Ratings agencies slap on labels as to the credit worthiness of debt instruments. AAA or Aaa etc etc. And the public consumes this information as truth. But it's pretty obvious given the disaster in fixed income during the financial crisis, that these ratings need to be taken with a very big grain of salt.
They are not truths but instead opinions.
This week's new litigation against ratings agencies shows that the system of rating assets may be far from absolute or perfect.
(Read More: US Sues S&P Over Mortgage-Bond Ratings)
Ratings agencies look at current financial conditions and expectations for the future. This is a logical methodology. But when events and extraordinary conditions that are more irrational than normal, that where the disconnect happens.
It's when this confluence of events occurs that the ratings agencies start to appear incompetent and investors begin to lose faith. But the reality is, investors that slavishly look at a rating from any rating agency and see this as a stamp of approval are sorely mistaken; one only needs to look at the disclaimers to know that's simply not true.
Agencies don't make guarantees; they are providing opinions.
Ratings for fixed income or any other instrument are merely indications and not guarantees. AAA by S&P may or may not be AAA in your perspective or in the view of another ratings agency. Just look at the United States government's rating which varies depending on the rating agency; it's subjective and impacted by a variety of factors. And of course, most investors have no idea what the methodology is in terms of how these ratings are arrived at and therefore believe the indications based on blind faith (a dangerous way to invest in a rapidly changing environment).
So what to do?
- Look at ratings as merely an indication of potential financial health.
- Understand how the rating is calculated and the differences between the different rating agencies.
- Ask yourself what tail events could occur that could negatively impacted the position and invalidate the current rating 4. Form your own conclusions about the trends that might affect all positions not just the particular instrument instrument being examined.
Like all investment decisions, operationalizing ratings and factoring them into your process is very much dependent on your own personal perspective and value system.
Dogma and pure belief is a deadly and dangerous combination as you invest in today's environment.
Use information provided as simply inputs and not endorsements. Don't be lulled into a false sense of security because ratings agency X says something is safe or highly rated; people and companies can be wrong and you should never trust completely the opinion of any source.
(Read More: More Steps Needed to Save US Credit Rating: Moody's)
Michael Yoshikami, Ph.D., CFP, is CEO, Founder and Chairman of the DWM Investment Committee at Destination Wealth Management. Michael is a CNBC Contributor and appears regularly on the network. DWM is a San Francisco Bay Area-based independent money management firm that provides fee-based wealth management services to institutions and individuals around the world. Michael was named by Barron's as one of the Top 100 Independent Financial Advisors for 2009, 2010, 2011 and 2012.