We wanted to communicate to you two different opinions regarding whether buy and hold still makes sense versus a more active approach to asset allocation. There was a very interesting article in the Journal of Financial Planning in our October issue regarding an interview by Shelly Lee with John Bogle who is 80 is and was the founder of the Vanguard Mutual Fund Group in 1974 and has been one of the world's most powerful and influential people. He has just written a book called Enough which is about an important concept about coming to grips with what you really want and need in life and your responsibility to self, family, career and community. It's particularly important now because our society has lost its bearings a bit. The financial sector has almost totally lost its bearings.
John Bogle made some comments regarding whether buy and hold was too simplistic for today's environment. His opinion is it's not dead and advisors know that and it's the journalists who are asking the question. His opinion is it's absurd to think that buy and hold is dead. In his opinion, the simple truth is that long-term investors win as a group and short-term investors lose as a group. It's pretty black and white. Another question that was asked is if free market capitalism still works. He said that yes we have a crisis and failure of capitalism at this point and time. Free markets can get abused easily by overreaching money managers, financial managers, bank managers and corporate managers who have put their own interests ahead of the interests of those they're supposed to represent. Mr. Bogle also believes it's important we return to a long-term mentality and honor our obligations to participate in corporate governance and then things will improve.
Now we'd like to share with you a counterpoint from Mohamed El‑Erian’s comments at the Schwab conference in September. Mohamed is the CEO and co‑CIO of the global mutual fund manager PIMCO, was with the International Monetary Fund for 15 years, has a doctorate in economics from Oxford University, and was the manager of the Harvard Endowment for several years. In his opinion in the narrowest sense the U.S. financial system is safe and he no longer believes there will be a repeat of the cataclysmic events of last September and October 2008. In a broader sense though he feels the global economy still faces many risks. He feels we're dealing with the solvency of large institutions and have inadvertently accelerated redesign of the global economy. What's more we are doing so in the context of a shrinking pie. The global economy is contracting. The government's new ownership stakes in numerous companies has fundamentally changed its role. Once a referee, it's now a player in his opinion.
The biggest lesson of the financial crisis he felt is that diversification is a necessary but not sufficient condition for maintaining adequate portfolio performance. He believes investors need more than just conventional diversification. Diversification in his opinion is no longer just about asset classes. Investors must recognize the markets will under and overprice certain kinds of risks and they won't necessarily do so at the asset class level. Over the next five years he said these considerations will become more important than asset class diversification. He felt it didn't matter what market you were in when the crisis hit. He said all markets collapsed with the exception of government bonds and high-grade investment bonds and treasuries. When the markets recovered, however, it mattered greatly where one was invested so the healthiest markets performed best. El-Erian cited some other reasons for the crisis. The policymakers must recognize that financial innovations like securitization will always be overproduced and overconsumed and that we must have a strong infrastructure to support innovation. Financial institutions must recognize that incentives matter but compensation must be structured to reward managers for long-term though and not short-term results.
Mohamed noted that investors must ensure against extreme adverse outcomes, noting that PIMCO has recently introduced funds that hedge against the worst outcomes. As many of our clients know we are using some of those funds to ensure against worst outcomes in our client portfolios as an additional hedge. In the future he feels the global economy will be driven by the economies of China, Brazil and other emerging markets rather than the US consumer. This transition to a global economy will take place in his opinion over the next 20 to 30 years and may not be a smooth one. He also noted that inflation is not a concern at this point in time because demand for goods is far less than the supply. It's very difficult to generate inflation with these conditions. Stagflation, which is slow growth combined with inflation, may emerge at some point and he said it's starting to show up in some industries.
We thought it would be beneficial for you to hear these two different points of view in the investment world from John Bogle and Mohamed El-Erian. Our belief is that you can incorporate a little bit of both. We still believe strongly in modern portfolio theory and broad asset class diversification but we also believe that overlaying that with appropriate hedging strategies makes sense. In the new normal, as Mohammed calls the economy that we're in today, we believe it makes sense to overlay some of these hedging strategies on top of a broadly diversified portfolio with safe or conservative bond funds as well to stabilize the risk. If you have any questions or would like further information, please don't hesitate to contact us.
Sincerely,
William T. Morrissey, CFP®
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