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It's been a trying couple of years for the stock market -- the kind of trying times that shake fundamental market beliefs.
Investments in one-time stalwarts like AIG (NYSE: AIG ) , General Electric (NYSE: GE ) , and Citigroup (NYSE: C ) shocked us all when they toppled from their perches. The severe market losses have caused many to question whether the cornerstone of value investors, "long-term buy and hold," still works.
A new normal
In an exclusive Fool interview earlier this week, Mohamed El-Erian, the CEO and co-CIO of Pacific Investment Management Co. (the world's largest bond investor) said long-term buy and hold is not dead. However, it has to be modified for a "new normal."
Translation: We are undergoing secular changes, not cyclical ones. The environment as we knew it before the financial crisis isn't going to return anytime soon.
By El-Erian's account, there will be a new normal brought on by de-leveraging, de-globalization, and re-regulation. Specifically, the new environment is characterized by languid gross domestic product (GDP) growth and high unemployment for some time. The government will play a large role in the private sector, consumers will not spend to oblivion as before, and the trust that has been broken in financial and regulatory sectors will take time to restore.
To that end, El-Erian recommends that investors build a portfolio based on three elements:
- A long-term view.
- A cyclical view.
- Very explicit risk management.
The first element of the strategy is to be forward-looking rather than backward-looking. "That speaks to asset allocation and geographical exposures," El-Erian said.
The second element is that the road forward will be mired with sharp turns and bumps. As a result, investors must position their portfolios to benefit from cyclical trends. "That bumpiness constitutes an additional challenge for buy and holds, which is to make sure that people can in fact hold -- because when you have a very bumpy journey, there is a temptation to stop holding at the wrong time," he said.
"So there has to be a much more responsive element of the portfolio that is looking to capture not long-term secular and structural trends, but looking to catch shorter-term cyclical and technical trends," he said.
The third element of El-Erian's plan is conscious risk management, which gets at diversification. In the past, El-Erian said, one of the problems with the buy-and-hold strategy was that it encouraged people to think that diversification was sufficient for risk mitigation.
"That's no longer the case. Diversification is necessary, but it's not sufficient," he said. It's necessary because it's the best method for mitigation of risk, but it's not sufficient because, as El-Erian points out, you can have years, such as last year, in which all the correlations go against you. Therefore, he said, buy and hold needs to be supplemented with much more responsive risk management.
"It's not enough to say I'm going to be able to buy and hold simply because I'm diversified. One has to go a few steps further and ask what does it look like when I'm actually buying and holding?" he said.
Building on that, El-Erian said a portfolio should be constructed such that only part of it is held for the "long term," which he defines "long term" as three to five years, max -- because it's difficult to forecast what happens much beyond that. "Part of the portfolio is buy and hold where values are going to be realized over a period of time," he said. "What the investor is taking advantage of is the ability to buy and hold, because there are lots of pools of money that cannot hold up through the ups and downs of a market."
More cracks in the "old normal"
To deal with this new normal, El-Erian has some more tactical advice:
- Start out by defining your objectives and your risk tolerance, because both determine how you build up your portfolio. "The more ambitious you are on your objectives, the more risk that you're going to have to be able to tolerate."
- Indexing may not work as well as in the past. In unstable conditions, "it's important that the core product be actively managed."
- Investing only in the U.S. could lead to subpar returns, since the U.S. will grow more slowly than the rest of the world.
- Blue chips like Wal-Mart (NYSE: WMT ) and McDonald's (NYSE: MCD ) will be around for years to come, but they won't dominate the markets, or investors' portfolios as in the past.
- Inflation is a potential portfolio danger. The best way to guard against inflation right now is with Treasury Inflation Protected Securities (TIPS): "Investors can also protect their portfolios with real assets, but TIPS certainly offer you the more predictable protection against inflation."