Advisor Blog

A recent New York Times article by Tara Siegel Barnard titled "Why Panic? A couple's Nest Egg Better Left Alone" discusses the experience of a typical retired couple during the market plunge of 2008-2009.  It makes a number of good points and it is particularly interesting to us because the retired couple in the article are the parents of a long-time friend and colleague at DFA, Mark Gochnour.  Mark was the guy who happened to answer the phone when I first called DFA a dozen or so years ago. 

Among other things, the article discusses the importance of disciplined savings, choosing a portfolio with characteristics that fit within your risk tolerance, and being able to draw income from stable high-quality bond funds during periods of stock market stress.  At a conference a couple of weeks ago, I got to see how some planners have referred to this as the portfolio's "liquidity ratio", to borrow a term from balance sheet analysis.  Essentially, this is how many years of expenses can be covered without selling equity positions in the portfolio.  For retirees that choose to work with us for financial planning/wealth management, this is typically many years - more than enough time for the stock market to recover from even a serious decline. 

“It is really the simple things that I call the blocking and tackling of investing,” Mr. Gochnour said. “And you have to stay disciplined and stick with your plan, not only in good times but in more challenging times as well."  As the author points out, it also helps to turn off the television.

Clifford S. Asness (pictured in his office), Roni Israelov and John M. Liew, all from AQR Capital Management, were named co-winners of the annual CFA Institute's Graham and Dodd Award for their article on the benefits of global equity diversification.  The award recognizes excellence in research and financial writing in articles in 2011 issues of the Financial Analysts Journal, a publication of the CFA Institute. Their article, “International Diversification Works (Eventually),” was published in the May/June issue.

The paper concludes that although critics of international diversification observe that it does not protect investors against short-term market crashes because markets become more correlated during downturns, this observation misses the bigger picture.  Over longer time horizons, underlying economic growth matters more than short-term panics with respect to returns, and international diversification does an excellent job of protecting investors.

The past year reminded investors that they should hope for the best, prepare for the worst, and be thankful when reality does not match their fears. Investors entered 2011 with hopes that the world economy would continue recovering from a long and painful deleveraging process. Equity markets had posted two straight years of positive performance, central banks remained committed to pro-growth monetary policy, and major developed nations were focused on reducing debt.

Another great article from Weston Wellington at DFA in his "Down to the Wire" column:

Equity investors around the world had a disappointing year in 2011 as thirty-seven out of forty-five markets tracked by MSCI posted negative returns. The US did well on a relative basis and was the only major market to achieve a positive total return, although the margin of victory was slim. Total return for the S&P 500 Index was 2.11%, and the positive result was a function of reinvested dividends—the index itself finished the year slightly below where it started.

Led by the excellent performance of US stocks, global equity markets posted strong returns in the quarter. Those returns, however, were not sufficient to overcome a dismal third quarter and most markets had negative returns for the year.

• Quarterly returns for the broad US market, as measured by the Russell 3000 Index, were 12.12%. Asset class returns ranged from 15.97% for small cap value stocks to 10.61% for large cap growth stocks. The strongest sectors in the quarter were energy and industrials, while the weakest one was telecommunication services. For 2011, the strongest sectors were utilities and consumer staples, while the weakest ones were financials and materials. Value outperformed growth in the quarter, but not in 2011.

• In US dollar terms, the quarterly returns for developed non-US markets were over 3%, above the historical average but far behind the US. For 2011, however, developed international markets as a whole lost over 12%. As in most of the past few quarters, there was much dispersion in performance at the individual country level. Greece, which remains at the center of Europe’s sovereign-debt woes, was by far the worst performer in the quarter and the year. At the other end of the spectrum, Ireland, the Scandinavian countries, and Australia were the top performers for the quarter.

• In US dollar terms, emerging markets gained about 4% in the quarter, in line with the historical average, but not enough to overcome their very poor performance of the third quarter. As a result, emerging markets lost almost 20% in 2011. Malaysia and other smaller emerging markets in Asia and Latin America such as Thailand and Peru posted double-digit returns in the quarter. At the other end of the spectrum, India, Turkey, and Egypt had double-digit negative returns in the quarter. 

As we near the end of a tumultuous year in the capital markets, it may be a good time to view recent events with a greater sense of perspective.  Jim Parker at DFA recently published an article on this topic.  Jim spent 25 years as a senior editor and writer for the Australian Financial Review and holds an an economic history degree from Deakin University and a journalism degree from Auckland Technical Institute.

The Good Old Days?

"The hardest arithmetic for human beings to master," wrote the great American working man's philosopher Eric Hoffer, "is that which enables us to count our blessings."

It's a piece of wisdom worth recalling after another year that has tested the nerve of many investors and prompted questions about what current generations have done to deserve to live in such a tempestuous stage of history.

As the year winds down (if that's the word for it!), financial markets are gripped by uncertainty over developments in the Eurozone crisis. Each day brings fresh headlines that send investors scrambling from virtual despair to tentative optimism.

While not seeking to downplay the very real anxiety generated by these events, particularly in relation to their effects on investment portfolios, it's worth reflecting critically on our often second-hand memories of the "good old days."

A Brief History of the 20th Century

Nearly 100 years ago, Europe was engulfed by a war that destroyed two centuries-old empires, redrew the map of the continent, and left more than 15 million people dead and another 20 million wounded. The economic effects were significant, with widespread rationing in many countries, labor shortages, and massive government borrowing.

Just as the Great War was ending, the world was struck by a deadly pandemic—the Spanish flu, which, by conservative estimates, killed some 50 million people. About a third of the world's population was infected over a two-year period.

A little over a decade after the Great War and the pandemic, the Great Depression cut a swath through the global economy. Industrial production collapsed, international trade broke down, unemployment tripled or quadrupled in some cases, and deflation made already groaning debt burdens even larger.

In the meantime, resentment was growing in Germany over its Great War reparations to the Allied powers. Berlin resorted to printing money to pay its debts, which in turn led to hyperinflation. At one point, one US dollar converted to 4 trillion marks.

In a new militaristic and nationalist climate, fascist regimes arose in Germany, Italy, and Spain. Under Hitler, Germany defied international treaties and began annexing surrounding regions in Austria and Czechoslovakia before finally attacking Poland in 1939.

This led to the Second World War, a conflict that engulfed almost the entire globe while Japan pushed its imperial ambitions in Asia, and Germany sought to conquer Europe. More than 50 million died in the ensuing conflict, including a holocaust of six million Jews. The war ended with the invasion of Berlin by Russian and western forces, while Japan surrendered only after the US dropped nuclear bombs on two cities, killing a quarter of a million civilians.

In economic terms, the war's impact was profound. Most of Europe's infrastructure was destroyed, millions of people were left homeless, much of the UK's urban areas were devastated, labor shortages were rife, and rationing was prevalent.

While the thirty-five years after World War II were seen as a golden age in comparison, the geopolitical situation remained fraught as the nuclear armed superpowers, the Soviet Union and the US, eyed each other. The breakdown of the old European empires and growing east-west tensions led the US and its allies into wars in Korea and Vietnam.

The cost of the Vietnam and cold wars created enormous pressures concerning balance of payments and inflation for the US and led in 1971 to the end of the post-WWII Bretton Woods system of international monetary management. The US dollar came off the gold standard, and the world gradually moved to a system of floating exchange rates.

In the mid-1970s, the depreciation of the value of the US dollar and the breakdown of the monetary system combined with war in the Middle East to encourage major oil producers to quadruple oil prices. Stock markets collapsed and stagflation—a combination of rising inflation alongside rising unemployment—gripped many countries.

While the 1980s and 1990s were a relative oasis of calm—aided by the end of the cold war—there still was no shortage of bad news, including the Balkan wars, the Rwandan genocide, and recessions in the early part of both decades.

In the past decade, there have been the tragedies of 9/11; the 2004 Asian tsunami; the 2011 Japanese earthquake, tsunami, and nuclear crisis; and now, the financial crisis sparked by irresponsible lending, complex derivatives, and excessive leverage.

Another Perspective

So from this potted history, it seems fairly clear that tragedy and uncertainty will always be with us. But the important point to take away from it is that previous generations have stared down and overcome far greater obstacles than we face today. And while it is easy to focus on the bad news, we mustn't overlook the good either.

Alongside the wars, depressions, and natural disasters of the past century, there were some notable achievements for humanity—like women's suffrage, the development of antibiotics, civil rights, economic liberalization, the spread of prosperity and democracy, space travel, advances in our understanding of the natural world, and enormous advances in telecommunication. (Oh, and the Beatles.)

Today, while the US and Europe are gripped by tough economic times, much of the developing world is thriving. Populous nations such as China and India are emerging as prosperous nations with large middle classes. And smaller, poorer economies are making advances too.

The United Nations in the year 2000 adopted a Millennium Declaration that set specific targets for ending extreme poverty, reducing child mortality, and raising education and environmental standards by 2015. In East Asia, the majority of twenty-one targets have already been met or are expected to be met by the deadline. In Africa, about half the targets are on track, including those for poverty and hunger.

Alongside these gains, new communications technology is improving our understanding of different cultures and increasing tolerance across borders while providing new avenues for the spread of ideas in education, health care, technology, and business.

Through forums such as the G20 and APEC, international cooperation is increasing in the field of trade, addressing climate change, and lifting the ability of the developing world to more fully participate in the global economy.

Rising levels of education and health, and workforce participation also mean the foundations are being built for a healthier and peaceful global economy, dependent not on debt, fancy derivatives, and fast profits but on sustainable, long-term wealth building.

Anxiety over recent market developments is completely understandable, and it is quite human to feel concerned about events in Europe. But amid all the bad news, it is also clear that the world is changing in positive ways that provide plenty of cause for hope and, at the very least, gratitude for what we already have. These are ideas to keep in mind when we scan the news and long for the "good old days."

Since 2008, economic uncertainty and market volatility have tested the staying power of investors around the world. Many people fled equities during the worst months of the global financial crisis, while others waited for signs of a turnaround before investing more. Their emotional reactions may have exacted a large price on their wealth.

The graph below documents investor behavior during the stock market downturn in 2008 and subsequent market rebound. It offers a few key lessons about investing in turbulent markets.

Figure 1: Quarterly Equity Mutual Fund Flows

Industry vs Dimensional Relative to S&P 500 Index Performance (Jan 2008-June 2011)

For illustration purposes only. Industry net new cash flow data for US-domiciled equity funds provided by Investment Company Institute ©2011. Quarterly cash flows are estimates that are adjusted to represent industry totals, based on reporting covering 95% of industry assets. Dimensional's figures are based on net new cash from financial advisors in US-domiciled funds. Industry and Dimensional data reflect investment in US and international equity markets and do not include funds of funds. S&P 500 Index performance is based on monthly returns data. The S&P data are provided by Standard & Poor's Index Services Group. The S&P 500 includes 500 US stocks chosen for market size. Past performance is no guarantee of future results.

Reading the Graph

First, look at the shaded graph in the background, which plots the performance of the S&P 500 Index (measured by growth of a dollar) over this three-and-a-half-year period. The market began falling in late 2008 and hit bottom in early March 2009. It then reversed sharply and began a long climb through June 2011.

Now consider how mutual fund investors responded to the stock market's downturn and recovery. The orange line plots quarterly net cash equity flows for the US mutual fund industry over the same period. (Net cash flow is the difference between redemptions and purchases of shares in a mutual fund. A net cash outflow occurs when redemptions exceed purchases.) Equity fund flows were cumulatively negative over the period. Investors were redeeming more shares than they were buying, and on a net basis, capital was leaving mutual funds.¹

Note that these fund industry outflows followed the stock market downturn, and net flows stayed negative even after the market rebound. Investors were reacting to the falling stock market by either redeeming their fund shares or delaying the purchase of additional shares.² When the stock market suddenly rebounded in March 2009, investors who had reduced their exposure to equities missed a good part of the recovery.

This apparent lack of discipline is well established over longer time periods too. Industry analyses and academic research suggest that investors tend to focus on recent performance and make decisions that compromise long-term returns in their portfolio.³

Recent history illustrates why the average fund investor may fail to earn returns comparable to those of the average fund or market index. Markets change quickly, and investors must be in their seats to capture returns. Unfortunately, many investors let their emotions get in the way of participating in long-term market performance.

Now consider the upward-sloping blue line, which plots quarterly net flows into equity strategies offered by Dimensional Fund Advisors. These flows were cumulatively positive throughout the entire period, suggesting that shareholders in Dimensional's funds continued to purchase shares during the 2008–2009 market decline and after the March 2009 rebound.

As a group, these investors did not flee stocks en masse. In fact, they did the opposite by adding to their portfolios. Their discipline positioned them for the market rebound.

A mutual fund's net cash flows also may reveal the collective discipline—or lack of discipline—among its shareholders. In fact, the direction of net flows can impact portfolio management and performance, especially for funds invested in less liquid markets. Large net redemptions typically increase the direct and indirect costs of a mutual fund, which compromise fund returns.⁴ The assorted costs are not borne by redeeming shareholders but by the shareholders who remain in the fund.⁵ Therefore, consistently positive net cash flows are helpful to a fund's expenses, strategy, and performance.

Summary

The large net cash outflows from US-based mutual funds since 2008 document investor reaction to market volatility, while Dimensional's stable and positive net fund flows suggest disciplined behavior. So why would shareholders in Dimensional's funds behave differently? One reason might be the education, encouragement, and discipline offered by their financial advisor at that difficult time, underscoring the value of sound investment advice.

An advisor's steady hand helps investors apply discipline in all types of markets, which can positively impact individual performance over time. Moreover, when advisors influence the collective decisions of shareholders in a fund, the greater cash flow stability can prove beneficial to the fund's strategy, cost management, and returns.

1. Mutual fund investors redeem their shares by selling them back to the mutual fund and receiving cash proceeds based on the net asset value (NAV) of the shares at day's end. Redemption is a normal activity in a mutual fund, and liquidity is one benefit of owning fund shares. A fund manager may use inflowing cash to cover the redemptions or keep cash in a "liquidity reserve" for this purpose. When cash balances do not suffice, the manager may execute trades to raise the cash.

2. According to the Investment Company Institute, mutual fund flows do not offer a good measure of total demand for equities since funds hold only about 20% of the total US equities outstanding, with the balance held directly by individuals, institutions, and governments. Academic research offers some evidence that mutual fund flows do not drive market returns but reflect investor reaction to markets. (Roger M. Edelen and Jerold B. Warner, "Aggregate Price Effects of Institutional Trading: A Study of Mutual Fund Flow and Market Returns," Journal of Financial Economics 59, no. 2 (2001): 195–220.)

3. A Morningstar study compared the dollar-weighted returns of the average investor in a fund with the fund's published total return for the ten-year period ending Dec. 31, 2009. In US equities, the average investor in all funds earned 0.22% annualized, compared with 1.59% for the average fund. (Russel Kinnel, "Bad Timing Eats Away at Investor Returns," Morningstar.com, February 15, 2010.) Lack of investment discipline also is documented among individual investors who hold common stocks directly. Those who trade frequently pay a tremendous performance penalty for their actions. (Brad M. Barber and Terrance Odean, "Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors," The Journal of Finance, April 2000.)

4. Direct transaction costs include commissions, bid-ask spreads, and price impact incurred when a fund makes trades in response to shareholder redemptions. Net outflows also may generate indirect costs on a fund by forcing its manager to alter the target asset allocation or make disadvantageous, uninformed trades to raise cash. See Qi Chen, Itay Goldstein, and Wei Jiang, "Payoff Complementarities and Financial Fragility: Evidence from Mutual Fund Outflows" (white paper, February, 2007).

5. Mutual funds typically meet a redemption based on the NAV at day's end but may execute a trade to raise cash on the following day. The redeeming shareholder cashes out at an NAV that does not reflect the trade, and the resulting costs are borne by remaining shareholders. See: "On the Run: Examining Patterns in Mutual Fund Redemptions," Knowledge at Wharton, http://knowledge.wharton.upenn.edu/article.cfm?articleid=2133, accessed September 27, 2011.

In early August, Standard & Poor's downgraded US government debt from a top-rated AAA to AA+.¹ In the weeks preceding the event, most market observers expected a downgrade to result in higher interest rates and lower stock returns.  After the downgrade, yields on US government securities fell across the term spectrum as investors around the world fled to the safe haven of US bonds. US stocks experienced negative returns in the following weeks but logged positive performance from the day of the downgrade to month end.²

These events raise questions about whether changes in sovereign debt ratings impact the financial markets. The short answer is that results are mixed, and that many other factors affect a country's cost of capital and stock market returns.

Regarding bond markets, history offers examples of major developed countries that experienced a credit downgrade without a significant rise in interest rates.³ Examples include Australia, Canada, and Japan, which lost their top ratings in 1986, 1992, and 1998, respectively.

Other research suggests that countries with high credit ratings may withstand a downgrade better than countries with lower ratings. One study looked at sovereign credit rating downgrades since 1990 and found that bond yields changed little among countries downgraded from the highest triple-A rating. However, countries with lower credit ratings (single A or below) experienced significant interest rate increases following their downgrade.⁴

Stock market impact

Another question is whether the US downgrade has played a role in the US stock market downturn—and research does not provide convincing evidence.

Below is a chart that summarizes stock market performance of respective countries before and after a ratings change. It is based upon a study of ratings changes made by Moody's from 1983 to 2009. During the twenty-seven-year period, the ratings agency made seventy-one upgrades and twenty-five downgrades to governments in the developed and emerging markets tracked by MSCI.

The study identified the date of each change and logged each country's market performance in the twelve months before and twelve months after the event. Each country's market returns were compared to the respective market index and the excess return averaged for all events. (Excess return refers to performance above or below the respective market index, either MSCI EAFE or MSCI Emerging Markets, as appropriate.)

Figure 1. Equity market performance before and after Moody's ratings changes, 1983–2009

Analysis conducted by Dimensional Fund Advisors using sovereign bond rating data from Moody's Investors Services, "Sovereign Default and Recovery Rates, 1983–2009." Returns are in US dollars and represent performance in excess of MSCI EAFE Index for developed markets and MSCI Emerging Markets Index for emerging markets. A positive excess return indicates market outperformance; a negative excess return indicates underperformance. The table reports the return of an equal-weighted, event-time portfolio. Past performance is no guarantee of future results.

The aggregate results show that stock markets of upgraded countries outperformed their respective market index in the twelve months before the rating change (13.83%), while stocks in downgraded countries aggregately underperformed the market index before the event. However, cumulative returns in the twelve months following a ratings change were almost the same for the upgraded and downgraded countries (3.87% vs. 3.73%).⁵

These results suggest that market prices reflect all available information and expectations about a country's economic prospects—including the possibility of a ratings change. By the time a country's debt rating is upgraded or downgraded, the market has already integrated the news into prices. Stock markets reflected positive economic developments prior to a ratings upgrade and negative developments before a ratings downgrade. After the event, markets did not appear to perform much differently, in aggregate.

Conclusion

This research underscores the importance of looking to market prices for signals about the fiscal health and prospects of a country or a company. Based on the foregoing analysis, markets appear to work faster and more accurately than ratings firms to assess a country's financial condition and evaluate the potential impact on its cost of capital and equity market.

1. A sovereign credit rating is an assessment of a government's ability to pay its debts. The US had held S&P's top rating since 1941. S&P made the announcement after business hours on Friday, August 5, but word of the downgrade leaked during the day. Although timing of the announcement was a surprise, the downgrade was mostly expected, as S&P had issued a negative long-term outlook for the US in April and July. The other top credit agencies, Moody's Investors Service and Fitch Ratings, have maintained top ratings for the US.

2. Two weeks following the downgrade, the US market, as measured by the Russell 3000 Index, logged a negative 6.82% return (August 5–19). However, from the day of the announcement to month end, the market returned a positive 1.6%. Russell data copyright ©Russell Investment Group 1995–2011, all rights reserved.

3. Tom Lauricella, "Lessons of Lower Ratings," Wall Street Journal, July 30, 2011.

4. Ivan Rudolph-Shabinsky and Dennis Shen, "When 'Risk-Free' Isn't Risk Free: The Impact of a US Treasury Downgrade" white paper, Alliance Bernstein, June 2011.

5. The twelve-month aggregate excess performance prior to the ratings change was statistically significant, while the twelve-month returns after the ratings change were not.

Once in a great while, the mainstream press manages to produce an article that provides good investment advice.  A recent article by Gary Belsky and Thomas Gilovich in Time Magazine's online edition is a great example of that rare phenomenon.  Of course, Belsky and Gilovich are not the average reporters.  They are co-authors of the book Why Smart People Make Big Money Mistakes—And How To Correct Them: Lessons from the Life-Changing Science of Behavioral Economics and Gilovich, a professor at Cornell, co-authored a previous book with Nobel Prize winning researcher Daniel Kahneman.

Market timing, somehow being able to know when to buy stocks and when to sell them based on some ability to predict the short-term future movements of capital markets has an understandable allure for investors.  Unfortunately, as the article points out, there is no evidence that anyone can do it correctly and consistently - and mistakes can be very costly.  Quite a few other experts have expressed their opinions:

"I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two." - Warren Buffet

"If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market." - Benjamin Graham, Author and "the father of securities analysis"

"Market-timing is bunk." - Pat Dorsey, Director of Morningstar Fund Analysis

"The market timer’s Hall of Fame is an empty room." - Jane Bryant Quinn, Author, Columnist

"Market timing is a poor substitute for a long-term investment plan." - Jonathan Clements, The Wall Street Journal

"No, I don’t believe in market timing. I’ve been around this business darn near a half-century, and I know I can’t do it successfully. In fact, I don’t even know anyone who knows anyone who has ever successfully timed the market over the long term." - John Bogle, Founder of The Vanguard Group

"Nobody but nobody, has consistently guessed the direction of the bond or stock market over any meaningful length of time." - John Markese, President, AAII Journal

"There is absolutely no evidence that anyone can time the market." - Bill Bernstein, Author

"Only liars manage to always be ‘out’ during bad times and ‘in’ during good times." - Bernard Baruch, Presidential Economic Advisor

"There is an overwhelming body of evidence to support the view that believing in the ability of market timers is the equivalent of believing astrologers can predict the future." - Larry Swedroe, Author

Despite the evidence to the contrary, it seems that everyone knows someone who knows someone who correctly predicted some event that caused them to be annointed as the long sought after guru of market timing.  And, of course, there are plenty of charlatans on the radio or publishing newsletters claiming to have amazing track records of past predictions.  In many cases, it's simply a lie (many of them are not registered representatives or investment advisors and are not subject to any regulatory oversight).  In others, it's nothing more than pure chance and probability theory in action.  The example in the article uses coin flipping as a way to understand why there are usually a few "gurus" that supposedly got everything right (usually by applying some super-secret forecasting method that no one else has ever thought of before).  If you start with 1000 coin flippers and everyone flips their coin 7 times, you'll end up with 6 or 7 people that flipped nothing but heads each and every time.  Are these people particularly skilled in coin flipping?  No.  Is there a higher statistical likelihood that they will come up with heads on the next flip?  Not a bit.  Would you bet your portfolio on it?  Probably not, if you're rational and you don't want to become a Dalbar statistic.

So, why do so many people fall for the siren song of market timing?  There are many reasons.  Warren Buffet said "Investing is simple, but not easy."  Author William Bernstein, writing in The Efficient Frontier, has this to say about the ability of the average person to do the math that's necessary to understand portfolio construction and performance:  "the horsepower to do the math... The Discounted Dividend Model, or at least the Gordon Equation?  Geometric versus arithmetic return?  Standard deviation?  Correlation, for God's sake?  Fuggedaboutit!"  As we've said before, a nice story often sounds better than the truth.  But, would you bet your portfolio on a bedtime story or on 60 years of evidence-based research into capital market behavior?

I read a great article last week that was written by an active manager about different portfolio management strategies and his opinions about them.  It was particularly interesting to me to read what he thought about what is, essentially, our strategy:

A passive investment strategy has been promoted as an intelligent strategy for two reasons. The first is that the strategy acknowledges that markets are relatively efficient and that it's very difficult to consistently price assets more effectively than the market mechanism. The second reason flows from the first: The significant costs associated with asset value analysis and the active management of an investment portfolio (management fees, transaction costs, etc.) make it even harder to outperform the returns obtained by passively accepting market prices.

He's exactly right, so far - and, he goes on to say:

Contrary to popular belief, the fatal flaw with this paradigm is not that it assumes that markets are relatively efficient. If anything, this assumption constitutes a great advantage of this investment strategy. For it would be quite absurd indeed to assume that the average individual (or portfolio manager) will consistently be able to price assets more effectively than the market mechanism. And it is a mathematical impossibility for the majority of people to outperform the overall market.

So, now he has admitted that the underlying methodology is correct, but let's examine his conclusion:

The problem with the passive investment strategy derives from an entirely different aspect of human nature that is distinct from analytical capacity: emotions. Constant exposure to markets means that passive investors will be subjected to intermittent episodes of hair-raising volatility. And the fact of the matter is that very few have the sort of emotional makeup that would allow them to sustain such a strategy over time.

The herding instinct is powerful. Very few individuals are emotionally equipped to stay the course and hold their positions -- much less buy -- when everyone around them is selling in a panic. The strategy of passive investing may be theoretically sound on its own terms. However, in practice, it tends to fail because most people are emotionally unable to sustain it.

Fortunately, our experience has been quite different. Why?  I think that there are several reasons, but the most important is that we use a process of measuring a client's risk tolerance and constructing a portfolio that adds high quality short duration global fixed income to the equity allocation.  This very effectively dampens the portfolio volatility to a level that the client should be able to tolerate.  In addition, we do our best to educate clients about what they should expect from capital market behavior.  And, looking back over the past 10 years, our portfolios have achieved outstanding risk adjusted rates of return for clients that stayed the course - even through two major rough spots in the market (2000-2002 and 2007-2009). 

The current renewed volatility in financial markets is reviving unwelcome feelings among many investors—feelings of anxiety, fear, and a sense of powerlessness. These are completely natural responses. Acting on those emotions, though, can end up doing us more harm than good.

At base, the increase in market volatility is an expression of uncertainty. The sovereign debt strains in the US and Europe, together with renewed worries over financial institutions and fears of another recession, are leading market participants to apply a higher discount to risky assets.

So, developed world equities, oil and industrial commodities, emerging markets, and commodity-related currencies like the Australian dollar are weakening as risk aversion drives investors to the perceived safe havens of government bonds, gold, and Swiss francs.

It is all reminiscent of the events of 2008, when the collapse of Lehman Brothers and the sub-prime mortgage crisis triggered a global market correction. This time, however, the focus of concern has turned from private-sector to public-sector balance sheets.

As to what happens next, no one knows for sure. That is the nature of risk. But there are a few points individual investors can keep in mind to make living with this volatility more bearable.

• Remember that markets are unpredictable and do not always react the way the experts predict they will. The recent downgrade by Standard & Poor's of the US government's credit rating, following protracted and painful negotiations on extending its debt ceiling, actually led to a strengthening in Treasury bonds.

• Quitting the equity market at a time like this is like running away from a sale. While prices have been discounted to reflect higher risk, that's another way of saying expected returns are higher. And while the media headlines proclaim that "investors are dumping stocks," remember someone is buying them. Those people are often the long-term investors.

• Market recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when market sentiment was last this bad—the S&P 500 turned and put in seven consecutive of months of gains totalling almost 80 percent. This is not to predict that a similarly vertically shaped recovery is in the cards this time, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.

• Never forget the power of diversification. While equity markets have had a rocky time in 2011, fixed income markets have flourished—making the overall losses to balanced fund investors a little more bearable. Diversification spreads risk and can lessen the bumps in the road.

• Markets and economies are different things. The world economy is forever changing, and new forces are replacing old ones. As the IMF noted recently, while advanced economies seek to repair public and financial balance sheets, emerging market economies are thriving. A globally diversified portfolio takes account of these shifts.

• Nothing lasts forever. Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.

The market volatility is worrisome, no doubt. The feelings being generated are completely understandable. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value will re-emerge, risk appetites will re-awaken, and for those who acknowledged their emotions without acting on them, relief will replace anxiety.

World Economic Outlook, IMF, April 2011.

Now, listen to this, and I'll tell you 'bout the Texas...
I'll tell you 'bout the Texas Radio.
I'll tell you 'bout the hopeless night
Wandering the Western dream.

    - Jim Morrison, 1971

It seems that every time I turn on the radio over the weekend, I'm assaulted by a slew of what amounts to financial "infomercials".  They are actually very similar to the late-night TV commercials hawking everything from weight-loss pills to miracle hair growth remedies.  And, they are just about as credible.

These shows always have a disclaimer that's run at the beginning and the end of the show stating that the show is "for entertainment value only and should not be construed as investment advice".  At least, the last part of that statement is certainly true.  Unfortunately, we all know that they really are investment advice regardless of the disclaimer.

Some of the most incredible claims come from insurance salesmen trying to sell insurance products as investments.  The claims are often outrageous and frequently just plain wrong.  Last year, we heard one such show making claims that we knew were false.  So, we contacted the Texas Department of Insurance and made them aware of it.  They didn't seem to care much and actually said that there wasn't much that they could do until someone who bought the product complained about it.  In their own words, "we have to wait until the fraud actually occurs."  They suggested that we talk to the Attorney General about deceptive advertising.  That got us just about as far.  Don't count on the State of Texas to protect you from these lies.

As usual, the securities regulators are a little more vigilant.  One of the biggest spenders on "infomercials" in the D/FW marketplace is a guy that tries to convince people that they can hire his firm to time the market.  The host of the show uses a lot of silly sound effects and promises the "world's best" cookies to people that will attend his seminars.  FINRA and the SEC finally cracked down on his advertising practices, but he's still on the radio constantly - just being a bit more careful.

Then, there are the real bottom feeders - the guys pushing life settlements.  Despite all of the recent investigative reporting, many are still out there making unrealistic claims.  We've written about one particular group before - and they still have a website where they claim that "Our clients have never lost a penny of principle!"  Really?  Would you trust an advisor that doesn't know the difference between principle and principal?

It seems obvious that you shouldn't trust this type of "advisor".  But, how do you know who you should trust?  We've talked about this issue in previous posts.  Scott Maxwell has written about it in his essay series.  There are several good books that have been published recently that explain it well.  One of those is The Investment Answer.  We've recommended it before.  Another good one is The Little Book of Bulletproof Investing by Ben Stein and Phil DeMuth. 

Like it does with most good ideas, Wall Street has taken a simple and practical product and turned it into something dangerously complicated and difficult for most investors to fully understand.

Exchange Traded Funds (ETFs) have now been around for over 20 years.  The first ETFs, and still the best known, tracked stock indices - like the S&P 500.  These funds simply replicated the index and arbitrage kept the fund price very close to the actual net asset value of the underlying positions.  It was simple, inexpensive, tax-efficient, and transparent.

Now, we have over 2,700 different ETFs available.  Many of these are leveraged, some are designed to provide a return that is the inverse of an index (and may also employ varying degrees of leverage), and some track obscure market sectors.  Many do not own the underlying assets, but are "synthetic ETFs", meaning that they own derivatives sold by a counterparty - often a large investment banking concern.  Although the shares of these products are designed to be highly liquid, the underlying assets may not be.  A related product called an Exchange Traded Note (ETN) is entirely dependent upon the credit of the issuer, much like a bond, and does not own any underlying assets.  It is unlikely that many investors truly understand this liquidity and credit risk.

We employ a few ETFs in some portfolio constructions.  These are reviewed by our investment committee before they are approved for use and liquidity is a major factor in the evaluation.  As a result of this analysis, we made the decision some time ago not to invest in any ETNs or synthetic ETFs.  During the "flash crash" of May 2010, many of these products exhibited extremely volatile behavior due to lack of liquidity. The Economist estimates that 60-70% of the trades that were subsequently cancelled when the Dow Jones Industrial Average briefly dropped 1,000 points were in illiquid ETFs.  Employing a review process, although it probably goes unnoticed, is required by our fiduciary duty to our clients and is another way that we serve our clients' best interest.

Have a safe and happy Independence Day holiday!

Dalbar is an independent research firm that evaluates mutual fund investor returns on an annual basis.  The research uses data from the Investment Company Institute (ICI), Standard and Poor's and Barclays Capital Index Products to compare mutual fund investor returns to an appropriate set of benchmarks.  The annual Quantitative Analysis of Investor Behavior (QAIB) covers the time period ending December 31, 2010.

For the 17th year in a row, the study shows that both equity and fixed income investors underperformed the broad indices.  For 2010, equity investors trailed the S&P 500 by almost 1.5% and fixed income investors underperformed the Barclays Aggregate bond index by more than 3.5%.

Why do average investors underperform broad indices by such significant amounts?  The primary reason is investor behavior - reacting to market movements and news results in never staying invested long enough to derive the benefits of a long-term strategy.  Retail investors, in particular, tend to abandon investing at the most inopportune times, often in response to bad news or market corrections.

Behavioral finance experts have identified psychological factors that help explain why investors often make buy and sell decisions that contradict best practices.  These include:

• Loss aversion – expecting high returns with low risk.  Searching for investments that don’t exist, resulting in taking no action or selling at an imprudent time.

In order to achieve desirable results, investors must manage the behaviors that destroy long-term success.  Working with an advisor can often be helpful in this regard.  It is also important to understand your risk tolerance and construct a portfolio that does not exceed the level of volatility that you are comfortable with.  Taking excessive risk often leads to decisions to exit the market at exactly the wrong time. 

Dave Smith recently read this book and thought that it was quite worthwhile.  The author, Charles Farrell, is an attorney and investment advisor who has written for CBS Moneywatch and Investment News. 

The book presents a series of simple formulas for managing most important aspects of your personal finances by calculating ratios related to savings, debt, investments, and insurance.  Following this methodology provides an objective view of the health of a financial plan.  The Wall Street Journal described these formulas as "some of the best tools we have seen for gauging where you stand."

The author also understands investing and wisely suggests ignoring Wall Street, the financial press and commissioned salesmen.  There is a well written chapter that discusses what to look for in a financial advisor, the "alphabet soup" of designations in the financial world, and the importance of working with a fiduciary.

The book is written in an approachable and easy to read style that is appropriate for most individuals. 

As the clock winds down toward a government shutdown and the politicians argue about reducing growth of the federal deficit, the subject of government debt and its potential impact on economic growth and capital markets is again a popular news item.

We wrote about this in December in the article titled Deficits, Debt, and Markets.  The same analysis is still relevant.  In addition, a presentation by Marlena Lee, Research Associate at DFA, covers some of the same material in more detail and examines the effect of debt on fixed income and equity returns as well as currencies. 

For those of you that just want the answer and don't want to read the articles, here is the summary:

• Are deficits related to higher long-term interest rates?  Yes.
• Do large deficits stifle long-term economic growth.  Yes, but only when the debt exceeds about 90% of GDP.  We're not there - yet.
• Do deficits predict bond or equity returns?  No.
• Does low future economic growth imply low future equity returns?  No.
• Do fiscal deficits and/or current account deficits predict short-term interest rate movements?  No.

Don't think that this means that we're advocating igonoring the growing "debt bomb".  If we don't rein in spending, the levels will rise to the point that they will start to have an impact on economic growth and competition.  But, at least according to the evidence presented here, our current level of debt does not signal Armageddon in the capital markets, as many of the so-called "experts" would have you believe.

The 2008 global market crisis and the struggling economy have left many investors fatigued. Despite two years of strong equity returns, some investors have been slow to regain market confidence. Many are accepting the talk about a "new normal" in which stocks offer lower returns in the future.¹

The concept of a new normal is anything but new. In fact, throughout modern history, periods of economic upheaval and market volatility have led people to assume that life had somehow changed and that new economic rules or an expanding government would limit growth. What they could not see was how markets naturally adapt to major social and economic shifts, leading to new wealth creation.

Let's look at other periods when investors had strong reasons to give up on stocks, and consider the parallels to today:

1932: The US stock market had just experienced four consecutive years of negative returns. A 1929 dollar invested in stocks was worth only 31 cents by the end of 1932. Hopes were sinking during the Great Depression, and many people felt as though the economy had permanently changed. Many investors left the market, and some would not return for a generation. Amidst what is considered the roughest economic time in US history, the markets looked ahead to recovery.

US Stock Market Performance after 1932*

All stock market returns based on CRSP 1-10 index.²

*Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

1941: World War II was raging, and the US had just entered the conflict. The US stock market had experienced two consecutive years of negative performance, and the economy had shown signs of sliding back into depression. Although conversion to a wartime economy would revive industrial production and boost employment, investors struggled to see beyond the conflict. Many expected rationing, price controls, directed production, and other government measures to limit private sector performance.

US Stock Market Performance after 1941*

1974: Investors had just experienced the worst two-year market decline since the early 1930s, and the economy was entering its second year of recession. The Middle East war had triggered the Arab oil embargo in late 1973, which drove crude oil prices to record levels and resulted in price controls and gas lines. Consumers feared that other shortages would develop. President Nixon had resigned from office in August over the Watergate scandal. Annual inflation in 1974 averaged 11%, and with mortgage rates at 10%, the housing market was experiencing its worst slump in decades. With prices and unemployment rising, consumer confidence was weak and many economists were predicting another depression.

US Stock Market Performance after 1974*

1981: The stock market had delivered strong positive returns in five of the last seven calendar years, and the two negative years (1977 and 1981) were only moderately negative. Despite these results, investors were weary from stagflation, which was characterized by high annual inflation, anemic GDP growth, and unemployment, and from fears of another economic downturn. In late 1980, gold climbed to a record $873 per ounce—or $2,457 in 2010 dollars. (By comparison, spot gold reached $1,256 per ounce in 2010.) Memories of the 1973–74 bear market lingered. A 1979 BusinessWeek cover story titled "The Death of Equities" claimed inflation was destroying the stock market and that stocks were no longer a good long-term investment.

US Stock Market Performance after 1981*

1987: On "Black Monday" (October 19, 1987), the Dow Jones Industrial Average plummeted 508 points, losing over 22% of its value during the worst single day in market history. The plunge marked the end of a five-year bull market. But in the wake of the crash, the market began a relatively steady climb and recovered within two years. The effects of the crash were mostly limited to the financial sector, but the event shook investor confidence and raised concerns that destabilized markets would increase the odds of recession.

US Stock Market Performance after 1987*

2002: By the end of 2002, investors had experienced the stress of the dot-com crash in March 2000, the shock of the September 11 attacks, and the early stages of wars in Afghanistan and Iraq. Although October 9, 2002, would ultimately mark the market's low point, investors had endured three years of negative performance and an estimated $5 trillion in lost market value. A younger generation of investors had experienced its first taste of old-world risk in the "new economy."

US Stock Market Performance after 2002*

2008–Today: The market slide that began in 2008 reversed in February 2009—gaining 83.3% from March 2009 through 2010. Despite two years of strong stock market returns, memories of the 2008 bear market and talk of the "lost decade" have led many investors to question stocks as a long-term investment. But earlier generations of investors faced similar worries—and today's headlines echo the past with stories about government spending, surging inflation, deflationary threats, rising oil prices, economic stagnation, high unemployment, and market volatility.

Of course, no one knows what the future holds, which brings the concept of "normal" into question. What exactly is the status quo in the markets?

The chart below shows the annual performance of the US market, as defined by CRSP deciles 1–10. Since 1926, there have been only four periods when the stock market had two or more consecutive years of negative returns. In addition, annual returns are rarely in line with the market's 9.67% long-term average (annualized). The most obvious normal may be that, over time, stocks offer expected returns reflecting the uncertainty and risk that investors must bear.

What's new about that?

1. Adam Shell, "'New Normal' Argues for Investor Caution," USA Today, August, 16, 2010. The term "new normal" originally referred to a post-global financial crisis environment characterized by several years of sluggish economic growth, below-average equity returns in developed markets, high market volatility and risk, high unemployment, and a world in which the range of possible financial outcomes is wider than normal and wealth dynamics are moving from developed to emerging economies.

2. Returns for all periods of the CRSP 1–10 Index are annualized. Data provided by the Center for Research in Securities Prices, University of Chicago. Data includes indices of securities in each decile as well as other segments of NYSE securities (plus AMEX equivalents since July 1962 and NASDAQ equivalents since 1973). Additionally, includes US Treasury constant maturity indices.

The Quarterly Investment Review for fourth quarter 2010 is now available. This update contains:

• Discussion of quarterly capital market behavior
• Review of significant events that occurred during the quarter
• Survey of long-term asset class performance
• Analysis of world market capitalization
• Returns of globally diversified portfolios
• Achieving market returns in 2010

Dow 3800 in 2010?  That's what famous prognosticator Harry Dent predicted on CNBC last year.  It didn't quite work out that way.  But, Dent is no stranger to being spectacularly wrong.  He predicted Dow 40000 (yes, that's forty thousand!) by 2009.  Despite this abysmal track record, he still appears regularly on talk shows, sells millions of books, and runs a successful investment firm. 

The list goes on:  Peter Schiff (has this guy ever been right about anything?), Nouriel Roubini, Henry Blodgett, Gary Schilling, et al.  They are wrong far more often than they are right.  In many cases, they got it right once and were annointed as prophets by the financial press, but they never got it right again.  Was the one correct prediction due to luck or skill?  Considering that the prescient predictions almost never repeat might suggest that it was due to the former, not the latter factor.

So, why do investors continue to pay attention to predictions that almost always turn out to be wrong?  For one thing, the financial press continues to spotlight these ridiculous guesses because it garners ratings or sells magazines.  And, we've found that people love a good story.  They may even take comfort in an "expert" opinion instead of listening to the truth - that no one can accurately predict short-term capital market behavior.

Of course, it's now time for the excuses to start.  The "I would have been right if not for... blah, blah, blah."  Or, the "I am still right, it just hasn't quite happened on the schedule that I expected."  These people have an amazing ability to believe their own hype and to spin it in a way that makes others believe it, too.  I once got into an argument with a famous trader who made the statement that he had never been wrong about a stock pick - just off on his timing.  Of course, that's absurd.  But, I'm convinced that he actually believed it.

Here are some predictions for 2011 that I'm fairly sure you can count on:

1. Markets will do something unexpected.  We don't know what it will be, but the odds are that something will happen that no one is predicting at the moment. 
2. Some obscure economist or analyst will have guessed it right and will have their 15 minutes of fame.
3. A six to twelve month track record will be used to define the next "great investment opportunity."
4. Most individual investors will underperform the market.
5. Most mutual fund managers will also underperform the market.
6. The fiduciary standard will continue to be be a point of contention between Registered Investment Advisors and brokers.  The regulators will sit on their hands and investors won't understand what any of it is about.
7. Unscrupulous salesmen will continue to pitch bad investment products and ideas on the radio.
8. No matter what happens, Jim Cramer will claim that he knew it was going to happen before it did.

Happy New Year and best wishes for a prosperous 2011 from Talis Advisors!

The Talis Investment Philosophy presentation has been updated with new information and more recent return data.  The presentation discusses the failure of active management, the size and value effects in global capital markets, risk/return tradeoff in fixed income securities, the importance of minimizing costs and explains the principals of successful investing:

• Markets work
• Diversification is key
• Risk and return are related
• Portfolio structure determines performance

Click here to view the presentation.