In case you missed it:
Click Here to read “Fragile and Investor’s Help Now – Part One”

As investors you already know most of the problems in the economy and the markets. Now you need solutions.  You probably also have many questions and you would like some answers. This report is intended to provide some much-needed help.

Investor’s Help Now was first issued on January 6, 2009 in response to turbulent financial and market action as a follow-up to our Urgent Update client meetings of September and October 2008. I believe it is equally valid and timely now. I have made a few edits and comments to bring it up to date. These are noted with the [ ] brackets. For our clients we will be following with a number of specific strategy recommendations as these scenarios unfold. We will schedule a new series of Urgent Update meetings if global credit conditions show signs of worsening.

One of the first questions in many people’s minds is this – are we in a depression like the 1930s, and if so, what does that mean to me?  While it has been confirmed that the U.S. economy is now in a recession by official definition, there is no such definition for a depression.  According to a recent issue of The Economist Magazine, one popular definition of “depression” is a decline in real GDP exceeding 10% or one that last more than three years.  By these criteria, we are nowhere near depression level now.

We are, however, in the throes of a serious recession that could last for some time.  Historically this has meant higher unemployment, declining corporate profits, rising bankruptcies and large government deficits.  This, in turn, has generally produced relatively poor stock market performance.  For people still employed this means potentially lower income or even job loss.  Even those with very secure job positions have heightened concerns over college education plans for children and the building of retirement funds for their own future. For retirees it raises the scary thought of having a lower capital base on which to draw retirement income and the possibility of running out of money. [The worst recession since the 1980’s officially began in November/December 2007 and ended in June 2009 though many people still feel the same effects as if the recession were still with us.]

Nobody has a pat solution to these many concerns or answers to all the questions raised.  However, from my [50] years of experience in the investment and financial planning business, I have learned certain principles that have served me well through many difficult times.  Here are a few of those principles along with some potential applications to the current situation.

SEVEN PRINCIPLES FOR SOLVING PERSONAL FINANCIAL PROBLEMS

1. Don’t Panic!  This is the first and most important principle.  Panic is an unreasoned and uncontrolled reaction to a stimulus.  We are all born with reflexes that serve us well under certain physical threats.  However, in intellectual pursuits such reflexes rarely serve us well.  It is important that we remain under control of our thoughts and not our emotions.  It is often difficult if not impossible to undo the damage done by a knee jerk reaction to a perceived threat.  Your actions must flow from your best reasoned decisions.

The best defense against panic is anticipation and preparation.  While this is not always possible, in the current situation it should be helpful to project some of the potential outcomes and prepare appropriate reactions.  Even if you have not anticipated the eventual problem, your prior preparation will help you to remain focused on finding an appropriate response.

2. Take Charge.  You are the only expert in the most important matter concerning your financial well-being.  That is what you want out of life and what you are willing to do to obtain it.  

Once you reach adulthood, it is absolutely vital that you understand that you are in total control of your own situation.  If you don’t take responsibility for the outcome, nobody else will.  Unfortunately, our government seems willing to bail out every entity except you and me.  You are on your own.

That may seem like the bad news, but it is also the good news.  We live in a land where you are free to make your own choices and to change them as often as you like.  One of the most difficult activities as a financial planner is to get clients to define their objectives in concrete terms.  Professional planners make it clear to clients that if they are not able to say where they want to go they are likely to wind up someplace they would prefer not to be.

Under very adverse circumstances such as we are experiencing today, it is no longer optional to decide upon realistic goals.  We know that trade-offs will have to be made and it is far better to make those intentionally rather than settle for whatever comes.  Now is a very good time to sit down with family members and other interdependent people to review your realistic choices.  Some people may need to defer retiring while others may choose to downsize their living standard in order to retire on time.  You can get professional help in reviewing the possibilities, but you are in charge.  The decisions are yours alone.

3. Make a Reality Check.  This naturally flows from your decision to take charge and define your realistic goals.  When the future is uncertain, it is important to define your rock-bottom needs.  Obviously those people facing a job loss or other serious financial setback are forced to do this.  It is far better to do this form of evaluation when you are not under the stress of necessity.

Hope is a wonderful and comforting thing, but it is neither a sound financial plan nor investment strategy.  In the current situation we can hope that the combined efforts of global government officials solve the financial crisis soon and well.  But what if they don’t?  What will that mean for you and yours?

My best response is to live for the best but prepare for the worst.  A good example of this approach is that of homeowners insurance.  We certainly want don’t want our home to burn down and we don’t expect it to, but having it insured gives us peace of mind.  Obviously we cannot insure everything in our lives even if we could afford to.  We can, however, develop strategies to help us make the best of adverse circumstances.

One approach that I have found very helpful is that of fallback positions.  Take for example a plan to retire at age 62.  If your financial resources are not sufficient when you reach that age, your plan may be to continue work to age 65.  If your resources are still not sufficient at that time your plan may be eager to continue working longer, take a part time job or reduce your living standard to an acceptable level.  The same type of strategic planning can be applied to other life situations such as having a child enter college right after high school or perhaps working a year or two to help with the finances.

The whole point of the reality check is to review what you would like to have happen against the realistic probability of that occurring.  If your first choice comes true – wonderful.  If not, you have a series of fallback plans that will enable you to stay in control of your life.

4. Understand that Cash is King.  Cash is the only thing you can spend. When people speak of “running out of money”, they mean not having spendable cash.

It doesn’t matter whether you’re talking about buying groceries or paying estate taxes, cash is the only thing that works.  Credit is just a deferral of cash.

Most people refer to this as income, but that is a misnomer.  If you derive your cash from your paycheck, that is income.  However, if you derive your cash from savings account withdrawals, it still cash but it’s not income.  The difference is very important. If you learn to think in terms of cash flow instead of income, it can make a huge difference in the amount of income tax you must pay over the years.

It is also important to understand the difference between what you make and what you keep.  You only have to look at your paycheck stub to see the crystal clear difference.  While your gross may say you made $5,000, your net may say that you made $4,000.  That’s all you can spend.  Similarly an investor may brag that he made 20% on a particular investment, but after fees and expenses and taxes his net may be only half that.

The most important single thing a person can do to prepare for retirement or adversity is to figure out their absolute rock-bottom net cash requirement.

Retirement planning, for the example, is less dependent upon how much money you have than upon how much you choose to spend.  The amount you have, as we have seen recently, can change dramatically due to circumstances beyond your control.  The only thing that is totally under your control is how much you spend.

The best way I have found to undertake this is to take a plain piece of paper and make a vertical line down the center.  On the left side, write down your Committed Expenses.  That is those things that you must pay such as mortgage, rent, utilities or credit card payments, etc. On the right side, write down your Discretionary Expenses.  That is those things you would like to spend on if your funds are available such as entertainment and vacations.  Since the Discretionary Expenses are mostly optional, they can be reduced or eliminated if need be.  This process may require several adjustments, but it can help you determine your rock-bottom cash need.

If your sources of cash are insufficient to meet your rock-bottom needs, you may have to make significant adjustments in your lifestyle.  While this is very unpleasant, it is much better knowing in advance and taking action rather than being forced to do so.

5. Adapt or Fail.  There is no single strategy, investment or asset allocation that will serve you well in all economic situations.  That is the most important lesson I have learned in [50] years as an investment professional.  

It may sound extremely harsh, but those who choose to stick with a single-minded approach to investing often get blown away by the winds of change. For example, for many years simply buying and holding good blue-chip stocks was considered the road to success.  Now, as we see what has a happened to the domestic automobile industry and several others, we realize the folly of inaction.  Unfortunately many investors who had most of their money in a relatively few such stocks have been nearly wiped out.

While nearly all investment professionals agree that asset allocation is important, we have seen that merely following a computer-generated asset allocation may be ineffective under extreme circumstances.  As an increasing number of investment managers converged on the same allocation strategy, the benefits of such a strategy were severely diminished.  The herd mentality simply ruined its effectiveness.

Because we are now in a global economy, there are now more investment opportunities than there have ever been.  There are also a greater number of sophisticated participants in the markets with different motivations and time horizons.  This suggests that we may continue to see opportunities appear and disappear quickly as these professionals react to them.

The old adage of “buy low and sell high” is as valid today it has ever been. Most investors, however, practically ignore the sell side and simply watch investments go up and then back down.  Where’s the profit? 

The bottom line is that you can’t expect to make a significant profit in a highly competitive market by doing nothing.

6. The Missing Detail – Strategy.  The difference between success and failure is often the absence of one detail.  Most professional investors and many individuals have a process.  Some even have an Investment Policy Statement.  Very few, however, have a clear understanding of strategy.  The key to strategy is recognizing the fact that in financial markets change is inevitable.  While there have been many theories and programs developed to mechanically adjust portfolios to changing markets, I know of none that have avoided eventual catastrophe.

Strategic thinking involves consideration of many potential events and outcomes along with possible tactics to optimize results.  This is a much broader and more subjective perspective than most investment plans utilize.  At any point in time the economy or a single investment can do one of three things.  It can go up, it can go down or it can stay the same.  As simple as this sounds, when we add in magnitude and timing, it becomes quite complex.

Suppose the global economy skyrockets for an extended period of time.  Do we just sit back and smile and wait for it to go back down?  Or do we take advantage of the excess and take some profits?  Likewise if the economy spirals into total collapse, do we simply crawl under the covers and hope for better days, or do we have a strategy to capitalize on the weakness?  Do we rely on preparation or whimsy?

The essential difference between strategy and program is in not only anticipating change, but also in evaluating magnitude and probability.  For example the higher and more extended the climb, the greater the probability of a fall and the greater the potential magnitude of that fall.  With investing we are seldom talking about certainties.  We are nearly always talking about probabilities and payoffs.

A competent strategist will take into account as many potential happenings as practical even considering rare but potentially catastrophic events.  He will then assign probabilities of occurrence to each along with likely payoffs.  It’s important to note that payoffs are two-sided.  That means most occurrences could have both positive and negative consequences.  The strategist will then take action in measured steps relative to the probability/payoff potential.  Finally, the strategist will regularly update the probability grid and adjust tactics accordingly.

7. Opportunity Out of Chaos.  While we do not know anything for certain about the future, we do have history as a guideline. We never know until after the fact what the highest or lowest value of a given item is.  But, we do have massive amounts of historical data that help us to understand relative valuation.

Economists and investment strategists frequently talk about the concept of “reversion to the mean”.  Most people would call that the “law of averages”.  Over very long periods of time a given economic series tends to fluctuate around the long-term average for that period.

While relative valuations are not particularly helpful in the short term, they can be very useful over longer periods of time. When a given series gets to the outer extremes of its historical range, either high or low, there is an increasing probability that it will revert to the mean.  That is, it will tend to move back toward its average valuation and perhaps move toward the other extreme.

This pendulum swing tendency brings us back to the concept of buy low, sell high. When we buy well below the historic average valuation or sell well above it, we tilt the probability/payoff potential in our favor.  This is more applicable to broad-based investments than to single issues due to solvency concerns with the latter.  Moving against the herd in this fashion takes patience, discipline and courage, but it can pay off handsomely.

When the financial markets are under severe stress as they are now, any numbers of investments are likely to move to extremes compared with their historical relationships. At these times it may be appropriate to make substantial adjustments to your asset allocation to defend against loss or to improve profit potential.  This is where a proactive strategy is of special benefit. By previewing possibilities and developing tactics in advance, you are in a position to move swiftly at the appropriate time.  I refer to this approach as an Adaptive Value Investing.

In the current economic environment there are probably as many projected outcomes as there are economists. But, there are three distinct schools of thought that will serve to illustrate how an adaptive value investing strategy might operate. [At this writing all three of scenarios are still being proclaimed by their proponents.] The severe vocal pessimists believe that we are headed for a depression accompanied by a serious deflation that will be disruptive for years to come. The stagflation theorists believe that we are in for an extended period of recession or very slow growth accompanied by creeping inflation.  The monetary theorists believe that because the government is creating enormous amounts of federal debt to bailout the struggling economy, this “printing press money” will cause an unstoppable hyperinflation.

It is obvious that these three views cannot possibly coexist. For example purposes only, let’s consider one possible scenario for the U.S. economy over the next several years that involves each of these sequentially. This will allow us to model what action we might take at each point.  Several respected economists have proposed just such a series of events with varying degrees of severity.

This outlook is called a “U-shaped” recovery since the economy traces the path of the letter “U”.  That is, it falls off sharply, flattens out then rises. This is opposed to the more common “V-shape” where the economy falls off then recovers.  The exact shape the “U” can vary substantially from sharper on either side to a very long flat part as in Japan over the past several years.

As we consider the first leg of the “U”, we can recognize that we are in a period of economic decline and possibly a mild deflation.  Historically, with low inflation or deflation, interest rates tend to fall drastically. As this happens, bond prices rise.  Because of current global credit concerns there has been an unprecedented flight to safety. As a result, interest rates have fallen sharply, but only U. S. Government Bonds have fully reflected this movement. This has pushed the difference between government bond yields and corporate bond yields will beyond their historic relationships.  As mentioned earlier, this type of divergence has always reverted to the norm. This would suggest a potential investment opportunity in non-government bonds. I am not making a recommendation, merely pointing out a potential opportunity. In this type of economy, stocks have historically performed poorly.

In the flat part of the “U”, where the economy stops falling and levels off, stocks in certain industries historically have fared well while other have languished.  Depending on the relative valuations of the different stocks a strategist can frequently profit from a sector rotation technique and some other proven approaches. There are professional managers who specialize in these management styles than can be utilized during these periods.

When the upswing portion of the “U” begins as the economy recovers in this instance, it is very probable that there will be a strong inflationary bias. This is very bad for bonds of all types as interest rates are likely to rise, perhaps rapidly. Stocks of certain industries, especially those connected with commodities or other “real” assets may do well.  But, many stocks of many other industries may perform very badly. This would necessitate some major changes in many asset allocations.

For the investor the important point is that each of the economic phases calls for radically different tactics than the others. As we have seen in recent months, a simple balanced asset allocation has been of little value in protecting investors from loss. The successful strategist must be ready to first identify the economic backdrop and willing to adapt to it.  This does not mean short-term hopping around, but rather regularly making intelligent adjustments as indicated.

While nobody can be certain of the true course of the economy, I am firmly convinced that within the next few years we will see the best investing opportunity of my lifetime.  The global economy will ultimately recover and the established mega-trends such as the emerging middle classes in the developing nations, and the supply shortages in food supplies and energy could reassert themselves. These mega-trends involve populations far exceeding the famous “baby boom” in the U.S. offering huge potential for growth.

It is easy to get discouraged and negative when the economy is in a really bad period. However, if you are willing to adapt, you can not only survive but prosper. It takes an open mind along with patience, discipline and courage. I wish you well and hope this report has provided you with some encouragement as well as some insight into new possibilities.