Wake up and smell the economy

"It's the end of the world as we know it," or so sang R.E.M. back in the heyday of the '90s -- pre-tech boom, credit crisis and the Pussycat Dolls. While Americans bought their first computers, CDs were still the way to buy music (iTunes, what iTunes?), and the ubiquitous Freddie Prinze Jr. was everywhere, was R.E.M. onto something with their prophetic lyrics?

Yes they were, according to a new paper soon to be published by Robert Seaberg, head of the wealth planning group at Citi Global Wealth Management, who hypothesizes that very few people believed the current financial disaster could actually happen.

In a recent New York Times article, Seaberg is quoted as saying that the rich were fixated in recent years on the great wealth-generating possibilities of concentrated stock positions; derivatives created from the very mortgages that, it turns out, others couldn’t pay; and hedge funds that locked up their money to take huge bets on the economy. The collapse of the housing, employment and financial markets, coming at once, was more than a shock to the system. Like so many others, many of the rich have gone back to the drawing board.

Seaberg’s new paper, entitled “A Flock of Black Swans,” (haha) says various advisers failed to impress on their clients the need to consider the possibility that highly unlikely events — so-called “black swans” — might indeed occur. The rich may not have done anything different, but at least they would have been aware of the risks they faced.

Seaberg's point is that because everyone was riding high, they didn't have to worry about "the basics," such as saving and budgeting, and instead had fun playing with high and ultra-high net worth. Although many of us know this is one of the reasons that led to the current fiscal crisis, it's always nice to get some affirmation from a legitimate economic source -- especially when that affirmation involves "the basics," which this blog knows and loves!

According to the Times, Seaberg has singled out four areas where investments were hit hardest and where they should be adjusted to ride out any future economic storms. Even though his points directly apply to those at the top of the wealth pyramid, I think people of all sized pocketbooks could learn from his tips:

Redefine a safe investment. Until this year, safe investments included U.S. Treasuries and bonds. Even though Treasuries are still safe per se, they aren't the greatests of investments right now because the yields (or money you earn back for making the investment) is almost nil. Translation: You could become that oft-posed cliche and stuff your money under mattress -- you'd get the same results.

Investment-grade corporate bonds, Seaberg tells the Times, are still trading but their yields are down, hit by the Lehman Brothers bankruptcy and AIG's struggles. Basically, this all means that the definition of a "safe investment" has become very narrow, mainly Treasuries.

Diversify more broadly. (Ed. note: If you're not sure what diversification means, read my post about it here.) Investments have increasingly shifted from just stocks to real estate, hedge funds and private equity, so-called alternative assets with higher returns for those willing to lock up their money for long periods of time. Seaberg says the problem is that many of these investments depend on borrowing, which means their values have plummeted as credit conditions tightened.

He says that in order to diversify your investments, you should look outside the U.S. and Europe to emerging and frontier markets, such as India or China. (These countries, global crisis aside, have begun to spend massive amounts on their infrastructure, so industrial companies benefit.)

Consider tax consequences. When the value of every investment was increasing, the portion lost to taxes on every gain wasn't a big deal. Gains far outstripped the tax elemtn. This isn’t the case anymore, Seaberg says. In an environment of lower returns, the after-tax piece is going to matter more. He points out that municipal bonds from cities and states that can meet their obligations are one lower-tax alternative.

Be more realistic on housing. Seaberg says that the era of the house as a constantly appreciating asset is over. In the last two years, the average house in America has dropped 20% in value, according to the Case-Shiller Home Price Index. This means people are going to be staying in homes longer, or will hold on to them longer as investments, versus selling property fast to make a quick buck. Seaberg says that should be a signal for homeowners to make sure they have the right insurance, i.e., theft, fire. and natural disasters such as hurricanes, floods and earthquakes. Although I see Seaberg's point about property owners holding on to their homes longer because of decreasing values, I don't fully agree that the era of the house as a good investment really is over. I think much of that depends on where you live (homes in rural West Virgina, versus say the Bay Area, obviously aren't congruent in value.) To make a broad-based assumption that it doesn't work anymore is too generalized. As a homebuyer who hopes to build equity in a home, you need to be realistic about the current and future states of employment, location, and property values in your individual zip code.

Seaberg tells the Times that in a recent internal memo, Wells Fargo gave its private bankers a checklist of questions that they should have been asking all along. The first question was, “Are you clear with regards to what is your true appetite for risk?” It is followed further down with, “No matter what, always live below or at your means” and “Are you saving enough?” Um, why were they not asking these questions in the first place? Oh wait, that would have saved us all this financial strife in 2008! Silly me.

Fortunately, there is an upside in all of this, according to article, in that it helps people understand the need to assess their true risk tolerance. That soul-searching, done amid the possibility of lower returns in the near future, could alter spending and saving patterns over the long term. That's a great thing. “Without a sense of abundance, people are going to be more careful,” Seaberg says.