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How to invest in a recession

Last updated on: June 11, 2009 19:53 IST

The stakes are high as investors today wonder how to manage their investment portfolios through the recession and survive this storm so they can be best positioned for when the economy recovers.

In these times, it's important to be focussed and diligent with investing, ensuring that your portfolio is aligned with your risk-tolerance and long-term financial goals. Over the coming months, I will address questions from investors, providing actionable ideas to help them manage their investments in today's difficult economic environment.

For starters, is there an investment opportunity within the emerging markets? How much of an investor's portfolio should be allocated to emerging markets?

The long-term outlook for emerging markets is bright. According to Banc of America Securities-Merrill Lynch research, emerging markets account for over 60 per cent of the world's population, yet emerging markets control less than 30 per cent of the world's gross domestic product (GDP).

Our economists at Banc of America Securities-Merrill Lynch currently believe that emerging markets in Asia will grow at 4.8 per cent in 2009, accelerating to nearly 6.9 per cent in 2010. In contrast, developed markets are expected to contract by 3.0 per cent this year, recovering to a higher level of growth in 2010.

Larger emerging economies such as China and India are slowly moving away from an export-oriented financial model and focussing on domestic demand, and this too bodes well for increases in GDP in the next several years.

In light of this forecast, Banc of America Securities-Merrill Lynch research supports the view that the current market dynamics in emerging markets provide long-term investors with a strong opportunity.

So where do you start? Talk to your financial advisor about employing a dollar cost averaging* strategy over the next year, as well as the investment opportunities within diversified emerging markets mutual funds or exchange traded funds (ETFs).

The percentage of your portfolio that you decide to allocate to emerging markets depends on your risk-tolerance and investment horizon.

Here's an example:

1. A growth-oriented investor with a five-year time horizon would typically allocate 30 per cent of the equity portion in his portfolio to international investments.

2. Within that 30 per cent bucket, Banc of America Securities-Merrill Lynch research suggests that investors should diversify between emerging markets and non-US developed markets.

And of course, it is important to remember that volatility is expected when investing in emerging markets and therefore should be thoroughly and thoughtfully discussed with your financial advisor.

What vehicles should I consider if I am interested in the absolute safety of my principal? Obviously, any return on investments can never be guaranteed.

However, when concerned about the safety of investment principal, Banc of America Securities-Merrill Lynch suggest allocating a portion of an investment portfolio to stable, fixed income opportunities and government insured deposits. Some examples include:

  • US treasuries
  • Insured certificates of deposit
  • FDIC backed debt
  • US government agency obligations
  • Municipal bonds

Currently, a laddered fixed income portfolio of municipal bonds in the 15-20 year maturity may generate tax free income of 4-4.5 per cent. This translates to a taxable equivalent yield of over 7 per cent in the highest tax bracket.

Michael Sullivan, Director of Municipal Marketing for Merrill Lynch, recommends focusing on quality with municipal bonds. 'The time may be right to consider buying high-quality municipal bonds, with underlying ratings of high single A or better.'

Investors may want to seek bonds that are backed by broad-based revenue sources, such as general obligation (GO) and essential purpose municipal bonds. If you are interested to see how municipal bonds align with your overall portfolio, here are some questions to ask your financial advisor:

  • What per cent of my portfolio should I have invested in bonds now?
  • Should I first consider munis from my home state because of their tax advantages?  Will income be subject to the alternative minimum tax?
  • How do I select from the universe of long-term, high-quality AAA-rated bonds?
  • What are the risks involved in municipal bond investing?

Should investors consider investment grade corporate bonds and/or high yield bonds?

The recent dislocation in the financial markets has resulted in wider spreads for corporate bonds. Specifically, investment grade corporate bonds are trading at a 5 per cent premium relative to US treasuries, whereas the historical spread has been close to 2 per cent.

High yield bonds, also referred to as "junk" bonds, are trading at over 12 to 13 per cent over treasuries, compared to a historical spread of 7 to 8 per cent.

Additionally, since the income from these bonds is taxable at ordinary income levels, investors may want to consider investing in bonds within a tax deferred account.

Both investment grade corporate and high yield bonds are subject to credit downgrades or defaults, so be sure to consult a financial advisor to determine that these fixed income investments are appropriate within the context of your portfolio.

* Dollar cost averaging does not ensure a profit or protect against loss in declining markets. Dollar cost averaging involves continuous investment regardless of fluctuating prices. Investors should consider their financial ability to continue purchases through periods of high or low price levels.

Raj Sharma can be reached at raj_sharma@ml.com


Raj Sharma is a Senior Vice President and Private Wealth Advisor for the Private Banking and Investment Group at Merrill Lynch in Boston. Raj Sharma recently gained recognition as part of the group of financial advisors who are ranked on Barron's 2009 list of the "Top 100 Financial Advisers."  For the sixth year in a row, Sharma was selected for this honor.  (The Barron's ranking reflects the volume of assets overseen by the advisors and their team, revenues generated for the firms and the quality of the advisors' practices. Less weight is given to assets of institutional clients and assets overseen by private bankers, who operate differently from advisors at brokerage houses and independent firms. The scoring system assigns the top advisor a score of 100 and rates the rest by comparing them with the winner.)  He can be reached at (800) 926-5579 or raj_sharma@ml.com.
Investing in securities involves risks, and there is always the potential of losing money when you invest in securities.
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Raj Sharma