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Just when you thought it was safe to get back into the investing waters, talk of deflation has creeped back into conversation.

Why does it matter? Well, how you position your portfolio to deal with these two scenarios will make a big difference to your personal bottom line.

With inflation, your money is worth less the longer you hold onto it. So you’re more likely to spend in the now because prices may be moving up.

With deflation, your money may buy more later the longer you hold onto it as prices continue to drop. (Not good for a seller but a better deal for a buyer – just ask someone trying to sell a house in Florida these days).

Since consumers respond differently to these two opposing forces, the ultimate direction of them can have a decidedly different impact on how the recovery progresses because of the way consumers react and business respond to their actions. Ultimately, this will impact how to position an investment portfolio accordingly.

The Right Hook
During a fight a boxer may expect to be hit from both the right and left. It’s just not known when and with how much force. But a good boxer, like a Boy Scout, knows to be prepared.

First the economy has been peppered with jabs from the right that could result in higher inflation: expanding money supply, ballooning government deficits, higher commodity prices, weak currency value.

Given the huge inherited, current and projected government deficits here and abroad, the conventional thought has been that all of this government stimulus will ultimately result in “crowding out” private investment and raise the ugly head of higher inflation down the road. The prospect of higher taxes to pay for these past deficits also lends support to these thoughts.

Recent run-ups in certain commodity prices like oil and energy products have resulted in a rise in consumer prices in January bolstering fears of inflation.

The Left Hook

Now comes the left hook – the deflationary threat: asset prices continuing to fall, increasing slack in industrial capacity, and continuing pressure keeping a lid on labor expenses because of high unemployment.

Credit is still tight with bank lending down. While dollars have been pumped into the economy through the TARP program, it’s mostly sitting in bank vaults. Money that isn’t circulating isn’t a cause of inflation.

Recent economic reports have indicated that core consumer prices actually are flat, well below the 10-year average of 2.2%.

Despite some recent reports, housing prices and rents are down and still expected to fall in key markets, dampening the immediate threat of inflation.

Defensive Portfolios: Lessons from Spencer

The best and strongest home depends on your environment and the threats faced.

Each evening before putting our infant son, Spencer, to bed, we read a story. The favorite for now is


    The Three Little Pigs
(undoubtedly because of Spencer’s dad’s animation).

We all know the story: Three pigs, three houses built from different materials, one pig survives because of his well-built brick house.

The same can be said for portfolios. Heck, a house of sticks can provide some shelter in some circumstances but what happens if a big bad wolf shows up?

Since we don’t know which type of bad wolf will be showing up at the door (inflation or deflation), it makes sense to be positioned to survive either threat.

The elements of a portfolio will likely be the same regardless of an investor’s mind-set. The differences will be in the proportion of the components used.

Inflation Protection Portfolio
To protect this type of portfolio consider elements more likely to retain value even as inflation increases. Example: Commodity funds or ETFs; inflation-linked fixed income funds that include TIPS and/or floating rate notes; Real Estate Investment Trusts or REIT funds (10%); Cash to take advantage of higher short-term interest rates.

Deflation Protection Portfolio
The majority of this type of portfolio is positioned in long-term Treasurys followed by cash and municipal bonds. As consumer prices and interest rates fall, the fixed income stream from the bonds would be worth more.

To protect against surprise inflation, a smaller proportion would be set aside into TIPS, commodities and higher-quality/large cap US stocks.

Little Pig, Little Pig, Let Me In
Not sure where the market will go? Not sure which threat to expect? Learn from the third little pig: Build the strongest house possible.

If there is inflation, the economy will be expanding. As such equities will be the place to be. So consider an allocation of 20% to 25% in the US and a like amount in foreign equities. A portion of these equities should include high-quality firms that are dividend-paying. Commodities and cash will likely benefit from inflation so a 10% allocation to each is prudent. The fixed income component can include some exposure to TIPS (5%) as well as intermediate high-quality bonds (20% – 30%).

To hedge against the risk of deflation, a portfolio with exposure to municipal bonds (5%) and long-term Treasurys (5% – 10%). And some of the equity portfolio should include exposure to consumer staples that tend to do well in such an environment.

To provide some added diversification consider adding positions in companies that focus on infrastructure and firms that can maintain pricing power like utilities, pipeline operators and the like.

Taking these steps should allow an investor to sleep better at night. At least it works for Spencer.

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Like the mythical siren’s call, the pitch is enticing – a seemingly perfect investment.

Investors can buy into a contract offering a minimum return with the potential to capture the upside of increases in the stock market while avoiding portfolio value declines if – and when – the market goes down.

This blend of promises can be found in ‘equity-indexed annuities” or EIAs offered by insurance companies.

And these offerings have become popular given the steep declines in the stock market.  According to a report in the WSJ (9/02/09), sales of EIAs during the first half of 2009 rose 20% compared to a year ago to $15.2 billion.

As compelling as these products may sound, they are anything but simple.  There are many complicated moving parts to each EIA contract. So buyer beware!

Think of investing as finding the route to your destination (a goal) and matching that with the appropriate mode of transportation (or investment vehicle) to get you there.  You may be traveling from Boston to New York and can choose highways or back roads. You can choose hi-speed rail, a car, a bus, a bike or even a plane.  You can drive or fly yourself or hire someone else to drive. All will get you to where you want to go but it’s a question of what kind of comfort level you want on the ride, how much time you have to get there and at what cost – in fees or simply mental health.

For those who may not have the stomach for the gyrations of the stock market but are looking to be more venturesome, the EIA may be a suitable compromise. It’s sort of like someone hiring a driver for the trip but traveling on main roads while avoiding highways.

First, understand that an annuity is offered by an insurance company and backed by the credit-worthiness and deep pockets of the insurer.  There is no FDIC backing. This is not a bank product (although you may find them sold by brokers with desks in banks).

Next, understand that an index can be any benchmark for any asset class or market.  The most common benchmarks include the Dow Jones Industrial Average (DJIA), the S&P 500 and NASDAQ in the US.  Overseas, indexes include the NIKKEI in Japan for instance.

An equity-indexed annuity (EIA) ties the amount that will be credited to an investor’s account to the performance of a particular index. 

But don’t expect to receive a one-for-one increase in your account value based on the index’s increase.  Instead, these contracts include a “participation rate” that sets a percentage of the index gain that is used.

The index-based interest credit may be further limited by “caps” that set a maximum amount of gain.

For anyone who has ever had an Adjustable Rate Mortgage, the process is very similar to how loan rates are recalculated.

Calculating the interest credit is further complicated by the method of measuring the change in the index value.  For instance, the insurer can determine the index change based on the “Annual Reset” – the difference between the index value at the beginning and end of each contract annual anniversary date.  Or a “point-to-point” method may be chosen that compares the index value at the beginning date with some future date like the fifth anniversary. Or the insurer will use “index averaging” taking multiple index returns and averaging them.

By the way, the index value won’t include changes resulting from dividends. While total return on the S&P 500 averaged 9.5% between 1969 and 2008, more than one-third of the return was attributed to dividends.  So these EIA market participation formulas will be calculated on a lower base when dividends are not considered part of the index return.

Typically but not always, there is a minimum amount of interest that is credited. But be aware that this minimum interest credit may not apply to 100% of the contract value.  It may apply an interest rate of 3% to only 90% of the value.  It may apply 1.5% interest to 85% of the total value.  It all depends on the terms of the contract.

EIA contracts have dual values:  the one based on the index value, participation rate and cap; the other based on the minimum interest credit.  And if you get out of the contract before the full term, you may be forfeiting the index-based account value. The insurer would then pay out the amount based on the minimum guaranteed portion which may be lower than what you expected compared to the index formula.

And how many football fans would be happy if their favorite team was on the 1-yard line and the referees moved the goal post?  Well, most EIA contracts reserve the right to unilaterally change terms reducing the participation rate or using stiffer lower, caps for example.

And most contracts have very steep surrender charges that can start at 10% to 15% of the contract value in the first year and declining from there for up to 10 years.

And be aware of the financial incentives that are part of these contracts.  Some EIAs offer “bonuses” to investors – an extra 5% or 10% added to the initial deposit.  But there is no free lunch.  In exchange for such a bonus, the insurer will likely increase the surrender penalty.  So as much as the bonus is an incentive to open the contract, the penalty is an incentive to not move the money out.

Follow the money, too.  Many EIAs pay out commissions to brokers between 6% and 10% and sometimes more.  An investor should be aware that there may be an incentive by a salesperson to offer this as a catch-all solution whether or not it fits the investor’s particular situation. 

The advantages to an EIA include the opportunity to participate in the upside of a market index as an alternative to investing directly through mutual funds for instance.  When an investor opens up an annual statement, there may be less apparent volatility because the account balances aren’t fluctuating wildly.  So this may help a conservative investor dip a toe in the market and sleep better.  And like most annuity products, investors have free access to a portion of their money without surrender charge (usually 10%). And like any other insurance product, it provides a guaranteed death benefit.  Like other annuities, it offers an income stream that you cannot outlive.

The average return on such EIA contracts has been reported to be in the 5%-6% range.  Given the complexities of these contracts and the average returns, it may be a costly way to limit your market exposure but it may make sense for those looking for a principal-protected CD alternative for the cash portion of their portfolios as well as a source of income to supplement retirement.

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The market’s are jumpy to say the least right now.  As I post this the market has ended four days down in a row after finishing August up 3.5% and up 45% since March. 

Despite signs of ‘green shoots’ and glimmers of positive economic activity, the US stock markets have ended the summer rally with a selloff of over 2% (on the DJIA Index).  Fears of a stock market correction or a “W”-shaped recovery loom large after several months of impressive gains.

Manufacturing activity in the US and Europe are mostly up.  Large money-center banks have been paying back the US Treasury for the money borrowed as part of their bailout.  US auto manufacturers are rehiring.

Yet fears that the mighty economic engine of China may slow coupled with worries about the commercial real estate sector in the US have lead investors to take cover.

What’s an investor to do?  Buy and Hold. Or is buy and hold dead as some commentators say?  What about diversification which really seemed to not protect anyone from the steep dive in all markets and all asset classes?

I personally believe that it’s important to follow the time-tested wisdom of grandma:  Don’t put all your eggs in one basket.

But diversifying doesn’t mean “set it and forget it” either which is typical among investors.

To all things there is a season.  And farmers planting crops and fisherman at sea all know that there are cycles in nature.  (El Nino, anyone?)

So why wouldn’t you expect there to be cycles in markets as well?

Considering that stock and bond markets reflect the collective expectations and emotions of millions of investors, it’s an easy leap to expect markets to be governed by cycles in the cumulative raw emotions as well as considered opinions of its many participants.

Example: Right now small-cap stocks have paid off big time this year.  According to the WSJ, stocks in the S&P Small Cap 600 index have leaped over 66% and midcap stocks are up nearly 62%, far outpacing the S&P 500 large cap index which gained “only” 51%.

What a typical investor will do upon hearing such performance will be to move money into this hot sector of the market. And of course that has been exactly what investors have done as more than $7.5 Billion of all fund flows have been to small-cap mutual funds versus outflows of $18.5 Billion from large-cap funds. What’s that saying about “when fool’s rush in?” 

This being said, there are ways to combine investment approaches.

Instead of “buy and hold” it’s time to consider “sit on it and rotate.” 

Ideally, we all want to a perfect investment that always goes up and never goes down.  But a look at one of those “periodic table” of investment returns shows, rarely does the same sector that was a top performer one year do a repeat the following year.

There is a way to get off the wild roller coaster ride between “gloom and doom” and “irrational exuberance.”

This is what I refer to as a “skill-weighted” portfolio.  Essentially, this approach combines various investments in different assets with different investment approaches to help reduce the roller coaster ride.

Even a nesting hen that is sitting on its eggs will rotate positions every once in a while.  And through this approach, too, an investor will maintain a watchful eye on his portfolio being positioned for opportunities by rotating between and among investments, sectors and trends.

Think of a house: a foundation, a frame and then all the visually appealing touches.

In this approach, an investor will have a core foundation comprised of index type investments (mutual funds or Exchange Traded Funds) with a frame consisting of actively managed mutual funds and topped off with a trend-following program for stocks and/or other Exchange Traded Funds to accent the portfolio.  The combination of all these elements will provide balance which helps reduce overall volatility while still positioning for opportunities.

Consider this:  If an investor owns and holds onto an index, he’ll get 100% of the upside … and 100% of the downside.  If an investor owns all actively managed mutual funds, more than 80% do not beat their benchmark.  And those who “market time” need to be right two times:  when they sell and then when they buy.

Not all approaches work all the time but by combining them (rotating between them) an investor may have a better opportunity to preserve, protect and ultimately profit.

What should matter most to any investor is not beating an individual benchmark but getting where they want to go with as few bumps as possible.

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