A group of dour forecasters is proclaiming the end of the world. They use cataclysmic terms like “financial catastrophe,” “grand disconnect,” and “credit supernova” to warn of the impending peril.
But just how impending is it really? Will it happen during 2013? Most of the doomsayers think probably not, unless there is some sort of shock to the economy that finally spooks investors out of their Pollyannaism. Such an event could be a drop in U.S. GDP caused by the new tax increases, the failure of a European bank, a Mideast flare-up that spikes oil prices, or a U.S. recession.
Yes, another recession could happen. It seems we just emerged from the “Great Recession” (another of today’s irksome honorifics: the Weather Channel has even started naming winter storms. What’s next, “Rain Shower Penelope”?) but it’s technically been over for three and a half years. And today’s plodding “recovery” is such that, far from requiring a shock, a mere tremor could shake us over the brink.
Okay, if it’s not necessarily impending, then what is it? Well, let’s say “inevitable,” i.e., the investment effects of global deleveraging now underway will cause a “grand disconnect” and “financial disaster” within five years.
Whether a five-year time horizon equates to “impending” is up to you. But for my purposes, it doesn’t matter – when “disaster” and “supernova” are being thrown around, impending means before dinner. I’m not going to play around with my wealth by trying to find the sweet spot on a five-year calendar. That’s like trying to time a perfect exit from Chelyabinsk.
And I would gladly suffer a meteor strike’s broken windows and minor cuts than the destruction of my wealth. After the salvation of my family’s individual immortal souls, and their mortal safety, the preservation of my accumulated net worth is my greatest desire. It should be as high as number 3 on your list, too, especially as we advance towards financial disaster, no matter when or how it occurs.
You’re thinking: “This guy is no fun to read at all” – and I don’t blame you. I’d feel the same way. But I’ll make the same claim as a certain TV carnival barker who says he’s here to help you. If you don’t want to hear it, I understand, but the fact is that the future is bleak, at least if you’re expecting annual returns anywhere near 10% over the next few years.
Therefore, for the time being, don’t be an adherent of “risk on” (a detestable neologism). This doesn’t mean you should go 100% to cash. It just means you shouldn’t try to achieve historical annual returns (around 10% for stocks) by taking undue risk. Thus, you must lower your expectations for several years, which in turn will help you allocate your investments prudently.
An investor in the 20- to 40-year age group would ordinarily be advised to have 60% to 100% of a portfolio in stocks. Under the impending scenario, I would suggest risking only up to 25% in stocks and sticking the rest in the “preservation of capital” portfolio described below. People in this age group have time to recoup losses, but why risk losses on 75% of your investible funds?
For middle agers (age 40-60), a maximum of 15% should be allocated to equities.
And for retirees or anyone above 60, why on earth would they take any equity risk at all right now? To keep up with inflation? What inflation? All of their investible funds should be in a preservation-of-capital portfolio consisting of the following:
Short-Term Bonds
For all age groups I would allocate at least 70% of their preservation-of-capital portfolio to investment-grade (BBB or higher) short-term bonds.
I prefer: 1) corporate bonds, because higher yields are available compared to Treasurys; 2) short-term bonds, because I’ll have the opportunity to reinvest as rates rise from today’s depths; and 3) individual bonds, because bond mutual funds expose you to the “maturity uncertainty” of not knowing with certainty what the value of your principal will be at a future date.
There’s no maturity date for most bond funds, so they may be priced lower than your purchase price when you sell them. No such uncertainty applies to individual bonds, as long as you hold them to maturity. (Stay away from callable bonds – they can be confusing.)
Granted, buying and holding individual bonds can become a management hassle for some individual investors, so short-term funds are perfectly acceptable as an alternative.
Two of the best are the Vanguard Short-Term Investment-Grade Bond Fund (VFSTX), and Vanguard Intermediate-Term Investment Grade Bond Fund (VFICX), both of which come with Vanguard’s characteristic low fees.
For a Little More Yield
Within your preservation-of-capital portfolio, you can assign up to 30% to higher yielding (and thereby higher risk) fixed-income investments. Remember, this is not 30% of your entire portfolio; it’s 30% of the money that you haven’t allocated to stocks, which should be most of your total. Among the candidates for this segment are the DoubleLine Total Return Bond Fund (DLTNX) and the Stable High Yield model that I manage at Covestor.
DLTNX has a duration of just 2.23 years, meaning that if interest rates were to rise 1% the net asset value of the fund would theoretically fall just 2.23%. That’s not bad for a fund that yields close to 6%.
The Stable High Yield model seeks to produce a return that approximates the historical average annual return of the stock market, but with less volatility.
When Will It be Over?
So when will a more conventional asset-allocation recommendation, one that gives the green light to stock ownership, re-emerge? Only after we spend the unavoidable time in purgatory. We have to experience the looming financial disaster before the healing can begin.
But just as in caring for one’s immortal soul, which mandates that we be vigilant at all times, we know not the day nor the hour when the financial disaster will occur. It’s therefore imperative to preserve our capital and remain in a financial state of grace.
Disclosure: The author is long VFICX, VMLTX, DLTNX and the Stable High Yield model that he manages at Covestor.com.
The investments discussed are held in client accounts as of February 1, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.
