Thursday, March 5, 2009

Tectonic Shift

The world is constantly changing. Mercifully we don't feel most of the changes. They are the incremental progressions that effect us subtly. Life changing for some, but not most. A new treatment for shingles, a breakthrough in silicon chips, a more efficient and cleaner engine. Tiny steps, quiet huge leaps that enter our lives but generally do not collide with them.

Economic and financial shifts tend to impact us more dramatically and immediately. Can we afford education, healthcare, shelter, retirement? These are in our face everyday and changes are felt quickly. Losing a job, winning the lottery, getting the tuition bill, getting ill. The global economic shifts taking place now are significant, will effect us directly and one ignores them at ones peril.

Mohamed El-Erian sees the world changing. El-Erian has been active in global finance for the past three decades. Born in New York City to an Egyptian father and French mother, he grew up both in the U.S. and abroad. He worked for the International Monetary Fund for 15 years, then did stints with Salomon Smith Barney and Pimco before running Harvard's endowment fund. He returned to Pimco, the bond powerhouse, in 2008. El-Erian is chief executive of Pimco as well as its co-chief investment officer (a title he shares with bond guru Bill Gross).

The shift is not necessarily bad for you, but it will require some adaptation. A tectonic shift is occurring. No longer will the world simply march to the U.S. rhythm. We will have to share leadership with emerging giants, such as China and India. If the US remains flexible and educated we will provide the world with goods and services easing our trade deficit and stimulating growth and jobs over time.

But stability is easy only once we get there. Transitions are hard. Vested interests struggle to keep their advantages. Just as blacksmiths and longshoremen, scribes and pick and axe coal miners pushed back against the tide so will we. Eventually the typewriter ribbon cannot be replaced, the rotary dial telephone cannot be repaired and the cassette tapes will have no place to load in the car. Imbedded thoughts do not go easily either.

Many of us are investing and saving based on rotary telephone thinking. Some of the truths that worked for a generation are now only half truths. Judging by the past several years in which so many assets we invested in moved in lockstep, diversification no longer means 60% stocks and 40% bonds. To continue in that vein will be mean having good times and bad times, but volatile times. Diversification is not dead, but the simple 60/40, buy and hold strategy will not decrease risk any longer nor will it find the dynamic opportunities.

Because of all these changes, El-Erian suggests that investors spread their money over a wider array of assets than was once thought necessary. That means shrinking U.S. stocks to smaller portion. Just 15% of your total portfolio in his view.

The world's financial landscape is being re-defined without a master plan. This has become a crisis-management phenomenon. As individuals, to attach our personal well being to global crisis management is not a strategy.

In El-Erian's world the traditional approach to diversification, "which served us very well, went like this: Adopt a diversified portfolio, be disciplined about rebalancing the asset mix, own very well-defined types of asset classes and favor the home team because the minute you invest outside the U.S., you take on additional risk. A typical mix would then be 60% stocks and 40% bonds, and most of the stocks would be part of Standard & Poor's 500-stock index.

This approach is fatigued for several reasons. First of all, diversification
alone is no longer sufficient to temper risk. In the past year, we saw virtually
every asset class hammered. You need something more to manage risk well. Second,it matters a great deal how you implement the asset allocation, because when the world gets bumpy, different investment types really do behave differently. Third, consider where we're headed. We are going toward a world where the U.S. will no longer be the most dynamic part of the global economy. Because of the debt excesses of the past few years, it will be a while before the U.S. economy returns to 3% or 4% annual growth. Therefore, the wise investor asks, "Where else can I tap into sustainable growth?" To do that, you need a more global approach. And one more thing. Don't become hostage to historical definitions of asset classes. Be flexible, because there will be opportunities that don't fit easily into those categories."

Now is the time to dig deeper, spread wings wider. We've seen what happens to the financial Icarus when soaring too close to the sun, but the wiser will still keep their wings.

John Barnyak