1st Quarter 2011 Client Commentary
Dear Valued Client:
The first quarter is always an interesting juxtaposition of seasons in the Northeast as we transition from the coldest months of Winter to the beginning of Spring. The changing of the season always reminds us that no matter how interminable the Winter seems, it always gives way to Spring. It is just a matter of conditioning yourself mentally and physically to endure until it arrives. The analogy to investing is obvious; that the investment seasons change as well, and that the environment we are in currently, be it Winter or Summer, will not persist forever. The Spring gives us another important lesson as well, reminding us that nothing in nature follows a straight line. Days, and sometimes weeks, of warm pleasant weather can be abruptly interrupted by cold snaps and even snow storms as late as the last week of March. But even in spite of these ups and downs, we never lose faith that Winter will give way to Spring and eventually Spring to Summer. So it is with investing. Recessions will follow periods of economic expansion, and bull markets will follow bears. Like Spring, we can’t predict the path it will take, but we never lose faith that one will follow another, and so we need to continue to be mindful as we plan your investment portfolio to meet the challenges that lie ahead.
Seven Laws of Investing
In a paper released in March, James Montier, from the investment firm GMO, wrote of the’ 7 Immutable Laws of Investing.” They are presented below, with a few slight alterations:
- Always insist on a margin of safety
- This time is never different
- Be patient
- Be contrarian
- Risk is the permanent loss of capital
- Be leery of leverage
- Never invest in something you don’t understand
These neatly sum up the core of our approach to investing, and we thought it would be useful to expound a bit on each, and how they are reflected in our approach to investing.
Always Insist on a Margin of Safety
As many of you know, one of our priorities with all of our clients is to confirm that they have adequate cash reserves set aside. This fundamental margin of safety is the amount necessary to meet any emergency needs that may arise from unexpected loss of income, or other extraordinary expense, without needing to tap other resources at a time that may not be advantageous to do so. Investors who did not have adequate reserves, and were forced to raid their portfolios in the latter half of 2008 or early part of 2009 experienced a permanent loss of capital since the assets that were withdrawn were not available to take advantage of the recovery which we are now experiencing.
In our client portfolios, we make sure that we identify and balance the various risks that your investments present to provide a margin of safety; we balance the risk of equities with fixed income and alternatives, we balance the risk of active management with passive index funds, we balance the risk of over concentration in the US Economy through foreign exposure, and so on. The balancing of risk provides a margin of safety since it is rare that every market is impacted by events in the same way. Even in 2008, when it seemed that all investments went down equally, exposure to US Treasuries lifted the Barclays Aggregate Bond Index more than 5%. This is one reason why we never build single asset portfolios. Reliance on a single asset class, whether all bonds or all stocks, represents an unacceptable amount of risk with no margin of safety during market declines.
This Time is Never Different
Sir John Templeton declared that the 4 most dangerous words in investment are “this time it’s different,” and this has played out in grand fashion over the last 12 years. An unprecedented run up in growth stocks to end the last century, followed by an unprecedented run up in real estate prices both justified by the phrase ‘this time it’s different.’ It is never truly different. The market moves in cycles, and always will. What is most favored today will be the most despised at some point in the future. You can spend your time trying to predict how this will play out, or you can accept that this is the case and design an approach to investing that uses this to your advantage. An asset allocation based approach does just that. As the ‘favored’ part of the portfolio grows, you are forced to sell it off in order to keep the overall balance. With the proceeds you buy what is currently ‘despised,’ having confidence that at some point, we don’t know when, the tide will turn, as surely as Winter will give way to Spring.
Be patient
Patience is probably the greatest virtue in investing. Being able to weather the often extreme daily ups and downs of the market, and keeping your eye on your long-term goal is a challenge. But we believe it is the best way to achieve your goals. Investing in areas that seem hopelessly out of favor also takes patience. We believe, however, that patience and discipline will not only allow you to better weather the ups and downs of the market, it also will periodically present you with opportunities, such as having capital to invest in equities at the bottom because you continued to invest in Treasury bonds, whether directly or through a pooled vehicle like a mutual fund or exchange-traded fund, when they were far and away the worst performing investment in the year leading up to 2008.
Be contrarian
As the noted economist, John Maynard Keynes, who during his tenure as manager of the ‘Chest Fund’ at King’s College in Cambridge achieved an annualized return in excess of 9% to the UK Stock Index’s -1%, wrote, “My central principle of investment is to go contrary to general opinion, on the grounds that, if everyone is agreed about its merits, the investment is inevitably too dear and therefore unattractive.”
Again, our approach to portfolio construction almost ensures a contrarian approach to investing. Staying disciplined, and not being blown about by the day to day movement of the markets, or the day to day commentary of the financial press, forces us to sell what is in favor, in order to buy what is out of favor. So whether it was growth stocks in the 90s or real estate stocks in the early 2000s, the farther they run, the more we sell in order to maintain the balance. What’s more, if we see a particular segment of the market performing well outside of historical norms, we may make a tactical move with regard to that market, again, holding firm to the belief that all markets are cyclical and it is not different this time.
Risk is the permanent loss of capital
Market volatility does not entail any real gain or loss. Losses and gains are only realized when an investment is liquidated. Permanent loss of capital occurs one of two ways: An investment becomes worthless, through default or business failure, or an investment is sold due to volatility, and bought back at a price higher than where it was sold. Both of these risks are lessened by our approach to investing.
First, we diversify your investment portfolio ensuring that your exposure to any specific company or credit is not such that a default or failure would be catastrophic to you achieving your goals. Diversification is the only way to manage risk to a specific company. The best analysis in the world cannot predict unforeseen events, such as the recent oil disaster in the gulf or the tsunami in Japan, or avoid outright fraud.
The second way our investment process lessens the risk of permanent loss is by focusing on you and your goals. We attempt to ensure that the investment portfolio we build is appropriate for you, and what you are trying to achieve. We often talk about taking no more risk than is necessary to achieve your goals. By taking only the risk that is necessary, we seek to avoid the situation where your losses are more significant than you can bear, both financially and psychologically. Any investment discipline is only as good as your ability to follow it.
Be leery of leverage
Leverage is borrowing money in order to enhance returns. It can produce outsized returns if it works in your favor. However, it cuts both ways. Real estate is where most of us have some experience with leverage. Suppose you buy a $500,000 house. You put 20% down, and finance $400,000. After staying in the house 5 years it goes up in value by 20%, and you sell it for $600,000. The return on your capital is close to 100%, slightly less because of the borrowing costs, real estate fees, etc. A 20% return was increased five-fold to almost 100% through the use of leverage. However, as many are unfortunately finding out across the country, there is just as much risk on the other side. If the value of the property drops 20%, you lose more than 100%, again because of the costs. This is just as true in other investments as it is in real estate. We, therefore, are very careful with any investment that uses leverage, making sure we understand how and when they are using leverage and how much, in order to understand how much risk we are actually taking in the portfolio.
Never invest in something you don’t understand
A recent AARP article told the story of several retirees who were sold very complicated investment products from the investment person at their bank, and ended up losing large sums of money. The article used these stories to decry an entire class of investment products called structured notes. The writer, however, missed the point. The products are simply tools. It would make no more sense to blame a hammer because someone used it and smashed their thumb. The point that the author missed was that these investors bought something that they did not understand, from someone they probably shouldn’t have trusted, in order to stretch for yield while interest rates are so low.
We evaluate many investment opportunities, and one of our prime criteria is: Do we understand it and what to expect from it? Good past performance is always nice to see, but we have to understand the source of the performance. Is it something that will likely continue? How will it perform in different market cycles? What are the drivers of performance? If we cannot understand it, then it does not pass muster. We have looked at the investments in question in the AARP article on several occasions. They do seem to offer compelling yields, but the terms that come with that yield are so complex, that we don’t have a good understanding of what to expect over the life of the investment, or how much risk they actually entail. For this reason we have opted to not make use of them for our clients.
These Seven Laws of Investing form the backbone of our approach to portfolio construction. They also inform other areas of our financial planning and advising. By following well tested principles, we are able to avoid the traps of the new hot investment, or the ‘it’s different this time’ argument, which inevitably leads to trouble. Each investment decision we make is evaluated through the lens of these seven laws, and we do not commit our clients’ hard earned money until we are sure that each is satisfied. This does not ensure that every investment will be successful. But it does mean that losses that we may experience on unsuccessful investments will not put your long-term goals in jeopardy.
As always, we thank you for your continued trust in Comprehensive Investment Solutions®, LLC.
Sincerely,
Thomas N. Alvaré, CPA/PFS
President
Robert M Vogel, CFP®
Chair, Investment Advisory Committee
Ryan Barrett, CFP® William T. Reynard, CFP®
Financial Advisors
Special Topic: Changes to Your Performance Report
In our continuous effort to improve how we do business, we have made some changes in the first quarter performance report. Although we have had global allocations for many years, the target benchmarks we used in our report did not reflect this. Using only the Russell 3000 for stocks and the Barclay’s U.S. Aggregate Bond Index for bonds, created a target benchmark with no direct international exposure. This is not how we invest, and created differences in returns due to the difference of domestic versus foreign investments. Initially this made sense as we highlighted our use of global investments, but as global investing has become the norm, it no longer provides as much meaningful information.
This change reflects our belief that a truly diversified portfolio must be global in nature, across all asset classes, and that over time the distinction between domestic and foreign companies, which has blurred considerably over the last several decades, will become less and less important.
We are pleased to report, that with new enhancements, we will provide you with more appropriate and comprehensive target benchmarks beginning with your first quarter report. Our target benchmarks will now be comprised of the MSCI All-Country World Index for global equities, and the Barclay’s Global Aggregate Bond Index for fixed income. A brief definition of each is below.
MSCI ACWI (All Country World Index) is a free float-adjusted market capitalization weight index that is designed to measure the equity market performance of developed and emerging market countries. The MSCI ACWI consist of 45 country indices comprising 24 developed and 21 emerging market country indices
The Barclay’s Capital Global Aggregate Bond Index provides a broad-based measure of the global investment grade fixed-rate debt markets. The Global Aggregate Index contains three major components: the US Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate. In addition to securities from these benchmarks, the Global Aggregate includes Global Treasury, Eurodollar, Euro-Yen, Canadian, and Investment Grade 144A index-eligible securities not already in the three regional aggregate indices.
These benchmarks will also be displayed individually as individual asset class benchmarks so you understand how the components of the target performed.
You will notice that the target benchmarks do not include alternatives. Our thinking is that, unlike equities and fixed income, the allocations to alternatives in our portfolio will be subject to more change over time. Additionally, there are many clients who, due to account restrictions, are not able to achieve the target allocation to alternatives. We have however displayed them as separate indexes. This will allow us to see differences in the performance of the alternatives relative to the target benchmark, giving us insight into how they affected the performance of your portfolio.
We will continue to display the Dow Jones-UBS Commodity Index as a representation of our allocation to commodities; however we are changing the benchmark for our real estate from the FTSE/NAREIT Equity REITs Index, a primarily domestic index, to the Dow Jones Global Select REIT Index, again to reflect the global nature of our REIT exposure.
We hope that these changes will provide you with a benchmark that better reflects the strategy with which your investments are managed, making for a more appropriate comparison. We will continue to provide the detailed Market Review below, for those who want more detailed market information at the sub-asset class level.