Racine Journal Times, WorkLife Section,  March 16, 2008

Purple is the new black

Fashion trends come and go.  Anyone who remembers those horrid bell bottoms in the ‘70s or big hair and heavy makeup in the ‘80s would agree that change is, thankfully, inevitable.  But one color – black – seems to be a constant.  Fashion designers try to throw it to the wind, but it comes right back like a boomerang.

Most women would agree that a simple black dress – sexy, slimming, timeless and classy – is a girl’s best friend when everything else in her closet looks drab or downright horrific.  So how do those on Fifth Avenue get us to buy the latest trends?  They throw “the new black” into the sentence to influence us to fall in love with the latest “in” color.

This year, purple seemed to be the new black.  Vera Wang – bless her heart – had a field day with it.  I actually love purple, but enough is enough.

I wonder if the crowd on Fifth Avenue gets together each year to opine on which color should be the new black.  Assuming the film, “The Devil Wears Prada” had some semblance to reality, I can just picture the elegantly dressed fashion moguls sipping cappuccinos and nibbling cranberry biscotti while deciding on behalf of the (fashion misfit) masses that, next fall, mustard will be the new black.

Fads on Wall Street come and go too.  Leverage (debt) was the “in” thing during the roaring ‘20s.  A lot of folks made a lot of money until an overheated, expensive stock market pushed up by greedy speculators turned on a dime due to weakness in the underlying economy, which was exacerbated by a Federal Reserve out of touch with reality.  Here we are, almost 80 years later, experiencing the aftermath of too much leverage coupled with a weakening economy.  The faces and names may be different, but the problem is the same:  lack of risk control.

Risk control:  Always in fashion

Risk control in your investment portfolio is what the little black dress is to a woman’s wardrobe. Timeless and classy, it’s something that will never go out of style over the long run.

What does risk control mean? At the very least, controlling risk means that you should have a good understanding of the potential downside risk (risk of loss) and upside return for each investment and your total portfolio. Risk and return are highly dependent upon the price you pay for the investment relative to its fundamental valuation. A higher (lower) price translates to less (more) cushion, or as Benjamin Graham labeled it, margin of safety.

That’s why so many on Wall Street obsess about whether stocks are inexpensive, fairly valued or overvalued. But do any of them really know? No, because the price that one is willing to pay for any investment is just a matter of opinion which, just like fashion, isn’t static. And opinions (prices) can get a little skewed when emotions like fear and greed are elevated.

For example, if you hear everyone you know, including your hair stylist and Aunt Mae saying, “I love ABC Public Company because it’s sure to be the next Microsoft,” especially when the market’s appetite for risk is strong, ABC’s stock could trade significantly higher than you would be willing to pay for it if you’re careful about controlling risk.

By knowing how much you’d be willing to pay for your investments, you’ll also discover the price at which to sell your investments – a difficult task for professional and Main Street investors.

What if, on the other hand, fear is running wild, causing the market’s appetite for risk to wane? Risk control, in this scenario, is counterintuitive because it’s hard to bring ourselves to purchase an investment, even though it’s offering juicy returns, when the market’s ever-changing opinion (price) is worrisome. No one wants to buy an investment and watch it drop 20%, so apply risk control by understanding that your aim is to control, not eliminate risk. After all, eliminating risk in a less risky environment (recessions typically end) isn’t much better than amplifying risk with leverage in a riskier environment.

Analyzing inflation trends

Another way to manage risk is to examine your investments and overall portfolio to determine if the positive outcome you seek or need (probably a positive return) is highly dependent upon a small number of factors. For example, when inflation is trending up, as it currently is, it can be quite damaging to financial assets – especially fixed income investments such as non-inflation-indexed bonds. Along with those ugly bell bottoms, a trip back to the ‘70s would quickly remind folks that too much inflation isn’t an attractive accessory for stocks and bonds.

Since the success of a bond-heavy portfolio in today’s environment is highly dependent upon inflation trending down, not up, it’s important to recognize that we have an expanding global economy, not to mention the Fed, pushing inflation in the opposite direction.

Change is certain, and so is investment risk. Those who were complacent about risk or, worse, snagged by the latest investment fads of the last few years are surely feeling some painful, purple bruises by now.

There’s nothing wrong with color in your portfolio as long as you understand the risks you’re taking and you know when to say enough is enough.

Michelle Ouzounian, CMFC, is the founder and President of Verity Investment Counsel, Inc. (www.verityinvcounsel.com), a fee-only, independent registered investment advisory firm in Racine. Michelle can be reached at 262-898-8400, or m.ouzounian@verityinvcounsel.com.

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This article contains the opinions of the author, but not necessarily those of Verity Investment Counsel, Inc.  Such opinions are subject to change without notice.  This article is provided for educational purposes only.  The information contained herein does not suggest or imply and should not be construed, in any manner, a guarantee of future performance and/or investment advice.  Information contained in this article was obtained from sources believed to be reliable, but not guaranteed.  No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Verity Investment Counsel, Inc.