Pack Your Own Parachute

12/02/2011 8:30 am EST

Focus: MARKETS

Paul Justice

Associate Director of North American ETF Research, Morningstar, Inc.

Precautions to minimize risks don’t impair the upside of the expected outcomes, and certainly mitigate the unlikely, but potentially devastating, downside, observes Paul Justice of Morningstar ETFInvestor.

Nearly three years ago, Chesley “Sully” Sullenberger pulled off the heroic feat of landing US Airways Flight 1549 in the Hudson River, saving all 155 people aboard his flight after losing both engines to, of all things, a flock of birds.

Not every pilot would have been able to pull this off. What separated Sully from many of his peers was his lifetime obsession with the nuances of aviation and frequently envisioning the steps he would take to avoid a fiery crash.

Of course, Sully’s tale would be uplifting at any point in time, but the United States was in dire need of a feel-good story in January 2009, considering we were sitting in the depths of the worst financial crisis since the Great Depression. The weeks following his calm yet courageous actions included countless news stories, an invitation to the presidential inauguration, and several television interviews.

Of all his quotes, the one that stuck with me was his session with Katie Couric, where he said, “One way of looking at this might be that for 42 years, I’ve been making small, regular deposits in this bank of experience: education and training. And on January 15, the balance was sufficient so that I could make a very large withdrawal.”

His statement resonated with me because so many people had recently exchanged their lifelong quest for wealth for a rapid dash towards capital preservation. However, many hadn’t repetitively or adequately rehearsed how they would react to a financial market crash.

Too many were unprepared, so they rushed out of investments too late and failed to re-enter the market in time to participate in the recovery. In short, they panicked at a time when a cool, calm, and collected demeanor was needed most.

How to Measure Success
Self-directed investors and professional stewards of capital have two competing agendas when venturing into capital markets.

Goal No. 1 for my team is to not lose money over the long haul. Of course, this can come into conflict with our other goal, which is to build wealth. In order to do this, we must take calculated risks.

Once we identify the goals and the means to reach them, we have several challenges. The first is to understand the risks. Why are we taking them? How do we minimize their downside potential while capturing their upside?

The second challenge is to measure performance: How will we know if we’ve been successful?

The final one is to be dynamic enough to adjust our holdings, or even change our goals, when things don’t go according to plan.

To put this process in perspective, think about Flight 1549. By strict interpretations, it was a complete failure. The goal was to deliver the passengers from New York to Charlotte. Not only did the plane not reach its destination, but several million dollars worth of equipment were lost.

However, expectations and measures of success changed instantly once both engines were impaired. Never before were so many delighted to land, everyone unharmed, in a freezing river.

For US investors, if you lost only 20% in 2008, consider that a huge success. Surrendering a sizable chunk of your portfolio was much better than the comparable 36% drop in the broader market.

Certainly those in balanced funds or those who stuck to strict rebalancing guidelines were giddy when there portfolios were back to breakeven by 2010. All one needs to do is realistically incorporate new information and unfolding events to realize that success is measured both by trying to reach the upside potential without incurring all the wrath of downside risks.

NEXT: Europe’s Exit Strategy

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Europe’s Exit Strategy
In November, we devoted most of our editorial space to the European sovereign debt crisis. Metaphorically, everyone has recognized that most members of the European Union have lost all thrust from their engines, but the conflicting agendas of the varied populace and decentralized policymakers have prevented them from taking decisive actions to remedy downside risks.

They are still taking the control tower’s advice to try to land at Teterboro, which will cause even more casualties to innocent bystanders on the ground, rather than minimizing the downside risk and landing in an unconventional manner. They have not adjusted their goals realistically, which may affect us all.

The first issue is that many won’t acknowledge the source of the problem. Instead of recognizing that the welfare-entitlement nations can no longer compete on a global basis, they’ve turned to finger-pointing toward the nations with the weakest balance sheets—starting with Greece.

While backstopping Greece might remove the immediate symptom, it does not solve the fundamental cause of the problem. And that fundamental problem is sure to infect several other countries until it is properly addressed.

Stanford professor Edward Lazear calls this popcorn contagion. Removing the first kernel that pops does not stop the heat from popping the other kernels. Throwing additional liquidity at the problem and imposing austerity in the future won’t stop Italy or Portugal from popping.

Removing the root of the problem, profligate spending, will require entitlement reform. Entitlement promises were made that can not be kept and need to be broken. This is being addressed now, albeit with fierce resistance, in Greece and Italy, but similar problems exist in Spain, Portugal, and even France.

In order to keep our assessment sober, some of these issues exist in the US as well. However, the union of our government with our fiscal and monetary policymakers has given us a longer timeframe to address the root problem. But when it comes time for the US to break its entitlement promises, personal savings will have to rise and consumption will fall.

While it is hard to prepare for this in our portfolios in this newsletter, we have tried to minimize our exposure to the most expensive or “growthiest” segments of the market. We have neither the inclination nor the ability to avoid the US market entirely in our Hands-On Portfolio, but we are avoiding Europe for the foreseeable future.

In other words, Charlotte will have to wait. We’ll be in the Hudson.

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