The FENG St. Louis

Why Our Advice Remains the Same

Jim Cornfeld — Mon, 20 Apr 2009 04:36:00 GMT

It can be hard to hear that the best course of action during tough market times may be to do nothing. It can be even harder to hear that same message over and over as things seem to get worse. But it is a message we would not repeat if we did not truly believe it was in your best interests. The following discusses why our message is not wavering despite the market.
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Buy and hold. Rebalance. Stay the course. That is the advice we repeat again and again. Over the long term, that advice has served our clients well. Yet, in the face of the persistent bear market, a common refrain from investors has gone something like this: “Yes, that advice has worked in the past. However, this time is different. It obviously isn’t working now! The market just keeps going down and down. There must be a better alternative than to sit and do nothing.”

While we empathize with investors who feel a great sense of loss, we don’t believe we are being stubborn. Our advice has always been (and will always be) based on the scientific evidence, not on our opinions about where the markets may be headed. And while this crisis is certainly different in some ways than other crises, we see no reason to change the investment advice.

Market Efficiency
For us to believe that we should abandon a long-term, buy-and-hold strategy, we would have to be first convinced that markets were no longer efficient. In other words, the market was now mispricing assets and was slow to react to new information.

It is hard to imagine that markets have gotten slower at reacting to news. In fact, markets incorporate news into prices almost instantaneously. After Treasury Secretary Timothy Geithner unveiled the Treasury Department’s plan to clean up toxic assets, the market reacted immediately, as evidenced by several indexes leaping to their highest one-day gains since last fall.

We see no evidence that active managers were able to predict this bear market. In fact, while there was a wide dispersion in individual stock returns (some stocks, like Wal-Mart were actually up), almost every single diversified mutual fund produced large losses. This would not be the case if markets were somehow inefficient. It is also important to note that there is no evidence that active managers consistently outperform in bear markets.

We believe that the market was and continues to be highly efficient. It is just that the news has been persistently worse than expected, causing prices to fall. This is what causes bear markets.

Market Timing

As to trying to time the market, we again rely on the historical evidence. When a client suggests just getting out until things are clear again, we point out that the evidence on market timing is even worse than on stock selection. For example, the publication Timer Digest showed that of the 112 market timers tracked from 1991 through 2000, only one managed returns that beat the S&P 500 Index. We don’t like those odds. Neither should investors.

One reason that market timing fails is that so much of the market’s return occurs during very brief and unpredictable periods. Another reason is that investors have to be right not once, but twice. Deciding to get out is easy compared to deciding when to get back in. Investors that go to cash may be “whipsawed.” They will get out after a severe drop, miss a big rally and jump back in only to experience another severe loss. They end up worse than if they simply stayed the course. That is why we believe going to cash is not the winning strategy.

The Difference Between Information and Wisdom

We can define information as facts or opinions. In terms of investing, wisdom is information that can be exploited to generate excess (above market) profits. When we ask people why they are so willing to abandon their well-designed plan, they say something like: “Isn’t it obvious that the situation is terrible?” Then they give a laundry list of negative items. The question they fail to ask is this: If it is in fact obvious, isn’t the bad news already built into prices? After all, that is why prices have already gone down.

They also fail to understand the following: If things are so bad, that must mean the market is perceived as risky. If the market is risky, expected returns are now higher. Why would investors decide to sell now when expected returns are higher than when they originally bought?

Many investors have considered selling because of concerns about the “Europeanization of our economy.” Should investors sell? To answer that question, one must understand that these concerns are well known by the market. While concerns about government intervention, higher taxes and an increased ratio of debt to gross national product can all affect stock prices, those concerns are already reflected in prices. That is why stock prices moved lower as the new administration unveiled its policies. As Bernard Baruch stated, “Something that everyone knows isn’t worth knowing.”

Investors feeling the need to sell should also consider the following. There is a “universe of risk.” Since all stocks must be owned by someone, someone must hold the market risk. For everyone who wants to sell, someone else must be willing to buy at the same price. And they will only buy in a time of distress if they believe the market price fully reflects the high risks.

The Relationship Between Risk and Expected Return

If the perception of risks are high (which they are during bear markets), so must be the expected return. And the historical evidence is that investors persistently demonstrate a pattern of buying high (after bull markets when risk premiums are low) and selling low (afterbear markets when risk premiums are high) when acting on their own. This destructive behavior is evidenced by the fact that investors typically underperform the very mutual funds in which they invest.

“Defensive” Strategies

Investing history is filled with examples of strategies that try to benefit from observable patterns of past market performance. Unfortunately, the realized returns haven’t matched the promise.

Vanguard examined the performance of several different signals based on “conventional wisdom” to see if they actually translated into better risk-adjusted returns.¹ As one example, the authors studied whether investors could improve portfolio performance by defensively shifting equity exposure toward less-cyclical, lower-beta sectors (such as health care, consumer staples or utilities). This strategy is based on documented evidence that certain sectors tend to thrive in different stages of the business cycle. Unfortunately, they found that "a defensive investment strategy based on the leading signals of bear markets and recessions (focusing primarily on recessions) would not have resulted in better results than following a buy-and-hold strategy." Among the problems they found are "the low predictive power of even the best signals of bear markets and recessions, and potentially high transaction and tax costs."

Another signal they examined is the presence of an inverted yield curve (short-term interest rates exceed long-term rates), which is a well-documented leading indicator of recessions. Vanguard found that the yield curve signal is noisy: "For the period 1952 through 2006, the yield curve has inverted 19 times, but the U.S. economy lapsed into recession only nine times."

They also examined the forward-looking price-to-earnings ratio. The concept is based on the idea that a bear-market signal is given when the ratio is at historic highs. Unfortunately, this indicator is also noisy and, thus, has provided no value.

While the historical record shows that various sectors tend to outperform during tough times, Vanguard reached the conclusion that, “Even the most reliable indicators have low predictive power when used to execute real-time strategies. Investors seeking to mitigate equity market risks are better served with a strategic allocation to fixed income investments.”

Summary

Noted author Peter Bernstein provided this insight: “Even the most brilliant of mathematical geniuses will never be able to tell us what the future holds. In the end, what matters is the quality of our decisions in the face of uncertainty.”² Thus, our advice will continue to be the same, because that is what the science demonstrates is the most likely way to achieve one’s goals. When we find compelling evidence, published in peer reviewed academic journals, that there is a superior alternative strategy, we will do what smart people do; they change their strategy in the face of new evidence. Until then, our advice remains: buy, hold, rebalance and stay the course.

¹ Joseph Davis and Christopher Philips, Noisy Signals: A Challenge to Tactical Strategies. Vanguard Investment Perspectives, Spring/Summer 2008.

² Peter Bernstein, Wimps and Consequences. Journal of Portfolio Management, October 1999.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2009, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments.

Hazardous to Your Wealth

Jim Cornfeld — Tue, 14 Apr 2009 20:32:00 GMT

The massive downturn in the market in 2008 provided active managers and stock forecasters several opportunities to demonstrate their value. The following shows that even with a low bar set for outperformance, they had a difficult time meeting the challenge.
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There’s little doubt 2008 was a tough year for investors, as the stock market turned in one of its worst performances in history. The S&P 500 Index, for example, was down 37 percent for the year — the worst performance for the S&P 500 since 1931, when it fell 43 percent.

But such a dramatic downturn in the market should have provided active fund managers with ample opportunities to outperform. Even turning in stock picks that simply finished the year in the same place they started would have significantly outperformed the market.

Given the massive amount of media coverage of the current market conditions, one would think that managers that beat the market would be heavily touted right now. But those stories seem to be few and far between. In fact, by looking back at some of the predictions offered in late 2007 and early 2008, investors can see that active management still has not proven to be the winning strategy.

Swing and a Miss

In a December 31, 2007 article “What the Pros Are Saying,” BusinessWeek surveyed several prominent investment analysts and managers about their thoughts on the performance of the stock market during 2008. One money manager surveyed had previously achieved fame by advising clients to sell before the stock market crash of October 1987.

Her outlook was much more upbeat this time around. She predicted that the Dow Jones Industrial Average (DJIA) and the S&P 500 would both post 20 percent gains. “Our models show the S&P 500 is undervalued by 25%.”

Not quite. The DJIA fell by 31.9 percent and the S&P 500 finished 2008 down 37 percent. As an added insult, this manager had been advising clients to buy stocks her firm felt were significantly beaten down, specifically mentioning Lehman Brothers (which failed), Bear Stearns (which was rescued by JP Morgan) and Merrill Lynch (which was absorbed by Bank of America).

Big Bets on Big Banks

The January 7, 2008 Forbes article “Seize the Day” acknowledged that financial stocks had been hit hard by the credit crunch. Still, investors looking for cheap stocks with good potential were steered toward banks: “Those who buy bank stocks should be well rewarded over the next couple of years.”

To be fair, the article’s author was looking further down the road than just in 2008. Still, the group of stocks recommended to investors reads like a who’s who of the top financial bad news makers of the year:

Company Name	2008 Return
Bank of America	–63.1%
Citigroup	–76.0%
KeyCorp	–61.6%
JP Morgan	–25.1%
Washington Mutual	–99.8%
Freddie Mac	–97.8%
Benchmark	2008 Return
S&P 500	–37.0%

Best of the Old and Best of the New

How about the top fund managers of today? Would they be able to spot value in the market chaos? Could they outperform the market and keep their impressive track records? The December 24, 2007 Fortune article “Old Masters and New Classics” profiled the magazine’s best bets for funds that would deliver solid returns. “Old or new, one thing’s for sure: With the stock market booming or swooning depending on the news of the day, it’s more worthwhile than ever to have one of these steady hands guiding your investment decisions,” the article read.

The article picked six funds: two large-cap, one mid-cap, one small-cap and two international funds. An evenly weighted portfolio of these six funds would have returned –41.7 percent in 2008. By comparison, a portfolio of two-thirds S&P 500 and one-third MSCI EAFE Index would have yielded a return of –39.1 percent in 2008.

Summary

Even though the poor market performance in 2008 provided opportunities for many prognosticators to demonstrate their abilities, few lived up to the challenge. Instead of following their advice, investors would be better served to listen to advisors who account for an investor’s ability, willingness and need to take risk and who build financial plans to match.

Is Inflation Inevitable?

Jim Cornfeld — Mon, 06 Apr 2009 22:30:00 GMT

The significant amount of stimulus being injected into the economy may have investors wondering what this will mean for inflation. The following discusses why inflation fears may be premature.

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One of the most frequently asked questions regarding the stimulus being pumped into the economy is: What should we do about the resulting inflation problem we are going to face? While there is risk that the massive budget deficits and the monetary stimulus will translate into rising inflation, this outcome is not inevitable. One only has to look to Japan to see that inflation is not inevitable.

In 1990, the Japanese economy went into a tailspin. The stock market and real estate values collapsed, and the Japanese government took action by both adopting a zero interest rate policy and also embarking on a program of massive fiscal stimulus, including significant spending on infrastructure. The Japanese government ran large budget deficits, and the result is that the country’s debt to gross national product ratio is nearly 200 percent. Yet despite the monetary and fiscal stimulus, the biggest concern for Japan has not been inflation, but deflation.

Regarding the United States, the velocity of money has been falling due to a rapid drop in spending. To offset the sharp drop in money velocity, the money supply must be increased, or the economy would collapse. And with banks, corporations and consumers deleveraging, the government is the only one left to offset deleveraging’s negative effects (hence the fiscal stimulus).

Because of the collapse of consumer and business spending, there is no real threat of inflation in the short term. (In fact, the greater risk is deflation.) However, once the economy recovers and the velocity of money increases, the Federal Reserve will need to remove the excess liquidity it has injected, or inflation will soar. Hopefully, the Fed has learned from the mistakes of 2003, when it kept the realfederal funds rate in negative territory. (The nominal rate remained at 1 percent while inflation was 2 percent, and the economy was already recovering from the recession.)

The need for fixed income investments remains unchanged. Investors should consider owning TIPS and high-quality, short- to intermediate-term securities to minimize the risks of unexpected inflation. In addition, TIPS provide the added benefit of having negative correlation to equities. Investors can also consider a small allocation to commodities through an investment in fully collateralized commodity futures as an inflation hedge. Commodities tend to have their best performance during periods of rising inflation.

Summary

While the size of the stimulus employed to counter the effects of the severe recession increases the risks of inflation, the Japanese experience demonstrates that the outcome is far from certain. Thus, investors should be wary about reacting to the noise from the “talking heads” advising them to alter their well-designed plans. Investors should check with their advisors to see how their investment plan is designed to address inflation fears. For those who are not adequately prepared for inflation possibilities, they should consider tailoring their fixed income allocations to address that need.

Disciplined Investing in a Difficult Market

Jim Cornfeld — Sun, 29 Mar 2009 18:19:00 GMT

When difficult periods of market activity arrive, they remind investors of the importance of a disciplined approach to investing. The following discusses some of the lessons recently reinforced.

Whenever a market crisis enters the picture, investors can count on certain words being bandied about in the media, such as unprecedented, new territory, unfamiliar and extraordinary.

The events themselves may well be unprecedented, but the basic lessons these events reinforce are not. But with the downfall of prominent companies such as Lehman Brothers, Merrill Lynch, AIG, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corp. (Freddie Mac), investors can take this opportunity to recognize some basic principles of prudent investing for the next time unprecedented market activity occurs.

What Happened
In the case of Lehman, the firm’s downfall was fueled by troubled real-estate investments. From 2004–2007, Lehman posted record profits, but also began accumulating billions of dollars in risky securities, loans and mortgages tied to real estate. This trend continued into 2008, as the company posted a profit in the first quarter while increasing its exposure to Alt-A loans (which are loans riskier than prime mortgages, but less risky than subprime).

As the values on those mortgages fell, the company attempted to raise additional capital, but was unable to do so. One of the final straws came shortly before the company announced its intention to file for bankruptcy. News leaked that talks involving a substantial investment from Korea Development Bank had failed.

Merrill Lynch faced a similar situation. Like Lehman, Merrill carried tens of billions of dollars in risky, hard-to-sell assets when the credit crunch took full effect in 2007. Those assets deteriorated in value, forcing the company to raise additional capital. However, losses continued to pile up, and subsequent attempts to raise capital did little to lift the company’s deteriorating stock price.

As The Wall Street Journal (WSJ) points out, AIG was healthy in many ways, but a single unit caused massive losses that weighed down the company. This unit sold credit-default swaps, which were designed to protect investors against defaulting assets, including subprime mortgages. “The division’s problems largely drove AIG to report $18 billion in losses in recent quarters, forcing AIG to put up billions more in collateral, straining its financial resources. Downgrades from ratings agencies and relentless pressure on the company’s stock exacerbated its already weak position.”¹

Market activity such as what has recently happened typically serves as a painful, yet necessary reminder of why equity investing has had greater returns than other, “safer” instruments. Risk is always present. However, bear markets also reinforce several other important investing principles.

Stock Prices Incorporate Known Information
Between January and September of 2008, several firms saw their stock prices battered as the market reacted to news about the health of each company. The firms mentioned above each saw their stock prices fall during 2008. However, investors still appeared to be shocked when each firm met its fate.

Changes in Stock Prices

	Stock Price Jan. 2	Stock Price Sept. 2	% Change Since Jan. 2	Stock Price Sept. 16	% Change in September
Lehman Brothers	$65.30	$17.45	–73.3%	$0.30	–98.3%
Merrill Lynch	$53.71	$29.11	–45.8%	$22.18	–23.8%
AIG	$58.59	$22.20	–62.1%	$3.75	–83.1%
Fannie Mae	$40.20	$7.50	–81.3%	$0.48	–93.6%
Freddie Mac	$34.42	$5.20	–84.9%	$0.26	–95.0%

Such a move augments the notion that markets incorporate known information into stock prices. In the case of these companies, the market recognized that they were in trouble, and the stock price fell. However, the market did not know the full extent of the trouble until each company met its fate. This is reflected in the changes seen in the stock prices in September. In all but one case, the price fell more percentage-wise in two weeks than it had since the beginning of the year.

Individual Stock Speculating
Consider the cases of investors who held individual shares of some of the battered companies. The collapse and subsequent takeover of Fannie Mae and Freddie Mac left many investors in its wake.

The WSJ discusses the tale of one investor who believed he could profit from the situation at Freddie Mac. In early September, this investor purchased about 25,000 shares of the company at $5 per share, believing the price would rebound. Instead, the government takeover drove the price down significantly further. “Now he says he is out more than $100,000 — money that he was saving for his young sons’ college education.”²

About the only solace this investor may find is knowing that even the most reputable of investors fell victim to investments in these companies. Famed investment manager Peter Lynch disclosed that he held Fannie Mae — which he has cited many times as a favorite stock — in his personal portfolio because he believed the company would post big earnings in 2011. “‘I can be just as dumb as anybody else,’ he says wryly.”³

Diversification
Lehman Brothers in particular reinforced the notion that investors should be wary of holding significant percentages of their assets in their company’s stock. Shortly after the news about the impending bankruptcy broke, the WSJ noted in a September 12 article that Lehman employees lost about $10 billion in paper wealth when the stock price plummeted to $4 per share. The employees owned an estimated 25 percent of the company.⁴

To say that Richard Fuld, the company’s CEO, held a significant stake in the company might be an understatement. Fuld had accumulated 10.9 million shares of Lehman stock during his 41 years with the company. As of January 31, those shares amounted to a worth of $695 million. That September article showed those shares had plummeted 93 percent in value, leaving Fuld holding shares worth $45.8 million.

However, the freefall did not stop there. Two weeks later, the WSJ reported that Fuld sold some of his shares after the company filed for bankruptcy. By that time, the share values had dropped to mere pennies, and Fuld sold 3.17 million shares (or about 30 percent) for $660,209.⁵ One can only wonder just how much equity vanished from the portfolios of other Lehman employees. Remember, the $10 billion in equity that Lehman employees lost was cited when the company’s stock was hovering at $4 per share, not the pennies per share where the stock currently sits.

Hindsight Bias
Investors may also hear about how “inevitable” each company’s downfall was. By now, some may be convinced that anyone who was paying attention could have seen each of these situations unfold long before it actually happened.

However, investors should be wary of the instinct to view such situations as easily recognizable. This sudden inevitability has another side effect, one that can be even more damaging to investors and their portfolios. In a September 16 article in the WSJ, columnist Jason Zweig points out that looking back at what now appears to have been obvious could create problems for investors as they look toward the future.

“By retroactively fooling us into thinking that we knew how the past would unfold, hindsight bias tricks us into thinking we know how the future will unfold,” Zweig writes. “But if the past took you by surprise, why should you believe you can decipher the future?”⁶

He related the story of Scott Jaffa, an investor who called the September 15 stock market plunge a test of his psychology.

“Because he does not need the money ‘for another 30 to 40 years,’ he asked rhetorically, ‘why should I worry myself about its performance over a period of days or weeks or even months?’”⁷

Investors would do well to follow in this investor’s footsteps. But as Zweig pointed out, it does not come naturally. “A year and a half ago, Mr. Jaffa destroyed the online access code for his 401(k) so he could no longer have instant access to his retirement accounts. His goal was to make it ‘significantly harder’ and to require ‘human interaction’ before he could trade on his emotions. That enabled him to watch the market's decline without acting on it.”⁸

Summary
Investors can look to their advisors for help controlling such emotions. A good advisor will help clients remember the importance of adhering to their well-developed plan.

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¹ Monica Langley, Deborah Solomon and Matthew Karnitschnig, "Bad Bets and Cash Crunch Pushed Ailing AIG to Brink." Wall Street Journal, September 18, 2008.

² Craig Karmin, "Small Fannie, Freddie Holders Take Issue With Washington." Wall Street Journal, September 12, 2008.

³ Karen Blumenthal, "Bogle's Bets: Pros Offer Advice on Investing Now." Wall Street Journal, September 24, 2008.

⁴ Randall Smith, Susanne Craig and Annelena Lobb, "The Lehman Stock Slide Hits Home: Employees Face $10 Billion in Losses." Wall Street Journal, September 12, 2008.

⁵ Nicolas Brulliard, "As Lehman Liquidates, so, Too, Do Executives." Wall Street Journal, September 24, 2008.

⁶ Jason Zweig, "How to Handle a Market Gone Mad." Wall Street Journal, September 16, 2008.

⁷ Ibid.

⁸ Ibid.

Black Swans

Jim Cornfeld — Wed, 25 Mar 2009 22:34:00 GMT

When the market experiences significant swings, some investors may be tempted to try to time the market in an effort to boost returns. The following explains why it is extremely difficult, if not impossible, to enhance returns through market timing efforts.

In his book The Black Swan, Nassim Nicholas Taleb notes three things that constitute a black swan:¹

It is an outlier, as it lies outside the realm of regular exceptions.
It carries an extreme impact.
Human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.

In other words, events that occur without any forewarning that they would occur are considered black swans. The events of September 11, 2001 are an example of a black swan, as is the stock market crash of October 19, 1987, when the Dow fell 23 percent in one day.

If investors could avoid the effects of black swans, the impact on investment returns would be enormous. Consider the following: The working paper, “Black Swans and Market Timing: How Not to Generate Alpha,” studied stock market returns in 15 developed countries (including the U.S.) for varying time periods, ranging from 31 years for Canada and Thailand to 79 years for the U.S. The authors found that if investors could avoid the worst 10 days, their returns would be 150 percent more than the returns of buy-and-hold investors.² This makes market timing a tempting strategy.

However, before being tempted, consider these words of wisdom from legendary investor Peter Lynch, who noted that he had never seen a market timer on Forbes’ list of the richest people in the world: “If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.”³ Lynch’s warning is supported by the evidence demonstrating the staggering odds against the likelihood of successfully timing the market, such as the aforementioned working paper. Here are some of the paper’s findings:

Stock Returns Are Not Normally Distributed
Black swans appear with far greater frequency than predicted by normal distributions. For example, for the Dow Jones Industrial Average, 29,190 trading days (107 years) produced a daily mean return of 0.02 percent and a standard deviation of 1.07 percent. This means investors should expect 39 days to produce returns above 3.22 percent and 39 days to produce returns below –3.17 percent. However, there were six times the number of returns outside that range — 253 daily returns below –3.17 percent and 208 above 3.22 percent. Also consider the evidence in the following table:

Mean Returns

	Returns	Standard Deviations From the Mean
Best 10 Days	11.10%	10.4
Best 20 Days	9.37%	8.8
Best 100 Days	5.92%	5.5
Mean Return	0.02%	N/A
Worst 10 Days	–10.46%	9.8
Worst 20 Days	–8.73%	8.2
Worst 100 Days	–5.87%	5.5

Impact of Missing the Best and Worst Days
The table above also demonstrates how the markets' returns (both good and bad) often come from short bursts. The following table shows how missing the best days and worst days of the market would affect overall returns.

Missing Best and Worst Days

	Change in Terminal Wealth
Best 10 Days	–65%
Best 20 Days	–83%
Best 100 Days	–99.7%
Worst 10 Days	+206%
Worst 20 Days	+532%
Worst 100 Days	+43,397%

The author concluded: “These figures speak for themselves and should help investors notice the odds they are against when trying to successfully time the market. A negligible proportion of days determines a massive creation or destruction of wealth. The odds against successful market timing are just staggering.”

International Markets Produce Same Results
The departure from normal distributions was clear in all 15 countries studied:

Australia	Italy	Switzerland
Canada	Japan	Taiwan
France	New Zealand	Thailand
Germany	Singapore	United Kingdom
Hong Kong	Spain	United States

Across all 15 markets, the average number of outliers was more than five times higher than expected. Also, in 14 of the 15 countries (with the exception of Australia) missing the 100 best days resulted in a loss of initial capital invested.

Conclusions
In his book Common Sense on Mutual Funds, John Bogle said “After nearly 50 years in this business, I do not know of anybody who has done it [market timing] successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.”⁴ Bogle understood that investors do not earn returns smoothly over time. Instead, they earn them largely as a result of unpredictable bursts and crashes. Given that so much of the action happens on a small number of days, the odds of successfully predicting the days to be in and out of the markets are close to zero. The real danger for investors is not being there when the big up moves occur.

The winning strategy is to both accept that markets cannot be timed and build the expectation of black swans into an investment plan. Forewarned is forearmed. In addition, broad global diversification (including an allocation to high quality fixed income assets sufficient to reduce overall portfolio risk to an acceptable level) helps mitigate the impact of the inevitable appearance of black swans. As the working paper’s author, Javier Estrada, concluded: “Much like going to Vegas, market timing may be an entertaining pastime, but not a good way to make money.”⁵

¹ Nassim Nicholas Taleb, The Black Swan. (Random House, 2007).

² Javier Estrada, “Black Swans and Market Timing: How Not to Generate Alpha.” Working Paper, November 2007.

³ Peter Lynch, “Fear of Crashing.” Worth, September 1995.

⁴ John Bogle, Common Sense on Mutual Funds. (Wiley, 1999).

⁵ Javier Estrada.

Seeking Shelter From the Storm

Jim Cornfeld — Wed, 18 Mar 2009 18:18:00 GMT

Investors seeking shelter from the current market storm may be tempted to try to bet on the next winning investment sector. The following discusses why such a strategy may not be in investors' best interests.

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Many investors may be seeking safe havens from the current market storm. Others may be looking for those "diamond in the rough" stocks or investing sectors that will get their portfolios back on track after such a devastating period. Perhaps lessons from the Great Depression can provide such investing insights.

As luck would have it, there is one sector that produced significant returns in the three years following the market crash of 1929. Those looking for that safe haven may want to get ready to jump into ... logging.

In a February 14, 2009 article in The Wall Street Journal, columnist Jason Zweig teamed up with the Center for Research in Security Prices (CRSP) to see how various investing sectors performed 1930-1932 (after the stock market had lost one-third of its value in the crash). Logging was the only industry to post positive returns during that time period with a cumulative gain of 40 percent. It should be noted that the sector contained two stocks: one company that made trees into packing materials and one that turned timber into matchsticks.

It is doubtful that many investors would have pegged the logging industry as being the mostly likely to rebound from portfolio devastation of the Great Depression, which is why remaining diversified is likely to prove to be the right strategy for investors. History has continued to show that rebounding returns come from some unexpected places. Consider some more recent evidence.

In the year following the 1987-1989 bear market, the top performing market sector was financial stocks, returning 64.9 percent in the 12 months following the trough of the preceding bear market. Of course, investing in financial stocks in this market may seem more like holding a lightning rod to the sky than ducking out of the downpour.

Similarly, the year following the 2000-2002 bear market saw information technology stocks rise up as the top performing investing sector. At that point in time, investing in technology-related stocks would likely have been a difficult call for many investors, as technology stocks are typically blamed for that bear market in the first place.

History has shown that market rebounds typically come quickly, and the top performing sectors are often unidentifiable. Some investors may still scramble to find the perfect place to park money until the storm passes. Few (if any) can know when markets will recover and what sectors will lead the way. And history has also shown that those who do make such correct predictions are more likely to be lucky than good.

According to the historical evidence, trying to pick winning stocks and time the market is more likely to lead to investors lagging the returns of the market, rather than outperforming them. Consider the evidence by Timer Digest, which tracks buy and sell calls from financial newsletters. The publication showed that of the 112 market timers tracked from 1991 through 2000, only one managed returns that beat the S&P 500 Index.

If that is not enough, consider the story of Benjamin Graham, considered one of the finest stock pickers to walk the earth.

The Father of Security Analysis

Graham wrote two books - Security Analysis (first published in 1934) and The Intelligent Investor (first published in 1949) - that are still considered among the finest investing books ever written, even today. Warren Buffett summed up The Intelligent Investor by simply calling it, "By far the best book about investing ever written."

Graham's basic investing philosophy was to thoroughly analyze stocks and to only buy stocks once they were considered dirt cheap. This underscores the premise that working hard enough at analyzing stocks will eventually produce superior returns.

However, Graham seemed to recant this stance shortly before his death in 1976. Here's what he told The Journal of Finance: "I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when Security Analysis was first published; but the situation has changed. I doubt whether such extensive efforts will generate sufficiently superior selections to justify their cost."

In an article in Slate magazine, Henry Blodget said that Graham's words reflected a more diversified and high-level stock selection strategy, rather than attempting to pick individual winners or sectors. "Specifically, Graham recommended screening stocks using simple valuation and fundamental criteria and then buying large groups of them, the same way a modern ‘passive' fund (such as a value-oriented index fund) does. What Graham did ‘recant' was the idea that by studying companies in detail, one could identify a few super-promising opportunities that could safely deliver market-crushing returns."

Summary

During difficult market conditions, many investors may be tempted to seek out the fast-recovering sectors in hopes of getting their portfolios "back on track." As history has shown, the odds of choosing the right stocks or sectors are slim and largely based on luck. Even investing legends such as Graham recognize the fallacy of trying to pick the next winners. The preferred strategy for investors should be to remain diversified.

Diversification: Is It Working?

Jim Cornfeld — Mon, 16 Mar 2009 15:27:00 GMT

Overview: Diversification has proven to be a winning strategy for most investors, who believe that it will protect them in all bear markets. However, the recent market volatility has shown that is not the case. The following discusses how investors should view diversification.

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A common refrain from investors during this financial crisis has been: "I am as diversified as it gets. I have substantial exposure to small-cap, value and international stocks. Yet every single asset class dropped during this downturn. As far as I can tell, there was no protection at all from owning all these asset classes. I would say that diversification does not protect during a steep downturn."

What went wrong? Absolutely nothing. The problem is that many investors do not fully understand the concept of correlation of returns.

Correlation of Returns

Prudent investors build portfolios that include asset classes with low correlation (the measure of the strength of the linear relationship between two variables). Values can range from +1.00 (perfect correlation) to -1.00 (perfect negative correlation). Positive correlation means that when one asset produces positive returns, the other tends to also produce positive returns, and vice versa. Negative correlation means that when one produces positive returns, the other tends to produce negative returns, and vice versa. Thus, the lower the correlation of returns, the more effective the asset class is as a diversifier of portfolio risk. The following table demonstrates the relatively low correlations of the S&P 500 Index to various asset classes.

Indexes	Annual Correlation to the S&P 500 Index
Fama-French Large Value	0.75
Fama-French Small	0.70
Fama-French Small Value	0.52
Wilshire REIT Index	0.18
MSCI EAFE Index	0.61
MSCI Emerging Market Index	0.33

Based on these historical relationships, many investors expect each of these asset classes to do poorly from time to time, but not all at the same time. Unfortunately, these investors make the mistake of not putting enough emphasis on the key words: "tends to."

The problem for such investors is they fail to understand that correlations are not stable; they drift. And while international stocks and emerging market stocks are exposed to some different economic and political risks than U.S. stocks, they are also exposed to some of the same risks that can impact the global economy. When those risks show up (typically during times of financial and/or political crises), correlations among all asset classes tend to turn high. Just when the benefits of diversification are needed most, they go AWOL.

A popular investing expression is that "the only thing you don't know about investing is the investment history you don't know." Knowing the history of returns would have prevented investors from misunderstanding the benefits of equity diversification. The latest financial crisis revealed nothing new about correlations. For example, major equity asset classes produced negative returns during the global recession of 1973-74 as the S&P 500, large-cap value stocks, small-cap stocks, small-cap value stocks and international large-cap stocks fell 37, 26, 53, 41 and 33 percent, respectively. There was no place to hide.

The same thing happened both during the Asian contagion in the summer of 1998 and in the aftermath of the events of Sept. 11. And the systemic risk of equities showed up again when the financial crisis that began with U.S. housing prices falling sharply spread around the world in the summer of 2008. Major equity asset classes experienced dramatic bear markets. In some cases, it was the worst since the Great Depression.

The following table shows the total return for various asset classes during each of the aforementioned crises. Note that in each crisis, the correlations of returns rose dramatically. The only difference this time is the depth of the bear market.

Asset Class	July-August 1998 (%)	September 2001 (%)	January-October 2008 (%)
Domestic Large-Cap	-15.4	-8.1	-32.8
Real Estate	-15.8	-4.2	-31.5
Domestic Large-Cap Value	-14.7	-7.8	-29.3
Domestic Small-Cap	-26.0	-14.8	-32.8
Domestic Small-Cap Value	-22.8	-14.4	-24.6
International Large-Cap	-11.5	-10.1	-43.3
International Small-Cap	N/A	-13.3	-47.9
Emerging Markets	-26.7	-15.5	-53.1

The Lesson

Most of the time, risky asset classes do not exhibit high correlation, and many even have very low correlations. Among the asset classes that have low correlation with U.S. equities on average are real estate, international small-cap stocks and emerging market stocks. The reason for the low correlations is that economic and political conditions impact the various asset classes in different ways most of the time. However, in times of global crisis, risky assets tend to correlate highly. And that leads us to the important lesson the markets teach us.

In times of crisis, the only effective diversifier of equity risk is very high-quality fixed income investments. (The safest of which are obligations that carry the full faith and credit of the U.S. government.) During the most recent crisis, while equity asset classes were experiencing severe bear markets, U.S. Treasury instruments were providing positive returns.

Before concluding, there is one more important point we need to address.

Is the Investment World Flat?

The financial media has run numerous stories about the rise in global correlations. The story goes something like "We are becoming one globally integrated economy ..." and gives the impression that the benefits of diversification are greatly reduced. It seems that this is becoming conventional wisdom - an idea so accepted that it goes unchallenged. However, before one accepts such "wisdom," we can look at the evidence.

Consider the correlations between the S&P 500 and the MSCI EAFE. From 1970-2007, the annual correlation was 0.586. By dividing the full period in half, we can see if there has been any trend toward rising correlations. From 1970-1988, the annual correlation was 0.623. From 1989-2007, the annual correlation was 0.614. Obviously, there has not been a general rise in correlations. The recent rise in correlations is nothing more than a result of the financial crisis. We have had crises in the past, and we will likely have them in the future. And the correlation of risky assets will likely rise as well.

Conclusion

It is important that investors understand that correlations are not static and are likely to rise to high levels during times of crisis. Thus, the winning strategy is to make sure that portfolios have sufficient allocations to high-quality fixed income assets - an amount sufficient to dampen overall portfolio risk to the level that does not exceed your ability, willingness and need to take risk.

Spanish philosopher George Santayana said: "Those who cannot remember the past are condemned to repeat it." The financial markets have provided investors with lessons to remind them that broad global diversification across equity allocations would not protect them from all bear markets.

Investors who do not have sufficient amounts of high-quality fixed income assets to reduce overall portfolio risk to an acceptable level are likely to fail the tests that the markets provide.

Finally, it is important to understand that even the smartest people make mistakes, but it is a mistake to repeat or perpetuate them. Therefore, investors without sufficient allocations to high-quality fixed income assets that dampen overall portfolio risk to an appropriate level (based on their ability, willingness and need to take risk) should rewrite their asset allocation plans to correct that error.

Lessons from 2008

Jim Cornfeld — Tue, 03 Feb 2009 20:27:00 GMT

Overview: Every year, Larry Swedroe takes a look back at the investing lessons the markets provided in the past year. Market conditions in 2008 certainly provided a challenge for investors, and there are many lessons that can be gleaned from the past year's experiences.

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While the economic recession provided some expensive lessons for investors, hopefully these lessons will not be soon forgotten. Here are some of the lessons reinforced during the past year that investors should keep in mind in 2009 and beyond.

Active Managers Cannot Protect Investors From Bear Markets

All crystal balls are cloudy, which is why Warren Buffett concluded: "The only value of stock forecasters is to make fortune tellers look good."¹ Active investment firms tout their ability to protect investors from bear markets, but some of the largest demonstrated they could not even protect themselves. If their money managers could protect investors, why did firms like Lehman Brothers and Bear Stearns go belly up and Merrill Lynch have to be rescued by Bank of America? As evidence of their lack of ability to forecast events, consider that in 2008 Lehman spent $761 million buying back its own stock at an average price of $49.60 and Merrill Lynch spent $5.27 billion buying back its stock in 2007 at an average price of $84.88.²

There is no reason to think that they would manage their clients' risks any better. Investors don't need to pay Wall Street big fees to have their money managed. Large fees are only likely to make managers rich, not investors.

Large individual funds fall in the same category. In 2008, the hardest hit sector was financial stocks. Financials comprise a significant portion of the asset class of value stocks, so let's look at the performance of some well-known actively managed value funds:

Value Mutual Funds
Active Managers	%
Legg Mason Value Trust	-55.1
Dodge & Cox	-43.3
Dreman Concentrated Value	-44.9
Weitz Value	-44.9
Schneider Value	-55.0
Columbia Value and Restructuring	-47.4
Benchmarks
Russell 2000 Value Index	-28.9
Russell 1000 Value Index	-36.9

Of course, some actively managed value funds beat the benchmarks. However, how would you have known ahead of time which ones they would be? As the SEC's required disclaimer states: Past performance is not indicative of future results. Thus, the prudent strategy is to use only passively managed funds.

Do Not Confuse the Familiar With the Safe

Working for a company does not mean the stock is a safer investment because you feel like you "know" the company. Consider the following: A September article in The Wall Street Journal noted that employees of Merrill Lynch, Morgan Stanley and Lehman Brothers had lost significant amounts of their retirement holdings in 2008 because they held substantial amounts of their respective company's stock. When the article was published, Merrill Lynch and Morgan Stanley employees had lost an estimated $400 million and $500 million respectively in 2008, and Lehman Brothers employees had lost about $200 million in the past year and a half.³

Even Blind Squirrels Find an Occasional Acorn

There is a great likelihood that each time there is a crisis, someone will have forecasted it with amazing accuracy. But that ignores two important facts. The first problem is that there are tens of thousands of these "gurus" making forecasts all the time. Given the number trying, we should randomly expect some to make accurate forecasts. For example, the crash of October 1987 was forecast with amazing accuracy by a little known analyst named Elaine Garzarelli. Having made such a prescient forecast, she was immediately elevated to guru status and everyone started seeking her opinions. She never came close to replicating a call like that, despite repeated attempts. It also did not help her as a fund manager. While her 1987 forecast helped her fund outperform the market, the fund underperformed five of the next six years before it was folded into another fund.

Each crisis seems to produce another such guru. This crisis produced Nouriel Roubini, professor of economics and international business at NYU's Stern's School of Business, who was among the first to predict the current economic crisis. A problem with Roubini (and almost all forecasters) is that we don't know how many other forecasts he has made and the track record of those forecasts. Perhaps the most interesting thing about Roubini is that, despite his forecast, his retirement account had a 100 percent allocation to equities. It seems that Roubini knows enough to ignore his own forecasts as they are not likely to lead to abnormal profits.

When it comes to economic forecasts, investors should remember the words of William Sherden, author of The Fortune Sellers. He said that the First Law of Economics was that for every economist, there is an equal and opposite economist - for every bullish economist, there is a bearish one. His Second Law of Economics was that they are both likely to be wrong. Sherden's research found no economic forecasters who consistently lead the pack in forecasting accuracy.⁴

Trust but Verify

The Bernard Madoff scandal - perhaps the largest in the history of the investment banking industry with losses reaching as high as $50 billion - was avoidable. Relying on social connections and reputations is to rely on hope, and hope is not an investment strategy. Investors that followed the basic principles of prudent investing would not have been taken in.

Investments should only be made within the framework of a highly regulated industry where there is complete transparency. An obvious requirement is that there must be audited financial statements from a well-known and highly regarded CPA firm. Audits verify the financial statements of the money manager as well as check correspondence with the custodians, brokers and transfer agent of the funds to confirm reported trades and securities held. The fund's accounting should be performed independently of the money manager. And the fund's assets should be held with an independent, regulated custodian such as a bank or trust company.

Summary

The key to successful investing is to stick to your well-developed plan until you reach your financial goal. And, if you don't have a plan, write one immediately. And make sure the plan includes Plan B - the actions you are prepared to take if the unexpected does happen.

¹ Warren Buffett, Chairman's Letter. March 1, 1993.

² Allan Sloan and Doris Burke, A Turkey Roast. Fortune, December 8, 2008.

³ Jason Zweig, Wall Street Lays Egg With Its Nest Eggs. The Wall Street Journal, September 27, 2008.

⁴ William Sherden, The Fortune Sellers, (Wiley, 1998).

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.

Madoff Scandal Draws Attention to Hedge Fund Risks

Jim Cornfeld — Mon, 29 Dec 2008 17:47:00 GMT

^{Overview: Investors around the country and around the world may have experienced some panic when the scandal involving Bernard Madoff - described as a $50 billion Ponzi scheme - became known. Some investors may be wondering if their assets may fall prey to the same kind of situation. The following discusses why investors in mutual funds are not exposed to the same kinds of risks.
_______________________________________________________
What do the Royal Bank of Scotland, Nomura Holdings (Japan), the Elie Wiesel Foundation for Humanity, Yeshiva University, Tremont Group Holdings, Steven Spielberg's Wunderkinder Foundation and the owner of the New York Mets all have in common? They are all victims of the Bernard Madoff scandal that might have a cumulative cost to investors of as much as $50 billion.
This loss is a tragedy of epic proportions. However, the real tragedy is that had investors followed some basic rules of prudent investing, the investments would never have been made.
There Is Nothing New in Investing, Only the Investment History You Don't Know
The exclusive nature of the hedge fund "club" creates an aura that seems to attract investors the way swim-up bars attract guests at all-inclusive resorts. Investors seem to value the sense of membership in an exclusive club. They yearn to be members of the "in crowd." In addition to their "sex appeal," hedge funds lure investors with the ever-present hope of market-beating returns. Many aspects of the Madoff affair are depressingly familiar:

Trust in the promoter due to some social affiliation encourages investment.
There is a lack of complete transparency of the investment strategy.
Investors received returns that seemed too good to be true and a lack of audited financial statements.
The whole affair unraveled at an amazing speed.
Investors should also have been aware that the very consistent returns reported by Madoff were inconsistent with his particular strategy of buying puts and selling covered call options on stocks in the portfolio. During bear markets, the strategy should have resulted in losses, though less than that of the overall market. Yet, Madoff was reporting consistent profits. That alone should have alerted investors. (In fact, some potential investors were scared off.)
There is an old saying about something being too good to be true. But if that were not enough, the number of trades that would have been required to execute the strategy far exceeded the number of trades reported on the entire exchange.
In addition to these problems, hedge funds have not only had a hard time keeping up with the risk-adjusted returns of riskless Treasury bills, there is no evidence of any persistence of performance beyond the randomly expected.¹ Therefore, there is no way to identify ahead of time the few winners (who receive all the press).
Perhaps it was the combination of the aforementioned problems and the historical evidence on returns that led Professor Eugene Fama, in an interview with Bloomberg Wealth Manager in November 2002, to state with great prescience: "If you want to invest in something (hedge funds) where they steal your money and don't tell you what they're doing, be my guest."²
Principles of Prudent Investing
At the very heart of our firm's investment philosophy is that our advice is based on scientific research, not our opinions. Strict adherence to that principle has served our clients well. We are just as proud of the investments we have helped our clients avoid as we are of the ones we have recommended.
Our management efforts are focused on the only thing we can control: risk. We do that by designing portfolios that provide our clients with the greatest chance of achieving their financial goals without taking more risk than they have the ability, willingness or need to take.
The scientific research also led us to conclude that the prudent strategy was to capture the returns markets provide. We recognized that while doing so basically meant giving up the hope of outperforming the market, it also meant that we would avoid the risk of underperforming the market (and the evidence demonstrated that this was the far greater likelihood). Thus, the only equity funds we recommend are those that are low-cost, tax-efficient, passively managed asset class funds (such as those of Dimensional Fund Advisors (DFA)). And our fixed income strategy is based on the same principle of earning market returns.
"Pay No Attention to That Man Behind the Curtain"
Madoff was able to execute his massive fraud because he operated behind "a curtain." On the other hand, publicly traded mutual funds operate with a high degree of transparency. Among the advantages of investing in publicly traded investment vehicles are:

Publicly held mutual funds are a highly regulated industry governed by the Securities and Exchange Commission. Hedge funds are basically unregulated.
Mutual funds are required to have audited financial statements. The audits verify the financial statements of the mutual funds including correspondence with the custodians, brokers and transfer agent of the funds that confirms the securities held. In the case of DFA, PricewaterhouseCoopers LLP, a major accounting firm, performs annual audits.
Mutual funds do not act as custodian of the assets. In the case of our clients, their funds are primarily custodied at either Schwab or Fidelity.
Mutual funds do not perform the fund's accounting themselves. In the case of DFA, fund accounting is performed by PNC Bank.
In addition to these benefits, the following is also an important consideration. There is no incentive for DFA to take risks to try to outperform. (The failure of such efforts often leads down the path to perdition as fund managers seek to recoup losses.) DFA does not attract assets the way hedge funds do by weaving stories about how they can beat the market or earn market rates of return while taking less risk. DFA's goal is simply to earn market rates of return. There are no incentive fees (to tempt managers to take risks) as is the case with hedge funds. And the historical evidence demonstrates that the returns earned by DFA's funds are consistent with their stated strategy. There are no episodes of either dramatic outperformance or underperformance beyond that which would be randomly expected.
Eggs and Tennis Balls
If you drop an egg and a tennis ball off the table, the egg will shatter while the tennis ball will bounce back. Investors who made the mistake of investing in opaque investments with Madoff have seen their portfolios shatter like the dropped egg. Once shattered, there is no recovering. On the other hand, those investors that have suffered losses in their public equity holdings at least have the opportunity to see their asset values bounce back, like the tennis ball. And history suggests that if they have the discipline to stay the course, the odds greatly favor their being rewarded for their patience.
Summary
Among those who experienced the greatest losses from the fraud perpetrated by Madoff are some of the largest banks and some of the largest hedge funds. Each of them touted their ability to identify the money managers who would deliver market-beating returns on a risk-adjusted basis. They proudly discussed their superior due diligence efforts that serve to protect investors. As the academic evidence has demonstrated, such claims are without merit.
The saddest part of this great tragedy is that if investors had known the historical evidence and followed the basic rules of prudent investing, this tragedy would have been avoided. It is hard to understand why anyone would give their hard-earned assets to someone who:

Invests those assets in a way that is not completely transparent
Lets investors take 100 percent of the risks while taking 22 percent of the returns
Provides returns to investors in a tax-inefficient manner
Demonstrates no evidence of any persistence of performance beyond the randomly expected
Simply put, it is the triumph of hype and hope over wisdom and experience. And hope is not an investment strategy.
¹ For more information on hedge funds, see Chapter 15 of The Only Guide to Alternative Investments You'll Ever Need.
² Lynn O'Shaughnessy, Brain Trust. Bloomberg Wealth Manager, November 2002.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.}

Does the Price You Paid Affect Your Decision to Hold?

Jim Cornfeld — Tue, 02 Sep 2008 21:02:00 GMT

You are a wine connoisseur. You purchase a case of a new release at $10 per bottle and store the wine in your cellar. Ten years later, the wine is selling for $200 per bottle. Do you buy more, sell your stock or drink it?

Faced with this decision, few people would sell - but few would buy more. And given the appreciation in value, many might choose to save it to drink on special occasions. The decision not to sell, but also not being willing to buy, is not completely rational. This decision is being influenced by the "endowment effect." The fact you already own the wine (an endowment) should not impact your decision. If you would not buy more at a given price, you should be willing to sell at that price. Not being willing to buy wine at the $200 price demonstrates that it represents a poor value to you and thus should be sold.

The endowment effect causes individuals to make poor investment decisions. It causes investors to hold on to assets that they would not purchase, either because they don't fit into the asset allocation plan, or they are viewed as so highly priced that they are poor investments from a risk/reward perspective.

The most common example of the endowment effect is that people are very reluctant to sell stocks/mutual funds that were inherited from a deceased relative. I have heard people say, "I can't sell that stock. It was Grandpa's favorite, and he'd owned it since 1952." Or, "That stock has been in my family for generations." Or, "My husband worked for that company for 40 years. I couldn't possibly sell."

Another example of the endowment effect is stock that has been accumulated through stock options or some type of profit-sharing/retirement plan.

Financial assets are like bottles of wine. If you wouldn't buy at the market price, you should sell, not hold. Stocks and mutual funds aren't people - they have no memory, they don't know who bought them, and they won't hate you if you sell. An investment should be owned only if it fits into your current asset allocation plan. Its ownership should be viewed in that context, and only in that context.

You can avoid the endowment effect by asking this question: If I didn't already own the asset, how much would I buy today as part of my overall investment plan?

If the answer is, "I wouldn't buy any," or, "I would buy less than I currently hold," then you should either immediately sell the asset (my recommendation) or at least develop a disposition plan.

There is another consideration when disposing of an "endowment asset." There may be substantial capital gains taxes involved. If so, consider donating the stock to a charity. By donating the asset in lieu of cash you would have donated anyway, you avoid the capital gains tax.

Tax avoidance is another reason investors become subject to the endowment effect. They hate paying taxes. But there is only one thing worse than having to pay taxes - not having to pay them. For example, do you think that investors in once great companies such as Polaroid or Xerox would have been happy to pay the tax, rather than holding on and eventually not having to pay it because the stock price plummeted?

The endowment effect is one of the many ways that emotions lead to investment errors. The best way to avoid such errors is to have a written investment plan to which you adhere. Do you have a written plan? Do you adhere to it?

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.

Is Your Home Exposure to Real Estate?

Jim Cornfeld — Fri, 08 Aug 2008 18:55:00 GMT

Diversification is critical to prudent investing because it reduces risk. To be effective, diversification must be across assets that have low correlation. Real estate has low correlation with other asset classes and thus is an effective diversifier that should be considered when constructing your portfolio. A problem arises, however, if you consider your home as your real estate allocation.

While a home is real estate, it is undiversified by type and geography. There are many types of real estate: office, industrial, hotel, and so on. A home is exposure to just the single-family sector of the asset class. And home prices might be rising in one part of the country and falling in another.

Another problem is that home prices may be more related to an industry than to real estate. For example, home prices in oil producing regions fell in the 1980s when oil prices collapsed, yet real estate investment trusts (REITs) returned 16 percent per annum during that decade.

A related problem is that employment prospects can be correlated with the value of your home. The problem compounds if your investment portfolio is loaded with stocks in the same industry to which your home is exposed. This is often true of executives who own stock/options in their company.

The following example illustrates the potential problem. Seattle was once a "company" (Boeing) town. An executive at Boeing who owned an expensive Seattle home and had a large percentage of her financial assets in Boeing stock might have thought she had some diversification of assets because of that home. However, there have been several periods when Boeing has been impacted by a recession in the airline industry. Overall, how did Boeing employees fare?

The company's stock, reflecting those troubles, fell sharply. Strike one.
Boeing reacted by firing many employees. Strike two.
With unemployment rising, Seattle home prices collapsed. Strike three.

The problem was that all of the risks - employment, stocks, home - to which our investor was exposed were highly correlated. This is less of a problem today in Seattle, but there are many places where this could be an issue.

Owning a home and considering it exposure to real estate is like being an executive with lots of stock/options in Microsoft and thinking you have exposure to large-cap growth stocks. The correlation of one stock to its asset class can be low. Stocks might be up, but your stock might be down. Similarly, REITs provided solid returns in 2006, yet home prices fell in many locations.

Another problem with treating your house as exposure to real estate is that you cannot rebalance or tax manage like you can with equities.

Don't Forget the Mortgage

If you financed your home, any mortgage should be considered a negative bond position, and netted against other fixed income holdings when calculating your asset allocation. The type of mortgage should also be considered. A fixed rate mortgage provides protection against rising rates. And if interest rates decline, you can refinance, providing protection against falling rates. On the other hand, the rate on adjustable rate mortgages change as interest rates change, exposing you to the risk of rising rates. Therefore, you should consider how a home is financed in developing your investment strategy.

Summary

While a home is real estate, the best way to obtain exposure to the asset class is to purchase an index fund (or exchange-traded fund) that invests in a broad spectrum of REITs. Treat your home as a consumption item, albeit one with value that should be on your balance sheet, just not part of your investment strategy.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.

Do You Avoid Admitting Your Investment Mistakes?

Jim Cornfeld — Fri, 25 Jul 2008 20:21:00 GMT

Behavioral finance studies have found that the average individual tends to be risk-averse. For example, behavioralists have found that to entice average people to accept placing bets, odds need to be in their favor.

Similarly, the field of behavioral finance has found individuals tend to feel the pain of a loss more intensely than the joy from a gain. Individuals tend to avoid admitting their investment errors, and the failure to admit such errors can lead to expensive mistakes.

One of the most common errors caused by the behavior known as "regret avoidance" is that investors continue to hold securities that have losses, feeling that as long as they don't sell, the loss is only theoretical, just a "paper" loss. For some, the act of selling is an admission that an error was made. This perception, plus the mental pain incurred when losses are realized, causes investors to be reluctant sellers.

A Different Way to View the Situation

How many times have you said to yourself, or heard others say the following: "I will sell as soon as the price gets back to what I paid for it."

The right strategy is that you should only continue to hold the asset if you would buy it today. In other words, what you paid for a security should have no bearing (except for the tax consideration) on whether you should continue to hold it. Ask yourself how the stock (or mutual fund) fits into your overall investment plan. If you didn't currently own any, would you buy it today? If your answers indicate the security wouldn't fit and you would not buy any, then you should sell immediately. The reason is simple: By owning the security you are effectively making a buy decision.

The same logic applies to load funds. You might be reluctant to sell load funds because you feel that the load would be wasted. Unfortunately, once the load has been paid, it becomes a "sunk cost" - gone whether you hold or sell. If you own a load fund, ask yourself whether you would buy the fund if it waived the load. If the answer is no, it would be prudent to sell.

Harvesting Losses

When you have an asset in a taxable account with a significant unrealized loss, you should consider the opportunity to sell and "harvest" the loss, especially if the loss is short term. Short-term losses are deductible at the higher ordinary income tax rate, instead of lower long-term capital gains rates. By realizing a loss, Uncle Sam shares some of your pain. If the asset with an unrealized loss still fits within your plan, consider these two options.

First, you can sell and repurchase the same security after 30 days, avoiding the "wash-sale" rule that would render the loss non-deductible. Second, swap the asset for a similar - but not substantially identical - security. For example, sell an S&P 500 Index fund and simultaneously buy a Russell 1000 Index fund as the two are relatively comparable. After 30 days have passed, you can reverse the swap.

Conclusion

You can prevent the paralysis induced by regret avoidance by remembering the following:

Base buy and sell decisions on a long-term investment policy.
Realize losses to obtain the tax benefit.
Remain true to your original investment objectives.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.

Variable Annuities

Jim Cornfeld — Fri, 11 Jul 2008 20:15:00 GMT

A variable annuity (VA) is a mutual fund-type account wrapped inside an insurance policy. According to one estimate, by 2005, VAs outstanding exceeded $1 trillion. The abundance of VA sales is not a result of the demand. Instead, it seems mostly the result of the efforts of commission-based salesmen. Let's examine three investment-related motivations for considering a VA.

Reason 1: Tax-Deferred Growth

Annuities allow for the tax-deferred growth of earnings. That "benefit" comes at a high price - the conversion of long-term capital gains into ordinary income. According to a 2005 working paper on VAs by Jeffrey R. Brown and James M. Poterba, "Even with a horizon of 40 years, under the [2003] new tax rates, variable annuities provide a higher net of tax return only if the expense differential is under 25 basis points." Yet, the authors estimated that the average VA has expenses of 1.65%.

And holding equities in a VA also causes the loss of the potential for a step-up in basis for the estate of the investor, the inability to harvest losses, the inability to donate appreciated shares to charity and the loss of the foreign tax credit. And should the buyer need liquidity prior to age 59½, unless the distribution takes the form of a life annuity, an additional 10% penalty would apply.

Reason 2: Insurance Component

Among the most common version of insurance is if the policyholder dies before annuitization begins, the heirs will receive the return of premiums paid. According to a 2001 article in the Journal of Risk and Insurance, while the median Mortality and Expense risk charge is 1.15%, the benefit is only worth between 0.01% and 0.1%, depending on purchase age.

Reason 3: Ability to Annuitize

Annuitization is the conversion of an annuity's value into a stream of income guaranteed for the policy holder's lifetime. While we cannot know what percent will eventually be annuitized, a 2000 paper reported that only about 1% of VAs had been annuitized.

Other Negatives

Investments inside the typical VA are both expensive and actively managed. Given the historical evidence on such funds, investors likely pay high prices for poor performance.

Sold vs. Bought

Why are so many VAs sold? It is because it is often in the best interest of the seller, not the buyer. The typical VA involves a high commission - 6%, or even more. The high commission may be why commissioned-based annuities also come with early surrender charges. The SEC became so concerned about abusive sales of VAs that they issued an "agency alert." They have also posted information to educate investors: www.sec.gov/investor/pubs/varannty.htm.

Reasons to Buy an Annuity

There are actually a few situations where the purchase of an annuity may make sense.

A) An individual wants to invest in a tax inefficient asset class such as REITS and does not have any room in tax-advantaged accounts. This makes sense if the annuity is low-cost, no surrender charge, and preferably has passive investment options. TIAA-CREF, Vanguard, AEGON, and others offer such VAs. Such annuities might also be good choices for those investors who currently own high cost VAs. A 1035 exchange from one annuity to another occurs without triggering taxes.

B) To one degree or another, many states protect assets in VAs from creditors. Doctors worried about malpractice suits, for example, might consider VAs. Because the laws are complex investors should consult their attorney before buying a VA for this purpose.

Summary

Investors are often tempted to buy products that offer seemingly attractive benefits. Unfortunately, the benefits are often either illusory or are accompanied by excessive costs. This is why VAs generally fall into the category of products meant to be sold, not bought. Education (or a fee-only advisor who is unbiased by commissioned-based compensation) is the armor that can protect investors from being misled.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.

Retirement Withdrawal Strategies

Jim Cornfeld — Fri, 27 Jun 2008 16:41:00 GMT

Overview: What is the generally accepted order by which an investor should make tax-efficient withdrawals for retirement? With a focus on asset location, this article introduces several points for investors to consider when building their own prudent strategy for making withdrawals from retirement accounts, including situations in which an investor may benefit from deviating from that generally accepted sequence.

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A winning investment strategy is about much more than choosing the asset allocation that will provide the greatest chance of achieving one's financial goals. It also involves what is called the asset location decision. Academic literature on asset location commonly suggests that investors should place their highly taxed assets (such as bonds or REITs) in tax-sheltered accounts and their tax-preferenced assets (such as stocks) in taxable accounts.

In general, the most tax-efficient equities should be held in taxable accounts whenever possible. Holding them in tax-deferred accounts can result in the following disadvantages:

Long-term capital gains are converted into ordinary income (upon withdrawal)
The possibility of a step-up in basis for tax purposes is lost
For foreign equities, foreign tax credit is lost
The potential to perform tax loss harvesting is lost

One part of this strategy includes using the most tax-efficient withdrawal sequence to fund retirement. A recent paper by William Reichenstein titled "Tax-Efficient Sequencing of Accounts to Tap in Retirement" provides some answers. For example, Reichenstein posed the question, "Should a retiree withdraw funds from the taxable account then the traditional IRA and then the Roth IRA or would another sequence be preferable?"¹

According to Reichenstein, "Returns on funds held in Roth IRAs and traditional IRAs grow effectively tax exempt, while funds held in taxable accounts are usually taxed at positive effective tax rates."² Reichenstein's paper also said that only part of a traditional IRA's principal is the investor's. The IRS "owns" the remaining portion, so the goal is to minimize the government's share.³

For those able, but not yet required to take distributions from tax-deferred accounts, it is typically most practical to withdraw from taxable accounts first. The withdrawals would be taxed at capital gains rates instead of ordinary income rates. Also, it may be preferable to sell tax-inefficient assets (such as bonds or REITs) held in taxable accounts before selling more tax efficient assets.

There are some exceptions to these rules:

If the main source of income comes from tax-sheltered accounts, withdrawals should be made from these accounts until taxable income at least reaches the lowest tax bracket. This exception should apply to any year when taxable income is low. For example, an individual with sizeable medical bills due to an extended stay in a nursing home would likely be in a lower tax bracket.
Other withdrawal sequences may be preferable if the IRA's beneficiaries will be in a higher tax bracket than its owner.
According to the paper, "Retirees who have substantial unrealized gains on taxable assets and will await the step-up in basis at death should withdraw funds from retirement accounts before liquidating the appreciated asset."⁴ An example would be a terminally ill person. The reason: The effective tax rate on the capital gains will be zero if they await the step-up in basis at death.
Delaying withdrawals from an IRA can mean a higher tax bill if the tax rate later rises to higher levels. In addition, if a retiree is in a lower tax bracket but doesn't need to withdraw funds from the IRA to meet spending needs, he or she should consider a conversion to a Roth IRA. Thus, it may not be appropriate to delay withdrawals from traditional IRAs for as long as possible (until age 70½).

Many individuals are also faced with deciding whether to withdraw from a traditional IRA or a Roth IRA. Consider what Reichenstein said about the decision.

"Withdrawing funds from the traditional IRA makes sense 1) in years when the retiree is in a low tax bracket and 2) if the retiree's beneficiary will be in a higher tax bracket. ... Withdrawing funds from a Roth IRA instead of a traditional IRA makes sense 1) in years when the retiree is in a high tax bracket and 2) if the retiree's beneficiary - whether an individual or a charity - will be in a lower tax bracket. ... In addition, Roth IRA withdrawals should be preferred if the retiree expects to have large deductible medical expenses later in retirement."⁵

Finally, he found that sequencing strategies are sensitive to the following:

The higher the tax rate, the greater is the advantage from first withdrawing from a taxable account. If capital gains taxes were increased, the advantage would increase. The advantage would also increase if an investor held an actively managed mutual fund that was tax inefficient because of its turnover.
The paper stated this "Taxable 1st strategy" has a strong advantage when a portfolio is generally evenly divided between retirement accounts and taxable accounts. In addition, such advantage can increase with an asset's rate of return.

Reichenstein's paper suggested it is important to fund retirement spending in the right sequence. Doing so should allow retirees' financial portfolios to last longer than would otherwise be the case. Finally, it is important for investors to consult a tax advisor before implementing any strategy.

¹ William Reichenstein, Tax-Efficient Sequencing of Accounts to Tap in Retirement. TIAA-CREF Institute, October 2006. Available at www.tiaa-crefinstitute.org/research/trends/tr100106.html. Accessed April 13, 2007.

² Ibid.

³ Ibid.

⁴ Ibid.

⁵ Ibid.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.

Stay Close to Home or Let Your Bond Portfolio Roam? Muni Bond Geographic Diversification

Jim Cornfeld — Fri, 20 Jun 2008 20:49:00 GMT

Overview: Following is a discussion of the benefits of diversifying an individual municipal bond portfolio geographically instead of only purchasing municipal bonds issued within your home state. The main advantage of geographic diversification is that it can reduce over-exposure to risks that might result from local events such as a natural disaster or political changes.

Introduction

Many investors feel that buying bonds from within their state offers them distinct advantages. The primary advantage would be tax benefits, since many municipal bonds are state and local tax exempt. (They are also almost always federal tax exempt.) However, tax benefits should not preclude consideration of out-of-state issues when building an individual bond portfolio. While it can - and often does - make sense to purchase some bonds within your home state, it is imprudent to build an entire portfolio from them.

In fact, even investors who reside in high-tax states (like California with one of the highest state tax rates in the country) can benefit from a diversified bond portfolio.

Hometown Connection Could Bring Additional Risk

There can be many risks associated with having a portfolio that is not geographically diversified. For example, after Hurricane Katrina, many New Orleans residents might have experienced a "three strikes, you're out" situation. For those who lived and worked in New Orleans and held a significant portion of their fixed income portfolio in bonds issued by the city of New Orleans (or the state of Louisiana), it is likely that they were simultaneously exposed to significant losses in the bond portion of their portfolio, falling real estate prices and uncertainty regarding their employment status. The problem with staying too close to home is that all of the risks incurred in employment, real estate, and other investments are highly correlated.

Diversifying Reduces Risk

Often, individuals can feel a personal connection to state-specific projects. For example, knowing it is possible to monitor the project's progress in the local newspaper, an investor might deem a local highway improvement bond to be "safer." However, we would argue that investors who fill their portfolio with their local community's bonds incur a greater amount of risk than they may realize.

Specifically, geographically diversifying a portfolio can reduce the risks caused by significant changes in a community or state. We will focus on two risks: 1) damage from natural disasters and 2) changes in the political landscape.

Damage brought on by extreme weather and natural disasters could reduce the credit rating of a bond, negatively affecting bond holders.

In the same way, legislative decisions can have adverse effects on a bond. For example, a decrease in a state's tax rate could also decrease the relative advantages for investors owning that state's bonds.

At that time, a resident of that state would receive less of a benefit for owning in-state bonds and might decide to purchase other available bonds (perhaps bonds issued by other states) that would now be more competitive with bonds of their home state.

Here's why: The benefit an investor would receive would be lower because of the state's lower tax rate. The yield investors could obtain on another bond from outside of their state - that may be subject to a state tax - would not be disadvantaged as much due to their own state's lower state tax rate. In addition, even taxable investments may now compare more favorably, even though they would be subject to federal and/or state taxes.

How to Proceed

When seeking geographic diversification and competitive yields, it is possible to find both in the bonds of other states, such as those that don't have state income taxes. However, it is important to remember that each municipal bond portfolio is different and should be customized based on the financial objectives of each investor.

The process of diversifying a portfolio begins with a portfolio analysis, checking the existing bonds' state of issuance and maturities. It is possible that the fixed income portfolio is already naturally geographically diverse and warrants only minor changes.

In closing, investors with individual municipal bond portfolios might wish to consider the benefits of geographically diversifying their fixed income portfolio with out-of-state bonds. By carefully selecting specific bonds with the help of an investment advisor who has expertise in building custom bond portfolios, the investor can seek to reduce the risk of the overall fixed income portfolio via geographic diversification, while minimizing adverse tax consequences.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.

The Wrong Ways to Approach Life Insurance

Jim Cornfeld — Fri, 30 May 2008 23:19:00 GMT

Overview: In this lighthearted article, we look at two surveys and a prominent company collapse that help demonstrate some of the misconceptions people have regarding insurance.

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Misconception 1: The Likelihood of Collecting a Policy Is a Factor in Buying

A common reaction to discussing life insurance needs is to assume most people have the need for coverage. However, many people are unsure who should (or should not) be covered.

A 2005 survey by the Life and Health Insurance Foundation for Education helps demonstrate this point. The survey asked which of five fictional characters was most in need of life insurance: Batman, Spiderman, Marge Simpson, Fred Flintstone or Harry Potter.

Holy Preconceived Notions, Batman!

It seems respondents put a little too much emphasis on the dangers faced by each character. Spiderman and Batman were chosen as the two characters most in need of life insurance, garnering 28 and 18 percent of the vote, respectively.

Neither character, however, demonstrates a large need for life insurance. Peter Parker (Spiderman) has no dependents and his significant other, Mary Jane, is an accomplished actress and model who would not need to be supported after his death. Bruce Wayne (Batman) is not married, has no dependents and is exceptionally wealthy. He does not appear to have any need for life insurance.

Fred Flintstone, on the other hand, may show the greatest need for life insurance. Fred, who finished third in the survey at 16 percent, is the primary wage-earner for his family, and his wife and daughter would need support if he met the grim reaper.

Harry Potter finished fourth with 15 percent of the vote. His battles with evil wizards and his games of Quidditch may put him in a high-risk category, but he has no parents or siblings, and thus no one who would be affected financially by his demise. And, lest we forget, James and Lily Potter did leave Harry a vault filled with gold at Gringotts Wizard's Bank!

Poor Marge Simpson. Just like on the long-running television show "The Simpsons," she gets little respect for how much she means to her family. Marge received 11 percent of the vote, placing her last among the characters in the survey. (Note: 18 percent chose none of the above or don't know.)

However, Marge's role as the family's caretaker should not be understated. Her husband, Homer, works full-time at the nuclear plant, and the few times he has had to take care of the family have ended in near disaster. Marge's premature death would mean the family would at least need a caretaker for the three children and help around the house.

The likelihood of collecting a policy should not be a major determinant in how much life insurance a person needs. Generally, people need life insurance if they have dependents who will be affected by their untimely death.

Misconception 2: Similar Situations Need Similar Policies

Identifying who needs life insurance can be tricky enough, but for those who need it, how much is enough? A separate survey by the LIFE Foundation in 2006 illustrates another common misconception regarding life insurance.

The survey involved asking people which of five TV dads needs the greatest amount of life insurance: Cliff Huxtable, Tony Soprano, Mike Brady, Ray Barone or Homer Simpson.

In another triumph of danger over need, mob boss Tony Soprano received the most votes with 25 percent. There's little doubt he has the most dangerous occupation, but he is also likely "self-insured" by having large amounts of money stashed away.

Mike Brady, on the other hand, received the fewest votes among the TV dads, finishing with just 10 percent. This happened despite Mike being the sole breadwinner supporting his wife, their six children and a housekeeper.

When choosing life insurance, people need to take the whole picture into account. Instead, completing a full assessment of life insurance needs would be the most practical way to approach the subject. Attaching a number to the need requires an in-depth look at each individual's situation, such as income, assets, debts and current and projected major expenses.

Misconception 3: Big Companies Must Be Great Companies

In the 1980s, Executive Life Insurance Company grew to be one of the top 20 companies in the insurance industry.

Yet things weren't as they seemed. The company was heavily invested in junk bonds, with about 66 percent of its assets in such investments. At the time, the industry average for junk bond holdings was 6 percent of assets.

Toward the end of the decade, Executive Life's parent company was forced to take a $515 million charge due to its bond portfolio declining. Junk bonds continued to decline, and in April 1991, California regulators seized control of Executive Life, marking the largest failure of an insurance company at that time.

"A new era began on April 11, 1991, when Executive Life, a large company based in California, was taken over by insurance regulators. The public then learned it is possible for a major company to fail," said Joseph Belth, editor of The Insurance Forum.

Should the public have seen this coming? That depends on what information was available. The company's financial troubles were being disclosed, and some people were indeed cashing out their policies.

On the other hand, the insurance ratings system sent policy holders mixed signals. A.M. Best issued an A rating, meaning excellent, to Executive Life, though it said the company could be downgraded. Standard & Poor rated the company BBB, meaning good, and Moody's gave it a Ba2 rating, meaning questionable.

Granted, the ratings systems have changed considerably since the collapse of Executive Life. For example, A.M. Best upgraded its rating system less than a year after regulators took over Executive Life. Still, the insurance company's collapse highlights that size is not a big factor in choosing a life insurance company.

"You should buy from a financially strong insurance company," Belth said. "Doing so increases the likelihood that the policy's benefits will be paid when they fall due."

Conclusion

Meeting with a financial advisor can help address any confusion about insurance and risk management needs. Specifically, a financial advisor can help determine the need for and amount of coverage and the appropriate companies to pursue.
A financial advisor can also review older policies to ensure those policies are still relevant and adequate to handle current and future needs.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.

What to Do With Your Company-Sponsored Retirement Plan

Jim Cornfeld — Tue, 20 May 2008 22:43:00 GMT

Overview: As more members of the baby boomer generation enter retirement, tremendous amounts of wealth are being transferred in the form of retirement plans. The following discusses options investors should consider regarding their retirement plans.

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Introduction

The baby boomer generation describes the population born between 1946 and 1964, estimated to be about 80 million individuals. A July 2006 report by the Government Accountability Office stated that the wealthiest 10 percent of boomers averages $1.2 million in retirement accounts and makes up more than two-thirds of the estimated $7.6 trillion of retirement savings. As these individuals enter retirement, the result is potentially the largest transfer of wealth from company plans to individually controlled accounts in history.

Options

For individuals leaving their jobs, there are three basic options for how to handle the assets in their company-sponsored retirement plans:

Keep the funds in a company-sponsored retirement plan, either with the previous employer or with a new employer if switching jobs.
Roll over the funds to an IRA.
Withdraw the funds in a lump-sum distribution.

It is important to understand the advantages and disadvantages of each before choosing an option.

Option 1: Leaving the Money in a Company-Sponsored Plan

Some of the advantages of keeping assets in a company-sponsored retirement plan (whether it is left in an old plan or transferred to a new plan) include continued tax-deferred growth without penalties and the fact that participants can borrow against the funds. Also, some plans do not require participants to take distributions after they reach age 70½ as long as they continue to work, thus allowing for longer periods of tax-deferred growth.

A significant disadvantage to leaving the funds in a plan is that individuals give up control and flexibility. For example:

Investment choices are often limited to those selected by the employer plan.
s For some plans, participants over a set retirement age may be forced to start taking distributions according to guidelines mandated by the plan.
Many plans do not allow the stretch options that IRA rules permit. Stretching an IRA involves the account passing to a beneficiary after the account holder's death and the beneficiary taking distributions from the IRA based on his or her life expectancy.
The guidelines of the plan are subject to change.

One of the major benefits of leaving assets in a company-sponsored retirement plan used to be that they would be protected from bankruptcy proceedings, while IRAs would not. However, the U.S. Supreme Court ruled in April 2005 that IRAs can also receive the same federal creditor protection in bankruptcy proceedings as qualified plans.

Option 2: Rolling Funds Into an IRA

A retirement plan rollover allows for continued tax-deferred growth and more control and flexibility over retirement funds when leaving a job. There are two types of rollovers:

A direct rollover occurs when assets transfer from an employer-sponsored plan directly into a rollover IRA.
An indirect rollover is when the employer-sponsored plan issues a check payable to the former participant, who distributes the money to an IRA within 60 days.

It should be noted that choosing an indirect rollover involves the chance that the check is not deposited within an IRA during the 60-day window. Investors who miss that window may be subject to mandatory state or federal withholding taxes as well as a 10 percent penalty.

Benefits of a rollover to an IRA include:

Investors have numerous investment options, allowing them to customize their investment choices to meet their personal needs and risk tolerance.
The assets will continue to grow tax-deferred.
Consolidating several employer-sponsored plans into one IRA makes management simpler and easier. For example, each plan will have its own distribution requirements and withdrawal options.
Investors who re-enter the workforce can roll the funds back into a new company's plan.
IRAs may offer individuals and their beneficiaries more flexible and tax-favored distribution options than a retirement plan.

Option 3: Taking a Lump-Sum Distribution

The lump-sum distribution option may be enticing because it gives individuals instant access to the cash in their retirement plan and gives them the most flexibility with how to use it. For example, it may be an easy solution for paying off debt, covering expenses between jobs or making a much needed (or wanted) purchase.

For individuals with a large percentage of company stock in their retirement plan, the IRS gives them a special tax break for taking a lump-sum distribution of this stock. Called the Net Unrealized Appreciation (NUA) rule, individuals are allowed to pay ordinary income tax on the original cost of the stock rather than its fair market value at the time of withdrawal. Once the stock is sold, the individual pays taxes at the 15 percent capital gains rate on this appreciation only. If the stock were instead rolled into an IRA, this tax break would be lost, and the value would be subject to ordinary income tax rates when IRA funds are distributed.

However, the costs for choosing the lump-sum option are perhaps the steepest of any of the options. For example:

The plan may require a 20 percent mandatory withholding for federal income taxes from the distribution. In addition, the federal tax liability could be greater as the distribution may significantly increase taxable income in the year taken.
A 10 percent distribution penalty will be added to the taxes for participants under age 59½.
The distribution will result in the loss of tax-deferred growth of the assets.

Thus, if there is no immediate urgent need for the cash and the NUA rule does not apply, there is little reason for taking a lump-sum distribution out of the tax-deferred environment and subjecting the funds to taxes and potential penalties.

Summary

The rise of account-based defined contribution plans (not to mention the uncertainties about Social Security) makes retirement security more dependent on individual saving and rates of return.

As a result, investors may need to become more educated about financial issues, both in accumulating sufficient assets and in learning to draw them down effectively. Part of that could involve investors seeking help from their investment advisor regarding their retirement plans.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.

Equity Markets and Recessions

Jim Cornfeld — Wed, 14 May 2008 14:10:00 GMT

With the U.S. economy currently in recession, investors may be tempted to move assets out of equity markets and into historically safer investments. The following discusses how equity markets have behaved before, during and after recessions and why moving assets may not be in investors' best interests.

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How do stocks perform before, during and immediately after economic recessions? What about the performance of small-cap and value stocks? One way to address this question is to consider the historical record. We did, and here is what we found.

We examined the periods six months prior to a peak in economic activity, the recession that followed and the six months following the trough in economic activity. The period of recessions varied from as short as seven months (January 1980 through July 1980) to as long as 17 months (November 1973 through March 1975, and July 1981 through November 1982). The study covers the period 1945-present and includes 11 different recessions. For the purposes of this study, we used the definition of a recession as provided by the National Bureau of Economic Research (NBER):

"The NBER does not define a recession in terms of two consecutive quarters of decline in real GDP. Rather, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production and wholesale-retail sales."

The results can be seen in the table below.

Monthly Average Return for All Periods
	Six Months Before Peak	During Contraction	Six Months After Trough
Market minus T-Bill	-0.35%	0.20%	1.69%
Small-cap minus large-cap	0.25%	-0.01%	0.92%
Value minus growth	0.35%	0.38%	0.37%

Source: Dimensional Fund Advisors

The "Market minus T-Bill" row shows the equity premium, or the performance of U.S. stocks in aggregate. The negative average equity premium for the six months preceding a peak explains why economists view the stock market as a leading economic indicator: A drop in stock prices generally precedes (and helps forecast) an economic downturn. It is important to understand the direction of this relationship. Economists look to the stock market for an early indication of where the economy is headed. Alas, this does not work in the other direction: As we shall see, an investor (or advisor) cannot tell where the stock market is going, based on the observed performance of the economy.

The equity premium has been positive on average (0.20 percent per month) during economic recessions. So, even if we knew that a recession was just about to begin, the historical data would provide no good reason to move assets from stocks to bonds. More importantly, the months immediately following an economic trough have been exceptionally good for stocks. The opportunity cost of missing the stock returns in those months was several times greater than the cost of having been fully invested in stocks in the months preceding the peak in economic activity.

The table shows that neither small-cap stocks nor value stocks are leading economic indicators, as both premia have been positive on average during the six months preceding a peak.

Small-cap stocks underperformed large-cap stocks by a minimal margin, 0.01 percent per month on average. In many cases, the cost of changing the allocation (adopting a large-cap bias) would be of the same order of magnitude. And, just as for stocks in general (the equity premium), the opportunity cost of not being exposed to small-cap stocks in the months immediately following the end of recessions would have been substantial, 0.92 percent per month on average.

Finally, by examining the value premium, we see that it does not seem to be related to economic cycles at all - at least on average across all recessions included in the study. Over the entire period, the value premium was about the same, on average, in the months leading up to recessions, during the recessions themselves, and in the months immediately following the recessions.

How can this information be used? During the past few months, investors may have experienced significant losses in their equity holdings. Recent losses, coupled with reasonable suspicion that the economy may be headed toward recession (or in recession already), have many investors concerned about their equity positions. Some investors may be tempted to sell their equity holdings and move into fixed income, or transition from a small-cap or value tilt to a large-cap or growth tilt, far from their target IPS allocations. The data shows the inherent danger in selling out of stocks in times of weak economic performance. Given the extreme difficulty of accurately predicting when the economy is at a trough and on its way to recovery, investors may not only sell at a bad time (when prices are low), but also miss out on the substantial gains that, on average, follow a recession.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.

All the Tea in China

Jim Cornfeld — Thu, 01 May 2008 22:59:00 GMT

Overview: Recent hot investment trends have favored markets in China and India, and given a cold shoulder to the trouble-plagued U.S. real estate market. Should investors try to capture gains and avoid losses by reallocating in response? Among our critical roles as our clients' investment advisor is to encourage them to tune out trends and focus on the long-term.

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History teaches that in investing, patience and fortitude -- or benign neglect -- are more beneficial than activity. To rephrase the familiar admonition: "Don't just do something, stand there!"

- Charles Ellis, Winning the Loser's Game

A couple of decades ago, it was Japan. Japan gave way to technological innovation and all things "www." Before that, there was the golden age of -tronics. Even when capital markets formed back in the 1600s, among the first corporate stock offerings ever - the Dutch East India Company - was quickly all the rage.

Some things never change. These days, it seems that renewed interest in the economies of India and China have caught the attention of Wall Street, with the usual pressures to "buy now!"

A few lucky investors will no doubt have their success stories. We allow them their 15 minutes of fame, even as we advise clients to ignore any temptation to reallocate their portfolios in response.

Among our primary roles as a trusted investment advisor is to reinforce that long-term investing is not about placing bets. It's about relying on carefully managed, globally diversified portfolios to pursue long-term investment objectives while minimizing the accompanying risk. This is the game at which we want to help investors win. Often, the best way to do so is to hold firm.

Not yet convinced? Consider two additional observations.

Stay Ahead of the Game

With our approach to portfolio construction, we typically help investors spread their equity portfolio across a broad range of globally diversified markets. And we help them keep it diversified via disciplined rebalancing. Thus, if an emerging markets allocation (China, India, etc.) makes sense for an investor, he or she already is positioned to capture its gains in a goal-based, cost-effective manner. As such, passive investors who may worry that they're missing out on a hot trend can remember that, quite the opposite, they are likely already there ahead of the crowd (to the degree that it is appropriate for their individual investment objectives).

The Grass Isn't Always Greener

Last year, those interested in marketing timing were heard inquiring about investment opportunities in India and China, and eschewing holdings in the real estate asset class based on a troubled U.S. real estate market. How did such an approach fare? At the end of the first quarter for this year:

The MSCI Emerging Markets India Index (USD) returned -27.1 percent (minus 27.1 percent).
The MSCI Emerging Markets China Index (USD) returned -23.7 percent. (minus 23.7 percent).
Both were down more than any broad-based asset class, in most cases by more than double.
The only asset classes that provided positive returns were commodities, fixed income ... and real estate.

Even if the data weren't quite so conveniently supportive of our point, we would continue to counsel investors to ignore the latest stock market beauty contest and stay the course with their carefully constructed investment plan. There is simply too much academic evidence and too many clear illustrations throughout history indicating that the "sure thing" of today too often becomes tomorrow's sure example of a past investment foible.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.

The Case of Bear Stearns

Jim Cornfeld — Thu, 03 Apr 2008 21:34:00 GMT

Overview: A little more than a year ago, Bear Stearns stock hit $171 per share. On March 16, JP Morgan announced it would acquire the company for $2 per share. JP Morgan has since offered $10 per share. The following are some lessons that investors should keep in mind as Bear Stearns' situation unfolds.

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JP Morgan's announcement that it would acquire Bear Stearns, the fifth largest investment bank in the United States, for $2 per share shocked the investing community, including investors who held substantial stakes in the company. The tale of Bear Stearns can serve as a reminder for investors about the importance of prudent investing. Here are some of the lessons Bear Stearns helped reinforce.

Individual Stock Speculating

British billionaire Joseph Lewis earned the nickname "The Boxer" not only because of the similarity between his name and the famous pugilist Joe Louis, but also because of his approach to his business ventures. One of his endeavors involved amassing a significant stake in Bear Stearns, giving him ownership of more than 8 percent of the company, and he was continuing to add more stock. On March 13, one of Lewis's entities purchased 569,000 Bear Stearns shares at $55.13 per share, a far cry from the $10 per share offered by JP Morgan.

Billionaires were not the only individuals hurt by investments in Bear Stearns. A financial consultant purchased 4,000 shares of Bear Stearns on March 14 at $30 per share, just before JP Morgan's initial offer. The investor said the loss, which would have been a $112,000 paper loss under the original terms of the deal, would have a significant impact on his family's finances.²

Such tales highlight the dangers of speculating on individual stocks. Prudent investors realize that while the rewards of sinking large percentages of assets into few securities can be sizeable, it is perhaps just as likely that they will see their investments lose value.

Diversification

It is hard to top the long-term performance of Bear Stearns stock. Bear Stearns stock had an annualized return of 24.8 percent per annum from 1986 through 1999, compared with 18 percent for the S&P 500 Index. The bear market of 2000-2002 failed to deter the stock, as its total return for the three-year period was 44.2 percent, compared with -37.6 percent for the S&P 500.

As if a strong track record wasn't enough to make investors shift their holdings to dominant stakes in Bear Stearns stock, the financial media may have helped some investors decide to load up. While the market was experiencing notable volatility, a Barron's article from August touted investments in Bear Stearns, even though the stock was also experiencing volatility. Prior to the article's publication, the stock rose to $142 per share in mid-July, dropped to $99 per share the Monday before the article's publication, rose to $125 per share two days later, then settled at $110 that Friday.³

Still, the article identified the company as an attractive takeover option for financial firms. The article's Bottom Line section summed up the article: "Bear Stearns is battered, but if it emerges intact from its latest crisis, it eventually could be sold at a price close to double its current price."⁴

A prudent strategy is to diversify assets. While investors who had concentrated positions in Bear Stearns suffered greatly, investors that owned globally diversified portfolios likely had a small percentage of their assets in Bear Stearns stock, even when it traded at its peak. This is clear demonstration of the importance of diversifying equity risks.

Confusing the Familiar With the Safe

Such a situation can be especially difficult for company employees who held large amounts of Bear Stearns stock in their retirement plans. A March 18 article in the Wall Street Journal (WSJ) stated that "employees at the firm are now worried not only about their jobs, but they are also helplessly watching their company-stock holdings plummet. Bear Stearns, which employs 14,000, is about one-third owned by its staff."⁵

We can only wonder exactly how much of the net worth of Bear Stearns employees was tied up in company stock because they "knew" what a great company it was. And surely they would know if there were problems. It is safe to assume those employees would not have invested in Bear Stearns stock if they were employed elsewhere. Bear Stearns was not any safer because the individuals worked there. Yet, many of those employees confused the familiar with the safe.

As the WSJ points out, confusing the familiar with the safe can be a problem with any firm, not just firms with records such as Bear Stearns: "One Citigroup Inc. executive who receives deferred stock as part of his bonus, said ‘I've heard people saying they have nothing but Citi in their 401(k). That is the classic mistake.' And a veteran Citi broker said, ‘Don't limit your investments to your company stock. That's standard advice to our clients,' and now ‘the same advice we give to ourselves.'"⁶

Summary

Bear Stearns appeared to be a strong investment right up to the day JP Morgan announced it was buying the company. Instead, the company became another example of the importance of following a diversified approach to investing in equities. Prudent investors should remember the lessons reinforced by Bear Stearns.

¹ Aaron Lucchetti, Lewis Signals Interest in Stopping Bear Deal. Wall Street Journal, March 20, 2008.

² Paul Waldie, JP Morgan's Bid for the Bear Leaves Investors Feeling Caged. The Globe and Mail, March 20, 2008.

³ Andrew Bary, The Opportunity in Bear Stearns' Adversity. Barron's, August 13, 2007.

⁴ Ibid.

⁵ Daisy Maxey, Jaime Levy Pessin and Ian Salisbury, The Job/Stock Double Whammy. Wall Street Journal, March 18, 2008.

⁶ Ibid.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.

Lessons From 2007 (Part 4 of 4)

Jim Cornfeld — Fri, 28 Mar 2008 13:18:00 GMT

Overview: Every year the market provides investors with lessons on the prudent investment strategy. 2007 was no different. This is the final installment of Larry Swedroe's annual review of some of the important lessons the capital markets gave us during the previous year.

Click here for Part 1

Click here for Part 2

Click here for Part 3

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Lesson 6: It's Called Risk Premium for Good Reason

From 1927-2006, value stocks provided an annual return about 5 percent above that of growth stocks. However, 2007 was a very different story. The subprime mortgage crisis led to a flight to quality across all financial assets:

Treasury bonds outperformed investment grade bonds.
Investment grade bonds outperformed junk bonds.
Large-cap stocks outperformed small-cap stocks.
Growth stocks outperformed value stocks.

This type of performance is not unusual. In fact, it is very typical of a financial crisis. Two relatively recent examples are from 1990 and 1998. In 1990, the savings and loan crisis was occurring. While the S&P 500 fell just 3.1 percent that year, small-cap stocks fell by 20 percent and small-cap value stocks fell 22 percent. In 1998, the world was experiencing the Asian Contagion. A crisis in several emerging market countries spilled across borders, and the events eventually led to the spectacular failure of Long Term Capital Management, which was the largest hedge fund in the world at the time. The S&P 500 turned in a good year (up almost 29 percent) that year, but small-cap stocks fell 2.3 percent and small-cap value stocks fell 10 percent.

Value stocks are stocks that exhibit characteristics of risky investments. For example, they tend to have high volatility of earnings and dividends, and tend to be more highly leveraged than growth stocks. Also, these companies typically have fewer sources of capital and tend to be cut off from these sources first during crises (like those of 1990, 1998 and 2007). While there are some academics who believe that the value premium is a behavioral story (that is, investors persistently overpay for growth stocks and overestimate the risks of value companies), it seems hard to argue against the risk-based story when value stocks often underperform when there is a financial crisis.

There are a few lessons here:

Value stocks have a risk premium for a good reason. These are stocks of risky companies and the risks will show up from time to time.
The evidence from academic studies suggests there is no way to time the value premium.

In other words, a streak of several years of value stocks outperforming tells you basically nothing about what the value premium will be in the next year. Sometimes value stocks outperform for a couple of years, and sometimes they go on long winning streaks. In fact, the streak of value stocks outperforming growth stocks from 2000-2006 was not that unusual. There have been other fairly long streaks: 1961-1965, 1972-1977 and 1940-1948.

On the other hand, the longest streak of growth stocks outperforming value stocks has been just three years: 1937-1939, 1978-1980 and 1989-1991. Investors seeking to capture the value risk premium must be prepared to accept that risk and stay the course.

Lesson 7: How Not to Make or Keep Wealth

Morningstar dedicates a large amount of resources to identifying the great money managers. It rates about 5,000 mutual funds, giving just 500 its coveted five-star rating. But why settle for the top 500? Why not invest in just the very best in each asset class? In November 2001, Morningstar created its Aggressive Wealth Maker and Wealth Maker portfolios. In May 2002, it added the Wealth Keeper Portfolio. Each portfolio contains less than 10 funds. It's Morningstar's effort to identify the best of the best.

How has Morningstar done? In last year's article "Lessons From 2006," it was noted that the three portfolios were trailing their benchmarks. This year is not much different, as all three of the portfolios still trail their benchmark portfolios that consist of simple broad market index funds. From inception through the end of 2007, the Aggressive Wealth Maker trailed its benchmark by 1.4 percent per annum, the Wealth Maker by 1.3 percent per annum and the Wealth Keeper by 1.8 percent per annum. And we should note that the hurdle is actually too low as Morningstar includes small-cap and value oriented funds in its portfolios while the benchmarks contain only total market index funds. Since small-cap and value stocks have outperformed broader market indexes, Morningstar's portfolios had a tail wind at their backs aiding their performance. Unfortunately, it has not been enough.

The lesson is that there is a reason the SEC requires that mutual fund advertisements contain the disclaimer about past performance. While investing in actively managed funds does give you the hope of outperformance, the far greater likelihood is that it will lead to underperformance.

Summary

Like most years, 2007 provided many reminders of the principles of a prudent investment strategy:

Build a globally diversified portfolio of passively managed funds that reflects the investor's unique ability, willingness and need to take risk.
Formalize that plan by creating an investment policy statement including a rebalancing table.
Adhere to that plan.

One key to achieving that objective is to ignore all economic and market forecasts, the noise of the market and the emotions that noise can cause. Doing so will also allow you to spend more time on the really important things in life, such as your family, friends and community.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.

Lessons From 2007 (Part 3 of 4)

Jim Cornfeld — Mon, 17 Mar 2008 00:48:00 GMT

Overview: Every year the market provides investors with lessons on the prudent investment strategy. 2007 was no different. This is the third installment of Larry Swedroe's annual review of some of the important lessons the capital markets gave us during the previous year.

Click here for Part 1

Click here for Part 2

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Lesson 4: Yesterday's Masters of the Universe, Tomorrow's Cosmic Dust

For believers in active management, the equivalent of finding the Holy Grail is identifying a manager who can persistently beat the market. The hero for many had been Bill Miller, manager of the Legg Mason Value Trust (LMVTX). 2005 was the 15^th consecutive year his fund beat the S&P 500 - the longest streak on record. To the faithful, surely 15 years was the result of skill and not random luck.

On the other hand, perhaps the streak was purely a lucky one. In 2006, the fund returned 5.9 percent, underperforming the S&P 500 by 9.9 percent. Perhaps that was just one bad year, and the market just did not see what Miller saw as real value. Unfortunately, the fund repeated that dubious feat in 2007, losing 6.7 percent and underperforming the S&P 500 by 12.2 percent. The past two years left the fund with a three-year record of underperforming the S&P 500 by 7.3 percent per annum.

Was Miller a skillful manager who had just lost his touch? Or was he lucky and Lady Luck had abandoned him? How is an investor to know which is the correct answer? What should an investor in the fund do now? If an investor chooses to stay with the fund, how long should that investor wait before giving up? What if Miller turns the performance around after investors sell the fund?

There is even more bad news. Most of Miller's great returns came when the fund was much smaller. The great returns attracted huge cash flows, which kept increasing as his streak continued. The worst performance came when the fund had the most dollars. Thus, the returns actually earned by many investors in the Legg Mason Value Trust are well below the returns reported by the fund.

Of course, this is not the fault of the fund. Instead, the fault lies with investors who chose to ignore the evidence from academic studies that there is virtually no persistence of performance beyond the randomly expected, at least among winners. (Losers tend to repeat losing because of high expenses.)

As history suggests it would, the fund experienced large outflows in 2007. Investors withdrew almost $10 billion of assets in the third quarter of 2007 from the Legg Mason family of funds. Thus, even if Miller manages to once again outperform, many investors will not be there to benefit.

Other Funds

It is also worth noting that the domestic fund with the longest current streak of outperforming the S&P 500 also saw its streak end. Cambiar Opportunity (CAMOX), which had beaten the S&P 500 for eight consecutive years, lost 1.9 percent in 2007 and underperformed the S&P 500 by 7.4 percent. The fund's three-year performance trailed the S&P 500 by 1.6 percent per annum.

The lesson is that ignoring the SEC's warning about relying on past performance of actively managed funds is the financial equivalent of ignoring the surgeon general's warning about the dangers of smoking.

Lesson 5: The Importance of Portfolio Diversification

Insurance plays an important role in managing threats to financial security. People insure against the risks to their homes, cars and personal property. And they insure against premature death (life insurance), medical expenses (health insurance and long-term health care insurance), disability and even longevity (lifetime payout annuities).

The same principles of prudent risk management apply to investment portfolios. There are two asset classes - collateralized commodity futures (CCF) and Treasury inflation-protected securities (TIPS) - that provide a form of portfolio insurance because their returns are negatively correlated with the returns of stocks and nominal return bonds (bonds whose returns are not indexed to inflation). When an asset produces higher than average returns, its negatively correlated counterparts tend to produce below average returns. Thus, the addition of negatively correlating assets to a portfolio dampens the volatility of the overall portfolio and reduces volatility's negative impact on compound returns.

Both TIPS and CCF provide hedges against inflation risks, and CCF also provides a hedge against some event risks (such as an interruption of oil supplies). Academic research and historical evidence suggest that adding these assets will likely produce less volatile and more efficient portfolios (portfolios with higher risk-adjusted returns). In 2007, both TIPS and CCF produced above average returns. The Vanguard Inflation Protected Securities Fund returned 11.6 percent and the PIMCO CommoditiesRealReturn Fund returned 23.2 percent.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.

Lessons From 2007 (Part 2 of 4)

Jim Cornfeld — Fri, 07 Mar 2008 23:44:00 GMT

Overview: Every year the market provides investors with lessons on the prudent investment strategy. 2007 was no different. This is the second installment of Larry Swedroe's annual review of some of the important lessons the capital markets gave us during the previous year.

Click here for Part 1

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Lesson 2: Globalization and Diversification

One of the more common recent investment themes revolves around globalization. The thought is that the correlation of returns of stocks around the globe is rising with increased globalization, reducing the benefits of international diversification. This train of thought suggests that no one needs to invest internationally. Instead, just invest in U.S. multinational companies, such as those that dominate the S&P 500.

Using the passive funds of Dimensional Fund Advisors (DFA), the following table presents the 2007 returns of the four major U.S. equity asset classes and their international counterparts. The returns for the various emerging market asset classes are included.

Fund	Change From 12/31/06 to 12/31/07
Domestic
DFA US Large	+5.4%
DFA US Large Value	-2.8%
DFA US Small	-3.1%
DFA US Small Value	-10.8%
International
DFA International Large	+12.5%
DFA International Large Value	+10.2%
DFA International Small	+5.7%
DFA International Small Value	+3.0%
DFA Emerging Markets	+36.0%
DFA Emerging Markets Small	+38.0%
DFA Emerging Markets Value	+45.6%

Source: Dimensional Fund Advisors

The benefits of global diversification should be obvious. The important lesson is that broad global diversification is part of a prudent strategy.

Lesson 3: Last Year's Winners Just as Likely To Be This Year's Dogs as They Are to Repeat

The historical evidence demonstrates that many individual investors are performance chasers - they buy yesterday's winners (after their great performance) and sell yesterday's losers (after the loss has already been incurred). This causes investors to buy high and sell low - not exactly a recipe for investment success.

Unfortunately, streaks in asset class returns occur randomly relative to expectations. Such streaks have no more meaning than streaks at the craps table - a good (poor) return in one year does not predict a good (poor) return the next year. In fact, above average returns lower future expected returns, and below average returns raise future expected returns. Thus, the prudent strategy for investors is to act like a postage stamp, which does only one thing, but does it exceedingly well: It adheres to its letter until it reaches its destination.

Similarly, investors should adhere to their investment plan. Adhering to one's plan does not mean just buying and holding. It means buying, holding and rebalancing - the process of restoring the portfolio's asset allocation to the plan's targeted levels.

Using DFA's passive funds (as well as PIMCO's CommodityRealReturn Fund), the following table compares the returns of various asset classes in 2006 and 2007. As you can see, some 2006 winners repeated, but some became losers.

Fund	2006 (Rank)	2007
DFA Emerging Markets Value	37.9% (1)	45.6% (1)
DFA Emerging Markets Small	37.3% (2)	38.0% (2)
DFA Real Estate	35.3% (3)	-18.7% (13)
DFA International Value	34.2% (4)	10.2% (6)
DFA Emerging Markets	29.2% (5)	36.0% (3)
DFA International Small Value	28.4% (6)	3.0% (9)
DFA International Large	24.9% (7 tied)	12.5% (5)
DFA International Small	24.9% (7 tied)	5.7% (7)
DFA U.S. Small Value	21.6% (9)	-10.8% (12)
DFA U.S. Large Value	20.2% (10)	-2.8% (10)
DFA U.S. Small	16.6% (11)	-3.1% (11)
DFA U.S. Large (S&P 500)	15.7% (12)	5.4% (8)
PIMCO CommodityRealReturn Fund (Institutional)	-3.5% (13)	23.2% (4)

Source: Dimensional Fund Advisors

It is also worth taking a little longer perspective. From 2003 through 2006, DFA's Real Estate, U.S. Small Value and Emerging Markets funds returned 28.7, 27.2 and 36.7 percent per annum, respectively. In 2007, DFA's Real Estate and U.S. Small Value funds lost 18.7 percent and 10.8 percent, respectively. However, the DFA Emerging Markets Fund once again produced favorable returns, with a return of 36.0 percent.

The lessons are that investors need to ignore the emotions that bull (greed and envy) and bear markets (fear and panic) create and that disciplined rebalancing is the winning strategy.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.

Lessons from 2007 (Part 1 of 4)

Jim Cornfeld — Tue, 04 Mar 2008 00:10:00 GMT

Overview: Every year the market provides investors with lessons on the prudent investment strategy. 2007 was no different. The following is Larry Swedroe's annual review of some of the important lessons the capital markets gave us during the previous year.

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Like many years, 2007 was filled with news that might have made investors sell stocks if they had a perfectly clear crystal ball. Let's review some of the bad news.

International Events

The showdown with Iran over its nuclear weapons program dominated the headlines. And Pakistan, a nuclear power already threatened by terrorism in the region, experienced a political crisis.

Commodity Prices

The price of a barrel of oil more than doubled to end the year at about $96. The price of many other commodities, including gold and silver, also rose dramatically. This raised the threat of inflation, which is a negative for both the stock and bond markets.

The Falling Dollar

The dollar collapsed against most major currencies, including the Canadian dollar and the euro. The headlines contained predictions about global investors abandoning the dollar.

Financial Mess

The U.S. capital markets experienced one of the most significant financial crises in history, fueled by turmoil in the subprime mortgage market. And with globalization, the holdings of subprime debt had spread around the world. The losses from the subprime mortgage meltdown are already in the tens of billions. This led to a general flight to quality, a drying up of liquidity in lending markets (not just mortgage-related lending), and a resulting widening of credit spreads. The central banks of the world had to orchestrate massive efforts to provide liquidity and keep the markets functioning.

Housing Recession

The U.S. housing market experienced its worst recession since the Great Depression. This created the threat of an overall recession.

Hedge Funds

Several large hedge funds experienced huge losses due to market volatility.

Lesson 1: Stay the Course

One can only wonder how many investors abandoned their investment plans in the face of all this bad news. Despite the bad news, the markets performed well overall. Treasury bond yields fell across the board in spite of rising commodity prices and the threat of a falling dollar. Thus, with the exception of junk bonds (and other risky credits), fixed income investments produced strong returns. Both the S&P 500 Index and Vanguard's Total Stock Market Index Fund produced returns of about 5.5 percent. And with the exception of small-cap and small-cap value and real estate asset classes, most equities around the globe provided good returns as well.

The lesson is that not only should investors ignore economic forecasts, but also that even if events were forecast accurately, investors still might make poor investment decisions based on that information. Thus, the prudent strategy is to have the right investment plan in place - one that reflects the investor's ability, willingness and need to take risk. Having such a plan gives investors a much better chance of ignoring the fear and panic caused by bad news.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455

The Five Curse Words of Market Volatility

Jim Cornfeld — Fri, 15 Feb 2008 21:23:00 GMT

Overview: When the market experiences significant volatility, investors get bombarded with messages about what they should do with their investments. The following discusses the messages pitched to investors and why investors should simply tune them out.

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On January 22, the Dow Jones Industrial Average (DJIA) dropped more than 460 points early in the day. The index swung back before the market closed, but still finished down 128 points, marking the fifth straight day of declines. The DJIA finished down 15.5 percent from its October 2007 high.

Other indexes experienced losses that day as well:

The S&P 500 Index fell 1.1 percent, down 16.3 percent from its peak.
The Russell 2000 Index dropped 0.2 percent, pushing it further into traditional bear market territory. It was down 21.5 percent from its record high.
The Chicago Board Options Exchange's volatility index (VIX) jumped to 37.57, its highest intraday level since October 2002. The VIX finished the day with a reading of 31.01.

While the market was oscillating, the talking heads on TV were having a field day, peppering their audiences with predictions and advice on how to deal with the market fluctuations.

Five "Bad" Words

Many of these commentators were using the curse words of investing, or as the Wall Street Journal's (WSJ) Chuck Jaffe put it, "the dirty words that seemingly have been on everyone's tongue over the past few weeks as stock-market turmoil has ordinary folks ready to abandon long-term plans in favor of safe havens."¹

1. Now

With the market spinning out of control, what should investors do now?

Many investors have been trying to avoid the pitfalls of falling stock prices. For example, trading at the New York Stock Exchange on January 22 hit 6.4 billion shares, the second-heaviest trading day in the exchange's history.

Did trading help some investors? Possibly. Did trading hurt some investors? Probably.

As Peter Lynch, legendary manager of Fidelity Magellan, said, "Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves."²

There are some steps investors can do right now: Read their investment plans and see if anything has changed. If so, they should address those changes with their financial advisor. If not, they need to remember the goal of an investment plan. It is not to make the most money this week. It is to provide a sound plan for the long term.

2. Next

The next thing to do is ...

It's funny how these commentators can tell investors what their next move should be. They do not know their audience's financial situation. They don't know their investment plans. They don't know if these investors are married or divorced, with or without children, or nearing retirement or just starting out in the workplace.

The truth is that the advice being dispensed may be good advice, and may appear to be the next logical step. It just might not be the right advice for everyone. As the WSJ noted, "Even if the advice is spot on (and studies of the financial press make it clear that doesn't happen all that often), there is no way to know if the message is appropriate for everyone who receives it."³

Investors listening to such advice should recognize it for what it is: A means of keeping people tuned in to the program. A lot of channels would get changed if the airwaves were filled with people saying "Just stay the course."

3. Must

Here's what investors must do to get through this ...

It certainly sounds like an enticing proposition (one of many that investors may have heard): Move assets around, concentrate in a few key spots and ride out the volatility.

After experiencing the turbulence that occurred on January 22, such advice would have likely sounded even better the following day, as the DJIA dropped more than 320 points by midday.

However, in keeping with the theme of volatility, the DJIA went through a 630-point swing to finish up nearly 300 points for the day. It was the biggest intraday swing since 2002.

As the WSJ's Jaffe said, "For most investors, however, success is built on having a plan filled with securities they believe in and not on changing directions every time the wind blows and brings out some new list of what someone must do now with today's top performers and best strategies for whatever market conditions come next."⁴

4. Top

Here are the top funds or asset classes for these conditions ...

The following disclaimer is repeated fairly often: Past performance is not a guarantee of future results. Still, situations like the current market volatility can make investors forget this cardinal rule of investing.

One study by the Financial Research Corporation (FRC) compared the return of mutual funds in the 1990s to the actual returns earned by investors.⁵ The FRC found that while the funds show a 10.92 mean three-year average annualized return, investors received returns of only 8.7 percent. The FRC also found that an average of $91 billion in net new cash flowed into funds in the quarters following high returns. After funds' worst-performing quarters, they received only $6.5 billion in new money, suggesting that these investors were chasing good past performance.

"The moral of the study is that investors who make investment decisions ... in pursuit of big stock market gains are more likely to lose out on the long run," said Jack Sharry, president of Phoenix Investment Partners, which commissioned the study.⁶

Instead of trying to time the market by being in the right fund or asset class at the right time, investors should continue following their investment plans, which were crafted with their particular situations in mind.

5. Best

The best thing for investors is ...

If the answer is anything but "to stick to your personally crafted investment plan," investors may want to stop listening. It's alright for individuals to turn off their television sets or change the radio station. It's also alright for individuals to read the sports section of their newspaper and forgo stories on recent market activity. Market volatility has happened before and it will likely happen again.

That is why proper investment plans are built for the long term. They are designed to give investors the best chance of fulfilling their financial goals. It is important that investors understand how their plan works and continue following it.

Summary

Volatile markets can create a time of uncertainty for investors. Not only are they watching their investment performance start to resemble a roller coaster, but they get bombarded with information from "experts" who tout ways to smooth out the ride.

Investors should remember why they hold diversified portfolios. One of the benefits of diversifying portfolios is that they are better equipped to handle severe market fluctuations. Investors who hold such portfolios are better able to ignore all the noise and to focus on the long term.

¹ Chuck Jaffe, Beware of ‘Now, Next, Must, Top and Best.' Wall Street Journal, January 24, 2008.

² Peter Lynch, Fear of Crashing. Worth, September 1995.

³ Chuck Jaffe, Beware of ‘Now, Next, Must, Top and Best.' Wall Street Journal, January 24, 2008.

⁴ Ibid.

⁵ Lee Barney, Chasing Hot Funds Translates to Diminished Returns, Study Finds. TheStreet.com, January 17, 2001.

⁶ Ibid.

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