In operation, the higher your capacity for risk, the more of your portfolio can be allocated to stocks which offer higher long term return potential but have greater short term volatility than cash and bonds.

The chart to the left demonstrates the historic ranges of returns for US Stocks going back to 1928.

As you can see the average one year return is 11.3%, but has been as high as 52.5% and as low as -43.8%.

Then as you look at longer time periods, losses become less likely, and over periods of at least fifteen years there has been only one loss of 0.2%.

Notice that while the difference between the best and worst returns gets narrower as you look at longer time periods, the average returns are close over all time periods.

Bond and Cash returns follow a similar pattern, with the difference between high, low and average returns being lower for bonds, and lowest for cash.

So a sound investment strategy should take into account when you are likely to need money from your portfolio, and allocate the money you won’t need for many years to stocks, while money you will need in the next few years should be in bonds and cash.

Below are some examples of how our Risk Capacity formula puts this into practice.

The more money you will need each year, the more you should allocate to bonds and cash and this results in a lower stock allocation.

If you are saving money for the next several years, you can allocate more to stocks and less to bonds and cash.

Risk capacity is also dependent on the amount of savings or withdrawals relative to the size of your portfolio as can be seen by the difference in stock allocation for examples C and F.

Example F shows that a maximum of $200,000 of the portfolio would be in stocks, thus allocating $300,000 to bonds and cash which would allow for six years of withdrawals at a $50,000 annual pace.

Example C would allocate $650,000 to stocks and $350,000 to bonds and cash, which would be seven years of withdrawals in bonds and cash.

Don't push the panic button

Probably not, even though it may feel like it.

What’s Going On

The financial markets have been hit with a steady barrage of negatives.

Europe is still struggling to address the problems inherent in the Euro — namely that they have a currency union but not a political union.

Here in the US the short term budget deficit caused by the Great Recession is being confused with the long term budget problems.

These long term problems are primarily about rising healthcare costs, tax revenues that are too low by historical standards, and to a lesser extent Social Security.

This confusion, combined with a toxic mix of politicians in this year’s Congress, caused a dysfunctional budget process. And this dysfunctional process caused Standard & Poors (S&P) to downgrade US Treasury debt (though that company’s past performance on debt ratings leaves substantial doubt about whether they should be listened to).

On top of all of this, we were already in a slowing industrial cycle directly related to China tightening their monetary policy to bring their inflation rate down.

Reactions

Fear that these issues could push the US and the world into another recession is causing falling stock prices.

Most tellingly, these issues have actually reaffirmed investors’ faith in US Treasury debt as Treasury prices have steadily risen as the negatives have piled up.

Clearly investors do not believe that S&P was correct with their downgrade, or US Treasury prices would be falling, which causes rates to rise.

In fact, since the beginning of the year, the yield on the ten year Treasury bond has fallen from 3.4% to 2.4% as fearful investors sought a safe haven. And most of this decline in rates occurred in the last two months as the debt crisis manufactured in Congress ramped up.

This Day in History

Our research tells us that it is not uncommon at this point in a recovery to have a slowdown, so the current economic slowing may not lead to a recession.

Furthermore, the current recovery is only a little over two years old, and in the last 80 years there have only been two recoveries that lasted less than 3 years. In both of those previous cases, the stock market did correct, but the decline was less than 20%.

Double Dip?

There are good reasons that this current crisis is not likely to be a repeat of 2008.

Households and corporations alike have spent the past few years rebuilding their balance sheets. Corporations have become leaner and added significantly to their cash positions.

This should enable them to weather an economic downturn without needing to make layoffs on a scale like we saw 2-3 years ago.

More Good News

We are also encouraged by attractive stock market valuations.

The current stock market’s earnings yield is around 7%, which provides a much higher return potential than high quality bonds which are only yielding about 2% to 4%.

We also believe that companies will see rising earnings over the next 5 to 10 years. Even though the decade of the 2000s was a poor one for the US economy, earnings of our big corporations still rose by about 60%.

For the decade of the 1990s, earnings rose by over 100%. So it is plausible to believe earnings will rise over the coming decade at least as much as in the 2000s.

What We’re Doing

As has been our experience with large market drops like this one (and large market rises as well), we have learned not to make investment strategy decisions based solely on short term market gyrations, though they can present opportunity.

Our research lead us to reduce stock allocations at higher stock prices in late 2007 and earlier this year. Conversely we will be increasing stock allocations at these now lower prices.

We are paying close attention to valuations as some sectors are not as reasonably priced as others.

We are continuing to emphasize large-cap, high-quality companies as they are more attractive than smaller stocks at current prices and better equipped to endure difficult conditions.

Our focus on international equities is in developed economies as they too, have better valuations when compared to emerging markets, though we are maintaining a position in emerging markets as we anticipate those countries to be the drivers of growth during economic expansions.

Many high-quality US companies are also uniquely positioned to take advantage of the emergence of a middle class in China and developing economies as they expand their operations into these markets.

Given that emerging market stocks have also declined, we may be bringing up emerging market allocations for the first time in several years.

The Bottom Line

When fear is high and confidence is low, people have a difficult time seeing how things will get better.

But they always do.

* Photo credit: jma.work

The first priority for what gets paid starts with the interest on our national debt which would take $207 billion.  The next priority would be military operations, which is budgeted at $965 billion.  The amount left over to fund all other U.S. government spending would be just shy of $1 trillion.  It would require a 60% cut across the board to all of the other federal programs in order to balance the budget.  This would affect every person who receives benefits from Social Security, Medicare and Medicaid, education, transportation and infrastructure, unemployment, low income housing, environmental services, national parks services, public safety, prison security and on and on.

Trying to predict what would happen if the politicians in Washington failed to reach an agreement is difficult.  However, because of the untenable nature of the spending cuts it doesn’t seem likely that a government shutdown would last long.  The last two times it occurred, it lasted a total of six days in 1995 and around three weeks in late 1995 to early 1996.

We believe that a deal will get done before a shutdown happens.  Our assessment of where things currently stand is that a deficit reduction package that both sides can come to an agreement on may not be possible by August 2^nd.  What can happen, however, is an agreement to punt the issue of making structural changes not only to spending but also our tax code (revenue) to the 2012 election.  The leadership in the Senate is working on a backup plan that would give the President the authority to raise the debt limit without a specific approval by Congress.  This would accomplish a short-term solution allowing more time for discussion of the two longer-term potential problems, health care costs and the appropriate level of tax revenues, to be addressed.

Photo Credit: iandavid via flickr

Healthcare Cost Percentage Projected through 2085

This article shows an interesting comparison with other countries.  While healthcare costs have been rising as a share of the economy across all countries, starting somewhere around the late 1970’s, our costs have been rising much faster than other countries.  And while portions of our system are better than most of the rest of the world, the entire system is not better than most developed countries.  In other words, we get very poor value for our money.

This leads us to the conclusion that our healthcare costs can be prevented from rising as quickly without sacrificing quality.  Just holding healthcare costs to the current percent of GDP would make the long term budget problem manageable.

And if our healthcare system also starts to look like other countries’ systems, we may even see our healthcare costs decline as a percent of GDP.  Looking at a few other countries, you’ll notice that  Japanese and German costs have risen the least since 1980 so they may provide the most interesting insights.

There is a school of economic theory that says that the level of taxation has a strong inverse relationship with economic growth.  In other words, some believe that low tax rates cause high growth and high tax rates cause slow growth.  This is why some believe that we should not use higher tax rates as part of a long term budget solution.

We do not share that fear.  The following chart shows average federal revenue as percent of GDP, and real GDP growth by decade.

Real GDP by Decade vs. Federal Revenue as a % of GDP

So tax rates and revenues were lowest in the 2000s, but that was also the weakest decade for economic growth.  If a strong inverse relationship exists, than the 2000’s should have instead been our highest growth rate decade of the last four.  And the 1990s should have been the slowest growth decade.

Of course we don’t believe that high tax rates cause strong economic growth and that low tax rates cause weak economic growth.  We think that the evidence indicates that tax rates simply do not have as much impact on growth as some people believe.

Closing the long term budget imbalance will be a positive for our economic future, and higher tax rates are most likely to be part of the solving the budget problem.

Recently, Fitch Ratings became the latest ratings agency to issue warnings of impending downgrade on U.S. debt.  A statement issued by Fitch’s warns that U.S. Treasury bonds would be rated as “junk” if the government misses any debt payments by August 15.  However, we interpret this as a lack of confidence based on short-term political wrangling rather than the real issue of our long term fiscal position.  Notice Fitch references the risk of “stalemate” leading to failure to raise the debt ceiling.

In other words they are afraid that in essence our government will choose to not pay its debt rather than the United States being unable to pay its debt.

Unfortunately, politicians are making hay by confusing two wholly separate financial problems- 1) the short term which is a high deficit caused by the worst recession since the Great Depression, and 2) the long term projection of US government debt.

For the short term problem we fortunately have examples of two other episodes where we had large deficits- the 1940’s and the 1980’s.  As you can see from the following chart, our current deficit is bigger than the 80’s but smaller than the 40’s.  Not only did the country not collapse after those episodes, but we thrived.

Notice that in the 1980’s we saw both decreased revenues and increased spending just like now.  Given that the 1980’s policies were successful in getting the economy going, it makes sense that we used Reaganomics on steroids to help pull us out of this deeper recession.

1940-2011 US Government Revenues & Expenses

As for the long term, the fiscal problem is mostly about two issues: 1) the appropriate level of tax revenues going forward and 2) getting a handle on rising health care costs.  We’ll be posting some additional blog posts to explain why these are not unsolvable problems.

Where did it all go?

We all hear about how the US is going broke. Depending on the viewpoint or agenda of the source of what we hear, read or see, the cause of the federal government’s financial problems varies.

Unfortunately, there is almost always a lack of actual facts and perspective, so the public is left to try to make sense of the issues with beliefs and emotions that are often manipulated by politicians wanting votes, vested interests wanting to maintain their sources of money, media outlets whose ratings are dependent on keeping their viewers and listeners emotionally agitated, and fund raisers who’ve learned that messages of potential disaster increase contributions.

Now it is possible to get just the facts about how your own tax dollars are spent. This link http://www.thirdway.org/taxreceipt allows you to input the total federal taxes you paid, and then breaks down where that money went. Most of us will likely have some surprises when we see the actual amounts.

Ofunato, Japan

The tragedy in Japan continues to be the top news story and warrants international support.  While the human aspect of this crisis continues to be devastating, we can’t discount the economic impact as well.  Well respected international fund family, First Eagle Funds, was heavily allocated to Japanese investments before the tsunami hit.  To find out how they are reacting to current events and their outlook for the future in Japan, please read their recent Manager Insights.

Photo Credit: DVIDSHUB

Mail piling up?

This is one of the more common questions we hear about the amount of prospectuses, annual reports, etc. that our clients receive from their investment companies.  Would you believe that this much disclosure could actually be bad for you?  Especially when it comes to the financial services industry, more disclosure is a benefit to the client, right?

Disclosure Debate

With all the hub-bub in Washington of who should police the financial planning industry of late, the debate about the effectiveness of disclosure is heating up.  At a recent industry meeting last fall, discussions centered around the idea that the more disclosure a company unleashes on the public the more confused they become in case after case.  Daylian Cain, assistant professor of organizational behavior at the Yale School of Management, discussed his findings of how heavy disclosure can actually harm an investor.  The standard example in these cases being the more pages in a disclosure document the less likely the investor is to read it.  Read more about this interesting discussion here.

Plain-English Descriptions

Last July, the SEC changed financial companies requirements for disclosure so that it will now be in a plain English narrative form with the hopes of making it easier to compare between different companies.  Reading the article above describes how several firms will look to drown their clients with pages and pages of disclosure.  We’ve been working hard over the last few months to make our disclosure form (Form ADV) to be more concise and meaningful to our business activities.  We’ll be sending out new copies of this document in the next few weeks.

Photo Credit: luxomedia