The World Poker Tour did an analysis which showed the players with the largest number of winning hands were not the biggest money makers.  Why is this?  Their success was attributed to the proper use of “the fold.”  How does this apply to investing?  Two words:  “Risk Management.”

The above analogy, with regards to investment management, doesn’t mean that we should all know when to just give up, sell everything and move to cash.  It simply means we should give a lot of thought as to the amount of risk one is taking by over allocating to the big hand of “equities.”  Even though we have seen the market move up over 50% since the March lows, it is still down around 30% since October 2007.  It took most people 60 plus years to accumulate their retirement nest egg, but with poor allocations and no risk management, many people saw a third or more of it disappear in a matter of months.  When this happens, all types of psychological circuits begin to be tripped.  Fear, panic…do we pull the plug, or assume more risk by “trying” to make that money back?

With our clients, we try to avoid having to make these decisions by concentrating on what we consider a bottoms-up strategy.  Most brokers or advisors start with “how much risk can you handle?  We like to ask, “How little risk do you need to take?”  Most brokerage marketing pieces that show portfolio strategies start with the most aggressive portfolio first, then digress to the most conservative portfolio.  We start out with conservative portfolios designed to meet cash flow needs so you can enjoy retirement.  We then determine the inflation and growth needs so you don’t run out of money.

As we have all enjoyed the comeback in the markets lately, we can’t help but worry about sustainability.  We feel strongly that cash-flow based portfolios (portfolios with good income) will be more important than ever over the next several years.  We also feel that real assets, such as commodities, will provide the needed inflation hedge and alternative growth vital to your nest egg.

We also see the beginning of the next bubble forming in the Treasury market.  As the Federal Reserve puts a halt to their asset purchasing in late March, longer term rates will start to move up.  Since 1962, the average yield on the 10-year Treasury has been 6.2%.  We might not see this in the next year or two, but higher rates are coming.  If your neighbor had massive debt and a shrinking income, would you only take 4% on the money he borrows from you?  Of course not, you would demand a higher rate.  Well congrats, you are now China.  With the above scenario, we recommend individual bonds (corporate or municipal) with relatively short durations to the portfolio, and we would definitely stay away from long-term government debt.  As we have often said, in a low interest-rate environment you need to wear a shirt, not get a tattoo.

With all the uncertainty over the next several years, we highly recommend more attention be paid to Risk Management.  Predictability of returns and minimizing drawdowns are extremely important in long-term investing success.  Good cash flow, alternative growth (not just depending on the stock market), diversified fixed-income holdings, all contribute to less stress, better sleep and a retirement plan based on more certainty and less gambling.  You don’t have to fold’em, just make sure your nest egg is diversified.