Euro chaos: The reason for strategic allocation

Here we go again. Greece is back in the headlines, and the future of the euro hangs in the balance. Unable to form a government and waiting for new elections, Greek citizens have started pulling large amounts of money out of banks, and fears of a run on their local banks have increased. Italian, Spanish and Portuguese bonds yields are spiking. France has embraced a socialist leader. The Euro Stoxx 50 index has dropped nearly 20 percent in the last eight weeks. In the infamous words of baseball legend Yogi Berra, “It’s like deja vu, all over again.”

Investors want to know whether this is an isolated crisis contained to Europe or whether it could spread globally.

That stock markets around the world have plunged may be due to mass profit-taking after a furious market rally from the market bottom of seven months ago. Conversely, the market drop could be attributed to a growing concern that other countries such as the United States could face a similar fate as the Greeks. Federal Reserve Chairman Ben Bernanke said last month: “It is very important to say that if no action were to be taken by the fiscal authorities, the size of the fiscal cliff is such that there is, I think, absolutely no chance that the Federal Reserve could or would have any ability whatsoever to offset that effect on the economy.”

Long-term investors need to take a step back and view the current events in perspective. This is not the first economic crisis, nor will it be the last, but eventually things tend to sort themselves out. In fact, many financial advisers would recommend that investors do absolutely nothing to their portfolios, hold tight and ride out the storm. They will produce all kinds of historical information about returns of various assets and the need to stay the course. They will say that their investment models not only produce efficient portfolios but that they accomplish that goal with limited risk and volatility. Sounds like the best of all worlds. Great returns and low volatility! So why don’t investors see this benefit in the monthly statements they receive? How does one define the time frame of “eventually things tend to sort themselves out”? After all, many major stockmarket indices haven’t budged in over a decade. How long are investors expected to be slaves to classic asset-allocation models before they realize that not only are they not making any money, but that all the promised stability never materialized? Maybe it’s time for a new approach that will add balance to their portfolios, potentially increase profits and leave behind the classic “buy and hold” asset-allocation model.

Strategic asset allocation
Classic asset allocation can be loosely defined as an investment strategy that aims to balance risk and reward by allocating a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon. The three main asset classes – equities, fixed income, and cash and equivalents – have different levels of risk and return, so each will behave differently over time. The downside to this strategy is that it doesn’t really change as markets do, and it provides little value added. It’s very static, and investors may suffer. It doesn’t take a rocket scientist to see that if the economic fundamentals in Western Europe are lousy, and there are all kinds of structural problems as well, why continue to invest there? That’s where strategic allocation comes into play. Investors can look at certain macro- or microeconomic data, country growth forecasts, stock valuations, etc. and decide whether an investment is appropriate at this time. It allows investors to actually think strategically to decide on the right investment mix based on the current climate, not based on models that use 100 years of data to determine investment policy (which has little relevance to current reality).

To illustrate this point, it used to be that allocation models would call from anywhere between 5%-10% of a portfolio to be held in cash. This was great when cash deposits actually paid 4%-6% interest. If you use a model based on 100 years of historical return, you would expect to get a 4%- 6% return on cash. Well, as we all know, investors today get virtually nothing on cash deposits. So by keeping up to 10% of your portfolio in cash, you are basically writing off any return for a significant part of the portfolio. We like to refer to that as “dead money.” Strategic allocation would take this into account, and a 2%-3% short-term bond or maybe a preferred stock would potentially be suggested instead as an alternative to cash.

The world is a dynamic place, and your portfolio should be smartly allocated. Investing strategically requires a more hands-on approach and may not be for all investors or advisers. Speak to your financial adviser to see if this strategy fits your investment profile.

aaron@lighthousecapital.co.il

Aaron Katsman is a licensed financial adviser in Israel and the United States who helps people with US investment accounts.