Attempting to predict what the future will bring has always been an exercise filled with guestimates, what-ifs, and loads of confusion. Throw in the “Fiscal Cliff” and the future becomes so cloudy and convoluted that mere confusion would be a blessing compared to the virtual paralysis that is overtaking the masses of investors these days. The dramatic question marks surrounding tax rates, governmental spending, entitlements, inflation, deflation, and the future of the global economy are enough to cause even the most seasoned investors to second guess themselves.
The one thing that I think everyone can agree upon is that there is simply no way for us to continue on our current path for much longer. Adding trillion dollar annual deficits to a government debt load that already exceeds our aggregate annual GDP is unsustainable to say the least. Allowing entitlement spending to grow out of control without making any meaningful steps to address the issue is borderline ludicrous. Turning the calendar over to 2013 without making any strides toward productive tax reform is downright foolhardy. And yet, this is the world that we live in today.
The easy thing to do is to bury our collective heads in the sand and wait until the dust settles in a couple years to see how everything shakes out. The problem with that tact is that while doing nothing may be okay in Washington, the rest of us must still wake up each day, interact with the world around us, and make decisions that will shape all of our tomorrows.
Let me be clear – doing nothing is making a decision, a decision to allow the current prevailing winds to determine how you’re able to live out your remaining days. Do nothing and you passively place your financial fate in the hands of other parties that most likely don’t have your best interest at heart.
So with all of the unknowns piling up around us and the future for the economy and the US Dollar in jeopardy, this is precisely the time that we need to take action. So how does a prudent investor proceed from here? The answer is actually quite simple… we must all revisit the most basic of financial planning concepts – DIVERSIFICATION! Shocking as it may seem, true diversification is really the best and only real tool to protect your financial future from all of the ills that are seemingly omnipresent today.
If a portfolio is truly diversified, the ebb and flow of individual market segments and sectors will work to balance one another out over time, leaving the most important aspect of your wealth protected. That aspect that we at South Coast are so concerned about protecting is Purchasing Power. Nominal prices of goods and services move up and down, as do valuations of hard assets, equities and fixed income securities. The goal of a well-diversified portfolio is to ensure that as these nominal prices fluctuate, our real purchasing power is not negatively impacted.
As we all know, inflation tends to raise price levels of the goods and services that we purchase day in and day out, and also generally speaking increases the nominal values of hard assets – real estate, commodities, precious metals, ect. On the other hand, deflation tends to lower price levels as a result of economic contraction. As the economy slows, hard asset values may fall, leaving us with less nominal wealth.
Given that these two concepts sits on opposites ends of the economic spectrum, how is it that we can plan for both? You guessed it, diversify, diversify, and diversify some more.
South Coast feels that there are six basic asset classes that should be represented in a well-diversified portfolio. Let’s look at each of these sectors as they related to inflation, deflation and prudent portfolio architecture.
Cash & Short Term Securities
As of today, the US Dollar continues to be the globes main method of exchange for transactions large and small. Until the day comes that that fact changes, cash is still king. Cash and other short term securities are an extremely important component to protect an investor’s well-being. We all must ensure that we keep an adequate stock of cash on hand to cover our basic living expenses in the event that our income sources are impaired for a period of time. Inflation will undermine the purchasing power of your cash, deflation will strengthen it, and whether you like it or not having enough of a cash safety net on hand or close by is an absolute necessity.
Investment Real Estate
Real Estate and other hard assets are widely viewed as viable hedges against inflation. I would like to also point out that there are certain types of real estate that can have a positive impact on your purchasing power during deflationary spells as well. During economic contractions, real estate subject to high leverage and/or short-term leases may face reduced operating margins as revenues decline. Conversely, real estate that is either leveraged only modestly or purchased all cash with long-term leases to credit worthy tenants may provide a steadying factor during tough economic times. While rental rates in apartments and self-storage may decline during these periods, the long-term leases that are common to single tenant, free-standing properties will help ensure that a portion of your real estate related income remains in place.
Equities play an important role in portfolio creation because of their liquid nature. They can provide flexibility to an investor. Investors should allocate a portion of their portfolio to tactical equity strategies that are designed to constantly analyze risk versus potential reward to determine whether exposure to certain sectors makes sense at a given time. During inflationary periods, nominal values of equities typically rise and conversely they fall during recessionary periods. If a tactical strategy is managed correctly, the exposure to equities can be either increased or decreased depending on the near-term outlook for the markets and the overall economy. One additional benefit to equity ownership is the ability to hedge against dollar losses with investments in non-dollar denominated stocks.
The Fixed Income markets have long been a mainstay of balanced portfolios. Today, many pundits challenge the validity of owning fixed income given the nature of interest rates and the likelihood that they will rise at some point in the future, depressing the value of longer dated maturities. During tough economic times, fixed income securities may become more valuable relative to their equity counterparts so abandoning fixed income outright may be a considerable misstep. Consider using debt securities that that utilize both fixed and floating interest rates as well as both public (traded) and private (non-trade) debt in your fixed income portfolio. If (when) interest rates rise, the floating rate loans will see an increase in the nominal interest rate charged to the borrower. If, on the other hand, bond yields decline on new issuances, the fixed rate debt will become more valuable and will protect a portion of your income stream.
Similar to my comments about real estate, commodity investments should play a role in building a well balanced portfolio specifically because of their natural ability to hedge against devaluation of the dollar. It is important to note that there are a variety of factors that play into the various markets for commodities, so it’s best to seek guidance from a professional before entering this arena. During deflationary periods, commodities may face downside pressure in their pricing so it is recommended to acquire investments in commodities without the use of leverage. By investing in commodities through liquid tools like mutual funds and ETFs, investors can utilize a variety of trading strategies to limit losses during downturns. Please consult with a professional for more information about those strategies.
Gold, silver, platinum, copper, and a whole host of other precious metals are yet another sector that may help to balance out a truly diversified portfolio. Not only can these potentially provide an inflation hedge but they may even work as a medium for exchange if circumstances become increasingly dire on the home front. Be sure to consider both tangible ownership of the metals as well as ownership in liquid formats like an ETF. This will give you the peace of mind of having the tangible metal in hand and also the flexibility to buy and sell the metals freely on the open markets.
Weightings should reflect YOUR needs
Diversification is the key to taking a proactive approach to protecting your future purchasing power however each portfolio must be unique to complement that individual investor’s needs and goals. Some of the portfolio components I mentioned may not have a fit in your portfolio and others like cash or fixed income may need to play a larger or smaller role to satisfy your tolerance for risk and need for return.
Future is NOW
I’d love to think that our elected officials will successfully work together to create a finite plan to solve some of the numerous headwinds that we currently face here in the US and across the globe. Unfortunately I’m not optimistic for any meaningful solution to completely put us back on the path to prosperity in the near term. Until then, please shake of the paralyzing fear of these unknowns and make the decision for yourself to build balance back into your portfolio so that you can sleep a little easier no matter what the future will bring.