The stock market “basically blew up in everybody’s face,” said David Twibell, director of wealth management for Colorado Capital Bank. “The world is different now in a lot of ways, and clients and investors want to know what the industry is going to do.”
Modern Portfolio Theory held that diversification among asset classes was enough to protect a portfolio, and that the actual selection of assets was secondary, Twibell said.
“But in the last 12 months, if you owned the right stock, you did fine – if you didn’t, you got killed,” he said. “”The vast majority of investment advisers held onto, as gospel, that asset allocation mix was what mattered – enough stock, enough bonds, and they wouldn’t move in sync.”
But correlations “disappear” in times of crisis.
“Thirty years ago, the concept of diversification didn’t really exist,” Twibell said. “Then a bunch of academic theory came out that diversity is the way to go – some assets will be up while others are down. But we lost the common sense aspect. We need to focus on both.”
The first step of the process is to be diversified. The second is to ensure that the individual investments also make sense.
“It’s not enough to own the world anymore,” he said. “It’s not enough to just put your money into an index fund and assume markets will go higher.”
And investors need to re-examine their “real risk tolerance.”
Not just what “makes you sleep at night,” but what they need to be able to retire.
Many people who were about to retire were taking risks they couldn’t afford.
“Diversification isn’t bulletproof,” Twibell said. “And the concept of diversification allowed people to take much more risk than they should. We’ve already seen two crises this decade.”
The idea used to be that you didn’t see a crisis very often, but now that takes a suspension of disbelief.
“You can’t look at this current crisis and say it’s just an aberration, too,” as was said of the 2002 recession, after Sept. 11. “Volatility is probably the new normal,” Twibell said. “And investors need to take that into account.”
That said, the question is, how much risk do you actually need to take?
There is no one-size-fits all – no template, such as 60 percent stocks and 40 percent bonds.
“It’s much more complex,” Twibell said. “The old rules of thumb don’t apply anymore.”
So investors need to understand the limits of diversification -”it’s not foolproof, and it does break down during extreme times”- and investors need to learn and understand what it is that they own.
What do you have?
If it’s a mutual fund, what does it cost you in fees to invest in it?
Next, the underlying assets.
What types of assets does the mutual fund manager invest in? Mutual funds underperform the market substantially, he said.
Does the fund have the ability to hedge or to hold cash? What level of discretion do the managers have? What can they do to protect during a down market?
If investors own several mutual funds, it can be too similar to the market. Investors need to know if the mutual fund manager can buy or sell when the market goes up or down.
And if the fund owns a lot of bonds, that doesn’t necessarily equate with safety.
Fund managers have been known to invest in “less-than-stellar paper, trying to get the extra yield.”
“Safe ” bonds include Treasury bonds, agency bonds – such as Federal Farm Credit Bank and Fannie Mae and Freddie Mac – that are backed by a solid government insurance. And bonds from the U.S. government, Britain, Western Europe and Japan are safer than emerging market bonds, he said.
Volatile bonds -”that act more like stocks”- include corporate bonds and asset-backed bonds (backed by mortgage debt, credit card debt, etc.).
As for so-called “balanced funds,” that have stocks and bonds, some of them had stocks and higher-yield (read unstable) bonds, and they tanked during the crash.
“And these were people who thought they had a balanced (safe) portfolio,” Twibell said. “Mutual funds across the board really let everybody down. Most people are schooled in the buy and hold philosophy, which works great in a bull market, which we had for 20 years. But now you have to have a critical eye for the individual stocks you buy. Investors will have to work hard at it.”
When buying stocks, people should look for a dislocation between what’s actually happening with a public company and what its management says is happening.
“You have to listen to conference calls, look at balance sheets, income statements, cash flow, sales and earnings – as painful as this can be at times,” Twibell said. “And if the choice is trusting what management tells you or trusting your own eyes – trust your judgment and instincts. If something doesn’t seem right – act, don’t wait. A lot of people’s instincts probably told them to act at the beginning of ’08, but they’d been conditioned to buy and hold. They assumed other people were smarter than they were.”
And learning someone isn’t smarter than you is a bitter pill to swallow.
“Investors should go with their instincts,” Twibell said. “They’re usually right.”
Rebecca Tonn covers banking and finance for the Colorado Springs Business Journal.