Twelve months ago, not many people expected 2008 to end in an economic downturn so severe that it would take many of the great 20th century financial institutions with it. Most of us had a basic understanding that a bubble was forming in the housing market, fueled by low interest rates and other pro-growth fiscal and monetary policies. However, the high level of risk within the financial sector was difficult for most investors to detect due to the inherent complexity of securitized assets. Like many things in life which seem too good to be true, people focus on the benefits without giving adequate consideration to the risks. Why rock the boat, right? Well, as the financial bubble continues to burst and scandals like Bernie Madoff’s come to light, investors are realizing that due diligence is more important than ever. This applies not only in a broad sense as a wake-up call for Wall Street and its regulators, but in our personal financial lives. 2009 is a good time to re-evaluate investment objectives, investment assumptions, and liquidity needs. In today’s column I’d like to consider whether cherished portfolio strategies such as diversification, asset rebalancing, and dollar-cost averaging should remain as fundamental to our investment philosophy as they were a decade ago. I’d also like to review some of the 2009 retirement plan contribution limits. Even if your investment choices become more conservative this year, taking advantage of tax-deferred investment accounts can be important to your longer-term financial success.
Money managers and financial advisors often cheer a diverse portfolio as the best way to defend against market volatility and achieve long-term growth potential. As the theory goes, a well diversified portfolio will be less susceptible to single-sector volatility because when certain sectors move up, others tend to move down. Similar rules apply to a variety of asset classes including international vs. domestic stocks, small-cap vs. large-cap, and growth vs. value. While following these rules has arguably reduced the overall volatility in your portfolio in the past, it hasn’t saved you a dime of late. The correlations between various asset classes have seemingly disappeared over the past few months with most assets simply shedding value at this point. One could argue that mass liquidations and de-leveraging within the financial sector are to blame for some of the fire-sale pricing. There’s very little an investor can do to diversify away these sorts of risks and others associated with recession. When a lack of consumer confidence pervades markets, we generally see a broad and extended decline in asset prices. Treasuries would be the notable exception in this case. What we can use diversification for is to help protect our investment portfolios against company-specific risks. This might include the labor union issues which tend to flair in the auto sector, and litigation risk which can affect any firm at any time without warning.
Next we explore asset rebalancing, the practice of establishing and maintaining a target asset allocation. If one asset class in our portfolio is outperforming another, we’ll move money from the higher performing asset class into others, potentially shifting some profits into weaker performing investments. If we believe markets work in cycles, rebalancing will help us when the tide shifts to benefit the weaker asset classes. The downside to this strategy in the short-run is that larger allocations get made into investments which continue to struggle. If you’re automatically moving money into an asset class as it declines, you may be throwing good money after bad without realizing it. Concerned investors need to be exploring the reasons why certain asset classes are declining to determine whether further exposure is potentially profitable, or downright disastrous. Consider the high-yield bond market for a moment. While the stock market has clearly priced in a recession at this point, many high-yield bonds are priced for a depression. The corporate bond spread, which represents the extra yield investors demand to compensate for risk, is near depression era levels. If you believe corporate bond defaults in 2009 could possibly rival the amount seen in the 1930’s, you may be better off shedding this asset class from your portfolio outright. You can always add it back in when the volatility has reduced to normal levels.
Dollar-cost averaging, or the process of depositing money slowly into markets rather than in one lump sum, is arguably as important now as ever before. Because of the wild volatility we’ve been seeing, where stocks have moved as much as 10% up or down in a single session, investors should remain extra cautious about getting into an investment just prior to a major market move. This is why 401k investing and other automatic investment plans work well for most people. Rather than falling into emotional patterns of buying high and selling low, securities are purchased at random times and prices. Theories vary as to the effectiveness of dollar-cost averaging in the long-run, but many investors seem to like the idea of testing the waters, especially at a time of peaking volatility.*
Overall I’m not convinced the time has come to abandon these fundamental rules of investing. If we assume this recession will pass like the others before it, adapting a new, more conservative approach might only lock in your losses and prevent you from participating in the recovery to come. That being said, this recession revealed an unfortunate interconnectivity between physical real estate and financial markets. The practice of securitization, which was originally pitched as a diversification tool, has allowed even the risk-averse to feel blindsided and taken advantage of. Investors need to pay closer attention to risk exposure inside their portfolios going forward. Speaking to your advisors and evaluating your overall investment strategy and eventual needs for liquidity is a smart idea for early 2009. Consider whether the speculative investments in your portfolio still have the same upside potential as they did in 2006. Rethink the total return potential of owning growth stocks versus dividend-paying consumer staple stocks. People will still be purchasing tissues and toothpaste even when they decide against that second I-pod.
Contribution Limits for 2009
Regardless of how your risk tolerance may have changed over the past year, qualified retirement plans still offer a way for law firm employees to reduce taxable income and grow savings on a tax-deferred basis. Some firms may offer a 401k plan. If so, the elective deferral limit will jump by $1,000 this year to $16,500. If you’re over age 50, you can defer up to an extra $5,500, for a total of $22,000. The same limits would apply to a 403b plan if you work for a non-profit. If you are self-employed or work at a small or mid-sized firm you may have a SEP IRA, Solo 401k, or Profit-Sharing Plan available to you. The contribution limits for these defined contribution plans will rise to $49,000 in 2009, up from $46,000 in 2008. Defined-benefit (pension) plans generally allow much larger contributions but are more complicated to administer. Like the rest of the financial industry, many large retirement plans will see changes in the coming year related to increased transparency for investors. A lot of trust has been lost this year on Wall Street. A genuine effort to better regulate financial firms and keep them honest will go a long way towards rebuilding trust and ultimately, promoting the recovery of our economy.
Premier Financial Advisors, Inc
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Securities and certain investment advisory services offered through: First Allied Securities, Inc., a registered Broker/Dealer. Member: FINRA/SIPC. Premier Financial Advisors, Inc. is a Registered Investment Advisor. First Allied Securities & Premier Financial Advisors are not affiliated entities.
Dollar cost averaging does not assure a profit or protect against loss in declining markets. This program involves continuous investment in securities regardless of fluctuating price levels. Investors should consider their ability to continue their purchases through periods of low price levels.