2008 Recession Lessons Learned

Wow! 2008 was a rough year for many investors. Once again we learned the painful lesson that risk and rewards are always intertwined. ( Nullum prandium gratuitum for those of you who are students of Latin.)

#1 Diversify your risk:

Asset allocation, investing in a well-constructed, broadly diversified portfolio of stocks, bonds, and cash equivalents is really critical during bear markets, especially if you’re concentrated in a sector that really got hammered, for example, the financial sector in 2008 . “Keep your nest eggs in many baskets, so they can’t all get broken at once.”  Attribute quote?

#2 Think long term, past the Recession:

Most of the recessions we’ve experienced over the last 60 years have lasted less than a year. Though your portfolio will likely move down in concert with the rest of the markets during a recession, the long term trend for equities has always been positive. Remember that most of the bad news has already been absorbed by the markets and is reflected in the stock prices;  the stock market is a forward indicator and tends to track about 6-12 months ahead of the economy  so that the market often recovers before the economy itself does.

#3 Act conservatively:

Don’t go climbing out on long and slippery financial limbs, especially when the winds and storms of recession are blowing hard.  .Make cautious, conservative financial decisions, but be ready to act when the time is right. For example:

• Don’t bite off more real estate than you can comfortably handle. If you’ve been saving up for a home, wait until you feel that the property market has bottomed.  Crystal ball statement
• If you’re buying a house now, consider applying for a fixed rate mortgage.
• Don’t take on additional debt unless you know you can handle it now and into the future.
• Sock away an emergency fund rather than spending for big items or making  investments.
• Live well within your means. Keep a lot of cash equivalent reserves available. You’ll sleep better at night, and when a great buying opportunity presents itself (real estate, business, or investment) you’ll have the ‘fiscal ammunition “to ‘pull the trigger “on the deal.
• Keep your income flowing .If you are working, be the most valuable, indispensable, well- trained employee you can be. Layoffs can be very painful emotionally and fiscally. If you have a reasonable concern that you could lose  your job, be proactive and flexible and start searching the job market for your next position.
• Continue to save as much as possible. Get a full employer-match through retirement fund contributions.

#4 Be patient and stay the course:

Lots of people are tempted to bail out on their poorly performing investments, especially when the market is reaching historic lows, but they may be missing the boat by unloading assets that could recover nicely once the markets improve. Remember the ultimate goal is to buy lower and sell higher. Many investors will miss the largest percentage of the upswing when it comes because they chose to get out of the market. The recession has given us lower stock prices and cheaper purchases everywhere! Avoid acting out of panic. The patient investor is usually rewarded for his equanimity.

#5 Look at future trends:

Realize that the markets and the global economy have political support and a long-term positive trend.  Whether or not you agree that the Fed should step in and “bail out” failing institutions and other financial channels, the Fed’s strategies and American ingenuity have worked in the past to ultimately turn things around. Over the past 80 years, the domestic stock market has averaged an annual return of about 10%. Also the global economy is expanding, especially in the developing countries. Brazil, India, and China especially, are predicted to grow  over the next several decades.

#6 Above all, learn to live a life of balance and equanimity:

Remember that there’s a whole lot more to your life than your financial net worth and your stock portfolios. Don’t get obsessed over the daily fluctuations in the stock market; that’s a formula for driving yourself crazy. Put your paper losses in perspective: many of your gains were only on paper too.  The fact that you are living in America in the 21st century, and that you even have the ability to have a portfolio of investments puts you in the top echelon of wealthy human beings from a global perspective. Stop and think a minute about all those poor souls living in refugee camps all over the globe, or living under ruthless dictatorships like Zimbabwe and Burma, or wracked by war like Afghanistan, the Congo, and the Sudan.

It’s definitely a good time to count your blessings, hug your family, and celebrate the start of a new year!

Retirement Readjustment Needed?

An article in May’s USA Today entitled “Shrinking Nest Eggs: How the ailing economy affects yours,”[i] painted a depressing picture for those nearing or in retirement. Citing slumping housing prices, decreasing 401(k) values and rising inflation, the article tells us that many investors will be revisiting their retirement plans and possibly delaying their retirement.

The piece goes on to proclaim that “many financial analysts are predicting a prolonged period of below-average returns on both stocks and home equity.” Its author concludes that Americans may need to face a sobering fact: that many of us will have to “save more, expect less, and work longer than we planned.”

If the article’s intent was to move its readers toward a lifestyle of living below their means, then we would applaud its value as financial journalism. However, after reading a bit further, we realized that the story had less to do with falling assets and a slowing economy, and more to do with the reality that many investors misunderstand their options and make inappropriate decisions. The article referred to a few examples of people grappling with their upcoming retirements:

• A California IT worker who believes that now, after a 4% decline in her portfolio and a 25% decrease in her home’s value, she may not be able to ever retire.
• A Wisconsin comptroller for a manufacturing plant who had planned to retire at the end of this month, but who is now delaying his journey due to “the recent declines in the stock and real estate markets.”

If the investors it cited above are in any way representative of those who are currently nearing retirement, then we might make a case that the reason for their distress is not only the economy, but possibly inappropriate asset allocation, diversification and lack of appropriate financial planning.

Some financial education might go a long way in improving their outlook. Here are our planning assumptions based upon what was written:

• The California IT worker seems to have four separate items to think about:
  • If a 4% decline has her worried, then she may have an inappropriate asset allocation in place and one that must not be matched perfectly to her risk capacity or tolerance.
  • A 4% decrease in assets is not terribly significant over the long-term when it is related to a retirement that is more than 5 years away; we wonder what her time horizon for retirement is? It doesn’t sound like she has clearly identified the goal that she would like to hit.
  • The 4% decrease has us wondering what she was investing in. A 100% all-equity/stock, high risk, investment in the S&P 500 would only have been down 2.93%[ii] over the same period.
  • Finally, she is counting on her home’s equity to fund her retirement. This is speculating, not investing; it can be likened to investing in a single stock. Moreover, counting on the equity from a single property type in a single city is the definition of a concentrated investment strategy, and in this case it performed poorly.
• The Wisconsin comptroller who is now delaying retirement until 2009 must have had a volatile portfolio indeed – and one that was lacking diversification. (In fact, we cannot figure out what mix of investments would have been so volatile over the last few months as to force him to delay his retirement). Actual Total returns from January 1 to May 17 (when the article was printed) was -2.1% for the Dow Jones Industrial Average, -2.9% for the S&P 500® Index (US Large Stocks), -2.57% for the Russell 2000 Index (US Small Cap Stocks), and +1.16% for the MSCI All Country World ex US Index (International Stocks)[iii]. If he was invested in these segments as part of an overall diversified strategy then his corresponding portfolio wouldn’t have been down all that much in our opinion. Our reaction to his story was once again more philosophical in nature:
  • Any investor rattled by market fluctuations should revisit his allocation policy and take some time to better understand the behavior of the equity/stock markets; this is especially true for an investor who has become this anxious after a few months of falling prices.
  • Imagine for a moment that he had a very volatile portfolio had invested only in the smallest, riskiest stocks he could find and that these stocks pushed his portfolio down 10%. If he had saved up $2,000,000 that would have represented a $200,000 decrease and his portfolio would have now been worth $1,800,000 (of course, only if he sold all his investments). We are left wondering why he couldn’t retire. He must have been treading a very thin line between success and failure.
  • Given that his portfolio must have been volatile enough to force a change in course for retirement, then we why he was still “swinging for the fences” and investing in such a risky manner when he was this close to his date for retirement. Good planning should have helped guide him to a less volatile portfolio on his final approach. In fact, excellent planning would have suggested that he begin preparing 2-4 years prior to avoid things like this.
  • If he had consulted an advisor maybe he would have realized that he could still retire.

We don’t wish to take the above investor concerns lightly, but the ideal retirement income solution does not exist outside the limited scope of the Social Security system where the investor receives a stream of guaranteed inflation-adjusted annuity payments. As a result, many are faced with a series of confusing tradeoffs in an effort to approach similar, desired result. The examples in the USA Today offer compelling evidence that making expensive mistakes with respect to key financial decisions is all too easy.

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[i] Block, Sandra. “Shrinking nest eggs: How the ailing economy affects yours.” USA Today, May 17, 2008.

[ii] Google. Google Finance. In http://finance.google.com, accessed June 19, 2008.

[iii] Google. Google Finance. In http://finance.google.com, accessed June 19, 2008.

Mr. Market and his sidekicks

Those of you who know us well, know that the Gold Medal Waters team would never attempt to forecast the future, nor would we try to predict the direction of the equity markets. To do so contradicts our philosophies and sets the wrong expectations.

Instead, we relish our work helping to create properly constructed portfolios that match our client’s needs (ie. your financial plan) and are goaled to reduce risk through diversification and through asset allocation.

However, recently Mr. Market and his media sidekicks – namely Mr. CNBC, Mr. CNN, Ms. Reuters, and few others – have had some idle time on their hands. Unfortunately, we have watched Mr. Market’s recent negativity become the focus of the media.

So, we figured that we better take a moment and address a few of the topics that have been on the tongues of some of these reporters (most of whom have a degree in Journalism and not Economics).

Let’s begin with the word they all love to say…Recession.

The word comes from the Latin language – recessio, from recessus.

In the English language, it could be used to describe many things – among them, thinning hair and clerics heading to the exit of a church – however, when it is framed in the context of Mr. Market and economics we have to look elsewhere for a definition…

According to The Economist magazine a recession is “a period of slow or negative economic growth, usually accompanied by rising unemployment.”[i]

The Dictionary of Economics has a similar definition. It claims a “recession is the lower phase of a business cycle, where most main macroeconomic indicators (GDP, national income, employment, consumer spending) are declining. Most economists define recession as the state of an economy in which the GDP value has been declining for at least two or three consecutive quarters.”[ii]

Both definitions point to a recession as a period of slower growth and most definitions of recessions hold that the GDP must be declining for at least two consecutive quarters.

Given these definitions, it follows that the only point when we can actually “proclaim” a recession is…after one has occurred. (And even if one is “discovered” it is only valid if you truly believe that GDP is an accurate measure our well-being and growth – some economists argue that GDP as a measurement itself is flawed).

Definitions aside, this raises two essential questions. First, if we don’t know whether or not we’re in a recession until after it has actually occurred, why is it that so many media outlets are shouting the word? And second, are any of them qualified to determine whether or not we are actually in recession?

My answers to these questions: 1. To sell newspapers/magazines. 2. Absolutely not.

If we are in fact in a recession, this is probably an appropriate point to discuss what to do during periods when the economy slows.

Paradoxically, our natural and rational reaction is most likely to become more cautious about spending. Yet, this only serves to make our collective situation worse.

Our behavior (or our reduction in spending) is a reaction to our expectations, and pretty soon we begin to get what we expect. If we all believe that the economy will get worse, then it most likely will. For example, a business owner’s decision to cut costs might end up costing you your job – a self-fulfilling prophecy, if you will, and quite a vicious cycle.

One of the first steps then, is to continue spending. And this is being encouraged – with incentives from Uncle Sam.

Another phrase being used in the media: Tax Rebates

When the government uncovers signs that the economy might be headed into difficult territory, they have the ability to employ one (or both) of their available tools: Fiscal Policy and Monetary policy.

Fiscal Policy uses the government’s ability to spend money and reduce taxes to get the wheels of the economy in motion. InvestorWords.com defines fiscal policy as “decisions by the President and Congress, usually relating to taxation and government spending, with the goals of full employment, price stability, and economic growth. By changing tax laws, the government can effectively modify the amount of disposable available to its taxpayers.”[iii]

We’ve already seen the government take action. On February 13, 2008, President Bush signed a $170 billion dollar stimulus plan aimed at spurring the economy. Among other things, this package included a major tax rebate to help encourage spending.

Another hot topic: Interest Rate Cuts

The government’s second tool, Monetary Policy, is like one of those highly caffeinated “power drinks” – it can jumpstart the economy with blazing speeds. The Chairman of the Federal Reserve, Mr. Bernanke, can enact this policy by raising or lowering short-term interest rates with simple phone call.

As the chart below shows, the Federal Reserve has cut interest rates 6 times in the last 7 months taking interest rates to their lowest levels since post-9/11. Lowering short-term interest rates makes it less expensive for consumers to purchase houses and other big-ticket items, again stirring up the economy.

[iv]

So, what can we take away from all this?

Well, the structure has been put in place for the economy to make a resurgence 6 to 9 months from now, but it all will come down to how the “collective we” reacts with our wallets.

At Gold Medal Waters we adhere to our philosophy that one cannot consistently predict the future of the economy and capital markets. We can certainly observe that the behavior of the capital markets may follows similar economic stimuli, as it has in the past, but determining how the market will respond to these stimuli would be considered “a good guess” at best. In the meantime, it becomes crucial to keep your portfolio intact and diversified to capture any potential upside down the road.

As always, if the recent market volatility has caused you any sleepless nights or concern, then it may make sense for us to revisit your risk tolerance and portfolio allocation. Please know that we are here for you and are happy to help you at any time.

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[i] Economist.com term Search, 2008

[ii] www.economyprofessor.com, 2008

[iii] fiscal policy definition, 2008

[iv] New York Fed, 2008

Why I Love This Job

Recently one of our prospective asked me to delineate exactly what being a financial planner entails.  I sent him a long description along with a detailed matrix of our various services which gives a good itemized and technical explanation of what we do.

Shortly thereafter my mind wandered off to a song I heard many years ago by Frank Sinatra entitled That’s Life. It’s a great song and one of my favorite sections are the lyrics that go something like this:

“I’ve been a puppet, a pirate, a pauper, a poet, a pawn and a  King…”

It’s wonderful to think that you can live a life continually playing different roles.

I started thinking about all of the skill sets involved in being a financial planner and investment advisor such as gathering data, establishing goals, analyzing information, making and implementing recommendations, and monitoring performance.

And I realized why this is such a great job; it has so many fascinating aspects that allow one to tap into the aptitudes of so many other professions.

Officially we work as investment advisers and financial planners, but metaphorically we are the financial equivalents of fishing guides, architects, actuaries, bodyguards, futurists, pilots, physicians, psychologists, psychoanalysts, quarterbacks, social workers, professors, and sometimes even priests! Hopefully, we never have to play the role of undertaker.

I wonder how I can fit all of that on my next business card!

Latin Lingo Lesson

There’s something wonderful and mysterious about the Latin language.  After all it’s the ancestor of all the romance languages and whether we know it or not we are using its linguistic descendents every day in our verbal expressions.

When I was studying for my Series 65 test to become an Investment Advisor , I was introduced to the term” fiduciary” (in fact you’d have a difficult time passing the Series 65 without fully understanding this term). It’s a beautiful, eloquent, polysyllabic word. But what does it really mean? It comes from the Latin word fīdūciārius – from fīdūcia trust – and means that you are legally agreeing to stand and act in a special relation of trust, confidence, or responsibility regarding financial matters on behalf of the party that you serve.

It means above all, that you place the financial and personal interests of the client that you serve, above your own personal interests. It means that you refrain from any obvious conflicts of interest and that you disclose any possible conflict of interest and that all of your actions, motives, and recommendations with respect to your client are honest, forthright, transparent, open and ‘above board.’ It’s a wonderful way to do business.

So what’s the Latin opposite of this?

I would suggest it is Caveat Emptor or “Let the Buyer Beware.” This phrase comes from caveat – the third person singular, present subjunctive of cavēre – to beware, and from ēmptor – or buyer.

Unfortunately, this is the way most business is conducted. It is the axiom or principle in commerce that the buyer alone is responsible for assessing the quality of a purchase before buying.

As an example, just recently I was checking out a martial arts course that I had some interest in. I went to a free introductory lesson which I enjoyed, and I was prepared to pay by check for and choose a sign up option giving me one free month of lessons and one paid month of lessons. However I was taken aback by a very complicated contractual document that I was asked to sign which required me to sign up via credit card or with a direct deposit from my checking account and with all kinds of hidden clauses and legalese verbiage that obligated me to pay a $50 discontinuation fee, that required me to give at least 30 days written notice by certified mail only in order for me to discontinue the course, that gave the owners of the martial arts course the ultimate authority to decide whether or not I had the right to discontinue the course etc. Ultimately I declined to sign the contract.

Unfortunately Caveat Emptor transactions are most commonly found in our society and many people have been badly burned by them. We at Gold Medal Waters feel that it is especially important for you the client to always know which of these two Latin relationships you are getting yourselves into especially when it comes to investment services and the large financial/wealth management and investment decisions that can directly and profoundly affect you and your family’s financial future.  As a fee only financial planner we take a strict fiduciary pledge on all of our client relationships.  This Is a Very Big Deal.

The majority of stock brokerage services do not sign any sort of fiduciary pledge. The majority of firms that sell you annuities, insurance products, hedge funds, loaded mutual funds, variable life insurance, credit cards, used cars, used trucks, and aluminum siding for your house are generally in the domain of Caveat Emptor.

Wouldn’t it be great if all of our relationships/transactions were at the level of a fiduciary trust?  It would mean that we all act from an ethical imperative of honesty, transparency, and always acting in the best interest of the client/customer/patient. Wouldn’t it be awesome if we could operate in a society that followed the Golden rule variation of philosopher R D Laing- “Do unto others as you would have others do unto you, if you were in the other person’s position.” Or the moral philosophy of Immanuel Kant “there is one categorical imperative. Act so that every action of yours should be capable of becoming a universal rule for action for all men”.

Hopefully that time will someday come. In the meantime find a good fiduciary or Caveat  Emptor!

The Gold Lining?

In a recent Forbes magazine report, Tom O’Brien, provided his insight into gold as an investment:

Rarely have so many factors pointed to a “buy” signal on gold. Yet, when the Federal Reserve announced a rate cut last month, the stage was set for a sustained bull market for the commodity.

They key markets for the physical demand are India, the Middle East, Turkey and greater China… the demand in these markets has increased by 37% year-over-year… when we look at these countries, we also see stronger income growth from the consumer looking to own gold.

Could he be correct?

While O’Brien’s statement might suggest the odds are on gold, the true odds are that we don’t know what the odds are…

Let’s look at an scenario to help us understand:

Economics Professor Richard Thaler of the University of Chicago has put the following question to a number of people over the years:

Steve, a 30-year-old American, has been described by a former neighbor as follows: “Steve is very shy and withdrawn, invariably helpful, but with little real interest in people or the social world. A meek and tidy soul, he has a need for order in structure and a passion for detail.” Which occupation is Steve currently more likely to have: that of a salesman or that of a librarian?

Can you guess how people answer?

Most folks think that Steve is more likely to be a Librarian… and given what we know about Steve, it seems his probability of that profession is high.

What if we had some more information?

The Bureau of Labor Statistics database suggests that in the United States there are 15 million salespeople and just under 200,000 librarians. Does this help to reframe the scenario? It should certainly help reinforce the odds…

This tendency to disregard or discount the overall odds is what Nobel Laureate Daniel Kahneman and Amos Tversky termed “ignoring the base rate,” and the evidence of this phenomena can be witnessed each year as thousands of otherwise sane investors throw away good money in the commodities markets as they are led astray by the opinions or recommendations of others.

After reading O’Brien’s comments, you might think that the time it right to buy some gold. Yet, if you understood the base rate – that an estimated three out of four investors, both amateur and professional, lose money when they trade in commodities – you would probably decide to look elsewhere.

Are Mutual Fund Fees Important When Investing?

Numbers and Prices can have an interesting impact on our decision-making.

Consider the following scenario that was presented in a study by Princeton’s professor of Behavioral Finance Eldar Shafir:

in three successive years, James, Joseph, and Chris each bought a home that cost $200,000, and each ended up selling their home one year later. During James’s year of homeownership, the country experienced 25% deflation – that is, the average price of all goods and services in the United States fell by 25% – and James sold his house for $154,000, or 23% less than he had paid. During the 12 months that Joseph owned his home, the situation was reversed: the average cost of goods and services actually rose 25%, and Joseph eventually sold his home for $246,000, or 23% more than he paid. As for Chris, the cost of living during her year long stretch of owning a home state pretty much the same, but she ended up selling her house for $196,000, or 2% less than she paid.

So who fared the best in this confusing scenario?

According to Shafir, a majority of the participants in his study – about six in 10 – thought Joseph (who notched a 23% gain during a period when the average price of goods rose 25%) came out on top and James (who posted a 23% loss versus a period when the average prices of goods fell 25%) fared worst. These majority conclusions are interesting, because they’re wrong.

James was actually the only homeowner who made any money. (Most of the respondents did not have understand the impact of inflation)

So what is this number confusion have to do with investment fees. Well, as it turns out, quite a bit.

You see, investment fees can be just as difficult to figure out…

Let’s try another example:

Suppose you had to invest $10,000 in one of two International Mutual Funds specializing in Mid/Large Value Companies, each fund with the following characteristics:
Mutual Fund A
Purchase Cost = $0
Yield = 3.18%

Fund has never had a negative return (13 yrs)

Mutual Fund B
Purchase Cost = $40
Yield = 2.67%

Fund has had negative returns (4 out of 12 yrs)
At first blush, Mutual Fund A really shines, but what if we dig deeper and looked at their return history:
Mutual Fund A
Purchase Cost = $0
Yield = 3.18%

Fund has never had a negative return (13 yrs)

5 YR Return = 22.74%

Mutual Fund B
Purchase Cost = $40
Yield = 2.67%

Fund has had negative returns (4 out of 12 yrs)
5 YR Return = 23.26%
Well, that changes the picture a bit. Fund B actually returned more than Fund A over the last 5 years. But those are just average returns. What if we used the actual returns on a hypothetical $10,000 investment (i.e. the year in/year out return used to make up the averages)?
Mutual Fund A
Purchase Cost = $0
Yield = 3.18%
Fund has never had a negative return (13 yrs)

5 YR Return = 22.74%

$10,000 (invested 2002) = $27,666 (2002-2006)

Mutual Fund B
Purchase Cost = $40
Yield = 2.67%
Fund has had negative returns (4 out of 12 yrs)
5 YR Return = 23.26%

$10,000 (invested 2002) = $27,208 (2002-2006)
Interesting. Now Fund A looks like slightly better fund given its order of actual returns for the last 5 years. Maybe we should compare their performance for the past 1 Year Period:
Mutual Fund A
Purchase Cost = $0
Yield = 3.18%
Fund has never had a negative return (13 yrs)

5 YR Return = 22.74%

$10,000 (invested 2002) = $27,666 (2002-2006)

1 YR Return = 16.18%

Mutual Fund B
Purchase Cost = $40
Yield = 2.67%
Fund has had negative returns (4 out of 12 yrs)
5 YR Return = 23.26%

$10,000 (invested 2002) = $27,208 (2002-2006)
1 YR Return = 27.92%
Fund B provided almost double the return; This certainly only serves to cloud the picture further.

So, here we have very similar funds that have returned very similar amounts over the years. This becomes a very difficult decision indeed.

But, of course, there is a catch…

If you have been reading my past columns, you know that I like to evaluate how numbers and money influence our decision-making – essentially concentrating on how our ego and the media get involved in the process.

Would it help to know that Mutual Fund A was a candidate for Morningstar’s International Manager of the Year and made the Top 100 Funds list produced by Barron’s? Indeed interesting media comments to consider…

But of course, I left out some figures in the scenario above…Would the decision be easier if you knew the following?

Mutual Fund A

Annual Expense Ratio = 1.12%

Commission/Load = 0.00%

Transaction Cost = $0

Ten Year Expense Projection = $1,860 (est. per $10,000 invested)

Mutual Fund B

Annual Expense Ratio = 0.48%
Commission/Load = 0.00%

Transaction Cost = $40

Ten Year Expense Projection = $640 (est. per $10,000 invested)
Over the longer term, the reduction in expenses from Mutual Fund B will help it to produce superior returns. In essence, given the above example, Mutual Fund A must earn an additional 0.64% just to keep pace with Mutual Fund B.

So, even though there was a $40 transaction charge to purchase Fund B, the total expense as represented by cost of ownership is well below that of Fund A.

Expense reduction in investing is one aspect in the process that we can control. However, it is important to make sure that it is done utilizing all available information to arrive at the actual result.

Failure to consider total impact will leave us choosing Joseph over James every time.

Tuning out the Noise. Some thoughts on Fair Pricing.

Our favorite holding period is forever.
Warren Buffett

In the early 1990s, Money magazine would periodically poll Americans to see how savvy they were about investing. Respondents sometimes were asked to choose among several numbers to find out the one closest to the recent level of the benchmark Dow Jones Industrial Average. Over time, the editors of the magazine began to recognize that, not knowing where the Dow was, could just as easily be a sign of investing intelligence as investing ignorance. They learned that the best investors often ignored the majority of what passes as important financial news.

Ignoring financial news is very difficult to do, especially now as we are getting bombarded with CNN updates on our cell phones. But as investors in the capital markets, it is a good skill to master; it is not reckless. As Warren Buffett explained, in his company’s 1993 annual report: “After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two. We don’t need a daily quote on our 100% position in See’s (Candy) or H.H. Brown (Company’s wholly owned by Buffett’s Berkshire Hathaway) to validate our well-being. Why, then, should we need a quote on our 7% interest in Coke?”[i]

This can be illustrated in the real estate market as well. Take your house for example. Can you imagine if you received daily quotes on the price of your home? (Essentially, you would have a realtor come to your house every day to put in a bid.) That would certainly become tiresome after a time and would most likely increase your stress levels.

And how exactly would the Realtors be establishing their prices anyway?

Consider the result of the 1987 study by the University of Arizona’s Gregory B. Northcraft and Margaret A. Neale, who is now at Stanford University. Working with real estate agents in Tucson, the professors took one randomly selected group of brokers to home in town and asked them to appraise its value. In addition to a guided tour, the agents received a 10 page packet of information about the house, including its $65,900 list price. Their average appraisal came in at $67,811.

Northcraft and Neale brought a second group of real estate pros to the house, giving them the same tour in the same packet of information, with one exception: the listing price was $83,900. This time, the average appraisal came in at $75,190 – a full $7,000 higher than the first group. Same house, same information. The only change was the anchor-the listing price, but that was enough to change the “starting point” for those professionals and therefore dramatically influence the way the house was valued. [ii]

Anchoring on a number, such as the “starting point” illustrated above can influence almost any financial decision you make, even when you have expertise about the issue at hand.

Speaking of anchors… On October 19 the Dow Jones Industrial Average marked the 19th anniversary of the stock market crash of 1987. By establishing another record – closing above 12,000 the first time. Now, the 12,000 mark is just an arbitrary figure of no special significance, however, it is interesting to see how other experts in the investment field have anchored around it:

• “Stocks stink and will continue to do so until appraised appropriately… the market needs the yield close to 3.5% before it approaches fair value, and that means Dow 5000… Nowhere near today’s level of 8500… Stocks historically returned more than almost all other alternative investments, but only when priced right and when the race begins.” (2002 – Bill Gross – manager Pacific funds)[iii]
• “A lot of companies–some 30% of the Standard & Poor’s 500–have benefited greatly from low interest rates and that buffer is coming to a fast and possibly brutal end.” (2004 – Charles de Vaulx – manager of the First Eagle funds)[iv]
• “I think the fair value on the S&P is about 700… I think the huge losses will come in 2005 in 2006, when the presidential cycle gets to the housecleaning phase.” (2004 – Jeremy Grantham – manager of Grantham, Mayo, Van Otterloo)[v]
• “2006 is the second year of the presidential cycle, which is typically been a week here for stocks. Recommendations for the first nine months of 2006: Cash and more cash!” (2006 – Jeremy Grantham)[vi]

Perhaps their warnings will appear more helpful in the future, but the behavior of the equity markets of the past two years offers a compelling illustration of how difficult it is to determine the fair value for stock prices.

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[i] Belsky, Gary & Gilovich, Thomas, 1999. Why Smart People Make Big Money Mistakes.

[ii]Belsky, Gary & Gilovich, Thomas, 1999. Why Smart People Make Big Money Mistakes.

[iii] Gross, William H. 2002. Investment outlook. PIMCO.com, September 2002.

[iv] de Vaulx, Charles. 2004. The funk on the street. BusinessWeek. May 2004.

[v] Morrison, Kurt. 2004. Why I think the S&P 500 is fairly valued at 625. Stock strategist, December 1, 2004

[vi] otter, Jack. 2004. What’s next for the market? Smart Money, January 2004

HP Behaviorial

Fact #1: from 1984 through 1995 the average stock mutual fund posted a yearly return of 12.3% while the average bond mutual fund returned 9.7% a year.

Fact #2: from 1984 through 1995 the average investor in a stock mutual fund earned 6.3% while the average investor in a bond mutual fund who earned 8%.[i]

If you are like me, you ask the questions, “What is wrong with this picture? How can this be?”

Well, what it shows is actually quite interesting. Rather than creating an appropriate asset allocation and “buying and holding” a diversified portfolio of mutual funds, it appears that most investors over that time period moved in and out of various mutual funds, probably in an effort to maximize their returns.

This is happening more often now as our society becomes entrenched in the “up to the minute” news phenomenon.

Consider a study done by former Harvard psychologist Paul Andreassen which compared the mock investment performance of four groups of investors:

Using actual prices and news reports, two of the groups made investment decisions about a relatively “stable” stock – its share price didn’t move all that much over the course of the experiment. In this study, one group was subjected to regular streaming news reports about the company; the other group received no news at all. In a subsequent study, the other two groups received a similar test, except that in this instance, the stock in question was a highly volatile company that was subject to wider price swings than the shares of the other company. In both instances, investors who received no news performed considerably better than those who received constant information; those who were kept “in the dark” actually earned more than twice as much money as those whose trades were influenced by the media.

How would you react under similar circumstances?

Imagine for a moment that you owned Hewlett-Packard stock eighteen months ago and read the cover story in Fortune entitled “Why Carly’s Big Bet is Failing” which provided an in-depth discussion of the demise of HP after the Compaq Computer merger.[ii] Written by veteran Fortune writer Carol Loomis, the article exam the promised benefits of the controversial merger with Compaq computer completed in May 2002 and found that the results had fallen far short of the mark. Loomis wrote, “This was a big bet that didn’t pay off, that didn’t come close to obtaining what (CEO Carlton) Fiorina and HP’s board said was in store.” She further argued that personal computers for HP were a “Big Lousy Business,” and observed that the real money and technology was earned by firms dominating their markets like Intel and Microsoft and apart from the printer business. Loomis observed, “HP doesn’t dominate anything.”

At the time the article appeared, Hewlett’s opposition appeared to be vindicated: HP shares had underperformed the S&P 500® as well as industry rivals Dell, IBM, and Lexmark, since the merger was first announced in September 2001.

After reading the above, would you have considered selling HP?

Contrast this to Fortune’s next major cover, a salute to Dell Incorporated, which appeared only one month later entitled “The Education of Michael Dell.”[iii] This glowing review of Dell went on to rank the company #1 in the magazine’s Most Admired Company survey. Fortune writes, “Be it desktops, notebooks, and servers, or in profits, growth, and margins, Dell is the leader. And it isn’t slowing down either.” Apparently, the combination of HP and Compaq appeared to pose little threat to Dell’s direct-sales model. As one observer said, it was “just a bigger butt to kick.”

Sounds like Dell is the stock to beat, right?

Well, subsequent earnings announcements and stock returns certainly illustrate how difficult it can be to earn the highest stock returns by backing the “winning” horse:

On August 16 Hewlett-Packard Reported fiscal third quarter revenue of $21.9 billion and net income of 1.38 billion-exceeding estimates from Wall Street analysts for the fifth consecutive quarter. Operating profits for Hewlett’s personal computer business were up 69%.

Dell reported fiscal second quarter net income of 502 million a 51% drop compared to a year ago. And the shares have fallen 26% for the year to date through August 18.[iv]

		August 31, 2001	August 18, 2006
Hewlett-Packard	HPQ	$23.21	$35.52	+53.04%
Dell	DELL	$21.38	$22.16	+ 3.65%
IBM	IBM	$99.95	$79.90	- 20.06%
Lexmark	LXK	$52.17	$53.32	+ 2.02

The evidence suggests that exhaustive analysis of a company’s prospects offers no sure path to excess returns.

---

[i] Belsky, Gary and Gilovich, Thomas, Why Smart People Make Big Money Mistakes, 1999

[ii] Loomis, Carol J. “Why Carly’s Big Bet Is Failing.” Fortune, February 7, 2005.

[iii] Serwer, Andy. “The Education of Michael Dell.” Fortune, March 7, 2005.

[iv] Yahoo! Finance, in www.yahoo.com, accessed August 22, 2006

A Stroll Down Memory Lane

Those Volatile Markets

With the recent fluctuations in the US and International Equity Markets, investors seem to be feeling a bit squeamish. Over time, this feeling of uneasiness festers and may induce a reaction that may not be altogether beneficial for someone’s investment portfolio. It does, however, underscore the need for a proper process when investing money in the Capital Markets. Here are some points to consider:

Understand Your Capacity for Taking Risks

If the recent market movements made your stomach ache, then you may want to reconsider the investments that you are making with your hard-earned funds; you could be taking on too much risk by investing too aggressively for your tolerance levels. Such discomfort can sometimes force poor decision-making.

Asset Allocate Accordingly

Simply owning a few diversified mutual funds does equate to allocating your investment portfolio appropriately with your risk comfort levels. A proper allocation should consider other important aspects such as the amount of equity (stock) vs. the amount of fixed income (bond) or the amount of Non-U.S. (international) equity vs. U.S. (domestic) equity. Of course, the right mix will depend upon your comfort with investments.

Take a Long-term View

Capitalism is an economic system in which capital is “invested” in the production, distribution, and trade of goods or services for “profit.” Without profit and growth, Capitalism becomes like a three-legged table – essentially just a pile of wood. “Investors” take part in this system by trading their capital (i.e. investing your savings in a company) for a future profit. In doing so, they must measure performance over the longer-term – time periods typically greater than 5 years. “Speculators” are concerned with shorter-term profits and measure performance over the shorter-term – time periods typically less than five years. A good question to ask yourself is “Are you an investor or a speculator?”

Save Appropriately

Anytime there is a blip on the “investment radar,” take some time to revisit your goals, your savings patterns, and your timeframe for investment. If you are comfortable with the risks and are saving enough to meet your goals, then such market movements shouldn’t really affect you. Your comfort levels will be maintained by what is known and controllable (your savings rates and taxes) rather than by what is unknown (the market’s future movements).