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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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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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.

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.

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.

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.
 

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.   

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.

Missing Best and Worst Days
 

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: 

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.

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.

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.

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. Please contact us if you have any questions at 314.725.0455.

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.

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.

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.

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. Please contact us if you have any questions at 314.725.0455.

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:

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.

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.

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.

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.

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.

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.

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.