Balancing Your Portfolio for All Seasons – For Good and Bad Times

August 24, 2001

INTRODUCTION

A lot of people have made good money in the stock market over the past few years. A lot of those people have now given back some or all of those profits in the current bear market which Wall Street denies is a bear market. And a growing number of investors now have net losses in their stock or mutual fund portfolios and those losses are growing.

Because these people refuse to listen to or consider the unpleasant facts about the economy, the financial system, and our growing vulnerability, many will be completely wiped out in the coming bear market – and we are talking about losing most of their life savings, of their retirement funds, oftheir net worth or wealth.

In the next year or two, there very well may be millions of very unhappy campers who will have no real idea why they have been impoverished. They will blame their stock broker, their banker, their financial planner, their trust officer, their spouse – or the politicians in office at the time. But the truth is that most of the fault for their losses will be their own – because they were dumb, greedy, gullible, stubborn, in denial, uninformed about the realities of the day – or some combination of these factors.

However, the main reason millions of investors will suffer great losses, give back their profits, or have mediocre results in their portfolios is that they have no plan, no coherent strategy for managing their assets, for obtaining a reasonable and consistent return, and managing or minimizing their risk. Why do highly successful investors like Warren Buffet consistently do well with their investments? Because they have a long-term plan or strategy; because they avoid letting their emotions get involved with their investment decisions; and because they avoid being greedy.

When this writer first went to work on Wall Street in the late 1960s, there was a saying which still holds true today: “There are three kinds of investors: the bulls, the bears, and the pigs – and the pigs get eaten.”

In today’s investment environment there are a lot of “pigs” – brokers, fund managers, Wall Street analysts and insiders, speculators, holders of large high-tech stock options, and investors – most of whom are driven by greed – to make easy, quick huge returns – in short, to become rich. Many, if not most of these “pigs” will be “eaten” in the coming bear market just as many thousands have already joined the “90 Percent Club” of those who have lost 90% or more of their Internet investments.

The Buffets of the world and the really successful investors believe there is a better way and this writer agrees. First, let’s look at some investment principles.

1. PRINCIPLES OF SUCCESSFUL INVESTING:

PRINCIPLE #1: Avoid losses or keep them to a minimum – If you take a 50% loss, you have to have a 100% gain to get even; if you take a 66% loss (which is common in today’s markets) you have to have a 200% up move to get even.

PRINCIPLE #2: Learn to manage risk – Never buy a single investment that can jeopardize more than 5-10% of your portfolio. Avoid speculative investments. In a primary bear market, 85% of all stocks will decline. A long-term buy and hold strategy exposes your portfolio to great risk in a long-term bear market.

PRINCIPLE #3: Diversify your portfolio – Don’t put all your eggs in one basket, or even severalsimilar baskets. Diversify as to kinds of investments – not just a lot of different stocks, different pieces of real estate, etc.

PRINCIPLE #4: Avoid greed – Avoid investments that promise to make great profits very fast. They usually don’t. If they are too good to be true, they are usually not true.

PRINCIPLE #5: Only buy value – That is, investments which are very undervalued and which are probably being totally overlooked by the great majority of investors. This is the cornerstone of Warren Buffet’s investment philosophy. Also of Bernard Baruch’s “buy straw hats in January…” approach. Value buyers never got burned in the speculative “no earnings” dot.coms, because they avoided them.

PRINCIPLE #6: Avoid buying what everyone else is buying – If there is already mass acceptance of an investment, a group of stocks, etc. then that acceptance has already been priced into the investment (i.e., such as the Internet/high-tech stocks over the past year or two). Remember, the majority is always wrong!

PRINCIPLE #7: Avoid get rich quick schemes or investments – Most investors who are driven by greed (which is a very powerful emotion) end up losing. Remember, the tortoise won the race, not the hare. Remember the ant eats better in winter than the grasshopper.

PRINCIPLE #8:: Anticipate trends before the are obvious to the crowd – For example, defense stocks will do well in a period where the U.S. must rearm over the next few years. Raw materials will rise with oil prices and Middle East turmoil.

PRINCIPLE #9: Be patient and aim for a reasonable return (i.e., 6-12% per year). A cabbage grows faster than an oak tree – but which one ultimately grows bigger and lasts longer. In a speculative time of quick riches, instant gains, and no-brainer investments, this principle is very unpopular. After a primary bear market, this principle will become very popular.

PRINCIPLE #10: Learn and utilize the principle of compound interest – The biggest buildings in most cities (i.e., the banks and insurance companies) are owned by people who utilize this principle. The wealthiest people on earth understand and apply this principle. It is the investment application of the tortoise and the hare race.

PRINCIPLE #11: Understand the times – If you get your information from the mainline financial press, the financial or mainline media, from brokerage analysts, or from Wall Street, you will not understand the times. You will understand only what they want you to understand to get you to buy more stocks and make Wall Street more money.

2. VALUE INVESTING: A FORMULA FOR FINANCIAL SUCCESS

Successful investors buy investments when they are cheap; when they are out of favor with the public; when they are undervalued. Hence, successful investors are mavericks who are willing to go against the flow. They are willing to be “wrong” for a while as Warren Buffet was when he avoided high-tech stocks and Internets in favor of less popular investments (including silver) – even as the tech/Internet bubble continued to grow. Who looks smart now?

Similarly, gold and silver investors have had to be “wrong” for a while as they have bought and held the metals at excellent, very undervalued prices, and have had to wait patiently for the stock bubble to run its course. Value investors are not speculators, they do not buy speculative investments (at least not with the great majority of their funds) and they take very little risk. They are also very patient – understanding that it is not who wins the biggest today, this week or this month, but he who wins in the long run really wins.

When stocks, bonds, real estate, art goods, diamonds, antiques, gold, or silver or other collectibles are great values, the value investor buys them. And if he (or she) can’t find any great values, he simply waits – leaving his money in a cash equivalent at a modest interest rate. He never overpays for anything, and he never chases a market as it is rising. He (or she) may wait months or years to find the right, undervalued investment – it’s called patience. Their investments are defined by quality, not quantity, or quick turns (or “killings”). They understand that quick profits almost always turn into quick losses – as the collapse of the Internet bubble has once again proven.

The value investor does not feel pressure to “make money.” It is not his living; he is not dependent upon turning a quick profit to succeed in life or maintain his standard of living or stimulate his ego. The value investor is not a gambler – he seldom goes to Las Vegas or buys lottery tickets. He knows there is no such thing as something for nothing or quick easy money. The value investor is risk adverse – he does not like to lose money, especially big money in the stock market, in options, in futures, in real estate, in bad loans, in mindless gambling or even in his own business.

The Bible says that “those who live by the sword will die by the sword.” In like manner, the value investor knows that “those who live by speculation will die by speculation.” The market always takes back the money (or gains) and then some from the speculators.

The value investor is not driven by greed or emotions. He or she makes calm, rational, well thought out long-term decisions – and then sticks with those decisions even if the market does not give them instant gratification (as Warren Buffet has demonstrated with his 130 million ounce purchase of silver over two years ago).

The value investor is willing to be wrong for a while and to be in a loss position for a while because his ego is not tied up with his investment decisions. He is also well diversified, so that no one investment decision can sink him if he is wrong.

The value investor tends to be a maverick who will go against the crowd. He knows that the majority are always wrong and that the majority buy high and sell low, while he buys low and sells high. The value investor is invariably a thinker and never a crowd follower – which sets him or her apart from the great mass of investors who simply follow the fad of the day or the current spin line from Wall Street or its financial media shills. Value investors such as Warren Buffet are not big fans of CNBC, Wall Street Week or other Wall Street stock tout television shows.

The value investor invariably seeks safety, an attractive return, and a good chance of price appreciation in an investment. In reality, the value investor is a very conservative investor. And finally,the value investor himself (or herself) is distinguished by quality – not quantity. There are not many of them in today’s bubble environment.

3.     THE MAGIC OF COMPOUND INTEREST

Most of the great wealth in our world has come from compounding principal which has multiplied over time via earned interest which has increased the principle upon which still more interest is earned, etc., etc. Several years ago Richard Russell wrote an excellent article on the magic of compound interest as the single most valuable principle in successful investing. Excerpts from that article follow:

Making money entails a lot more than predicting which way the stock or bond markets are heading or trying to figure which stock or fund will double over the next few years. To the great majority of really successful investors, making money requires a plan, self-discipline and desire. I say, ‘for the great majority of people” because if you’re a Steven Spielberg or a Bill Gates you don’t have to know about the Dow or the markets or about yields or price/earnings ratios. You’re a phenomenon in your own field, and you’re going to make big money as a by-product of your talent and ability. But this kind of genius is rare.

For the average investor, you and me, we’re not geniuses so we have to have a financial plan. In view of this, I offer the following that we must be aware of if we are serious about making money.

One of the most important lessons for living in the modern world is that to survive you’ve got to have money. But to live (survive) happily, you must have love, health (mental and physical), freedom, intellectual stimulation – and money. When I taught my kids about money, the first thing I taught them was the use of the “money bible.” What’s the money bible? Simple, it’s a volume of the compounding interest tables.

Compounding is the royal road to riches. Compounding is the safe road, the sure road, and fortunately, anybody can do it. To compound successfully you need the following: perseverance in order to keep you firmly on the savings path. You need intelligence in order to understand what you are doing and why. And you need a knowledge of the mathematics tables in order to comprehend the amazing rewards that will come to you if you faithfully follow the compounding road. And, of course, you need time, time to allow the power of compounding to work for you. Remember, compounding only works through time.

But there are two catches in the compounding process. The first is obvious – compounding may involve sacrifice (you can’t spend it and still save it). Second, compounding is boring – b-o-r-i-n-g. Or I should say it’s boring until (after seven or eight years) the money starts to pour in. Then, believe me, compounding becomes very interesting. In fact, it becomes downright fascinating!

In order to emphasize the power of compounding, I am including this extraordinary study, courtesy of Market Logic, of Ft. Lauderdale, FL 33306. In this study we assume that investor (B) opens an IRA at age 19. For seven consecutive periods he puts $2,000 in his IRA at an average growth rate of 10% (7% interest plus growth). After seven years this fellow makes NO MORE contributions – he’s finished.

A second investor (A) makes no contributions until age 26 (this is the age when investor B was finished with his contributions). Then A continues faithfully to contribute $2,000 every year until he’s 65 (at the same theoretical 10% rate).

Now study the incredible results. B, who made his contributions earlier and who made only seven contributions, ends up with MORE money than A, who made 40 contributions but at a LATER TIME. The difference in the two is that B had seven more early years of compounding than A. Those seven early years were worth more than all of A’s 33 additional contributions.

This is a study that I suggest you show to your kids. It’s a study I’ve lived by, and I can tell you, “It works.” You can work your compounding with muni-bonds, with a good money market fund, with T-bills, with five-year T-notes, with a fixed or indexed annuity, etc.

Note that investor B only invested $14,000 while investor A invested $80,000. Investor A got an 11-fold return and investor B, through the magic of compounding – a 66-fold return.

4. THE INVESTMENT TRIANGLE: PRESERVING AND PROFITING FOR THOSE WHO AREN’T PROPHETS

Throughout the years investors have heard hundreds of different opinions about the correct way to invest. Some claim that the stock market is the “only place to be.” Others of a more conservative nature have maintained that gold and silver offer the only real long-term security against all types of economic scenarios.

The majority of the people who are not in either stocks or gold tend to keep their nest egg in bank CDs for want of a better idea that is safe. Unfortunately, none of the above-mentioned investment approaches offer a consistent return or security over the long-term. This writer has found that in the long run, any investment strategy that is not balanced enough to eliminate having to predict the future may in time be both very humbling and costly.

Over the past several years there has been a very powerful media campaign promoting the excitement and “almost certain riches” to be reaped by investing in the “New Economy.” This “New Economy” was advertised as the way that those who had vision for the future could profit in astounding ways never before imagined.

The reason for this new unstoppable rise that was to occur in the stock markets and the overall economy was primarily based on the revolutionary impact new technology would have on our society for years to come. Care was thrown to the wind by many investors who were new to the stock and mutual fund markets. Many of these investors put some or all of their money into high tech companies based on fad promotions, Wall Street hype, and word of mouth (i.e., at cocktail parties, at laundromats, from bellhops, cab drivers and newly enlightened housewives) – completely ignoring the poor earnings fundamentals of these Wall Street “favorites.”

At first these stock investments can offer great gains and excitement. Over the past 15 years the overall stock market has given double digit returns each year on average. The problem with investing primarily (or only) in the stock market or mutual funds is that they only do well when the economy is strong or stable, or when the government is fueling the economy with newly created liquidity (which is a temporary fix followed by inflation and recession).

Many investors have found that their stocks, which had almost a meteoric rise last year, have had a precipitous fall in value this year. To be only in the stock market also requires continued vigilance and management time, which most investors just don’t have. Investing primarily in stocks requires accurate prediction of the future, which over time, through the various up and down cycles of the economy, proves to be very difficult.

This leads us to the opposite end of the spectrum: The precious metals investor. For many years this writer has recommended that one-third of a person’s nest egg should be placed into a mixture of gold, silver and platinum. The reason for this is simple. Gold and the other precious metals offer a kind of security that no paper investment on Earth can: They have always had value and have never gone to zero. All paper investments and currencies, if given enough time, evaporate away to nothing.

Paper assets all represent value, as defined by man (i.e., by governments, monetary authorities, securities markets, bureaucrats, etc.). Gold is value and is far more than just a paper promise to pay. The problem, however, is that many investors have owned precious metals for years waiting for the inevitable downturn in the economy to occur, only to be disappointed that the crash hasn’t occurred yet. Owning only precious metals without a balance in other investments is just as out of balance as owning only stock.

So what is the solution? Your answer could be that you won’t invest at all, but just keep the money in the bank. Unfortunately, even this is a form of risk investing when you consider that the bank takes $.90 of every dollar deposited and loans it out, hoping for future repayment. During a severe economic downturn or even inflation, bank deposits can become worthless instantly or whittled down over time. No, just staying in the bank is not a perfect solution either.

The need which value conscious, conservative investors have, is to have a relatively simple strategy that doesn’t require accurate prediction of the future in any given market or the economy. They need a balanced plan that prospers both in good times and in bad. They need something that has very good upside potential without the threat of losing most or all of our money.

In the 11th chapter of the book of Ecclesiastes, Solomon gives very wise advice that came both from the wisdom of God as well as from experience in the school of hard knocks. Solomon had learned what most people, given enough time, realize: You shouldn’t have all your eggs in one basket. A diversified strategy that will maximize total portfolio return and minimize total portfolio losses in all seasons is based on:

THE INVESTMENT TRIANGLE

a) THE FOUNDATION: GOLD, SILVER AND PLATINUM – Imagine for a moment a trianglerepresenting the three categories of investing. This investment triangle is very similar to a financial house and is broken into equal thirds. The base (bottom line) of the investment triangle is thefoundation. Very much like building a house, the foundation is the first thing that is put in place and it ultimately supports the rest of the structure.

In the case of the investment triangle, the foundation is in gold, silver and even platinum. This one-third portion of the triangle truly functions as a foundation, in that when all else fails, gold and silver have always had value (at least for the last 4,000 years, which seems to be a good test of time). This foundation in precious metals rises sharply in value when the people’s faith in the accepted paper financial system is shaken (i.e., as in the 1970s when gold and silver each rose 2,500%). But to have only the precious metals foundation is simply not balanced – it is not good diversification. This takes us to the left side of thetriangle.

b) GROWTH/INCOME: STOCKS, BONDS, MUTUAL FUNDS AND ANNUITIES – The left side of the investment triangle represents “Growth/Income.” It is the side that holds stocks, bonds, mutual funds, annuities, etc. Though these can be a more volatile form of investing, a balanced portfolio with precious metals as a foundation allows a person to enjoy the fruits of a stable or growing economy, and yet be hedged for more difficult times.

As stated earlier, the left side of the triangle has yielded double digit returns on average for the past 14 years and even though we may now be facing a sharp downturn in the economy and equity markets, there will be great opportunities again sometime in the future for profitable stock and mutual fund investments. Since we know we cannot predict with precision when the good years will be, we choose to have one-third of the total portfolio invested in either growth or income investment vehicles – or some combination of the two.

For those who need income, this left side of the investment triangle includes assets that yield better income than bank or T-bill interest rates. For the person who wants to enjoy the up-years in the market, but not lose principal during the down-years, there are even annuities that offer this kind of protection that have built-in guarantees. For the moment and the foreseeable future, this writer believes it is wise to switch completely out of stocks and mutual funds and into interest-bearing investments (i.e., conservative short bonds [government or municipal] or interest bearing annuities.

c) SAVINGS: CASH, BANK ACCOUNT, TREASURY BILLS – This brings us to the right side and final one-third of the investment triangle. The right side is what we call “Savings.” This side is made up of the three things we normally think of when we think of liquid savings: cash, bank accounts (for bill paying, etc.) and US Treasury Bills or T-Bill money markets. This is the side of thetriangle that does not fluctuate in value.

This is also the side that allows you to have instant liquidity and access to your money when you need it. These funds can be in a conservative bank or in T-Bills or T-Bill money markets. Avoid regular (non-government) money market funds because many of these play the highly speculative derivatives markets to increase their yields. While the right side of the triangle doesn’t offer growth (other than compounding bank or T-Bill interest rates), it does give peace of mind and ready access for current needs.

The beauty and symmetry of this strategy allows for a great deal of growth and flexibility without the inherent problem of having to predict when the economy is going to grow or contract. The emotional highs and lows can be avoided as well, because over the long haul the triangle should be growing most of the time. In times of economic prosperity the growth/income side of the triangle will grow more than the foundation.

But during times of economic uncertainty, the foundation should far outpace the growth/incomeside. It doesn’t matter which side of the triangle is growing, however, because one will offset the other over time. The last one-third that is kept in the Savings side allows you as an investor to have liquidity for any current needs without having to sell the longer-term investments of the other two sides of the investment triangle.

[ED. NOTE: In the 1970s this writer was the National Sales Manager for the world’s largest gold share investment company. We commissioned New York University to do an independent study of how gold related assets diversified in an institutional investment portfolio could maximize the return.The underlying premise of the study was that gold is contra cyclical to the stock and bond markets for at least two-thirds of the cycle – so that when stocks and bonds were strong, gold would be weak or flat and when stocks or bonds were weak gold would be strong and offset the losses in the securities.

The conclusion of the study was that if a portfolio was split 80% stocks and 20% gold-related assets; or 80% bonds (or Treasuries) and 20% gold, that the overall portfolio fluctuations would be ironed out and portfolio return would be maximized over any 10-year period of time. Based on that study several large pension funds including one for the State of Alaska acquired sizeable positions in gold or gold stocks.

This concept of the contra cyclical price action of gold (or silver or platinum) versus stocks or bonds is the underlying rational for the investment triangle.]

Looking at the last 40 years of investing, the triangle has proven to be an excellent strategy for those who have used it. During the decade of the 1960s, one could realize double digit returns from the growth side (stocks, etc.,), but not from the foundation side (gold, silver). In the decade of the 1970s, however, the growth side only gave single digit returns at best but the foundation gave an average return of over 30% per year! We all know that the last two decades (1980s & 1990s) have again belonged to the growth side with sometimes spectacular returns.

Will the 2000s be the decade wherein the foundation kicks in and repeats the performance of the 1970s? We really don’t need to know the answer to that question if we are properly diversified in theinvestment triangle. An added advantage to this strategy is this: should our economy suffer a total collapse through war or depression, the base of the triangle will never go to zero. In fact, in such times of total collapse, history has shown that it is gold and silver that ultimately save the assets of owner. Even if the other two-thirds of the triangle are completely lost, the foundation in gold and silver usually rise far more than enough to offset any losses in the other two sides!

If the investment triangle works so well, you may ask why don’t all investors use it. There are many answers, most involve a short-sighted view of history. Many people look at the last few years and assume it will always be just the way it is now. Even those who know history are not immune to short-term thinking. The investment triangle is a protection from our own emotional short-term thinking – it takes our emotions out of the investment equation.

To use a strategy such as the investment triangle takes a certain degree of humility and discipline. Why? Because on any given day we have an opinion as to where the economy is going. We may be right or wrong that day, but having to consistently be right to make money grow is an impossible challenge for most people. If we use longer term thinking applied to the triangle and the balance it brings, we will be successful. It may be time to admit that we cannot perfectly forecast the future and then invest for any potential outcome.

Ecclesiastes 11 says: “Cast your bread upon the waters, For you will find it after many days. Give a portion to seven, and also to eight, For you do not know what evil will be on the earth. If the clouds are full of rain, they empty themselves upon the earth; And if a tree falls to the south or to the north, in the place where the tree falls, there it shall lie. He who observes the wind will not sow, and he who regards the clouds will not reap. As you do not know what is the way of the wind, or how the bones grow in the womb of her who is with child, so you do not know the works of God who makes everything. In the morning sow your seed, and in the evening do not withhold your hand; for you do not know which will prosper, either this or that, or whether both alike will be good.”

CONCLUSION

While we cannot accurately or precisely predict the future, there are certain indicators which point to shifts in the markets, the economy and the financial system and there are still consequences to our actions – good or bad. The stock market is breaking down and appears to be heading into an even more severe bear market. Losses are piling up in investors’ portfolios and the economy, long overdue for a major correction, seems to be headed into a substantial recession.

This writer strongly believes that it is time for stock and equity mutual fund investors to move to the sidelines and reposition their assets for what could be very difficult times. Yes, we believe it is time to become very conservative with investments. Conservative income bearing investments and precious metals should be the investments of choice for conservative investors for the next few years in the opinion of this writer.

The principles of successful investing discussed above should be considered for all investors who wish to conserve assets and prosper in the years which lie immediately ahead. Value investing, the avoidance of big losses, proper diversification, and the principle of compound interest are all essential for prudent investors. Likewise, the reduction of debt burdens. The investment triangledescribed above should be utilized, with emphasis on conservative income and precious metals over the next year or two. It is a time to watch the bear market from the sidelines and keep your powder dry.

10 karat gold is 41.7% pure gold.