There’s a front page article in the July 10 Wall Street Journal: Failure of a Fail-Safe Strategy Sends Investors Scrambling that discusses the failure of diversification among asset classes to protect investors from large portfolio losses during the current stock market decline. The article specifically discusses target-date retirement funds. These mutual funds shift their assets from riskier investments, such as stocks, into safer investments, such as bonds, as the fund approaches its target date. The theory being that investors will receive the benefits of appreciation from stocks and will be invested for a long enough time to withstand market volatility at the beginning of the fund’s life. As the fund approaches its target date the manager shifts into safer assets to lock in the fund’s gains and avoid loses due to a stock market downturn. The stock/bond mix varies with the fund’s maturity and the manager’s judgment. Target-date funds failed to protect investors in the market meltdown because fixed income securities declined in value along with equities. The point of the Wall Street Journal article, and this one, goes beyond target-date funds and addresses the more general topic of asset allocation.

Equity and fixed income prices moved in tandem because we are in a financially induced recession. Classic asset allocation theory was based on the belief that bond prices rose when stock prices fell and vice versa. History supported this belief but that was when recessions were induced by declining consumer and industrial demand brought about of their own accord or because the Fed raised interest rates to slowdown the economy and control inflation. During the current financial meltdown investors have fled riskier debt instruments and re-priced, by demanding higher premiums, every class of fixed income securities except U.S. Treasuries. The result is that fixed income prices declined along with equity prices.

A related diversification issue is the high level of global economic interdependency. No longer can investors expect a low correlation between U.S. stocks and foreign securities. The world’s economies are too inter-related through multi-national corporations, international trade and banking. I wrote about this two years ago in my blog article: The CIAs Guide to International Investing, published on 11/20/07. Investors must now look at international securities as an extension of their U.S. holdings. International equities are attractive if a county’s stock market is reasonably valued and, particularly, if the country’s GDP is expected to grow faster than the U.S., i.e., China and India. International equities definitely have a place in your portfolio but they aren’t a hedge against a decline in the U.S. stock market.

Other asset classes for portfolio diversification are gold, commodities, real estate and cash. Commodities and real estate (housing and commercial) prices fell in tandem with the stock market. The real estate markets rose, then fell, along with the rise and collapse of the subprime and exotic-instrument mortgage markets.   Commodities appear to have responded to changes in demand, although there is growing evidence that oil (and other commodities) prices were influenced by speculators. Gold’s price always is speculator influenced and I’ve never been a gold bug anyway.

Financially induced recessions have not occurred in some time, we’d have to go back to the financial panics of the 19^th century and the stock market collapse of 1929. They may become more common, even the most common cause of future recessions as we move from a manufacturing economy to a service economy, because of the size of financial institutions as a percent of our economy, widespread use of financial instruments and globalization.

Interest rates have been in a secular decline since 1981. With Fed Funds and 3 month LIBOR virtually at zero, they can’t go lower. It’s likely we’re at a secular bottom for interest rates. Large U.S fiscal and trade deficits, and emerging economies demands for capital support this view.   If this is correct, we’re in for a secular bear market in long term fixed income securities.

What’s an investor to do?  Invest in equities for growth. A good equity portfolio includes U.S. and international stocks. The remainder of your investments should be in cash, e.g., money market funds, CDs, and short-term bond funds -- all investment grade. For the more aggressive investor, although personally I wouldn’t since I don’t understand the market, some commodity exposure, which can be achieved through mutual funds and ETFs. The asset mix depends upon your time horizon and risk tolerance level. I’d further adjust the mix by where I thought we were in the economic cycle. Right now, that means overweighting equities.