A reply to Roubini bashers: investing at the precipice

As a regular reader of Nouriel Roubini's blog, I am dismayed by how rude people are toward his market forecasts. He believes that a recession will develop ca. this quarter and that investors should beware. Fourth quarter 2006 has been fairly strong, bringing the market up to where it was in summer 2000. Whoop de doo. Now, Nouriel may be wrong. Being premature in exiting the market is a good way to not make money. But... such is the nature of forecasting. The Hurricane Pam exercise predicted that New Orleans would be wiped out, and doubtless there were people sneering at them,too, right up until the Industrial Canal retaining wall broke. At any rate, I wrote a response regarding the detractors that I think proposes a good investment style. The basic idea is grading investments by their beta. A zero beta investment is like cash. It's value doesn't change with the market. A stock with a beta of 1 follows the market exactly. A stock with a beta greater than 1 goes up faster than the market. The right way to invest in times like this, in my opinion, is three-tiered beta. Hold enough quality low beta investments (including cash-like investments) to absolutely ensure that you can ride out or even exploit whatever happens. Have a certain amount in The Usual Suspects (near-unity beta) to get some dividend income and maybe a little growth. And include some risky high-beta investments so that you can skim some froth. This allows one to harvest gains on one's own schedule. Consider what happens to a portfolio which is, say, 40:40:20 in the face of a 30% downturn. Category 1 is unchanged. Category 2 drops to 27. Category 3. if we assume it's 2 beta goes to 8. The overall portfolio is now at 75 (40 x 1 + 40 x .7 + 20 x .4) and 40 percent of the assets are fully liquid. By contrast, a portfolio of unity-beta stocks is at 70% (100 x .7) but, worse, depressed stocks have to be sold to raise cash. Alternatively, suppose the market is good. The first portfolio earns 0%/7%/14% to give net growth of 6.6%. A portfolio of unity-beta stocks earns essentially the same (7%). As they say, never bet what you can't afford to lose. But don't be afraid to bet what you can. I actually think the greater risk is from currency. You can make money in dollars and still end up poorer if you aren't aware of what's going on internationally. Currency adjustments tend to be slow, but they can be rapid. And my guess is that the most expedient way for the world to deal with the dollar overhang is devaluation.