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Newsletter
Summer Storms 2011
In This Issue
Turn Off and Tune Out... The Financial Media
The Randomness of Returns
Mutual Fund Marketing
 Summer Storms 2011

It is hard to predict storms.  It is even more difficult to predict the consequences of financial ones. Staying on course is usually the best recourse.    

 


Mark Sladkus 

Turn Off and Tune Out... The Financial Media 

 

 

Between various debt crises, US Treasury downgrades, double dip recession fears and European banking problems, it is hard to pick up a newspaper and not be concerned.  With all these problems, it may seem natural to think that it is time to exit, or at least reduce, risky assets in your portfolio.  We often hear the refrain that there is something fundamentally unusual about this economic period: the "New Normal."  And yet being an intelligent investor also means realizing that it really is not different this time. The essential relationship between risk and return has not changed.  By the time that you read about "news" in the papers, you can be sure it is already reflected in asset prices. Furthermore economic forces may not impact financial markets in a straightforward manner.  For instance: 

 

Even if the prediction is correct:

US Treasury debt will lose its triple-A status

 

The capital markets may react "unexpectedly:"

US Treasuries rise in price following S&P's downgrade

 

Consider the prior decade.  If you had been told prior to the start of the decade that the US would face 2 wars, two recessions (one of which was the largest downturn since the Great Depression), a housing crisis and a credit market meltdown, you might have been tempted to keep your money in cash.  Certainly the financial press lamented that this was the "lost decade," and indeed the S&P 500 was down about 9.1%. Yet there was plenty of opportunity for investors who had a broad based diversified strategy. As the chart below shows, a globally diversified balanced portfolio (60% equities/40% bonds) had very robust returns for the last decade. 

 

 

 


Growth of Wealth DFA Normal Balanced 

 

  

 

 

 

What conclusions can be drawn?  Markets are unpredictable and adverse economic news does not necessarily translate into poor portfolio performance. While financial pundits are quick to suggest, "This time it's different", news both bad and good, is already priced into the market.  As a consequence, we believe that a globally diversified and balanced portfolio that focuses on the long term is essential.

 

 

 

The Randomness of Returns  

 

 

It would be very profitable if one could discern those asset classes that are likely to do well in the coming months or years.  And certainly many financial "experts" purport to have some unique insight into next year's hot asset class.  Unfortunately, just as it is very difficult to successfully pick which country's stock market is likely to outperform, it can be equally frustrating to forecast which asset class is going to shine and which is going to lose its luster.

 

At the start of this year how many predicted that TIPS (Treasury Inflation Protected Securities) would soar (up over 12% so far this year).  At the beginning of 2010, few would have predicted that the best performing asset class for the year would be US Real Estate, up 28.07%. 

 

The difficulty of predicting asset class performance can be illustrated visually.  The top chart, below, ranks the annual returns for ten asset classes over the last 13 years.  Each color corresponds to a unique asset class.  The bottom chart displays annual performance by asset class.

  

Randomness of Returns  Annual: 1998 - 2010  

 

 

 Randomness of Returns

As one can see from the rainbow like patterns, there is little predictability from one period to the next. Studying the annual data in the slide reveals no obvious return pattern that can be exploited, strengthening the case for broad diversification across asset classes.

 

Asset class returns vary considerably from year to year, and past returns offer little insight into future performance.  But over the long term, risky asset classes increase the expected return of the portfolio.  By combining asset classes that are not perfectly correlated, we reduce the risk of the portfolio while capturing the risk premiums associated with risky asset classes.

 

Investors who follow a structured, diversified strategy are more likely to capture the returns wherever and whenever they happen to occur.

  


Mutual Fund Marketing 

 

 

As we saw in the article above, asset classes tend to move up and down sometimes quite dramatically. The best performing asset class in 2007 was emerging markets, up a staggering 39.78%.  Yet that same asset class was the worst performer the following year, down a breathtaking 53.18 %.  A diversified strategy that is systematically rebalanced provides the discipline of buying low and selling high.  Unfortunately mutual funds and brokers tend to promote the opposite behavior.

 

Performance chasing is a common problem in the financial industry.  Investors have a tendency to purchase those funds and asset classes that have done well in the recent past while selling those that have lagged.  Mutual fund marketing tends to promote those funds with the best recent track record.  This timing into hot asset classes and out of lagging ones hurts performance. There have been many studies that have demonstrated that those mutual funds that are among the best performers in a given period perform no better than chance in subsequent periods.  (cf. Burton Malkiel, Passive Investment Strategies and Efficient Markets, European Financial Management, Vol. 9, No. 1, 2003, 1-10)

 

In a recent article in the New York Times (The Mutual Fund Merry-Go-Round), David Swensen, the highly successful head of Yale's endowment, discusses problems in the fund industry.  He explains how many investors are ill served by mutual funds and the brokers who continuously push investors into those funds with the top ratings.  Investors often rotate out of poor performing mutual funds tracking a lagging asset class and into the hot ones at precisely the wrong moment.

 

Yale's Swensen makes a few suggestions:

 

"...individual investors should take control of their financial destinies, educate themselves, avoid sales pitches and invest in a well-diversified portfolio of low-cost index funds."

 

"...the Securities and Exchange Commission should ... encourage individual investors to embrace low-cost index funds and shun the broker-driven churning of high-cost, actively managed funds."

 

" ...the S.E.C. should hold the mutual fund industry to a "fiduciary standard," one that puts clients' interests first. Currently, retail brokers operate under a weaker standard."

 

As a fee-only Registered Investment Advisor (RIA), Red Lighthouse acts as a fiduciary, which requires the firm to put our clients' interests first.  A low cost, highly diversified, passive approach is at the core of our investment philosophy.

 

 

 

 

 

 
                  
Disclaimer: This newsletter is for information purposes only.  Past performance is no guarantee of future results.  While the information and data contained herein is believed to be reliable, we do not represent it as accurate.  Any opinions expressed herein are subject to change without notice.  Nothing contained herein should be considered a recommendation to buy or sell any security or fund.

 

Red Lighthouse Investment Management, LLC is a fee-only registered investment advisory firm based in New York City.

 

 

Red Lighthouse Investment Management - 212.799.3532 www.redlighthouseinvestment.com 

 

 

 

 

 

Copyright 2011 Red Lighthouse Investment Management, LLC