In This Issue

Third Quarter Review

Reflections one year after the “Global Financial Crisis.”

All Weather Portfolio

The Average is less than the Norm

Portfolio Diagnostics

It has been one year since that momentous weekend when Lehman Brothers went bankrupt, Merrill Lynch was acquired, and AIG was bailed out by the US government. A mere six months ago it seemed to some that the global financial system might implode.  We have come a long way since then, with markets up 50% or more since the lows.  While volatility  continues to be very high, and is likely to stay so for some time, the capital markets continue to heal.  Below I review the latest quarter’s performance and comment on investing in such an unsettling time.

 Third Quarter Review

Much like the prior quarter, the most recent one showed gains in all asset classes.  US and non-US stocks and Real Estate Investment Trusts (REITs) showed the largest increases.  While employment numbers continue to weaken, there are signs that the recession plaguing the US economy may have actually ended.  Confirmation will have to wait further analysis by the National Bureau of Economic Research (NBER), the traditional arbiter on such matters. 

Not surprisingly, there continues to be much commentary suggesting that this is a “bear market rally,” and that markets will retest their March lows.  The reality is that one never knows these things in advance.  While the confidence ⁽¹⁾ of many or most investors is still modest at best, capital markets have recovered significantly.  As noted in the table below, most asset classes are in positive territory compared to one year prior.  The equity markets, however, still remain far below their peak.  Unemployment is likely to remain high for some time.  The economic recovery, whenever it does take place, may be tepid in comparison to recent expansions.    But the rise in the equity markets, and the improvement in the credit markets, are reflections that the worst case scenario that many feared seems to have been averted.

 “All Weather Portfolio”

“As an economist and policymaker, I have plenty of experience in trying to foretell the future, because policy decisions inevitably involve projections of how alternative policy choices will influence the future course of the economy.  The Federal Reserve, therefore, devotes substantial resources to economic forecasting. With so much at stake, you will not be surprised to know that, over the years, many very smart people have applied the most sophisticated statistical and modeling tools available to try to better divine the economic future.  But the results, unfortunately, have more often than not been underwhelming.  Like weather forecasters, economic forecasters must deal with a system that is extraordinarily complex, that is subject to random shocks, and about which our data and understanding will always be imperfect.  In some ways, predicting the economy is even more difficult than forecasting the weather, because an economy is not made up of molecules whose behavior is subject to the laws of physics.  To be sure, historical relationships and regularities can help economists, as well as weather forecasters, gain some insight into the future, but these must be used with considerable caution and healthy skepticism.” 

Chairman Ben S. Bernanke

Commencement address, Boston College School of Law, Newton, Massachusetts

May 22, 2009 

The world is an uncertain place.  The economy and the capital markets no less so.  The Chairman of the Federal Reserve says that it may be easier to predict the weather than the economy.  And we know how difficult that can be.  But, by acknowledging such uncertainty, we are able to plan and prepare accordingly.  This is far better than being overconfident in our projections and assumptions.  While psychologists tell us that overconfidence is a human trait that has served us well over the millennia, the emerging field of behavioral finance has ample evidence to suggest that overconfidence⁽²⁾ is a trait that does not serve us well in our investment life. 

One way to proactively help overcome the unknown economic climate is to diversify systematically.  Among other things, this means searching for asset classes that have low correlations.  Bonds provided such a cushion in 2008.  Likewise REITs did well when equities were falling following the technology bubble of the late 1990's.   A broadly diversified portfolio helps to insulate against unexpected events.  Portfolio rebalancing is also very important.  Rebalancing back to one’s asset allocation leads to selling those assets that have done relatively well and buying those whose performance have been lacking, at least relatively.  This forces the discipline of buying low and selling high.  Another way to help prepare an all weather portfolio is to not fool oneself into “timing the market.”  One can always get lucky.  But the preponderance of evidence suggests that it is near impossible to successfully time entries and exits from the market.  Such a strategy often leads to a significantly worse result, as is documented in the following article. 

 ⁽²⁾ For an excellent discussion of how overconfidence plays into financial decisions see Jason Zweig, Your Money and your Brain (Simon & Schuster 2007), chapter 5.  Men seem to suffer from overconfidence more than women.

The Average is Less than the Norm – Where is Garrison Keillor?

In Garrison Keillor’s iconic radio show, A Praire Home Companion, he discusses the town of Lake Wobegon where “all the women are strong, all the men are good looking, and all the children are above average.”  When it comes to the average experience of investors, “we should be so lucky.”  DALBAR (www.dalbar.com) is a research firm that, among other things, has been tracking the performance of the average investor’s returns in mutual funds since 1984.  Dalbar’s research documents the success or actually failure of market timing. 

As noted in the table below, the average equity investor was greatly harmed by poor timing decisions.  For example, in 2008 the S&P 500 returned -37.72%, whereas the average equity investor earned -41.63%.  Over the 20 year period ending in December 2008, the average investor earned 1.87% whereas the S&P 500 was up 8.3%.  By attempting to time the market, the average investor ended up underperforming the S&P 500 by 6.48% and even underperforming inflation by 1.02%.                                                                                       

Source: Dalbar, DFA, S&P 

Investors tend to time their entry into the equity markets after most of the return has been made. Similarly they tend to reduce their exposure near the bottom of the cycle.  Furthermore, investors tend to pile into those specific funds that have had the best recent performance.  Jack Bogle, the founder of The Vanguard Group, provided the following testimony to the US Senate^(3). 

“Consider first the “hot” funds of the day—the twenty funds which turned in the largest gains during the market upsurge. These funds had a compound return of 51% per year(!) in 1996-1999, only to suffer a compound annual loss of –32% during the subsequent three years. For the full period, they earned a net annualized return of 1.5%, and a cumulative gain of 9.2%. Not all that bad! Yet the investors in those funds, pouring tens of billions of dollars of their money in after the performance gains began, earned an annual return of minus 12.2%, losing fully 54% of their money during the period.” 

In aggregate, the behavior of investors has significantly reduced their returns relative to a buy and hold strategy that is coupled with periodic rebalancing.  Why have investors poured their money in at such disadvantageous times following a large run up?  In particular why have investors purchased the “hot” funds right before they peak?  A lot of this is due to marketing, the subject of a future article. 

⁽³⁾  In Testimony before the United States Senate Governmental Affairs Subcommittee on Financial Management, the Budget, and International Security.  November 3, 2003

Portfolio Diagnostics

Is it time for a portfolio checkup?  Individual investment decisions, taken over time, can result in a very inefficient portfolio.  At Red Lighthouse Investment Management, all investment decisions are made in a “holistic” manner.  Readers, who are not clients, may benefit from an objective portfolio review of your holdings.  Portfolio theory tells us that a given investment should not be judged in isolation but rather in the context of one’s total portfolio. Indeed every investment decision should be evaluated in the context of one’s total portfolio, not in isolation ⁽⁴⁾.  In the real world, people often accumulate investments without properly evaluating how they relate and correlate to one’s entire portfolio.   

Some common portfolio problems, grouped by category: 

Allocation

· Inappropriate asset allocation relative to one’s risk profile/preferences.

· Home country bias: Is the home country bias appropriate?

· Recency: Being overly biased by recent performance.  It is difficult to try to buy low and sell high.  Attempting to do so requires knowledge of how asset classes have performed over extended periods.   We tend to overweight recent observations⁽⁵⁾.

· Over concentration: a common example is having a high concentration of the stock of one’s employer. 

Implementation

· Duration Risk: Particularly in the current environment, a period when inflation risks seem high, long duration bonds offer a poor risk/return tradeoff.

· Fees: Investments in products with high and/or non transparent fees.

· High Turnover: Expensive and tax inefficient.

· Poor choice of investment products: underperforming, high fees, high turnover, style drift.

Other

· Discipline of rebalancing: Required to ensure asset allocation stays consistent with objectives.

· Tax location: Inefficient placement of assets from tax perspective.

Please contact us if you, or someone whom you know, might benefit from such a comprehensive and non-binding review.  

⁽⁴⁾ An asset that would be “risky” in isolation ends up reducing the total risk of a portfolio if it has a low correlation with the portfolio.

⁽⁵⁾ Neurobiologists, e.g. Paul Glimcher of New York University have shown at a biological level how we tend to overweight recent observations in assessing probabilities.

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