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The economic landscape is changing quickly.  Financial hurricanes are on the horizon.  Adding to the growing geopolitical risks caused by war and terrorism are the potentially detrimental effects of a seriously slowing housing market and its repercussions throughout the economy.  Of course, the future is unpredictable and the past shows that markets can surprise us and go up even though logic and common sense seem to indicate they should go down.  Despite the inability to see the future clearly, you should act responsibly now to protect your nest egg. 

One development to note is that several smart financial advisors are throwing in the towel on the Nobel-prize-winning Modern Portfolio Theory. That theory emphasizes that a wide diversification of managed investments can give a good investment return over time, with moderated volatility. Modern portfolio theory claims that there should be a diversification in the major classes of investments such as cash, bonds, equities, and real estate, and that within the equities class, there should be diversification between growth and value, between domestic and international, and by sectors and industries. The usual result is that gains in one type of investment would offset the losses in another, and, over time, the total portfolio is expected to earn over 10% annually. These investment returns would go a long way toward helping with a person's retirement or other financial goals, when combined with continued employment, tax planning strategies, a savings program and moderation in spending.

Instead, these towel-throwers have recently been guiding their clients on investment strategies, which are almost the opposite, and look more like methods from a bygone era – and therefore I use the term “Un-Modern Portfolio Theory.”

The four elements of Un-Modern Portfolio Theory are as follows:

1. Protect principal - Reduce the portion of the portfolio for which principal is unprotected to a very small percentage, like 10%, of the total portfolio. Thus, a smaller portion of the total portfolio should be invested in stocks or real estate. Stay away from investing in straight stocks or in mutual funds, neither of which provides principal protection. Instead, equity investments should be protected through insurance or other strategies (e.g. certain variable annuities offer certain principal protection). Bond investments should be made directly in quality bonds, insured if tax-free, with definite maturity dates. Investors are very concerned about investment loss in view of the trillions of dollars lost in equities in the last three years, mostly as a result of a burst bubble and the loss in confidence, with some stocks of big companies now worth just pennies. If pledges from terrorists become realized, the future losses could be even much greater.

2. Avoid management risk - Avoid managed investments in order to reduce management risk, which rises in uncertain times, and instead invest via indexed investments. Many managers not only make bad decisions but also often work for companies with significant conflicts of interest, as has become evident from huge settlements paid by major investment firms in recent times.  In the case of bonds, move out of managed mutual funds and put the proceeds into a portfolio of bonds, laddered for maturities and noncallable in order to hedge against interest rate risk.

3. Rebalance quarterly between cash and a stock index fund - For equity investments that ideally should have some from of principal protection (e.g. puts; guarantees), investors should utilize a “barbell” strategy that uses rebalancing, at least quarterly, between an index fund and a money market fund in order to take advantage of volatility in the stock market. A study I've seen shows that during the period 1929 to 1939, albeit a severely volatile period (but perhaps appropriate in view of today’s uncertain times), such a rebalancing strategy would have gained 63% instead of losing the actual 39%, or a net gain of 102%, a whopping 10% per year differential.

4. Diversify geographically within the United States - For bond investments and certain equity and real estate investments, diversify geographically in case one section of our nation is more adversely affected by terrorist activity or panics than other sections. For example, an attack on the Indian Point Nuclear Power Plant in Buchanan, NY could cause havoc for all types of investments (stocks, bonds and real estate) throughout the New York metropolitan area. Reduce the portion of international investments to a minimum because foreign countries and companies have even less wherewithal than the United States has to protect its citizens and economies.

Investors should seek guidance from financial advisors who are generalists, who understand the historical patterns of investment volatility over very long periods of time  (200 plus years) as well as over short periods, and who are familiar with assessing risk in extreme geopolitical environments and potential turbulent economic times.  It used to be that investing one's wealth in many different baskets was good enough.  Now, because of additional risks, it appears that the Modern Portfolio Theory needs to be reexamined and a lot more care taken to protect your nest egg, including the strategies outlined above.

About the author.

Frank Sisco is a CPA and Personal Financial Specialist, and author of many articles about personal finance and issues of life and money.   His firm, Financial Management Corporation, is located in New Rochelle, NY.  Frank makes his home with his wife and daughter in New Rochelle, NY.  He can be reached at 914.740.4422 or by email at ideasmoney@aol.com.  Visit his website at www.LifeAndMoney.com, which contains this and prior articles.