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How Would a Global Depression Affect Your Investments?

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I have no idea where the economy is headed. I do not want to trivialize the problems which caused the current crises. It could get better or worse--much worse.

I am struck by the sensationalism of the financial media and suspicious of its motives. Stirring the pot with breathless speculation about a "financial meltdown" and the coming "depression" boosts ratings and sells magazines and newspapers.

Here are some objective facts to consider:

We are not in a recession, much less a depression.

A "recession" is defined as a period of two quarters of negative growth in the Gross Domestic Product (GDP).

According to the Bureau of Economic Analysis, real GDP increased 0.9% in the first quarter of this year. In the second quarter, it increased at an annual rate of 2.8%.

A "depression" is defined as an economic downturn where real GDP declines by more than 10%.

In the Great Depression, real GDP declined by 33%.

During the period 1973-1975, real GDP declined by 4.9%. That was the worst decline in the past sixty years.

Readers of this column know that I advise investors to determine their asset allocation and invest in a globally diversified portfolio of low cost index funds.

What exactly does "globally diversified" mean, and how has this kind of portfolio held up in the current economic climate?

Let's take a look at a hypothetical, diversified portfolio. It is invested solely in index funds, Exchange Traded Funds or passively managed funds, with 60% exposed to the stock markets and the balance in bonds. This asset allocation is typical of the ones used by most pensions and trusts, managing trillions of dollars in assets.

This portfolio would have over 17, 000 total holdings The bond portion of the portfolio would be invested in short and intermediate term bond index funds.

The total market value of the stocks in this portfolio would be in excess of $36 trillion. Total sales would be more than $34 trillion. Net profits would be around $2 trillion. The companies in this portfolio would sell their products and services in more than 192 countries.

This portfolio would still lose money in this market, but it would lose significantly less than the S&P 500.

Recent recessions have lasted 1-2 years.

The Great Depression lasted 10 years.

In order for a depression to dramatically affect the value of a globally diversified portfolio, it would have to be global, not one limited to the United States alone.

The Great Depression was triggered by the failure of the Federal Reserve to increase the money supply, which fell dramatically.

In response to the current crises, central banks around the world are engaged in a coordinated effort to pump money into their various economies. Whether it will be sufficient to stave off another Great Depression is unknown.

What is known is that investors whose asset allocation is appropriate for them and who invest in a globally diversified portfolio of low cost index funds will be in the best position to limit their losses. History also tells us that investors who held on during hard economic times were rewarded with the long term annualized returns consistent with the underlying risk of their portfolios. For this portfolio, those returns would range from 8%-10%.

Dan Solin is the author of The Smartest Investment Book You'll Ever Read (Perigee Books 2006) and The Smartest 401(k) Book You'll Ever Read (Perigee Books 2008).

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