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STRESS TEST

Surviving a month like September 2008 is a tough way to earn strategic perspective. Mercifully, bearish runs of that magnitude are rare in any calendar month, which makes them all the more valuable as targets for study.

September was more than just a month of sharp losses. It was also a stress test--for the financial system and investment strategies. Among the lessons learned (or re-learned) is that red ink can spill faster and stain more deeply than intuition and history suggest.

September was extraordinary for many reasons, including the hard truth that losses infected virtually everything, everywhere. In dollar terms, no asset class was spared, save cash. Even there, the classic safe harbor wasn't universally safe, depending on how you defined cash.

U.S. Treasury bills remained true to their riskless aura, but even modest steps beyond short-term government bonds tempted trouble in the tsunami that was September. The poster child for what can go wrong with "cash" is the Reserve Fund. This unlikely victim acquired the painful distinction of becoming only the second money market fund to suffer a loss since the niche was invented in 1970 by, ironically, this very same fund. The problem in September was corporate paper, which is usually a boring cash equivalent. Unfortunately for the Reserve Fund, it became a little more exciting that month when otherwise "safe" securities were whipsawed to extremes many thought unlikely--if not impossible--just a few weeks earlier.

Another September shock was witnessing all the major asset classes go down... simultaneously. A frightening sight, but should we be surprised? Deploying capital around the various asset classes, after all, is supposed to be the basis of prudent risk management. True enough, but expecting that one or more pieces of the globe's markets will always shine, each and every month, is asking for too much.

Looking back over the past 10 years uncovered three episodes of monthly losses in everything. A longer survey of history would undoubtedly turn up more of the same. Anyone expecting otherwise hasn't studied history. As the table above reminds us, pain in the capital and commodity markets can sometimes be absolute, based on broadly defined asset classes.

The underlying catalysts behind the all-encompassing red-ink change through time, of course. Sometimes it's obvious, at least with hindsight. There was no mystery behind the tumble in September 2008, for instance, although the catalysts were many. Excess leverage, questionable mortgages, ill-conceived derivatives, to name a few, were all obvious factors. But no matter the cause, total selloffs in monthly terms arrive at times--not often, but enough to remind investors that expecting anything else is an exercise in fantasy. The three incidents of the past 10 years represent a 2.5% failure rate, if you will. Fortunately, that's quite low, but it's higher than zero.

Strategic-minded wealth managers should be prepared for such events. Illusions of any kind are dangerous in money management.

The future's always unclear, of course, but to the extent that we can look at the past as a guide, imperfect though it is, we should avail ourselves of whatever crumbs of insight fall from the historical record's table.

Preparing for the possibility of extreme events is a good start for thinking about how you'll react when and if such moments reappear. The advent of market excess--up or down--has been known to create opportunity at times. That's not always the case, but when asset allocations are dramatically thrown out of whack within days or weeks, it's time to revisit one's strategic outlook and take stock of any freshly minted opportunities.

Yes, it's dangerous to assume that every dramatic market stumble is an all-clear sign to buy. That's why historical perspective comes in handy. Knowing that September's monthly losses as far as they eye can see weren't unprecedented, for example, is a great starting point for further analysis. Ditto for recognizing that the frequency of loss for all asset classes in the same month drops sharply as we extend the time horizon.

There are no cases of across-the-board losses for the broad asset classes for rolling 12-month periods since 1998, for instance.

Is greater stability in a multi-asset-class portfolio over one-year periods versus monthly returns just plain dumb luck? Unlikely. Broadly defined asset classes--emphasis on "broad"--collectively reflect true diversification because the underlying mix of risk and return factors differs. That may not matter in any one month--particularly when all hell breaks loose. But the prospect of everything dropping month after month after month is virtually nil.

Diversifying across asset classes has always been a strategy about reaping superior risk-adjusted rewards over time. That's true even if the strategy falls out of bed every now and again.

In the short run, anything's possible. That may be good news for traders, but it's noise for strategic-minded investors. Sometimes the noise is deafening, but it's still noise.

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