Investing in 'The New Normal'

Investing tip of the month from Morningstar Investment Research Center by Christopher Davis, Fund Analyst.

In this age of diminished expectations, how should you invest?

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 (FPPTX) 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.

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. 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.

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.

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