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Does Your Investment Plan Address the Euro Zone Crisis and the Fiscal Cliff?

Events in Europe, particularly Greece’s future participation in the Euro zone, have been the overwhelming focus of investors worldwide in recent months.  The crisis is a complex, multi-faceted, and constantly evolving story.  But at its heart, the volatility in markets globally reflects worries over the capacity of policymakers to deal effectively with mounting debts and demand for social services.  Issues related to effectively managing debt levels are not unique to Europe.  Concern in the US, in particular, continues to mount as politicians attempt to reach some sort of agreement or risk jumping off the ‘fiscal cliff’.

Outside the debt issue, there is also concern about the impact of the Euro-crisis on the global banking system.  Refinancing by the European Central Bank in early 2012 provided short-term relief for the banks, but market pricing points to worries over the longer-term solvency of many institutions. 

While parallels have been drawn between this phase of the Euro zone crisis and the Lehman Brothers collapse of October 2008, measures of stress in equity and money markets are far below the levels seen during that period.  

One equity measure is the Chicago Board Options Exchange’s “Volatility Index.” Sometimes known as the “fear index,” this is a barometer of the market’s estimate of future volatility of the US equity market over the coming thirty days.   The index has been hovering around 20 in recent weeks, significantly lower than its 2008 peak levels near 80.  

Another measure of sentiment is the credit default swap market. Credit default swaps (CDSs) are a form of derivative that allows investors to take out insurance against a loan default.  Greek CDSs have been prevented from trading since early March. The pricing of other Euro zone CDSs, particularly in the Iberian Peninsula (Spain and Portugal), moderated earlier this year as refinancing agreements were reached, but they have since returned to near the elevated levels of December.   In this case, risk measures are much higher than in 2008 when most of the focus was on the banking system rather than on sovereign debt.

So with conflicting risk indicators and a highly uncertain economic and political environment, what are investors to do?  Should you move to a more defensive position?  Should you take advantage of discounted prices in Europe?  Should you do nothing?

The answer is in your investment policy or financial plan.  It was developed to guide decision making when decision making is difficult – like now.  Many of the provisions are specifically designed to protect your portfolio from permanent market losses.  Such as:

  • Balance between stocks and bonds.  The longer term your objective is, and the higher level of risk tolerance, the greater your allocation to stocks (seeking long term growth).
  • Required levels of diversification.  Restrictions should be made in the level of concentration among individual securities (other than US Treasuries), industry sectors, and countries.
  • Minimum average fixed income credit quality.  Whether you allow an allocation to non-investment grade bonds is far secondary to having a specific, minimum average credit quality for the overall allocation to fixed income.
  • Minimum average fixed income maturity.  The longer term your portfolio’s average fixed income maturity is, the steeper your losses will be when interest rates rise. 


In addition to provisions that protect your investments, having a plan for rebalancing will help instill the behaviors that have served long term investors well historically.  A policy to require an asset class (International stocks for example) to remain within fifty percent of its target (10% for example) will consistently result in buying international stocks lower (if the allocation falls to 5%) and selling them higher (if the allocation rises to 15%). 

Taking the emotion out of investment decision making is a key to long term success.  Good luck!

Index Performance                                  Sept.     3Q      YTD  Trailing 1 Yr       

US Stock (Russell 3000)                              2.85%   6.58%   15.37%    30.41%        
Foreign Stock (FTSE AW ex US)                3.82%   7.64%   11.03%    15.12%        
Total US Bond Mkt. (BarCap Aggregate)   0.09%   1.58%    3.96%     5.05%         
Short US Gov. Bonds (BarCap Gov 1-5 Yr) 0.02%   0.46%   0.91%      1.33%
Municipal Bonds (BarCap 1-10yr Muni)     0.50%    1.41%     3.25%     5.14%
Cash (ML 3Month T-Bill)                             0.01%   0.03%    0.07%     0.07%