Is There a Reason You’re Not Using the 90/10 Strategy?

By MoneyMorning.com.au

Six years.

That’s how long it will have been from the financial meltdown in 2008 until the U.S. Federal Reserve plans to start raising interest rates.

That’s what they say this month.

Of course, it was only a few months ago the Fed said it would start raising rates in 2013. Now it won’t likely happen until 2014… at the earliest.

The bad news is markets will stay volatile. The good news is you’ll have plenty of chances to buy stocks at cheap prices. The only question is, how should you do it?

Well, that’s easy. You do what the old pro hedge fund managers used to do…

Back to 2005 Prices

For the past three-and-a-half years we’ve suggested a simple strategy: hold cash and gold for safety. Quality dividend-paying stocks for income. And small-cap stocks for growth.

We suggest this strategy because if you don’t keep your assets secure, market volatility could see 20% or more wiped off your savings.

You only have to look at the S&P/ASX 200 in 2011. Investors who bought “safe” stocks at the start of the year are down nearly 20% today. Naturally, the buy-and-hold mob will tell you to just hold in there… things will be fine.

But how long should you have to wait?

Today, the main blue-chip index is back to where it was in 2005. Buy-and-hold investors have waited seven years. For nothing. And we assume they didn’t sell at the peak in 2007 because… well… they’re buy-and-hold investors.

And what about those poor souls who bought in 2007? They’re down 40%. They haven’t even had the chance to make a profit yet. And odds are they won’t for a few more years… unless they change things.

In the old days hedge funds and capital protected funds used a pretty simple strategy. (Although they’re probably more “sophisticated” now.)

It was designed to make sure investors in the fund couldn’t lose money. It was almost fool-proof. The last thing these funds wanted was to blow up their clients. Because that would mean losing clients money. And if the client lost money, they may have closed their account and that would hurt the fund managers’ pay cheque.

But if they could just make sure the client didn’t lose money, they would be half way to making money for the client and making stacks for themselves.

Hedge Funds Aren’t What They Used To Be

As we say, things are probably different now. We’ve seen some of the hedge fund performance tables for 2011 and they don’t look pretty.

Even one of the world’s biggest hedge fund managers – John Paulson – had a terrible year.

According to a Bloomberg News report last November:

“Paulson’s main fund, the Advantage Plus Fund, which seeks to profit from corporate events such as takeovers and bankruptcies and uses leverage to amplify returns, reduced its year-to-date loss to 44 percent.”

Paulson’s fund manages USD$30 billion… or it does today. Doubtless it managed nearly twice that at the start of the year, before the losses.

Clearly Paulson and most other hedge fund managers aren’t using the 90/10 Strategy.

That’s a shame. Because the concept is simple. In fact, it’s so simple you can start using it today. So, what is it? Well, it works like this…

To protect and guarantee investor returns, hedge funds would take 90% of the client’s cash (say $90,000) and put it into a government bond. If the bond paid a 3.5% yield, after three years the client’s bond investment would be worth just over $100,000. They’ve broken even.

But what about the other 10% ($10,000) the client invested at the start?

That’s where the fund manager was smart. They would take this cash and – for want of a better term – use leverage to punt on the markets. It could be anything: stocks, currencies, commodities or even high-risk bonds.

If they made the right bets it would mean big returns for clients and big fees for the hedge fund guys.

Sounds great right? Even better, you don’t need to be a big hedge fund client to put this strategy into practice. Because it’s something you can start today, with your own 90/10 Strategy.

Your Personal 90/10 Strategy

You start off putting 90% of your savings into “safe” assets.

Around half this amount should go into cash and term deposits. Put some in a high interest online bank account and the rest in a couple of term deposits (for instance a one-year and two-year term deposit). When they mature, reinvest for the same period.

With the rest, split this between good quality dividend stocks for income (if available, take part in the dividend reinvestment plan if you don’t need the income now) and precious metals (gold is our favourite, but we like silver too).

That’s the 90 of the 90/10 Strategy (we said this was simple). Now for the 10…

This is where old hedge fund managers leveraged into high-risk/high-return plays. You can do this too. And like the hedge fund guys, you don’t have to choose one type of investment.

Our personal choice is small-cap stocks. Simply because you get the benefit of leverage if the stock goes up, but you know your maximum loss if the stock goes down. And the great thing with small-caps, you can start with as little as $500.

That means even if you’ve only got $5,000 in savings, you can invest like a hedge fund today. Like this…

Stick $3,000 in a high interest bank account and/or term deposit
Buy $1,000-worth of a good dividend paying stock
Buy about one-quarter of an ounce of gold (or about 15 ounces of silver)
Buy one high-risk/high-return small-cap stock for potentially explosive gains

It’s simple. Then for every $5,000 you save, just repeat the steps above.

If you’re not investing using the 90/10 Strategy you should stop and ask why. In our view there’s no reason you shouldn’t use it. Once you’re convinced it’s right for you, drop everything and start implementing the 90/10 Strategy today.

It’s the best way of keeping your money safe while still benefiting from volatile markets.

Cheers.
Kris.