Part of an article that is being written for a financial publication

by Frank Sisco, CPA, PFS

Everything has changed after 9/11! As a result of uncertainties caused by terrorist attacks and pledges of further terror, a growing number of smart financial advisors are throwing in the towel on the nobel-prize-winning modern portfolio theory. That theory stresses that a wide diversification of managed investments can give a good investment return over time, with moderated volatility. Modern portfolio theory suggests 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 the term Un-modern portfolio theory.

The four elements of un-modern portfolio theory are:

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 2 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 terror pledges 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. 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 which should have principal protection, 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. Statistical modeling studies show that during the period 1929 to 1939, albeit a severely volatile period, 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 be guided by financial advisors who are generalists and who understand the historical patterns of investment volatility over very long periods of time as well as over short periods.

By Frank Sisco, 12/2/2002