French on the Markets

Ken French, Carl E. and Catherine M. Heidt Professor of Finance at the Tuck School of Business at Dartmouth College and Director of Investment Strategy at Dimensional Fund Advisors, recently discussed current market conditions in an online forum with Henry Blodget on Yahoo! Finance. In the three video segments below, Professor French comments on buy-and-hold investing, active vs. passive management, and the role of commodities in a portfolio.

Buy and Hold vs. Timing the Markets

Stock Picking vs. Index Investing

Commodities and Your Portfolio

Why You Should Stick Around in a Tough Market

David Booth, the chairman and CEO of DFA, offers insightful perspectives on the challenges and opportunities existing in the equity markets. Booth's comments are a must see for investors. The University of Chicago announced this week that in recognition of the Booth family's gift of $300 million it was naming its business school the University of Chicago Booth School of Business. Click here to watch the video.

The Nation and Markets Move Forward

Yesterday, Election Day, the Dow Jones Industrial Average posted a 3.3% gain, the largest increase on any election day. The markets like clarity and yesterday's election provided that. No matter whether our favored candidates won or lost, the United States and the markets will do just fine. Capitalism and the United States are strong and resilient. Now is certainly the time for all of us to come together and solve the significant issues we face and build a bright and prosperous future.

Buffett's View

We often make reference to that wise and successful investor, Warren Buffett. His honored name comes up when the difference between value and growth stocks are explained. (He is a value investor and long-term value beats growth.) We also regularly share his wise advice to individual investors to stick with index and asset class funds and maintain a long-term perspective.

In an opinion column in today's New York Times, the Oracle from Omaha shares with readers that he is a buyer of stocks despite what he calls the "mess" the financial world is in.

Buffett says that he can't predict the short-term movement of the markets. However, in the long haul stocks will do well. As he says, "if you wait for the robins, spring will be over."

Click here to read the column.

Buffett says equities will almost certainly beat cash over the next decade. He quotes Wayne Gretsky's advice to "skate to where the puck is going to be, not to where it has been."

Is It Different This Time?

How the current market downturn compares to past bear markets and the resilience markets have historically shown is the topic of this 17-minute video by Weston Wellington with Dimensional Fund Advisors. We encourage you to watch it and to share it with family and friends. This video should be required viewing for all investors. Click here to open the video.

Noise

Noise is what we call the near term movements of the market (up and down) and the ensuing blabber by financial pundits and commentators.

Noise is the distraction that keeps many investors focused on the short-term when the meaningful gains the markets provide are found in the long-term.

One of our clients emailed us this amusing cartoon that depicts this point.

A trader is on the phone and tells his caller that he has a stock that could really excel. The other traders mistake him as to have said sell. So in a panic they all do so. In the next scene another trader relays to his caller that this is all madness and closes the call by saying good bye. The traders then all take that to mean buy and proceed to do just that frantically.

More Sage Advice

In our recent issue of Dimensions, we shared with our clients some wise advice from well known experts on what investors should do in light of the turbulence of the markets. We did not have sufficient space to provide the opinion of as many of these experts as we would have liked. Here are others worthy of contemplation.

Henry Blodget
Reformed Internet stock cheerleader and author of The Wall Street Self-Defense Manual
Don't pick stocks. Don't time the markets. Don't change strategies as market conditions change. Do continue to invest a set amount each month in a diversified portfolio of index funds covering all major asset classes. If an asset class tanks, take advantage of the opportunity to buy more cheaply by re-balancing.

Terrance Odean
Professor of banking and finance, University of California, Berkley
Try to take your mind off the market. Got to the beach or if you are so unfortunate as to live on the East Coast or in the Midwest, go to a movie.

William Goetzmann
Professor of finance and director, Yale's International Center for Finance
Calmly assess if your portfolio is diversified. If it is, that's the best you can do. You may get lucky switching to cash or you may not, but history suggests a diversified portfolio with a significant share in equities will do well in the long-term.

Insights from a Disgraced Wall Street Stock Analyst

Do you remember Henry Blodget? Blodget was the highly touted Merrill Lynch internet analyst that later banned for life from the securities industry by the S.E.C. after is was disclosed that he gave private, internal assessments on stocks that were less than glowing from the reports he published for his firm. He initially came to fame at Oppenheimer where he predicted Amazon would hit $400 (presently trading at $71.60), which it did one month after his pronouncement.

Blodget has turned to writing and is now doing articles for Slate, The Atlantic, and The New York Times. He’s also editor-in-chief of the Silicon Alley Insider, which he launched last year.

What does a former stock analyst who intimately knows the ins and outs of the markets and Wall Street think about index funds and asset class investing?

Here are his comments from the current issue of Fast Company?

“After I left Wall Street, I studied a lot of academic research, and I was startled to discover that stock picking, market timing, and other popular investment activities usually hurt investors rather than help them. This is an indisputable fact, but it’s actually not common sense. On the contrary, most people think it’s ridiculous. Most people assume that index funds only do well because most investors are stupid – which is delusional. Until you understand why indexing works, you’ll always be wasting money and time searching in vain for the next great stock-market guru.”

You wonder how many Wall Street investment managers earn fortunes charging high fees to pick stocks, but privately invest like Asset Class investors.

Gold Bugs

Volatility in the Markets coupled with the run-up in the price of gold (recently hitting $1,000 an ounce before backing off) has caused us to get more than a few questions from clients asking our opinion on the wisdom of investing in gold.

Gold and other commodities do not in and of themselves created value. Only entrepreneurs do that through the manufacture of goods utilizing commodities. Other than this, purchasing gold is purely speculative with no expected rate of return.

As far as buying gold in times of turmoil, Scott Burns, the financial columnist, recently said he would rather buy lots of bullets than gold if he feared calamity.

Has gold been a very good investment? Jeremy Siegel, the Wharton finance professor and best selling author, calculated that after inflation one dollar invested in gold 200 years ago would be worth all of $2.55 today.

That same dollar invested in stocks would have grown to be over $750,000.

In the long-term investing in broadly diversified asset classes beats gold bugs hands down.

Avoid These Three Costly Investing Mistakes

Barron’s, that weekly chronicle on the doings of the financial markets and the active investment managers who futilely try to beat it, published an article this week advising investors on how to avoid the most common and costliest investing mistakes.

The three biggest errors, according to Barron’s, are failing to diversify wisely, trying to time the market, and overpaying on investment expense. (Sounds like the average active manager.)

Researchers for Barron’s calculated that an investor with a $1 million portfolio would have missed out on $375,000 of gains during the 10 year period ending January 2008 by making these three serious errors. This same Barron’s portfolio “wisely” invested and free of these three errors had an annualized return of 6.86%. Factoring in the three serious errors shrunk performance down to 4.59%.

Our own 60:40 Asset Class Portfolio invested over the same period of time, paying the normal advisory fee would have returned 7.59%. No reason to calculate the portfolio with the errors, as Asset Class investors know not to make those!

Here are some of the top reasons cited for avoiding these three investment mistakes:

Neglecting Asset Allocation
The best way for an investor to achieve the highest risk-adjusted return is to allocate broadly across different asset classes. As one advisor quoted in the article stated, “we need a portfolio with assets moving in different directions. The best analogy is: Look at is as a perennial garden. If everything is in bloom at the same time, that probably means everything will wilt at the same time.”

Timing the Market
Investors and pros alike have a dismal record on being able to time the market. Don’t even try.

You don’t need to be near a long-term market top or bottom to do serious damage to your portfolio. Consider these numbers. From 1980 through 2006, an investor who missed out on the five best-performing days in the S&P 500 Index wound up with 26% less than someone fully invested during the entire period. If the same investor missed the 30 best days the value of their account would have been reduced by 73%.

Paying Too Much
Front-end loads, 12b-1 fees, and high mutual fund operating expenses are major drags on portfolio performance. Also watch for excessive trading, which can pull down portfolio performance and increase your tax bill.

While no investor is loving the short-term performance of the markets lately, Asset Class Investing clients can rest comfortably knowing that they have avoided the biggest mistakes outlined by Barron’s and are positioned to earn all the markets offer, which we know in the long-term is likely to be a very healthy return.

Buffett Says Passive Investors “Must Win” Over Active Managers

In his recent letter to stockholders of Berkshire Hathaway, Warren Buffett explained why index or passive investing beats out active management.

According to Buffett, everyone naturally expects to be above average, and active managers encourage their clients (“bless their hearts,” he says) into believing it is possible when investing.

However, active management must deliver below average returns since they incur high transaction, management, and advisory costs.

This means, concludes Buffett, that passive investors “must win”.

Interestingly, Buffett was just named the wealthiest person in the world overtaking his friend, Bill Gates. Could there be a connection? Value investor who believes in asset class investing.

Do Active Managers Shine in Down Markets?

Equity markets got off to a rough start in 2008; total return was -6.0% for the S&P 500® Index, and many non-US markets fared even worse. It was the weakest month for the S&P 500® Index since April 2002 (-6.1%) and the worst January performance since 1990, when the monthly total return was -6.7%. Losses of this magnitude are uncommon but hardly unprecedented. January's performance ranks in the bottom 8% of all monthly periods since January 1926, finishing 74th out of 985 months. August 1998 (-14.5%), September 2002 (-10.9%), and March 1980 (-9.9%) were considerably worse.

We often hear the argument that active money managers add value by preserving capital more successfully in difficult markets. Fans of this approach claim that experienced active managers can adjust risk exposure in response to changing market conditions, while naïve indexed strategies have no flexibility to trim their sails when the storm clouds roll in and are doomed to poor relative performance.

If active managers possess the skills to heed the storm warnings, the evidence is hard to find in last month's mutual fund returns. Relative to the average US equity mutual fund, Dimensional buy-and-hold strategies generally outperformed their industry peers across a wide range of asset classes for the one-month period ending January 31, 2008.

Dealing with Volatility

Many of us saw negative portfolio returns over the last couple of months of 2007, and the first month of the New Year is shaping up to be a down month, as well.

Monthly returns are really just noise like the financial pundits who try to explain why the market went up or down on any given day and predict what tomorrow will bring. Believing them or acting on short-term market results is usually done at great peril to one’s financial well being.

As much as we encourage investors to keep a long-term perspective and not look at monthly returns, we know a lot of you do take a peek at those monthly numbers.

We also know that investor psychology being what it is makes two months of negative performance tolerable (barely), but three months seems close to the threshold of pain for many.

January is very likely to be that crossing point month.

How will you react?

It may seem like a broken record, but having a long-term perspective is the antidote.

If you look at the performance of the underlying asset classes that make up our globally diversified Asset Class portfolio from 1973 to 2006 the performance with all fees netted out is 14.90%. Great performance by almost any measure and a return that will enable most of us to well meet our financial goals and objectives.

Studying the monthly returns of this same high performing, diversified portfolio over these same 33 years, though, you would see broad swings that would look like a not particularly healthy EKG read-out. This, again, is noise. It is the smoothing out of these numbers through time that provides the double-digit return the portfolio has provided.

Return without risk can be had. The yield, however, is likely to be in the very low single digits and it will come from short-term bonds. The equity markets only provide higher historical returns because there is risk. Diversification and time puts the odds in the court of the successful investor.

But what about those short-term numbers you may be looking at?

Well, going back and looking at the S&P 500© we find that in 1990 there were five months of back-to-back negative returns. From June through October 1990, the S&P 500© had a return of -14.69%.

For the four months prior to this period the index had a positive return of 11.26%, and the seven months following October 1990 the S&P 500© earned investors a 31.04% return.

If an investor had reacted to the first two, three or even five months of negative statements look at what they would have missed? Seven great months.

Being invested from February 1990 through these five difficult months and then earning the return of the next seven high performing months would have provided a total return of 24.38%.

Will our current downturn in the market be three, four, five or more months? No one can say for sure.

The market does cleanse itself and has always sought new highs.

The best advice remains the same: believe in efficient markets and capitalism, and maintain a long-term perspective.

Heavy Metal: You Heard It Hear First

The year 2007 left most investors underwhelmed with their portfolio performance and overwhelmed with the market's volatility and day after day of new stories about subprime.

In a year marked by concerns over a slowing economy and financial hocus-pocus, there was one group that turned in a whopping return of over 77% (based on purchasing equal amount of each the securities) over this past year. We call this amazing group the Heavy Metal Portfolio.

Why bother with investment firms associated with collateral debt obligations, credit default swaps, or other arcane financial instruments you can’t explain to your grandmother? It’s immeasurably more satisfying to put your capital to work in companies making things that rumble, clank, and are often capable of crushing small objects.

We’re not alone in this assessment. While many Wall Street observers had been expecting Warren Buffet to put some of Berkshire Hathaway’s excess cash to work by pouncing on one or more distressed financial firms, he surprised them by orchestrating the $4.5 billion acquisition of Chicago-based Marmon Industries in mid-December.

On a more serious note, we are not suggesting that investors limit their holdings to firms selling large, heavy objects that rust in the rain. The strong performance of the Heavy Metal Portfolio is just another example of the importance of broad diversification. The year 2007 was treacherous with sharp declines in shares of widely held firms such as Citigroup (C, down 47.1%), JC Penney (JCP, down 43.1%), and Starbucks (SBUX, down 42.2%). A truly diversified strategy minimizes the impact felt by many this past year with substantial gains from firms investors fail to include in their portfolio.

Broad global exposure with reduced portfolio costs is the approach successful investors take. Knowing that their portfolio will not beat every index every year, but winning through minimizing losses and the compounding of positive returns that the market will provide over time.

Thanks goes to Weston Wellington with Dimensional Fund Advisors for his contribution to this post.

The Father of Modern Financial Science Speaks

This week Mike McClain attended Dimensional Fund Advisor's biannual Advisor College. Here are some of his notes from the conference.

This week I had the opportunity to hear Professor Gene Fama from the University of Chicago, who many regard as the Father of Modern Financial Science. Those that are our clients will remember that Professor Fama authored the Efficient Market Hypothesis and he and Professor Ken French developed the model that explains equity performance.

Professor Fama said that he believed the sub-prime real estate lending "crisis" was likely overstated and he did not believe the impact will be as significant as some are evaluating it to be. Besides, he said, "financial markets are incredibly flexible and adjust to things such as this."

The key to successful investing, according to Professor Fama is to have a disciplined investment strategy, a diversified portfolio, and a long-term perspective. Diversity, he said, "is your buddy."

Ill-fated attempts to time markets, which can't be done consistently, along with shifting investment strategies are two reasons Fama poo-pooed hedge funds. Fees were another one which typically run 2% and 20% of the profits. The riches earned by managers -- whether or not investors do well -- Fama joked had even lured a few of his former students into starting hedge funds.

Fama encouraged conference attendees to keep their clients away from long-term bonds, which research shows do not sufficiently reward investors for the undue risk incurred. "I would personally never buy long-term bonds," Fama said.

Not surprisingly the Father of Modern Financial Science warned, "stay away from active management."

That evening I had the opportunity to have dinner with Scott Burns, the syndicated financial columnist. Scott echoed Professor Fama's comments about hedge funds saying that the lure of hedge funds was more about having something interesting to talk about at cocktail parties than actual performance. Scott's advice was to invest in a diversified asset class portfolio.

Most Mutual Fund Managers Don't Put Their Money Where Their Fund Is

A report on a study published in the Journal of Financial Economics caught my attention. According to the paper, mutual fund managers who invest in their own fund have better performance than managers that don't. The difference was pretty significant. In 2005, those that owned their fund averaged 8.7% while these that had none of their own money invested averaged 6.2%. That is 40% better.

While interesting, it is not particularly surprising.

What is fascinating and perplexing is how few managers actually invest in their own fund. Only 43% of the managers had any of their personal assets in their own fund. Over half or 57% did not think enough of their own fund to invest in it.

Not only that, but those that did invest did not invest all that much. Mutual fund managers are a pretty well compensated group, yet the average investment of the 43% who put their money in their fund was just $97,000.

Clearly most managers don't think enough of their own cooking to take a bite much less make a meal of it.

Our view on Asset Class Investing is quite different - we have conviction.

We believe in our cooking, or should I say in the academic work over the last 50 years that is the underpinning of Asset Class Investing.

Our stockholders, our senior management, and even our pension plan is invested as we recommend you be in Asset Class Investing. Personally, 100% of my portfolio is invested this way and has been as long as I have been aware of this superior approach.

Why don't more mutual fund managers invest in their own fund?

Hard to tell for sure, but it ought to cause shareholders to pause.

Asset Class Investing is a proven approach to building and preserving wealth, and that is why we have conviction.

Regulators Support Investing In Equities for Retirement

It is usually hard to get excited about government regulation, but an announcement from the Labor Department on Tuesday was good news for working Americans who badly need to save.

In their ruling the Department made it clear that employees need to take risk to receive adequate return to fund their retirement.

Last year Congress passed the Pension Protection Act, which makes it easier for companies to automatically enroll their workers in retirement plans like 401(k)’s.

The Department’s ruling made it clear it favors three strategies for these automatic enrollments. They are diversified and involve equities and fixed income. Fixed rate investments, such as those offered by insurance companies, were not included.

Companies that default workers into appropriately diversified portfolios will be shielded from liability.

We have long believed that exposure to equities is vital during the savings or accumulation years to grow your asset base and in retirement or the distribution years to keep up with inflation.

It is great to see even government regulators get it.

Dollar Hits New Low

Today the U.S. dollar hit a new low against the euro.

Where is the value of our currency going? No one can say for sure, and we sure don’t believe in guessing and market timing. For sure, whichever way the currency moves there will segments of the economy that benefit and others that don’t do as well.

This is one of the principal reasons we believe in being broadly invested across asset classes.

Jonathan Clements the well-regarded personal investments columnist at The Wall Street Journal was recently asked what investors should do to insulate their portfolio from the impact of the dollars decline.

Clements advice was the same he regularly gives on portfolio construction: have 30% of your portfolio invested internationally.

By maintaining a 30% international exposure, according to Clements, our portfolio will be better diversified and our performance will likely be smoother. (Remember, we want asset classes that are not correlated - don't move the same way in like markets.)

He suggests that focusing on large international and also investing in emerging markets and international small cap.

Clements guidance is very similar to the construction we follow with our Asset Class Portfolios. We also hold an allocation of 30% international. Our portfolio composition is closer to a third in each large, small, and emerging. Emerging and small international have historically provided excellent performance and portfolio diversification.

Clements says that more than 30% international is not needed in an investor’s portfolio even if the dollar falls more or even stays low for an extended period of time.

His reasoning is that we invest to use our wealth at some point to purchase goods and services principally here in the United States, so we want to keep a substantial position in U.S. securities.

Don't Let Inflation Corrode Your Buying Power

The Wall Street Journal reported Friday that economists surveyed by Dow Jones expected the Labor Department to report an increase for September in its producer-price index, which is a measure of what manufacturers charge, after having fallen the previous month.

Is this a precursor to higher inflation in our future? No one can possibly know for sure. That is why we believe in Asset Class Investing and don’t try to guess or outguess the markets.

Investors should, however, always be concerned about inflation.

Inflation’s impact on our wealth is just like rust on metal -- over time it corrodes.

Our increase in longevity due to medical advances means we have even more time to feel the effects of inflation and we need to be even more cognizant of how inflation can erode our buying power.

For retirement income planning purposes we talk to our clients about using 95 years old as the age our clients need to have as a goal to have a secure source of income. Probably in the not too distant future that number will move to 100 years old!

Here is an example of just how serious the impact of inflation can be. Lets assume a couple retires at age 65 and needs $100,000 of income from their portfolio during their first year of retirement. To keep up with inflation at year 10 they will need $134,391.64, year 20 they will need $180,611.12, and on year 30 the sum rises to $242,726.25 they need to pull out of their investments.

Stated another way, $100,000 worth of buying power today with inflation nibbling away at 3% a year will be worth $41,198.68 in 30 years.

You can input your own numbers using the inflation calculator found at moneychimp.com (scroll to the bottom of the page).


Is there a “primer” we can apply to our portfolio to prevent this corrosive effect of inflation?

Yes. Maintain exposure to equities throughout your lifetime. The long-term expected return of equities provides the growth to allow investors to maintain a prudent income stream over a lifetime adjusted for inflation.

Learning from Yale

Yale University reported this week that its endowment had gains of 28% for the fiscal year ended in June.

For two decades Yale has been the top performing endowment and for most of that time under the management of David Swensen.

Swensen, considered by many to be one of the top money managers, is often compared with legendary investor Warren Buffet.

Swensen’s advice to investors is the same as Buffet’s: invest in index funds. Swensen has often been critical of the fees of actively managed funds that so often fail to beat their benchmarks.

Where is Yale investing to get such incredible returns? We don’t know the specifics, but much of their equity investments are low cost asset class/index funds. They also have a substantial percentage of the endowment in alternative investments, such as hedge funds and private equity. With a $22.5 billion asset base, they have the resources to obtain the best of such offerings.

Jefferson clients would have received a 24.35% return net of all fees at the highest level for the same period through investment on their 100% Equity diversified asset class portfolio - trailing Yale with their substantial allocation in alternative investments by 3.65%.

The recent sell-off in the credit markets created havoc on many hedge funds, and we don’t know what impact this might have had on Yale’s endowment.

The average endowment had a return of 17.5% for the same period. The University of Texas Management (University of Texas and Texas A&M) came in sixth among university endowments with a return of 18%.

Is Your Fixed Income Strategy a Risk Reducer?

A multi-billion-dollar hedge fund managed by one of Wall Street's most powerful investment banks lost 30% of its assets in a single week in early August. Moody's and Standard & Poor's downgraded credit ratings on hundreds of mortgage-backed securities. The Dow Industrials plunged over 300 points on July 26 on record volume of 5.87 billion shares.

The recent fall in stock prices around the world has served as a reminder of the reason for which many investors hold a portion of their portfolios in fixed income securities. Many investors are wondering what effect the current turmoil in the credit markets is having on their fixed income portfolio.

If you are utilizing Jefferson’s Asset Class Portfolio’s the answer is "not much."

Our portfolios invest exclusively in high quality fixed income with maturities from one to five years. If our stategic partner, Dimensional Fund Advisors were a conventional money management firm, we might attribute this pleasing result to the wisdom of Dimensional's portfolio managers in predicting the turmoil in the mortgage market and adjusting the portfolio accordingly. But no such predictions were involved; the absence of mortgage-backed obligations (regardless of credit rating) simply reflects Dimensional's ongoing policy to exclude such securities and focus on obligations with predictable maturities in order to properly implement the shifting-maturity strategy.

If the primary purpose of fixed income, as we believe, is to dampen the sharp fluctuations of an all-equity account, it should be a dependable risk reducer.

As many investors are discovering, fixed income strategies with seemingly impressive positive returns may be vulnerable to impressive returns in the other direction.