Invesra, Invest in your Future

Bill Miller of Legg Mason and famous for his string of calendar years of beating the S&P 500 is having a rough time. Year-to-date through June 12th, Legg Mason Value Trust is down over 23% versus the S&P 500 loss of 8%. His 32 stock portfolio is invested heavily in financial services, home builders, and the consumer services. Most of his holdings experienced severe losses. Bill Miller, a good fund manager over the long run, has had bad things happen to his fund in the short run.

Another very well known investor, Warren Buffet has had his share of bad times. With his value orientation, Warren Buffett was practically pronounced dead when the tech bubble was in full bloom in late the 1990’s. Buffet’s Berkshire Hathaway was a sluggish and stagnant investment while other funds were soaring with hefty technology bets. Thankfully for Buffett’s investors the bubble collapsed and Berkshire Hathaway was once again on top.

So here is the question, what can be expected from the mortal investor?

Miller and Buffett and others like them are paid to manage and to provide superior returns compared to an index. Based on historical data, Miller’s Legg Mason Value fund could be expected to outperform or underperform two thirds of the time by 8 percentage points. This means that if you invest in this type of fund, you will be either very happy or very sad.

Remember that fees for active management are not a guarantee that the fund will provide you a better return. You are simply paying for the POTENTIAL of outperforming an index.

There is an alternative to the angst and emotional upheavals of actively managed funds. You can choose not to play this game of trying to beat the markets by just investing in a low cost index fund and receive roughly the same return as the market. What you get is no additional volatility from outperformance or underperformance, only the pure volatility that the markets deliver.

In fact, many of the most sophisticated and largest pension plans and endowment funds do not spend money, time and energy trying to outperform most of the US equity market. They invest in very low cost index strategies to gain exposure to the asset class. Their funds are large enough to invest in strategies and asset classes that are not available to the average retail investor.

At the Berkshire Hathaway Annual meeting, Warren Buffett said that the single best investment that someone in their 30’s could make would be in a low cost index fund from a reputable firm. Buffett has great investment intelligence and perception. For those who love to hate Microsoft, Buffet ousted his good friend, Bill Gates, as Forbes Magazine’s world’s richest person in 2008*.

As far as investing is concerned, I would take Buffett’s advice any day.

*Side note on Forbes Magazine’s billionaires for 2008: only 2 out of 10 are from the United States.

If you read the headlines and financial blogs, you might have seen the word “stagflation”.

Stagflation may be the worst of all possible worlds. When you marry “stagnation and inflation”, you get stagflation. Stagflation occurs when inflationary conditions collide with low economic growth. Many current definitions of stagflation make no reference to unemployment but in older definitions, higher unemployment is another hallmark of stagflation.

What causes stagflation has varied opinions. The popular press cites price shocks (rapidly rising oil prices) as the catalyst for stagflation. Others argue that expanding money supply too quickly can create stagflation. Perhaps a combination of these two events can drive an economy towards stagflation. The 1970’s was the first time that the U.S. had seen these two economic conditions collide.

Why is stagflation such a dreaded economic foe? No matter what the cause, stagflation renders our economic tools suboptimal. To combat either inflation or recession (stagnation), the Fed may raise or lower interest rates. In either case, the Fed is inflating or deflating the economy. How do you revive an economy that is sluggish without fueling inflation?

If you are lucky enough to not remember the 1970’s, here are the key similarities:

• rapidly rising oil prices,
• rising unemployment,
• highly stimulative monetary policy, and
• stimulative fiscal policies to finance the Vietnam War (substitute Iraq).
• Fashionistas from the 70’s and today will note the return of platform and wedge heeled shoes!

So what is to be done? In a stagflationary environment, look to reduce costs and save more if you can. If you are in a position to borrow for a first time home, this may be a good time provided you are comfortable with your job stability and the monthly payments are affordable.

Take a financial inventory to see how much you have set aside, how much exposure you have to equities and bonds, and how much consumer debt is riding on your shoulders. If you suspect you could be an employment casualty of a slowing economy with rising prices, it pays to have PLAN B.

PLAN B is an indirect strategy. It is what you do before you lose your job. It is also what you should do on a regular basis no matter what the economy is doing.

1. Network with friends and old colleagues. Do not cutoff your social and business outlets just to save money. That kind of money is well spent if you truly believe you could be laid off.
2. Research businesses that can withstand varied economic cycles. These companies may be able to hire during this period.
3. Learn new skills that may help you through a period of unemployment with temporary work.
4. Don’t panic if the equity markets falter during this period. These are the risks of investing and to time the ups and downs is much more difficult than it would seem.
5. If you do not have retirement goals and a plan to meet those goals, establish a savings plan and a long term asset and income goal.
6. Focus on the things you can control such as entertainment expenses, dining out unnecessarily, movies. Spend time doing items 1, 2, and 3.

Remember: the only economy that should concern you is YOU:

• your job (source of cash),
• your cost of living (use of cash) and
• your financial health (assets vs. debts).