As we enter October, we're now three quarters through a very eventful 2012.  I'm writing to provide perspective on what has happened this year and to share my thoughts on how to position portfolios for the period ahead. Here's a summary of 2012 to date: 

This year has been a tale of three quarters. The first quarter saw the strongest start for the U.S. stock market since 1998, driven by a reduction in fears about Europe and stronger economic data in the U.S. 

The second quarter gave many of those gains back, due to escalating concerns about the European currency and union as well as slowing global growth, accompanied by discouraging data on employment. We also saw a slowdown in China and India, putting downward pressure on the prices of oil and other commodities and stocks in general. 

The last quarter saw markets bounce back, as the U.S. Federal Reserve Board and the European Central Bank (ECB) put measures in place to stabilize economies and to boost growth prospects. In particular, European confidence was boosted by the ECB's announcement that it would backstop Greece, Spain, and other countries whose economies are struggling. 

Here's a summary of global market performance in 2012 to date, all in U.S. dollars. It's of note that the global "flight to safety" over the past 12 months has led to a stronger dollar, depressing returns outside the U.S. when denominated in the dollar.

Rational Investing in an Irrational World 

One of the challenges of investing is being caught up in the emotions of the market and also the tendency to root our investment outlook in what happened in the immediate past rather than in what's happening today and what will happen tomorrow.  This is no different from military officers who attempt to prepare for the next war by applying the lessons from the last one, without recognizing that the context has become entirely different.

I wanted to share this quote from Barton Biggs, a Wall Street legend who helps explain peculiarities such as massive inflows into government bonds during a period of all-time low rates, leading to the virtual certainty of capital losses when interest rates rise:

Biggs went on to refer to a comment by Warren Buffett about investing - that it is like being in business with a partner who has a bipolar disorder: 

The Psychological Makeup of Successful Investors 

As a result of the strong emotions at play, many money managers find it hard to stick to their strategies. Here's what Biggs had to say about the importance of immunizing yourself from the psychological effects of the swings of the market: 

So you may be wondering, what does this mean for your portfolio? 

Below are five guiding principles I use in building client portfolios.

1. Taking the right level of risk
    My starting point with clients is to identify the rate of return they need in order to achieve their goals (be it saving for college funds, a home renovation or purchase, retirement, or all of the above) and then to construct a portfolio based on that return objective. My goal is to take the right level of risk for each client - enough that we can be fairly confident that over time you'll achieve your objectives, without taking more risk than is necessary. 
   In fact, it's my view that one of the biggest mistakes is to focus on how much risk investors want to take (which in markets we've seen of late is as little as possible) rather than the more important and fundamental question of how much risk investors need to take in order to hit their long-term goals. Taking excessive risk increases the psychological stresses that Biggs describes, but taking insufficient risk, while comfortable in the short term, is a sure route to a long-run failure to achieve your objectives.
2. A buffer, especially for retired clients
    All that being said, for retired clients, I believe in maintaining secure, liquid funds to cover three years of expenses. Having that buffer means that we reduce the risk of having to sell holdings at depressed levels; this also lessens the stress and anxiety that Biggs alluded to in the statements above.
3. Adhering to your plan
    Given strong stock performance in the first quarter, some clients asked about increasing equity weighting above the maximum boundary in their portfolio guidelines. And then in May, in the face of significant declines, I got questions about selling stocks that would have taken equity weights below the minimum range (in a couple of cases, from the same clients.) 
   In both instances, I strongly recommended against making changes. While I am always happy to discuss adjusting portfolios on a case-by-case basis, I advise against deviating from the range that we established going into 2012 unless there has been a significant change in personal circumstances. 
   In light of stock valuations and the risk in bonds, for some clients earlier this year we increased equity weights to the upper end of their range. Given strong stock performance in the last quarter, for some clients at the top of their range last spring we recently rebalanced holdings to bring the equity weight back down within portfolio guidelines. 
4. Diversifying portfolios
    When building equity portfolios, I've always advocated building a strong diversified portfolio. That means taking advantage of the difference asset classes not just in stocks and bonds, domestic and international, but also in other types of investments like real estate and commodities.
5. Focus on cash flow
    The final principle relates to the role of cash flow from investments. In an uncertain environment for immediate economic growth and equity returns, I continue to place a priority on the cash yield from investments. That's because having a steady cash flow reduces the psychological tensions that many investors have when experiencing market volatility. 
   In my view, the returns on some REITs, investment-grade corporate bonds, the better rated high-yield bonds, and dividend stocks in selective sectors continue to make these investments more attractive than the alternatives. We do have to be increasingly selective, however. Some stocks that pay steady dividends now look expensive by historical standards and appear to have stretched valuations because investor appetite for yield has bid up their price.

Should you have questions about anything in this article or about any other issue, please feel free to give me a call.  And as always, thank you for the opportunity to serve as your financial advisor.