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brian milner

Kevin Van Paassen

The news on the U.S. economic front was somewhat less than upbeat last week.

Sales and average prices fell for both new and existing homes (more than a few of which are in the hands of unhappy mortgage lenders). And government supports for the battered sector are about to run out. In January, U.S. employers revealed the heftiest planned job cuts since last summer, nearly 60 per cent higher than the previous month. No wonder the throngs of unemployed receiving extended benefits hit a record and one consumer confidence measure posted its worst reading in 17 years.

But wait. Didn't the U.S. economy grow faster than expected in the fourth quarter, a revised 5.9 per cent annually? True, but much of it stemmed from that old standby, inventory-restocking. The all-important, credit-card-carrying U.S. consumer is still largely missing in action, and no one knows what to expect once the easy money is gone and the fiscal stimulus runs out.

None of this comes as a surprise to renowned U.S. money manager Rob Arnott, who sees years of misery ahead for investors who are betting that things will eventually get back to normal and that this will be reflected in their returns.

He has described the first 10 years of this century as the "Lost Decade" for investors, and warns the fat years that typically follow the lean ones are nowhere in sight.

Forget about Vs, Us or Ws when thinking about the slump, says Mr. Arnott, chairman of Research Affiliates in Newport Beach, Calif. Before you can have a V- or W-shaped recovery, "the economy has to turn and go back up. In this case, it's just a stretching out of the L. We will see another dip, and it will be in full swing in 2011. I think we're in for a tough slog."

One of Mr. Arnott's guiding investing tenets is to make sure you get paid for the risks you're taking. And right now, he insists, that just isn't the case in much of the market.

But it's particularly true for the vast majority of investors, those relatively conservative folks who have stuck with the time-honoured 60-40 split of stocks to bonds so beloved by your favourite fund adviser.

This asset allocation model hasn't worked for at least a decade and isn't about to start producing acceptable returns now, Mr. Arnott insists.

Humans are social creatures "who like the comfort of doing what others are doing," he says, donning his behavioural cap. "It shows up in the markets in investing where others want to invest. If the average allocation is 60-40, there's a comfort factor in saying that's going to be my anchor. If everyone's got that as an average allocation, I can't be too badly hurt by it."

But as it happens, it's a lousy way to invest, and Mr. Arnott has done the math to prove it.

One simple way to gauge equity returns is to take the yield and add expected growth. The dividend yield on the S&P 500 was 2.1 per cent at the end of last year, which compares unfavourably with the long-term average of 4.5 per cent. Adding the historic growth rate brings the annualized long-term expected real return for stocks to 3.3 per cent, provided valuations remain unchanged.

Add in the contribution from the bond part of the investment mix, and "a reasonable expectation" over the next 10 years "is a real return of 2 to 3 per cent per year." And that's assuming no change in valuations - not a safe bet.

Mr. Arnott is heralded in investing circles as an architect of fundamental indexing, which assigns weightings to stocks based on a combination of measures of economic success, such as sales, profits, book value and dividends. It ignores market caps, the basis of traditional indexes, and the reason so many equity players have fared poorly, he says.

Needless to say, his approach colours his investing strategy in deep-value hues.

His advice for these grim times: Own a wide variety of assets and pay close attention to inflation risks. "Put a little bit in a lot of buckets, and it mitigates your risk."

But he recommends steering clear of the frothier assets, which run the gamut from commodities, emerging market equities and high-yield bonds to U.S. growth stocks.

"This is not a time to be heroic and take a lot of risk. This is a time to hunker down, protect what you've got and have resources at your disposal to pounce when something gets cheap again and people are terrified."

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