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End of First Quarter Update
At the end of each quarter, I sent out a letter summarizing events of the past three months. For this quarter's letter, I would like to highlight two important lessons for investors from the recent events in Japan. One is the need to construct portfolios that expect the unexpected and anticipate the unanticipated. The other relates to avoiding one of the costliest traps that ensnares investors.
Before getting into detail on those lessons, here's a quick recap on the first quarter.
Market performance in the first quarter
Markets in January and February 2011 saw a continuation of last year's positive sentiment. This was spurred by solid corporate profits and a broad consensus that while the global economy might not experience a strong recovery going forward, it would see growth.
March did see a setback. The earthquake and tsunami in Japan on March 11, which took a dreadful toll in human life, have also clearly reduced short-term prospects for the global economy. The turmoil in North Africa, while positive for oil prices, also had a negative impact on markets due to concerns about the effect on consumer demand. (there is more about how the turmoil in Africa and the Middle East may impact investments in the article below)
Notwithstanding this, developed markets generally saw gains at the end of the first quarter that put them on track for solid performance in 2011. Of note, results outside of the U.S. were boosted by the weak dollar. For example, first-quarter gains in Europe were 6% in dollar terms, 2% in local currency.
If they operate efficiently, stock and bond markets incorporate all the available information at a given point in time. That's why, when sovereign debt problems emerged in Greece early last year, other European countries seen as having potential problems along the same lines saw an immediate spike in the cost of insuring their debt. Even though they hadn't run into problems yet, the market factored this possibility in.
Market analysts spend many thousands of hours each year looking at these kinds of issues with enough time and research, slow-forming problems like government debt issues can be analyzed beforehand.
What can't be anticipated are developments that are by their nature unpredictable. We've had at least four such events in the past year:
· Last April's volcanic eruption in Iceland that spewed ash in the air, shut down 100,000 transatlantic flights, and cost the airline industry $2 billion
· Also last April, the explosion of the Deepwater Horizon oil rig in the Gulf of Mexico
· Commencing in December, street protests resulting in changes of leadership in a number of countries in North Africa, leading directly to the current military action in Libya
· And, of course, the earthquake, tsunami, and nuclear-reactor crises in Japan.
In light of episodes like these, investors need to take away two key lessons
Lesson One: Expect the unexpected
The only way to deal with uncertainty and manage the impact of unforeseen events is to build strict risk controls into portfolios, similar to those used by the most sophisticated pension funds. While the risk of one-time incidents can't be eliminated, through diversification and risk management we can limit the damage when negative events occur whether they be massive frauds such as Enron, sudden bankruptcies like Lehman Brothers, volcanic eruptions, oil rig explosions, or earthquakes.
I thought it might be useful to provide an overview of my approach to risk management in portfolio construction. There are three steps in this process.
Step one is to identify the target mix of stocks, bonds, and cash that based on historical precedent and current valuation levels will over time have a high likelihood of providing the returns you need to achieve your long-term goals with a level of volatility you can live with along the way.
In step two, we and the money managers we work with carefully diversify your portfolio by placing limits on the exposure to any one company, industry sector, or region. For individual holdings, it's typically an absolute percentage of your portfolio. For example, no one stock should make up more than 5% of your equity holdings, and no one bond should represent more than 3% of your fixed-income exposure
As well, no matter how high our optimism about an industry sector or region, its weight should never be more than 50% above its underlying importance in the market as a whole.
In the final step, at least once a year, we conduct an in-depth analysis of each portfolio. Over time, asset classes, industry sectors, and individual stocks that do well will increase their presence in your portfolio and bump up against the risk control limits.
At that point, your portfolios need to be rebalanced back to the target asset allocation, and some of the positions that have outperformed might be trimmed to stay within risk control limits. Some investors find this very difficult after all, you're selling exactly those investments that have done the best.
But it's the only way to stay truly diversified and control the risk that accompanies overexposure to any one stock, industry sector, or geographic region. And it's also the only way to get some protection from things that simply can't be anticipated.
Lesson Two: Avoid overconfidence
Aside from the time entailed, there is one big negative to the risk-controlled approach to portfolio construction: in the short term and mid term, there will always be someone who's made a big bet that has paid off and who is doing better than you as a result. Because it eliminates big bets, a risk-controlled approach to investing will seldom give you bragging rights on the golf course.
Investors who take the big-bet approach typically have a high degree of confidence in their investments; after all, if you're absolutely certain about a company or industry, why bother to diversify? On the other hand, research by the University of Chicago's Richard Thaler has demonstrated that overconfidence is among the most costly traits an investor can have.
Look no further than the many employees in Silicon Valley during the tech boom. They were 100% confident about the future of their firms and often had all of their retirement accounts invested in the companies they worked for as a result. These investors saw sterling results for a while right up until the tech bubble collapsed.
I believe that we will work through the recent events and that investors with a balanced approach and a long-term view will be well rewarded. The approach to risk management I've described may not be fun or sexy in the short term, but all the evidence at hand suggests that over time it will serve you well, getting you to your goals with the least amount of stress and distress along the way. | 
