As investors begin to regain their confidence in the market, financial advisers and mutual fund executives are beginning to map out changes in investor behavior and give the old rules some new twists.

The scorched-earth mentality that permeated the investing world last year has all but disappeared, and the market rally has given investors much of their confidence back. But, as many predicted, investors of all ages have been unalterably changed. They have gained renewed respect for diversification, are grateful for even single-digit returns, and are only slowly moving back into stocks.

"People now realize that housing is still a market, and equities don't always go up," said Don Quigley, manager of the Artio Total Return Bond Fund.

As with any other market, housing is volatile, Quigley said. People developed "a sense of entitlement" about their home equity; they believed it would always appreciate and that they didn't need to save and invest their money.

Yet a recent survey by the MetLife Mature Market Institute found that 35% of older Americans still see their homes as collateral for a loan. About 14% of these people are taking cash out of their house through a home equity loan or reverse mortgage.

Quigley also admonished investors who have gone from swearing off equities and taking all of their money out of the market during the crash, to now believing, once again, that equities are always going to go up because of the tremendous rally that has occurred since March.

So instead of moving everything into cash or betting all of it on stocks, investors are beginning to realize they need to successfully diversify into far more asset classes, which may be one of the reasons emerging markets mutual funds attracted so much cash in 2009.

"The thing that shocked me last fall was not the market crash, but the rise in correlations-the fact that normally diversifying markets crashed too," said Robert Arnott, chairman and founder of Research Affiliates in Newport Beach, Calif.

He said broad diversification continues to be promoted as one of the "new" rules of investing after the crash-new because many investors aren't as diversified as they think they are.

"Most investors don't avail themselves of any meaningful allocations outside of mainstream stocks and bonds, and that's just dumb," Arnott said. "The typical investor has perhaps 90% or 95% of their money in them. Usually there is some alternative market that's more interesting and priced more attractively."

He cited a few examples. Convertible bonds are more interesting than stocks at current prices. High-yield and emerging-markets debt remain "mildly interesting," despite the enormous rally they have both had. A "small dose" of commodities makes sense for any investor, Arnott said, because it reduces the portfolio risk and provides some protection against the risk that the Federal Reserve tightens too late, leading to rising stagflation. Commodities are one of the few ways to make money during stagflation.

Jerry Miccolis, a senior financial adviser for Brinton Eaton Wealth Advisors in Madison, N.J., said that while the economic downturn was "severe, sudden and unexpected," it should not change the way one goes about investing. He said the biggest financial threat for investors over the rest of their lives is inflation, not short-term market fluctuations. And the best way to protect a portfolio against inflation, he said, remains a well-balanced, diversified portfolio whose asset allocation is consistent with the investor's risk tolerance.

Analysts said investors have to careful not to take on too much risk-or too little.

Even those who recently retired likely need their investments to work for them for another 20 to 30 years, "so they should not jump to an ultraconservative risk-tolerance level simply because of recent market movements," Miccolis said.

Because interest rates have collapsed, investors are actually being paid to take on equity risk right now, said Ron Holt, president and chief executive of Hansberger Global Investors in Fort Lauderdale, Fla.

$3.5 Trillion Sidelined

On the other hand, there is still a lot of cash on the sidelines, which could signal investors are unwilling to take on as much risk as some believe. The amount of money on the sidelines could be as high as $3.5 trillion, according to data released in September by the Investment Company Institute.

"The time to take more risk on was nine months ago, when people were terrified," Arnott said. "The time to take risk off the table is when people feel like it's back to normal."

The stock market has gotten ahead of itself and remains "deeply vulnerable," but that vulnerability is on the growth end of the market, Arnott said. He sees a lot of interesting investments on the deep value side-"the companies and sectors that are loathed and feared."

Arnott is eyeing assets such as financials, industrials, and consumer discretionary.

"Nine months ago, the value side of the market was priced as if Armageddon was next door," he said. These assets "are still priced as if Armageddon is three or four doors away. If those parts of the market are right, the growth side of the market is wrong, because it is priced as if the recession is over and it's back to the races."

After such a cataclysmic market crash, which burned so many investors, it is difficult not to look at what investors should be doing after the recession through the prism of what they should not be doing. A good first rule of thumb, Miccolis said, is that there is no point trying to position one's portfolio too defensively to guard against losses that already happened or revamping it too aggressively to quickly regain lost money.

But more generally, Miccolis said, timing the market is "a loser's game."

Brinton Eaton recommended investors design their portfolio to reflect the market environment that has and will continue to be the case for over 95% of the rest of their lives. They can "insure" their portfolios against extreme market events the other 5% of the time with items such as puts or structured notes. For older investors, as we all know now, this 5% is disproportionately important.

In the run-up to the market crisis "a lot of folks set common sense aside and ignored basic arithmetic," Arnott said. People were expecting lofty returns from equities despite dividend yields that were below 2%, which is where yields have now returned, he said. They were ignoring that earnings and dividends cannot grow faster than the overall economy. Profits and payments have to grow slower, because part of the growth of the economy is the growth of existing enterprises and part is the creation of new enterprises. The advisers agreed that investors need to be ready to invest more internationally. Arnott said that with U.S. valuations high by world standards, the more you move out of domestic investments, the better.


(c) 2010 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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