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How to Invest in the “New Normal”

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Top Investment strategist reveals his formula for success

You may have noticed that the financial world has seemed anything but normal in recent years. What’s an investor to make of all this economic and financial upheaval, which has left millions of people with meager returns and paltry yields?

It’s the “New Normal,” according to Mohamed El-Erian, the investment company CEO who helped coin that phrase and turn it into a tremendously popular shorthand explanation of what seems unexplainable. And he says it isn’t going away anytime soon.

Bottom Line/Personal asked El-Erian to explain what the New Normal means for worried and confused investors who are seeking to protect their money and make it grow…

Why does investing feel so risky and uncertain nowadays?

We’re in the midst of a tectonic shift in the world economic power structure. Emerging markets, such as Brazil, China and India, are becoming wealthier and more influential, while many developed nations, especially the US, are burdened by huge debts and are seeing their economic power diminished. Since the financial crisis of 2008, it’s been a very bumpy, unpredictable journey characterized by scary headlines about major events, such as the near-collapse of entire economies like that of Greece, and roller-coaster ups and downs in the stock and bond markets.

Should investors get out of stocks and bonds altogether and seek refuge in ultrasafe investments, such as 30-year US Treasury bonds?

That’s fine if recent 30-year Treasury yields of 3.74% meet your goals… and you are willing to hold the bonds for a long time. But for most long-term investors, it’s an excessive flight to safety. The world isn’t ending… it’s just changing. I expect the worst of this rocky transition to last another three years. Then we will stabilize both in the US and globally. That’s when people can make clearer predictions about where the markets are headed.

Is there anything clear about the outlook today?

One thing is certain — in the New Normal, there will be many engines of growth powering the global economy and lots of opportunities, but the US no longer will be the most powerful engine or the most dynamic place to invest. Unfortunately, I expect that slower economic growth and higher unemployment here will persist for many years. Investors also will get lower returns than they have traditionally averaged for both a diversified US stock portfolio (I estimate about 5% to 6% annually instead of 8% to 10%) and a diversified US bond portfolio (I estimate two percentage points above the rate of inflation). You still will be able to earn robust returns in the New Normal, but you will need a different approach than the 60% stocks/40% bonds that has served many of us so well for so long.

How can investors get decent returns but feel safe?

If your priority is heightened safety, the most important change is to shrink your US stock holdings to about 15% of your overall assets. Most of the world’s growth will come from outside the US in the future. While retirees will need to be especially careful to safeguard principal, most investors will need more exposure to global assets, including foreign stocks, bonds and currencies.

What portfolio works best today?

The New Normal portfolio that I recommend has a total of 48% of assets in stocks, including 15% in US stocks… 15% in foreign developed markets… and 18% in emerging markets.

In addition, bonds should take up 20% of your overall portfolio and also have an international flavor. That 20% should include 6% in the US (a diversified mix of corporate bonds, Treasuries, high-yield bonds — and municipal bonds for those in higher tax brackets)… 9% in foreign bonds… and 5% in Treasury Inflation-Protected Securities (TIPS).

TIPS are important because I believe that the decades-long trend of low inflation is coming to an end. As billions of people around the world become more affluent and join the middle class, rising demand will cause the prices of everything from oil to beef to shoot up.

What should investors do with the other one-third of their portfolios?

I would keep at least 10% in cash. Over the next few years, we will continue to have much higher odds of another out-of-the-blue financial shock. Cash will help stabilize your portfolio and give you a reserve that can be used to buy low if markets drop sharply.

Keep your remaining 22% in “real assets,” physical assets that the rest of the world will need in great quantity and that typically do very well in inflationary environments. This 22% includes 6% in real estate investment trusts (REITs)… 11% in diversified commodities funds with many categories of commodities, such as wheat, oil and precious metals… and 5% in infrastructure plays.

What are infrastructure plays?

This is an example of one of the outstanding opportunities created by the New Normal. As people in the rest of the world get richer, they will need more infrastructure — roads, airports, water and electrical stations. The companies that develop and build these facilities will see enormous profits and become global powerhouses. You can get easy access to infrastructure investments through several diversified exchange-traded funds (ETFs), including iShares S&P Global Infrastructure (IGF)… SPDR FTSE/Maquarie Global Infrastructure 100 (GII)… and PowerShares Emerging Market Infrastructure Portfolio (PXR).

What sort of returns can I expect from a New Normal portfolio?

A portfolio such as the one I suggest in this article would have generated an 8% to 10% return, on average, each year over the past decade versus a loss of 1.8% for an all-US stock portfolio and a gain of 1.1% for a 60% US stock/40% US bond mix.

How quickly do I need to make these portfolio changes?

Because financial markets are moving so erratically, you probably don’t want to make any big bets or wholesale moves right away. I would phase in changes over the next few years and do it in as tax-efficient a manner as possible for nonretirement accounts.

With interest rates so low, how are retirees who are living off fixed incomes supposed to deal with the New Normal?

That’s a very tough question. Retirees are getting hit hardest of all. Given their need to earn income without endangering principal, it is important for them not to stretch excessively for yield by moving into lower-quality bonds now. The risk of an economic slowdown is just too great. Consider funds that buy high-quality corporate bonds overseas, which take risks equivalent to those taken by their US counterparts but often offer better yields.

What happens if I just decide to stick with my old portfolio?

You won’t lose all your money in the stock and bond markets, but you may suffer some unpleasant outcomes. Your old portfolio will not be as powerful at generating returns or mitigating risk.

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Source: Mohamed El-Erian, CEO and co-chief investment officer of PIMCO, Newport Beach, California, a mutual fund firm that manages more than $1.1 trillion for more than 8 million investors. He is author of the best seller When Markets Collide: Investment Strategies for the Age of Global Economic Change (McGraw-Hill). www.PIMCO.com.
Date: November 1, 2010 Publication: Bottom Line Personal
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