The Educated Investor

Madoff Scandal Draws Attention to Hedge Fund Risks

2008-12-29T17:47:00Z

^{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.
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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?

2008-09-02T21:02:00Z

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?

2008-08-08T18:55:00Z

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.

Do You Avoid Admitting Your Investment Mistakes?

2008-07-25T20:21:00Z

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.

Variable Annuities

2008-07-11T20:15:00Z

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.

Retirement Withdrawal Strategies

2008-06-27T16:41:00Z

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.

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

2008-06-20T20:49:00Z

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.

The Wrong Ways to Approach Life Insurance

2008-05-30T23:19:00Z

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.

What to Do With Your Company-Sponsored Retirement Plan

2008-05-20T22:43:00Z

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.

Equity Markets and Recessions

2008-05-14T14:10:00Z

Overview: With the U.S. economy showing several signs of 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.

All the Tea in China

2008-05-01T22:59:00Z

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.

The Case of Bear Stearns

2008-04-03T21:34:00Z

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.

Lessons From 2007 (Part 4 of 4)

2008-03-28T13:18:00Z

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.

Lessons From 2007 (Part 3 of 4)

2008-03-17T00:48:00Z

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.

Lessons From 2007 (Part 2 of 4)

2008-03-07T23:44:00Z

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.