An Investment Strategy for the Next Depression

08/31/2010 09:02 pm ET | Updated May 25, 2011

You can't avoid the predictions of the "inevitable" depression. There's plenty of ammunition to support them, including a slower than anticipated economic recovery, high unemployment, record foreclosures, declining housing prices and the prospect of runaway inflation (or deflation).

Every day I get calls from investors who are absolutely certain we are headed for a depression. They want to know if I agree and what they should do to prepare.

I have no idea whether we are headed for a depression or a recovery. Neither do those who make predictions so confidently. In 1987, one of the bestselling books was The Great Depression of 1990, by Ravi Batra. In 1929, Irving Fisher, Professor of Economics at Yale University, famously stated: "Stocks have reached what looks like a permanently high plateau." Jim Cramer told his viewers shortly before Bear Stearns filed for bankruptcy: "Bear Stearns is fine." Hank Paulson advised us on May 7, 2008 that "The worst is likely to be behind us." My personal favorite comes from financial expert Donald Luskin. On September 14, 2008 he wrote an article in the Washington Post stating "...anyone who says we're in a recession, or heading into one -- especially the worst one since the Great Depression -- is making up his own private definition of "recession." And probably for his own political purposes."

But I digress.

Let's assume we are headed for a depression. How would it affect your investments and your investment strategy?

The best data we have relates to the Great Depression of 1929. I looked at the worst rolling periods during that time to see how different portfolios were affected. The time period I selected was July 1, 1929 to June 30, 1932.

A globally diversified portfolio consisting 100% of stocks lost more than 87% of its value. Ouch!

At the other extreme, a portfolio consisting 100% of bonds had a positive return of more than 8%.

Before you rush out and buy bonds, you should focus on basic principles of asset allocation.

I would not permit my clients to invest in an all stock portfolio unless they confirmed they had a time horizon of at least fifteen years before they would need 20% or more of their invested funds. When I extend the end date from June 30, 1932 to June 30, 1944, the total return on the all stock portfolio is more than 23%.

Investors are focused on the wrong issue. The critical question is not: Will there be a depression? That's a question no one can reliably answer. The financial media has an interest in making dire predictions because fear means more readers and viewers and that translates into advertising dollars.

The real question is: Am I in the right asset allocation? The focus on asset allocation is the same whether you are investing for a depression or a recovery.

Here are some general guidelines:

  • If your time horizon is less than 5 years, you should have no exposure to stock market risk;
  • If your time horizon is 8 years, you should have no more than a 60% exposure to stock market risk;
  • If your time horizon is 15 years or longer, you can have a 100% exposure to stock market risk (but I would still encourage you to have at least 10% of your portfolio in bonds).

On average, an asset allocation of 60% stocks and 40% bonds is suitable for most investors.

Historical data tells us those who had the right asset allocation and didn't panic withstood the ravages of the Great Depression. Unfortunately, historical data is not necessarily predictive, but it's far more reliable than the musings of "financial astrologers".

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.

Here is the trailer for my new book, Timeless Investment Advice.