Finance Space

The four most dangerous words in investing are widely believed to be “this time it’s different.”

“But this time it is,” said Mohamed El-Erian, co-chief executive and co-chief investment officer of Pacific Investment Management Co. Pimco is the world’s largest bond fund company, with $812 billion in assets.

What’s different is the financial world has turned upside down, El-Erian told attendees at the 20th annual Morningstar conference in Chicago last week. Money managers must drastically shift their investment approaches to stave off financial disaster in the next few years.

Once unthinkable factors have completely changed the traditional financial picture, he said: The U.S. and U.K. banking systems are in crisis, the credit crunch has spread and emerging economies are supplying capital to struggling financial firms as U.S. capital dries up.

“I mean, (fiscal) policy change on a Sunday night?” he said. “That was once unthinkable, but it became reality March 16.”

That was the night of the Federal Reserve’s controversial consent to a $30 billion backing of ailing Bear Stearns assets in its takeover by JPMorgan Chase. (JPM)

El-Erian, a former deputy director of the International Monetary Fund and former manager of Harvard University’s endowment, addressed the investment professionals on Wednesday after the Federal Reserve left interest rates unchanged. The Fed cited higher inflationary risk thanks to rising energy and commodity prices for the decision.

Fed officials also said they see the economy returning to a healthy growth clip soon. But El-Erian predicted U.S. growth will be just 1% to 2% over the next two years. Inflationary pressures will increase as consumers struggle with the excesses in the housing sector and excesses in consumer sectors, he said.

Rising demand for commodities in emerging economies likely will keep prices high permanently, El-Erian said.

Overall, investment portfolios face a bumpy ride for the near term, he said. But investors shouldn’t let fear paralyze them and then pull out of the market altogether. Above all, “passivity is the worst choice.”

‘Constructive Paranoia’

Nor should they think we’ll eventually return to business as usual.

“Since 1978, we’ve been in a sequential recapitalization of the most vulnerable market sectors,” he said. “In the late 1990s to early 2000s, it was energy markets. In the early 2000s to the mid-2000s, it was the corporate sector. Today, it is the financial sector, and tomorrow, it will be the U.S. consumer. When we finish, we’ll have a much stronger system.”

But there’s much to do to shore up the system, he said.

Both money managers and individual investors should instead start relying on what El-Erian called “constructive paranoia” when making financial decisions.

“Retooling is necessary. Think in terms of collateral damage,” he said. Any decisions made to respond to a crisis will have long-term effects. “Ask not just what can go right, but what can go wrong.”

Investors should avoid narrowly framed asset classes, he said, and check themselves repeatedly.

He also suggested that fund groups should focus on making shareholders’ money grow rather than new products. For example, Pimco is looking for ways to ease investor woes over auction-rate preferred shares issued by closed-end funds, because the credit crunch froze the market and they’re now unsellable, El-Erian said.

Investors shouldn’t dismiss all new products, he said. Instead, they should move with extreme caution, avoiding those investments or products that haven’t been vetted.

“History shows that the first round of innovation ends in tears because people overproduce and overconsume,” he said. “Not enough questions are asked. You don’t ask the question, ‘Can we handle it?’ You should ask that over and over.”

To protect existing portfolios, El-Erian strongly recommends investing in a mix of fast-developing countries, bonds, commodities and hedging instruments. Focus should be on capital structure, not asset classes, he said.

Think Globally

While portfolio diversification isn’t new advice, El-Erian underscored the need for international exposure. The flight to quality is now overwhelmingly pointed outside the U.S., he said.

“The market thinks that Brazil and Mexico are better risks than Goldman Sachs, (GS) ” he said. “The market is telling us something. U.S. investors need to get over the idea of avoiding international exposure — even the traditional S&P 500 investor is getting international exposure.”

Finally, investors need to hold on to optimism despite grim forecasts, El-Erian said: “Remember, there is opportunity in crisis.”

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Tags: Personal Finance