The Persian Gulf war has ended but the recession has not. Small investors, therefore, still face uncertainty in making short- and long-term investment decisions.
The plunge in consumer confidence that followed Iraq's invasion of Kuwait gave rise to widespread hope that the war's successful conclusion would help lift the U.S. out of recession. It would, it was argued, bolster consumer attitudes and, in turn, their spending.
But spending hasn't resumed, That is not surprising, given the current strain placed on consumer purchasing power. The strain is partly the result of the Federal Reserve's slow-growth approach to inflation reduction over the past two years.
What's more, America's businesses and financial institutions have been bruised, leaving investors concerned about the fiscal health of these companies. Combine those concerns with the effects of a sluggish economy, and the result is an understandable tilt on the part of investors toward a short-term, wait-and-see mentality.
"Investors shouldn't stop confronting basic investing issues because of their worries about the economy, or about the health of their financial institutions," says Frederic "Fritz" Yohn, a corporate economist with Aetna Life & Casualty. "My advice: Don't be inactive or assume that short-term options are the best bet for dealing with uncertain conditions."
At the same time the Fed lowered short-term interest rates in general, banks cut back on their certificate of deposit rates. To regain lost yield, investors are faced with a number of options, such as higher-yielding money market mutual funds, shorter-term Treasury notes and so-called brokered CDs.
The rapid growth of money fund assets over the past two months suggests that investors have aggressively moved away from CDs in response to bank solvency concerns and declining CD rates. While short-term Treasury securities are as safe as insured CDs, money market funds in general are not guaranteed, and even brokered CDs in less credit worthy banks carry some risks should the institution be closed.
Shifting to somewhat riskier short-term investments to regain yield, while understandable, has its drawbacks, according to Yohn. In contrast, declining short-term interest rates have greatly increased the incentive to move into longer-term investments. This combination of lower rates and longer duration rewards those who are willing to tie their money up for longer periods of time.
"There's nothing wrong with reaching for yield," Yohn says. "But
investors should pay careful attention to the difference between maturity risk, credit risk and liquidity risk. They should also think about balancing their risk by going into longer-term maturities, such as Treasurys or high-grade bond funds, rather than going into lower-quality investments."
Whatever investment vehicle they choose, Yohn urges people to check out the health of the institutions to which they entrust their money. Institutional solvency now must be factored into investment decisions. "The basic laws of economics and finance suggest that if one institution is paying substantially higher rates than average, it's because the investor is being asked to assume higher credit risk," Yohn points out.
If you're contemplating taking out an annuity policy with an insurance company, for example, refer to the reports of major ratings agencies such as Standard & Poor's and Moody's, who rate insurers on their ability to meet claims obligations. Banks, by contrast, are not rated for their financial strength. But again, a
bit of research -- investment newsletters, for example, or your local brokerage house -- can yield insight into what makes a banking enterprise profitable, liquid and safe.
Yohn stops short of encouraging investment in long-term securities to the exclusion of short-term ones. After all, the ideal personal portfolio combines investment vehicles of different types and durations. Not only that, certain short-term vehicles, such as Treasury bills, are obviously considered risk-free forays into the money market world. And longer-term securities are not without theirdownside.
Yohn's point is that, by traveling the route of longer-term maturities, investors are more likely to gain the assurances of quality they need,while still realizing fairly attractive returns.With the prospects for a quick economic recovery less imminent,businesses and financial institutions will continue to experience strain.Yohn feels that the most important tools for the cautious and wary individual investor are intellectual-research and forethought.