Should the National Debt and Deficits Matter to Investors?


Recently, Congress and the President cooperated to pass omnibus spending and budget legislation, therefore removing (at least for the time being) the threat of another government shutdown. Naturally, the political pundits laud or lambast the compromise, depending upon their respective political agendas.

But should any of this matter to an investor? My simple answer is yes… and no. How is that for sounding like a politician?

Let's examine first why it should matter to investors. The primary reason is because budget deficits, surpluses and aggregate public/private debt affect the distribution of capital and, ultimately, the flow of capital. We as investors must acknowledge that this creates risks, but also that these risk factors are omnipresent and fundamentally uncontrollable from an individual perspective.

On the other hand, why shouldn't all this matter to investors? It is precisely because risk factors are omnipresent and uncontrollable. Our only rational response would be to ask the most important question: If I cannot control the macro risks in the world, what tactic can I use to manage the risk to my portfolio?

The answer to that question is simple, eternal and practical—diversification.  Since the number of risk factors in the global financial economy are virtually infinite, we must strive to isolate the primary risk factors that “cause” the effects we most fear. From those “causation factors,” we then allocate hedges seeking to counter those risks to reduce or optimally mitigate the consequences of those risks. This suggests that the primary goal for investors is not return optimization but, rather, risk optimization.

The challenge for most investors (and sometimes even their advisors) is that we can become carelessly unaware of future risks because evolution has designed us to focus on immediate or obvious risks. This means that we must reign in our desire for rewards and, instead, harness our natural fear instinct in a proactive way and focus it on hedging risk before it hits us.

This is the same behavior pattern we engage in when we invest in life insurance, property and casualty insurance, umbrella liability insurance and disability insurance. We are exchanging one financial asset for a hedge against a future uninsured or unhedged risk. The expected return is the dampening of volatility in our lives, should that risk manifest itself.

What is surprising is that investors don't really seem to understand the odds. The odds of dying before age 65 are remarkably lower than the near certainty that sometime within the next 10 to 15 years we will certainly experience negative downdrafts in our portfolio of 20% or more due to unhedged risks in the stock and bond markets.
I think our job as advisors and investors is to ask ourselves the rational questions: will the effect of “xyz event” (budget deals/deficits/shutdowns) affect at some point my net worth? And, if so, what will cause that effect and how can I hedge against it?

So, does the latest budget deal matter to investors? The answer is yes—but ONLY if investors use this (or any such event) as the impetus to identify and then manage the risks that are there and approach with an open mind an expanded definition of diversification in order to put into place a hedge that has a chance of working BEFORE the risk becomes reality.

Frank Muller

As CEO of Provasi Capital Partners, Frank Muller brings nearly 30 years of experience in building and managing multi-channel distribution services. Frank has been a featured contributor in numerous industry publications, bringing his unique insights and perspectives to relevant issues impacting financial advisors and their clients.

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Frank Muller