Don't Let Terror Threats Stop Finance Plans

This week, Gail addresses the recent terror threats against the U.S. and advises readers on securing investments and the psychological effects of warnings on financial planning.

Dear Gail,

This new terrorism threat the government came out with has scared the heck out of us. It's not because we live in New York City or Washington, D.C., although I am afraid for those who do. We live in a medium-sized midwestern town — not exactly on a terrorist's radar screen (I hope).

Like most people, my husband and I have been trying to save for retirement through IRAs and the 401(k)s offered by our employers. We also have 529s started for our two children, ages 6 and 8.

Now we find ourselves questioning whether we should be making any more investments because of what could happen to them if there's another terrorist attack.

My husband wants to cash in everything we currently own. I'm thinking we should hold onto the investments we have, but just not buy any more. Instead we could put the money into a savings account or CDs.

What do you think?

Mandy

Dear Mandy —

The world changed for all Americans on Sept. 11, 2001. While I have no doubt that the terrorists who carried out those despicable acts against the World Trade Center and Pentagon intended to kill as many people as they could and destroy as much property as possible, these were not their main goals. The top priority of terrorism is psychological damage. That's why just the threat of another terrorist attack can have such a powerful impact on people.

The feelings you are expressing are exactly what terrorists aim to create: fear and uncertainty. They want us to doubt our government, our institutions, our values, our children's futures, our basic notions of right and wrong, and our lifestyle (which they abhor).

In a terrorist's ideal world, we would hide in our homes, stop going to the movies, stay out of the malls, never attend a baseball game, and never set foot on an airplane. We'd use our existing cars until they fell apart because what's the point in buying a new one if you might not be here next year? We'd stop saving for a vacation because, well, maybe we shouldn't take the chance of going to the beach/mountains/lake. Heck, let's really take this to extremes and suggest we all stop brushing our teeth because you probably don't need them to last 80 years or more!

In other words, we would "what-if" ourselves into inert blobs of scared individuals who do nothing, go nowhere, and see no future.

And that's precisely what terrorism aims to accomplish: Since this country is too big and diverse for terrorists to impact in its entirety, they selected a few symbolic targets and are trying to control the rest of us through fear.

But that didn't happen after 9/11 and I sincerely doubt it would happen if there were another terrorist incident here. Are the financial markets likely to react, especially if, once again, they are one of the targets? Undoubtedly. But the question you have to ask yourself as an investor is how long is the reaction likely to last?

Alan Skrainka, Chief Market Strategist for the firm Edward Jones, points out that following the terrorist attacks in 2001, the Dow Jones Industrial Average fell from 9605 to a low of 8235. Less than two months later, on Nov. 9, to be exact, the Dow hit 9608, exceeding its pre-9/11level.

"Investors who sell in anticipation of a decline," said Skrainka, "rarely get back in time to take advantage of the next upturn. There are also transaction costs to consider."

Quite simply, what you're proposing to do, Mandy, is time the market. And as Skrainka said, you not only have to pick the "right" time to get out of your investments, you have to be correct in determining when to get back into them. Because, let's face it, with interest rates on short-term investments hovering around 2 percent, you can't afford to stay there for long. If you do, you will never achieve your college or retirement savings goals.

If your kids were starting college in 6 months or you were planning to retire by the end of the year, that would be a different story. It's difficult to predict where prices will be over the short term. Nevertheless, Merrill Lynch currently recommends that even their most "conservative" cautious investors keep no more than 25 percent of their portfolios be in cash. This declines to 10 to 15 percent for investors who are comfortable with "moderate" risk. Merrill Lynch clients who fit the profile of "aggressive" investors are being advised to have a maximum of 10 percent in cash.

It's worth noting that these cash recommendations were in place before the government raised the terrorist threat level and that Merrill has not seen a need to alter them since that announcement.

Michael Hartnett, Merrill Lynch's Global Macro Strategist, said the most important thing for all investors, regardless of the economic or terrorist environment, is to be well diversified. "Don't panic," said Hartnett, "Try to avoid fear and greed, motivations which are normally bad for your wealth." He called your husband's idea of going completely to cash "overdoing it."

That's not to say that having some money in a liquid account is a bad idea. Cash and equivalent investments such as CDs are an important part of a diversified portfolio, which, said Hartnett, should also include stocks — both U.S. and international — bonds, and alternative investments. The percentage you have in each category is your "asset allocation." This will vary based on your time horizon, your investment experience, other assets you own, and your financial goals.

The simplest way to get a diversified portfolio is to invest in what are called "asset allocation funds." These are mutual funds that own a wide variety of investments, with sometimes as many as ten different categories. Aided by sophisticated computer strategies and their own market experience, the managers of these funds adjust the amounts in each category to minimize negative events and take advantage of positive market trends.

With an investment in one of these funds, a significant decline in one particular asset class — U.S. stocks, for instance — is not going to devastate your portfolio since you own a little of everything. A diverse portfolio is also a less volatile one because the daily price fluctuations that make some investors nervous may not be as extreme. That's due to the fact that although some things you own might go down, in a properly diversified portfolio, other investments are probably going up in value. I like to say that "diversification dampens the Maalox moments." Of course, diversification does not guarantee a profit, and you can still lose money in a diversified portfolio.

Moreover, when you remove yourself from the decision-making process, your return is likely to be better. The fact is, as human beings we get emotional about our money. And a new branch of economics called "Behavioral Finance" has proven that emotions lead us to make bad investment choices (such as when and what to buy and sell). With an asset allocation fund, the decision-making is out of your hands: the management team determines how large a percentage should go into each investment category as well as which individual securities to buy.

The other reason I like this type of mutual fund is they come in different levels of risk. If you're a nervous investor, or will be needing your money within a relatively short time frame (say, 5 years or less), then you should consider a "conservative" asset allocation fund. Generally, this type of fund invests most of its assets in bonds, with just 25 to 30 percent in stocks. "Balanced" and "growth"-oriented asset allocation funds hold proportionately larger amounts of stock. But the thing to remember is that even in the "stock" portion of each fund, there is diversification: U.S. large, small, and mid-capitalization stocks, well-known foreign stocks, as well as emerging market equities.*

Readers, please remember that international investing involves certain risks, such as currency fluctuations, economic instability, and political developments, with additional risks associated with emerging-markets securities, including illiquidity and volatility. Investments in small to midsize companies have an increased risk of greater price fluctuations, and bonds are subject to their own risks, including interest rate risk, credit risk, and inflation risk. As interest rates rise, the prices of bonds fall. Long-term bonds have more exposure to interest rate risk than short-term bonds. Lower-rated bonds may offer higher yields in return for more risk. Unlike bonds, bond funds have ongoing fees and expenses.

Keep in mind that the heightened terrorism alert is just one of a number of things buffeting the financial markets this year: Skrainka and Harnett both told me that the war in Iraq, the upcoming presidential election, plus a sight uptick in inflation and interest rates already had investors nervous. But they agree the biggest factor is higher oil prices. Notice that the Dow Jones industrial average closed higher the day after the terrorism threat was raised. But stocks fell sharply when crude hit another all-time high. Said Hartnett, "If I could wave a magic wand, it would be directed to make oil prices drop to the mid-30s."  

If you're going to adjust your stock holdings at all, these two experienced market strategists agree investors ought to be moving toward "quality," i.e. large, well-known companies with proven track records and strong balance sheets, with dominant positions in their respective industries. Since these stocks were not the "darlings" of Wall Street last year, many are still priced below what you'd expect.

Still not convinced? Consider this fun factoid from Skrainka: "Through June, we've had four consecutive quarters of 20 percent or better growth in earnings for the companies that make up the S&P 500. That's only happened four times in the past 50 years."

But that's not what makes headlines or the evening news. Terrorism, the war in Iraq, political jabs from both parties, and higher gasoline prices all make juicier copy.

"If you can just get past the screaming and the shouting [over all these other things]," said Skrainka, "you'd realize that despite this, the performance of corporate America has been outstanding. Investors need to be patient and remember their long-term goals."

By definition, to be an investor you have to believe in the future. That's exactly what terrorists want to take away from us.

Keep the faith,

Gail

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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.