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Wall Street Turmoil - Are Your Investments Safe?

Over the past eight years, investors have experienced at least three major bubbles, which are now culminating into one of the most challenging credit crises in many decades. Legendary investor Sir John Templeton warned us 15 years ago that investors would live through an "information overload" period in which volatility and extreme global swings would be much more commonplace and regular investment cycles would fade into a distant memory. The volatility of the past eight years has once again proved the late great Sir John to have been right on target. In true fashion to his proactive style, many experts warned about the overvalued financial and real estate sectors up to 1 1/2 years ago. For those investors who underestimated the effects of subprime loans last summer, there were many other warning signs that should have not been ignored. On July 31, 2007, two Bear Stearns funds that invested in mortgage securities filed for bankruptcy. One week later, French bank BNP Paribas froze three funds with U.S. mortgage exposure as a presage to what was to come for investors worldwide. Even if you did not understand the ripple effects of how subprime loans would create a delirious influence on the entire U.S. financial system, there was plenty of time with these subsequent events to be proactive and lessen one's exposure in these high risk/low return areas.

It was the massive leverage and layered complexity of these complicated securities, such as the credit default swaps, collateralized mortgage obligations and counter party derivatives that so intertwined our financial firms and markets. The fees and commissions on these financial instruments were enormous and the more the transparency dissipated, the more popular (easier to sell) they became. The instruments may change, but it seems the world of finance can never escape the strong influence of both fear and greed. In fact, with the credit crisis well over a year old, we are still seeing investors taking far too much risk in emerging markets and other investments that many times are not suitable for their situation.

Click here to read what ABL wrote on June 27, 2007

For the past decade investors have just jumped from one investment category to another, chasing performance without taking into consideration any measure of risk. For ten years now, passive investors are showing a lost decade of no gains whatsoever in the S&P 500. Investors who chased performance have suffered startling negative returns, but investors who have utilized these extremes to their advantage by strategically taking profits, avoiding the tech/internet craze in 2000, the housing and real estate bubble and the more recent emerging markets and commodity bubbles have done well with a far lesser degree of risk. Which brings us to what may turn out to be one of the most expensive sources of the problem, and that is the lack of direction by many advisors. Here are some of the biggest mistakes and most costly errors we have seen with the recent market turmoil as well as over the past three decades:

1. Complacency - We've lost count of how many times new clients have told us their advisor did nothing during events like what we have experienced since last summer. If statements like "be patient, the market will come back" or "you are diversified, don't worry" ring familiar, it has most likely proved costly to your portfolio.
   
   
2. Costs - we are still seeing large accounts - many of which are taxable - that are in mutual funds or separately managed accounts (SMAs) with high costs. In many cases, the unsuspecting investor is not even aware of the total cost of their investment program. Investors must factor in annual expense ratios, commission costs, and any front end loads & 12b-1 fees just to get an idea of the costs behind their investments. Keep in mind that according to Lipper, your after-tax return was reduced by anywhere from 17-44% over the past decade due to taxes alone.
   
   
3. Risk - everyone likes to talk performance but a key to long term success is to ascertain, and limit, risk prior to making every investment. This includes a daily assessment of risk, not periodic rebalancing or over-diversifying into all asset classes, which may sound good, but falls short in volatile global markets. Arbitrary rebalancing is a reactive, novice measure to reduce risk in these volatile markets and investors hoping to limit risk by investing in a broad range of asset classes have learned this past year how interrelated such asset classes can become. We have never understood why an investor would want to hold financial stocks from their all time highs during the summer of 2007 or technology stocks at ridiculous valuations during the start of this decade.

The U.S. financial picture is filled with such a multitude of asset gatherers that sound like they know what they are doing, but who are putting many Americans in precarious financial situations. Perhaps they even believe that rebalancing twice a year or diversification into many asset classes will be enough to protect investors. These are times to be more concerned with the return of your investment dollar rather than the return on your dollar. Since many advisors sound so authoritative and knowledgeable to the average investor, we feel the old questions of "how are you compensated", "are you registered with the Securities & Exchange Commission", and "what are you doing to protect investor's assets" are not enough and specific follow-up questions are needed to verify that the advisor's actions match the talk:

• Do you sell a product?
• Have you ever recommended to a client or sold any of the following: Auction-Rate Securities, Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac or AIG products?
• How much exposure in financials did your clients have during the summer of 2007?
• What, if anything, was done to lessen this exposure and when?
• How much international and emerging market exposure did you have going into calendar year 2008?
• If you were in business in 2000, what was your technology exposure for clients at that time?
• Do you ever raise cash (take profits) in good times to have the ability to selectively buy when valuations go down?
• How much cash did your accounts have one year ago, for example, when the credit crisis was already on investor's radar or in prior extreme times like 1987?

These questions are just a start to see if your advisor shows an actual record of being proactive, or is just talking a good game. During times like these we would rather steer towards advisors who have protected capital in the past, rather than ones learning on the job. The upcoming $700B rescue plan in the U.S. is the first step in correcting all the excesses of the past 7-8 years. It is a move that is much more dramatic than what it would have been if the heads of our financial companies would have acted right away instead of ignoring the problem. This will protract any recovery and make the entire process much more costly - both in terms of future taxes and inflation - for many years to come. After being negative on financials since early summer 2007, we are finally seeing a light at the end of the tunnel with the passage of a major bail-out plan. Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, AIG and Wachovia were all band-aids that failed to address the systemic problem. Now a course for the cure is finally being coordinated, but after such delays and mismanagement, the journey will be much more difficult and challenging for everyone.

1. Spreading risk does not eliminate, or even limit, risk during volatile markets. This is true at all levels from asset allocation strategies to complex derivative securities. If it is a risky asset to begin with, it will be risky in combination with other assets, no matter what Wall Street tells you.
   
   
2. During volatile times it is critical to be proactive, rather than reactive. It is definitely easier to do the latter and follow the herd, but investors must learn to continually monitor and reduce risk on an ongoing basis - not just periodically.