What to do with your cash when the financial system is “broken”

[Editor’s note: Tim Staermose, Sovereign Man’s Chief Investment Strategist, is filling in for Simon today.]

January 9, 2012
Manila, Philippines

A few days ago, I read a that famed hedge fund manager John Paulson, who’s best known for personally making over $5 billion from the sub-prime meltdown, lost more than HALF of his investors’ money last year.  His Advantage Plus fund was down a whopping 52%!  That’s not a misprint.

Paulson’s thesis that US financial stocks would come bouncing back, for one thing, proved totally unfounded.

That one of the world’s previously most successful investors can blow up so spectacularly is yet another indication to me that the old rules of investing and money management currently don’t apply.

Markets have been taken over by politics… which means that Paulson and many of his hedge fund cohorts must accurately predict what central bankers and politicians will do, correctly guess how such actions will affect the markets, and nail the timing.

This is a dangerous game to play.  Paulson’s epic failure last year is proof enough to me that it’s useless trying to play this game.

The worst part is, even if their investment thesis is well-grounded, the politics can still push the market in the other direction. You know that old Wall Street saying—“The market can stay irrational longer than you can stay solvent.” It certainly truly rings true now.

But it wasn’t only Paulson who imploded spectacularly in 2011.

According to data from Bloomberg, the average hedge fund return was -4.9% last year.   Hedge Fund Research says it was -5.17%.  Whatever way you slice the data, the bottom line is that performance was lousy.

Even these traditional alternatives to the mainstream “buy-and-hold” strategy espoused by Wall Street failed investors in 2011.

So, what to do?

Well, as I’ve written before, cash is not a bad place to be right now.  Playing defense is likely to serve you best until we get some sort of “system reset.”

But, with interest rates in most places across the globe negligible, the next question become how you can earn a return on your cash.

Seeking out higher yielding currencies is one way. Simon has reported that his bank in Mongolia is paying up to 14% per annum in local currency (and SMC members will find out how to do this in their upcoming February edition).

But if this sounds far too exotic or risky, there are still other options. Australian and New Zealand bank accounts consistently pay comparatively higher returns than their counterparts in the developed world—4% to 5.5% on savings or short-term time deposits.

[Editor’s note: regulatory constraints unfortunately prevent us from mentioning the bank names in this public forum; the last time we did this several months ago wasn’t pretty…]

In order to maximize the risk-adjusted returns on my own cash, I developed a proprietary system long ago called the 4th Pillar. This is a unique strategy that makes very low risk bets on a specific niche of takeover deals that meet a set of clearly defined rules.

When developing this system, my primary consideration was to NOT LOSE MONEY.  And it’s stood the test of time through various market ups and downs over the years. The system’s long-term success rate has exceeded 90% with minimal volatility.

And since we formally launched the 4th Pillar subscription service last year, the portfolio returned a very healthy 11.8% (in USD terms). At no point has it ever been in the red. Meanwhile the S&P 500 lost 3.5%, and as I told you already, the big hedge funds are down even more.

To be perfectly candid, it’s not because I have a crystal ball. The difference is that the fund management business depends on the ability of a single person to correctly divine the direction of markets (and politics). Our system, on the other hand, was designed to return superior results with much lower risk… irrespective of politicians and central bankers.

Whatever you choose to do, I encourage you to heed the lesson of the John Paulson story—investing based on the old rulebook is truly dangerous to your portfolio. Success in these markets requires unconventional thinking and a fresh approach.