Finance: Playing devil’s advocate with your investment strategy

By Timothy F. Terry, founder, World Trend Financial & Terry Lockridge & Dunn, Cedar Rapids

My children routinely question my judgment on virtually every aspect of life. Our conversations can sometimes resemble mock debates.

Fortunately the Jesuits instructed me in the art of playing the devil's advocate. It was a skill necessary for debate preparation to fine-tune arguments and remove weak links.

The actual Devil's Advocate was a person charged with challenging the submission of candidates nominated for sainthood. The office has been abolished - not surprisingly, we have had a lot more saints show up.

I believe the process of taking a contrary view just to identify the weaknesses in one's own position is an essential aspect of management. Whether you are managing a business or an investment portfolio, your ability to challenge your best thoughts and ideas is critical to your success.

Let's face it - success does not always breed success. In fact, we can cite numerous examples in which it has provided fertile ground for failure.

In the investment arena, the tables are stacked in favor of apparent previous successes. No place is this more evident than the asset allocation model.

These models are ubiquitous. As with my 5-year-old daughter, Rosie, they come at you from all directions. Not unlike Rosie, when they are good they are very, very good, and when they are bad ….

Let's begin by considering the concept. What exactly is an asset allocation model? The Securities and Exchange Commission offers a good definition under the heading of Asset Allocation 101: “Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds and cash.”

This seems simple enough. However, the devil is in the details.

How you structure that allocation really drives the success or failure of your portfolio. If you create a bias to cash and equivalents during a rising market, there is a “lost opportunity.”

On the other hand, a bias to stocks during a severe market decline will result in losses that may shake your confidence as an investor.

As we look at the investment horizon today, we are struck by the love affair investors are having with bonds - especially U.S. Treasuries - while avoiding stocks like the plague.

This is a classic investor mistake. Investors are grabbing the 10- and 30-year Treasuries with both hands. The fact their yields are 1.956 percent and 3.22 percent, respectively, seems to be lost in the panic to buy.

While there is the possibility of further declines in rates, most investors seem oblivious to the overall effect sustained low rates will have on the economy. Worse yet, they may be unwarily setting themselves up for epic losses that would eclipse anything they have ever experienced in stocks.

This point was brought home to me last week during a discussion with an investor. He inquired why I was so negative on bonds.

When I mentioned QE2, he interrupted me with the comment: “I thought it was retired a few years ago.” After I explained I was referring to the second round of “quantitative easing” by the Federal Reserve, not the Queen Elizabeth 2 ocean liner, the conversation returned to common ground.

However, it soon became evident he did not fully appreciate the vulnerability of his disproportionately large bond position.

The inability to play devil's advocate with one's portfolio has led investors to exit equities in favor of bonds at just the wrong time.

The evidence is overwhelming with $75 billion exiting equity funds since last April. Incredibly this exit tops the $72 billion mark set in 2008.

Now, as then, investors are convinced the sky is falling and want out at any price. The difference this time is they are flooding into an asset category that will make them increasingly vulnerable to both inflation and market risk.

Like Rosie after she has lost her favorite shirt, it will not be a pretty scene.