Investing in 'The New Normal'

In May, real estate developers met in Las Vegas to discuss the future of the American shopping mall. Judging by The New York Times' account of the conference, many developers were reluctant (or unwilling) to entertain the idea that the post-financial crisis world could be much different than the environment that preceded it. Not only were they less-than-attentive to environmental and sustainability concerns, they seemed indifferent to the fact that consumer spending had fallen off a cliff and is likely to remain subdued for years to come. Many, though not all, were waiting for things to get back to normal--the way they were before the crash.

Bill Gross would tell them that is wishful thinking, and he'd say the same to investors who are waiting for a return to the good old days. Gross, manager of the huge and hugely successful  PIMCO Total Return (PTTRX), argues that a "new normal" is emerging, one characterized by slower economic growth, lower investment returns, and higher unemployment and inflation. The culprits behind this new and unsettling normalcy, Gross says, will be greater government regulation, diminished access to credit, and increased savings. At the recent Morningstar Investment Conference, Gross told 1,000-plus attendees that the old global financial order, driven by the dominant U.S. economy and its consumers' ability to borrow heavily to buy foreign goods, is fading away. Gross wasn't the only one to make this argument. In an impassioned speech, Bob Rodriguez, skipper of  FPA Capital  and  FPA New Income (FPNIX) and three-time winner of the Morningstar Manager of the Year award, said that fund managers who didn't adapt to a world where American consumers spend less would wither away.

The rise of this new order, should it unfold as Gross and Rodriguez predict, probably will be messy and probably will lead to many unforeseen consequences, but Gross took a stab at predicting some of the repercussions. He argued that the U.S. dollar would eventually lose its status as the world's reserve currency, reflecting the decline of the U.S. economy relative to the developing world. That shift may take place gradually, but other implications of the new normal are clearer and have more immediate relevance. One is that the economy will rebound much more slowly than after previous recessions. That, in turn, will make it more difficult for your portfolio to recover fully from the late 2007 to early 2009 crash.

I'm doubtful of some of Gross' conclusions, namely that the traditional buy-and-hold portfolio is dead. I'm doubtful that average investors could pull off the alternative--which would require them to time the market--successfully. I'm not alone in my skepticism. Legendary Vanguard founder Jack Bogle certainly disagrees with Gross. My colleague David Kathman also recently defended the virtues of traditional asset allocation here.

Even if Gross' "new normal" doesn't argue for a radical portfolio overhaul, it still has some important implications for how you invest.

1. Spend Less, Save More, and Pay (Even Closer) Attention to Costs
In an era of lower returns, your investments will do less of the heavy lifting in building your nest egg than they did before the market crash. There are a couple of things that you can do to cope. The biggest is simple: Save more. You can begin by gradually upping your contributions to your 401(k) or other retirement accounts. At the very minimum, ensure that you're investing enough to take full advantage of any 401(k) match that your employer offers. Leaving free money on the table means that you'll be building your savings more slowly. If you're nearing or in retirement, you don't have as many coping options if future investment returns are underwhelming. You can reduce your withdrawal rate, thereby giving your portfolio a greater shot at lasting throughout your retirement years, or plan to work longer or part-time.

Second, you should be even more vigilant in keeping your costs down. The more you pay in fund expenses, the less you'll have left over to spend on your retirement or kids' college. Look for domestic stock funds with expense ratios below 1%, international funds charging less than 1.25%, and bond funds with annual levies less than 0.75%. Remember: Cheaper is better.

Fund expenses aren't the only costs that you need to keep an eye on. Taxes, too, can take a heavy toll on your nest egg. (For tips on reducing Uncle Sam's take, click here). Finally, don't forget about transaction costs. If you're a stock or ETF investor and trade heavily, you'll pay a lot in commissions, which will take a bite out of your investment return.

2. Think Globally
In his speech at the Morningstar Investment Conference, Gross argued that investors should invest more abroad, especially in developing markets such as China and India. If the U.S. is going to grow more slowly than the developing world, that's a logical conclusion. Keep in mind, though, that certain companies in the developed world will be among the biggest beneficiaries of growth in emerging markets.  Coca-Cola (KO), for instance, earns 80% of its revenues overseas. That's an example of why you don't necessarily have to go hog wild in loading up on foreign investments, despite emerging markets' compelling long-term growth prospects. Moreover, emerging markets may come with a heavy helping of risk, as my colleague Bill Rocco recently noted.

That said, most investors probably have too much of their portfolios invested in the U.S. This isn't an unpatriotic sentiment. Investors are making an enormous and potentially unwise bet by following the conventional wisdom, which suggests that you should keep only 20%-25% of your stock portfolios abroad. It's a big bet because 60% of the world's total stock market value lies outside of the U.S. An outsized U.S. stake also means that you're staking a lot of your portfolio on the fortunes of the dollar, which may dim if it loses its status as the world's reserve currency of choice. Of course, trying to predict future currency movements is a fool's game. But you can protect your portfolio against such uncertainty by ensuring that it has exposure to many different currencies. For that reason, I'd consider favoring international investments that don't hedge their portfolios against foreign currencies. Most international mutual funds don't hedge, but if you're unsure of your foreign holdings' hedging policies, check with the fund companies to find out.

There probably is no one right foreign allocation; investors will come to different conclusions based on their age and tolerance for risk. To think through how much foreign exposure you need, check out this article.

3. Beware of Inflation
At the Morningstar Investment Conference, inflation came up again and again as potential concern from many of the fund managers. They all cited good reasons why. Huge budget deficits and a dramatic expansion in the money supply historically lead to inflation. Of course, the Fed is well-aware of this fact, and it says that it stands ready to take action if inflation becomes a problem. But will it be willing to raise interest rates and risk quashing what's almost sure to be a slow and fragile recovery? It's not clear.

To be sure, not everyone agrees that inflation is going to be a problem. Nobel Prize-winning economist and New York Times columnist Paul Krugman isn't as concerned. He points to Japan's long bout with deflation in the 1990s, which took place despite its central bank's easy money policy. Also, while many market commentators point to a big recent spike in U.S. Treasury yields as evidence that investors are worried about inflation, yields are low by historic standards and long-term bonds factor in modest inflation.

Still, there's a good argument against waiting until the inflation menace appears imminent before reacting against it. PIMCO's Viner Bhansali likens waiting until the threat appears certain is a lot like trying to buy insurance against hurricanes when one is on the way--it will really cost you.

Even if worries about inflation are overblown, you should still aim to protect your portfolio from rising prices. Even moderate inflation can have a heavy impact on your future purchasing power. One of the best ways to insulate your portfolio against inflation is to invest in Treasury Inflation-Protected Securities. Unlike conventional Treasury bonds, the principal on TIPS adjusts in line with the consumer price index. Other decent inflation hedges include real estate and commodities such as gold, but they should be held as a small part of a diversified portfolio. Morningstar.com Premium Members can find our analysts' favorite real estate funds here, precious-metals funds here, and natural-resources funds here. (The natural-resources category includes funds with broad commodities exposure.)

For more on inflation-proofing your portfolio, click here.

4. Don't Give Up on Stocks
This sounds counterintuitive. After all, if lousy returns are in the offing, why bother investing in stocks?  Davis NY Venture's (NYVTX) Chris Davis (no relation to me) supplied a pretty good answer at the Morningstar conference: It's still possible to make money in lousy environments. We could all agree, I'm sure, that the lousiest (and probably not most likely) outcome to this financial crisis would be a second Great Depression. But as it turns out, the Great Depression wasn't an awful time to invest. Davis points out that had you invested $10,000 every year in the Dow Jones Industrial Average at the start of 1929 and an additional $10,000 in every year after, stopping in 1954 when the index returned to its Roaring '20s' peak, your $260,000 investment would have turned into $1.7 million. That's an annualized return of 12.5%--not too shabby for a time period that included a lengthy depression and a world war. Investors who missed several short but sharp rallies in the dismal 1930s would have never fared as well. That fact argues for sticking with stocks, even if we're in for a period of prolonged weakness. (It's worth noting that Davis pointed out that dividends accounted for a big part of stocks' returns over that period, suggesting that income should play an important role in your investment strategy.)

The alternative--attempting to time the market or staying out of stocks altogether--strikes me as riskier. As Davis noted, missing even a handful of the market's best days can have a devastating effect on long-term returns: Over the past 20 years, the S&P 500 Index returned 8.4% annually. But had you missed the index's best 30 days, your return would have been 0%. (But, as readers point out, missing the index's worst days is immensely helpful.)

That's not to say that you should expect miracles from stocks. Jeremy Grantham--the GMO founder who rightly predicted 10 years ago that the S&P 500 would generate negative returns in the ensuing decade--expects that the index will return 5.9% on an inflation-adjusted basis over the next seven years. (His expectations for high-quality U.S. stocks are higher, however, with an 11.5% real return.) Vanguard's Bogle was a little more pessimistic, predicting an 8% annual return for stocks. Assuming 3% annual inflation (and that may prove too conservative), you've got a real return of 5%. That's surely nothing to crow about, but that (sadly enough) might be the best game in town.