Primary Investment Strategies

Diversification is a fundamental concept of investing.  Because markets are unpredictable it is important to invest in a variety of asset classes, such as U.S. and international stocks and bonds, in an effort to spread your risks and spread your opportunities to capture gains as they occur across many different markets. 

During any given time, some investments may thrive, while others may languish or decline.  At other times, some investments may be out of step with the current economic environment while others may experience their heyday.  By diversifying, you give yourself exposure to all types of profit opportunities, and you spread your risk of having too much of your portfolio concentrated in the wrong investment at the wrong time.

I take the concept of diversification one step further.  I believe it is just as important to diversify among different types of investment strategies in addition to diversifying among different types of asset classes.  As it is true with different types of investments, some strategies may thrive while others languish at times.  Although there are no guarantees, some strategies work better in certain economic and market environments than others.

I view investment strategies in three broad categories: 

• Asset Allocation,
• Absolute Return Investing, and
• Guaranteed Return Investing. 

I use all three strategies to some degree and may vary my recommendations based on each client's unique needs, goals, assets and risk tolerance.

Asset Allocation  is my core investment approach.  I implement the strategy using a diversified mix of U.S. and international stocks and bonds, and cash.  The goal of asset allocation is to provide the greatest potential long-term return for a given level of risk.

MFS Investment Management has produced a very informative chart showing the annual returns for various asset classes for each of the last 20 years and ranks them in terms of best to worst performance.  Click to view A Case for Asset Allocation Diversification. 

"Everyone wants to be in the best-performing asset class every year.  The thing is, few people are savvy enough to choose the best consistently.  That's why diversification is the key.  This chart shows annual returns for five broad-based equity classes, bonds, cash, and a diversified portfolio, rank from best to worst.  Notice how the "Leadership" changes.

The allocation or mix of stock and bonds may be remain static, commonly referred to as strategic allocation, or the mix may be varied and adjusted periodically, commonly referred to as tactical asset allocation.  I recommend both strategic and tactical asset allocation approaches and use a select list of professional money managers and mutual funds to implement the strategies.

Absolute Return Investing usually include hedging techniques and non-traditional investments.  The goal of absolute return investing is to generate positive returns, regardless of market conditions.   The appeal of Absolute Return investing is the potential to produce positive returns in declining markets.  It has grown in popularity over the last few years in response to the severe 2000-2002 bear market when most investors suffered considerable losses. 

There are a growing number of professional money managers who have adopted the Absolute Return Investing approach.  These manages may use a variety of investment techniques.  Most employ hedging techniques, such as the use of options and futures contracts, and leverage.  These techniques may be used in include long/short strategies, market neutral strategies, and bear market strategies.  Until recently, these types of hedging techniques were available only to wealthy investors and institutional investors such as pension funds and endowments.  Now they are available to almost all investors.  

In addition, these managers may use non-traditional or alternative investments such as global real estate, commodities, precious metals, specialized global stock and bond market investments, and foreign currencies.  Most employ a very flexible approach to portfolio management in response to changing investment risks and market conditions.   Some may carry a large cash position if attractive investment opportunities are scarce.

Recently, in a welcomed development, many Asset Allocation money managers have begun to incorporate some of the non-traditional investments and strategies of Absolute Return investing, thereby blending the strengths of both approaches. 

Rydex Investments has produced an excellent chart similar to the one above.  It includes not only the performance of traditional asset classes such as stocks, bonds and cash, but also the more specialized asset classes of Absolute Return investing, which include alternative investments and hedging strategies.  Click to view Modern Markets Scorecard.  Adding a few specialized asset classed or strategies to a portfolio can potentially help to smooth out the markets' ups and downs over time.

The traditional Asset Allocation approach usually stays fully-invested in a diversified portfolio of stocks and bonds in an attempt to capture gains and reduce risk and and rides the markets ups and downs.  Performance relies primarily on long-term financial market returns.  The Absolute Return approach is much more actively managed.  Performance relies mostly on the manager's skill in adapting to changing market conditions.  The traditional Asset Allocation approach makes money only when the markets go up.  Absolute Return investing may make money in both rising and declining markets.   

Guaranteed Return Investing is a term I coined to describe this strategy.  It has grown in popularity recently because of the financial peace-of-mind I believe it provides, especially for investors who are accumulating assets for retirement and want to provide a high level of predictable lifetime income.  Please click here for a detailed explanation from one of the leading companies in the industry.   

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