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June 01, 2009 at 04:00 AM
With the Fed pumping money into the economy, advisors and economists are concerned about another potential problem: inflation. While the inflation rate in 2008 was just 0.1 percent, experts say it may very well make a comeback when the economy emerges from the current recession.
I spoke with several advisors to find out what they are doing to protect their clients against the possibility of high inflation as we move through these difficult times. Interestingly, as advisors continue to evaluate traditional inflation hedges from commodities to Treasury Inflation-Protected Securities (TIPS), many are concerned first with implementing a more defensive approach to allocating assets in order to rebuild portfolio value and position portfolios for future opportunities.
Rethinking Allocations
According to John L. Jenkins, AEP, EA, CFP, president and CEO of San Diego-based Asset Preservation Strategies, effective asset allocation meant dividing assets between stocks and bonds according to the client’s risk tolerance and financial goals. Over time, however, as financial instruments became more complex, asset allocation strategy has had to evolve to reflect the increasing number of sub-asset classes and investment styles within both the stock and bond asset classes. Jenkins and his partner Gregory R. Banner, CFP, CLU, CRTP, use a unique mix of asset classes and sub-asset classes designed to reduce risk, enhance return and put clients at the optimum place along the efficient frontier.
“We still embrace the premise behind Modern Portfolio Theory — that the greater one’s diversification, the greater one’s protection,” Jenkins says. “After all, historically the various asset classes never moved in tandem. If stocks were down, bonds bolstered your portfolio — or vice versa. That is until 2008 when the unthinkable happened and virtually every asset class, save government bonds, collapsed.”
“Today, effective asset allocation requires financial planners and investors to think outside the box — or, more accurately, to ensure that the individual investor understands the function of each box,” Banner adds. (See Table 1.)]
“While broad asset allocation among cash, bonds, stocks, real estate and alternative investments can help to control total portfolio risk, it’s crucial in this uncertain market to understand that each box provides a particular ‘line of defense’ in your quest to help your clients reach their long-term goals,” Jenkins says. “We think of the construction this way: If, in the draw-down phase, the client uses up all the assets in their most conservative box, they can move to the next box, thereby allowing assets in the other, riskier boxes more time to generate a positive return.”
At the inception of the portfolio, Jenkins and Banner create a “base policy mix” (based on expected returns). Because the value of assets can change quickly given market conditions, the portfolio constantly needs to be readjusted to meet the policy. With Box 1 and Box 2 providing significant “lines of defense,” it likely is easier for clients to commit to the longer time cycle required to own — and potentially profit from — stock and other riskier and/or illiquid investments.
Typically, Jenkins and Banner put no more than 5 percent to 10 percent of the client’s assets in Box 5 out of concern for both risk exposure and alternative investments’ illiquid nature. “Many of the alternatives out there have a very low or negative correlation to the stock and bond markets,” Banner says, “but it is also critical to diversify within this asset class. Alternatives make up a critical component of true diversification because of their independent movement relative to stocks and bonds. Because alternatives add another layer of complexity to the portfolio, we commit ourselves to thorough due diligence and never make an investment the client does not fully understand.”
Inflation Hedging
For Terry M. Anderson, president and founder of Wealth by Design and Management in Greenwood Village, Colo., protecting his clients from a potential spike in inflation also involves a reevaluation of asset allocation. “If the rate of inflation increases dramatically, investing in traditional stocks may not be the best way to go,” he says. “In an inflationary environment, I think there are better investment strategies than just investing in corporate America — buying perhaps some IBM, some Pfizer, some Coca Cola and some small caps. It may take those companies 10 or 15 years to come back, and retiring baby boomers can’t afford to wait that long. They have to find investments that are going to produce some type of positive results on an annual basis.”
