Our philosophy on fixed income positions is to remain in high quality rated bonds and for short duration. Falling interest rates typically cause existing bonds to increase in value while the inverse is true of rising interest rates (they typically cause existing bonds to lose value, temporarily).  Rate movements in either direction affect portfolio returns; this is true of any market environment.  Therefore, consider these principles about the bond positions in your portfolio: 1. Interest rate movements are unpredictable – Academic research offers strong evidence that the bond market is efficient and that bond prices and interest rates are not predictable over the short term.  Last year's Wall Street Journal forecasting report surveyed fifty economic forecasters, 43 of which predicted the ten-year U.S. Treasury note yield to move higher over the next year.  Only two predicted rates to fall below three percent.  The ten-year treasury yield fell to 2.95% on June 30, 2010 and rates on thirty-year mortgages fell to their lowest level since Fannie Mae began tracking rates in 1971.  Since no one has a reliable method for determining whether interest rates will rise or fall in the short term, investors should avoid making fixed income decisions based on forecast, media coverage, or "hunches". 2. Pursuing higher expected returns requires more risk taking – Earning a return above short-term government instruments is usually a function of assuming more term and credit risk.  Term risk refers to a bonds maturity date or length of time and credit risk refers to the worthiness or default potential of the borrower.  Bonds with longer maturities and lower credit quality are usually considered riskier and therefore offer higher yields.  Investors who commit their capital for longer periods of time are exposed to the amplified effects of changing interest rates.  Prices and rates move in the opposite direction: when rates rise, the value of bonds decline; when rates fall, bond values rise.  On the credit risk side, the government is considered the strongest borrower.  While creditworthy companies are relatively safe they must still pay investors a higher yield for taking on more default risk.3. Investment strategy should drive fixed income decisions – Investors hold fixed income securities (bonds) for a variety of reasons such as: reducing portfolio volatility, generating income, maintaining liquidity, pursuing higher returns, or to meet a future funding obligation.  Investors seeking long-term wealth appreciation may commit most of their portfolio to equities and keep their fixed income investments short term and high quality to buffer the volatility of stocks.  Therefore you should know the difference between controlling risk and avoiding it.  You cannot eliminate risk, but you can manage your exposure by diversifying across maturities, industries, countries, and currencies, to reduce the impact of rates, inflation, currency valuation fluctuations, and other risks.  Many factors influence the direction of interest rates and these are too complex for anyone to reliably predict.  So rather than placing your faith in "the experts" or reacting to economic news, manage your fixed income component from a portfolio perspective. Simply put the difference between a stock and bond is: owning a piece of the company (a stock), versus lending to the company or government (a bond).  To believe that all bonds will become worthless is to believe that all governments will fail and all companies will fail.  If this is what you truly believe, then you are better off investing in guns, ammunition, canned food, and bottled water.  We manage your fixed income component in both U.S. and International bond portfolios from one-year to five-year duration periods.  Higher creditworthiness (governments) means lower yields, shorter durations (one to five years) also means lower yields.  Our approach is to allocate the risk that you are willing to take on the equity (stock) side of the portfolio where expected returns are much higher per unit of risk.   

       A few days ago a local stock broker sent us some information to read that his company uses to analyze stocks.  I suppose he was doing us a favor by sending us this dissertation, but other than being a cure for insomnia, I’m not sure what good it serves.  The analysis consisted of about 30 pages; company specific relating to forecasts, net income and so on.  What struck me was not just amount of information; but the waste of time, money and resources that went into researching, writing and analyzing it.   I suppose the reports were meant to make predictions about which companies were going to outperform the others.  Instead of getting into why I think stock picking in general is an enormous waste of time and money, I want to talk about making predictions and acting on them.      Is the market going to continue to go up or go down in the next few months?  Are we headed towards a “double-dip” recession?  Will jobs come back soon?  Is gold going to hit $2,000 per ounce?  Is there a gold bubble…asset bubble…fixed income bubble…?  Are we headed to inflation or deflation?  Is the debt crisis that hit Europe going to hit the US?  Is the Fed going to keep printing money?  Are we monetizing the debt and what does that mean?      These are common questions that many people have these days, and the answer to these questions may have a significant impact on your life.  Human nature urges us to make a prediction about one or more of these questions and act on it.  If you think the dollar is going to get weaker, you may put all your assets in gold.  But if you think gold is in a bubble, you may sell all of it and leave your funds in cash.  Actually, most investors will take one of two approaches to these types of questions; they will either try to predict what is coming, or they will ignore everything and do nothing.  However, both of these approaches can be very dangerous to your financial future. Making Predictions      When you make a prediction, you are either right or wrong.  Let’s say you think that it is going to be warm tomorrow, so you dress lightly and don’t wear a coat.  If it is warm tomorrow, then you dressed appropriately, and you can laugh at everyone else who is uncomfortable.  If you are wrong, then you are going to get cold.  What if you predict we are headed for a double-dip recession and pull all of your funds out of the market?  You may be right, or you may be wrong.  Most investors (and “experts”) thought the market was still headed down in 2003, but that year turned out to be one of the best for the stock market in modern memory.  Some predicted that real estate values won’t ever go down.  I think we all know how that turned out.  Some investors and advisors predicted that a well diversified portfolio could not drop substantially in value; looks like that one didn’t pan out either.       Are you starting to see the problem with making predictions?  You could be right four out of five times; but the one time you are wrong could devastate you. Do Nothing      Another approach is to ignore all that is going on and assume that everything is going to work out.  We’ve gone through recessions before after all.  This approach may work out if you are young and still accumulating funds for retirement.  Mathematically, you may even be better off if the market and economy stay down for a while (as long as you have income).  But, let’s say that you are close to retirement and took this approach leading up to the market downturn.       Assuming that everything is fine and understanding that equities have a long-term return of 2 – 3 times inflation may have allowed you to get too aggressive.  You may have had 80% or greater of the value of your retirement assets invested in equities (stocks) while you were just a few years away from retirement.  Then, instead of losing 20% - 30% of your portfolio, you lost closer to half due to the market drop.  That may be fine if you could afford the time to allow your nest egg to recover, but many people don’t have that luxury.      Most of the news that we hear and read may not be beneficial, so one approach is to tune everything out.  By not paying attention, you won’t be tempted to act irrationally.  Ask anyone who has lived in Florida – especially in the Keys.  Virtually every year they are told to evacuate due to a hurricane; sometimes many times per year.  After a while, it would be easy to just ignore the evacuation requests and assume that everything is going to be okay.  Every now and then though, the big one really does hit. Prepare in Advance      The third option is to prepare for what may happen rather than predict.  Preparation will allow us to be ready for what may happen without betting on one outcome or another.  If you think it will be warmer than normal tomorrow, dress lightly, but bring a coat just in case.  We don’t have much effect on what happens in the economy, markets and so on, but we can prepare ourselves to have the best chance of reaching our goals – no matter what they are.      Preparation may not be as sexy as picking stocks or making market predictions, but it will give you the best chance of living the rest of your life with dignity and independence.  That sounds like a pretty good trade to me. -Cory S. Colquette MBA, CPA/PFS    

  What does history tell us about future stock market returns? The obvious answer is that it goes up over time and it can be quite rocky in the short-term. That’s about as deep as some analysts and advisors get; so their advice tends to be, “focus on the long-term because the markets always come back.” That is true on the surface, but let’s dig a little deeper. The “long-term” historical return of the S&P 500 is around 9.8% (from 1926 – 2009). During this tenure we have had many short-term market downturns, or bear markets as we like to call them. We have also had a few intermediate time periods of bad market returns though. The most notable encompasses the Great Depression – the 15-year period that ended in 1943 had only a 0.6% annual return. Granted that is an extreme time period, but if someone was lucky enough to invest at the beginning of 1929 for the next 50 years without taking money out, she would have only gotten about a 7.7% annual return (if invested in the S&P 500).   A 16-year time period ending in 1984 yielded about 7.6% annual return. That doesn’t sound too bad unless you know that inflation over the same period was 7.0%. These are two examples of rather long periods of time with substantially below average returns. Not coincidentally, these two time periods covered two of the roughest economic time periods in our nation’s history (at least since 1926).   Of course, there have also been some quite long periods of much higher than average returns as well. A 31-year period ending in 1972, the S&P had an annual return of 13.7%. Most of us have experienced at least part of the 33-year period that ended in 2007 where the S&P yielded about a 13.3% return. We all like the “good times” of above average returns and relatively low volatility. Investing seems almost easy in these times - put your money in the market, pick a few funds (or stocks) and watch your money grow. The problem comes when investors start to believe these good times are the norm; then they are caught completely off guard when a real downturn hits.   So, where are we now is the big question? No one knows, but if history is any guide, it could be a while before we get back to the “good times” of high market returns. That’s not saying that you shouldn’t invest, but it is good information to keep in mind when making a plan and building a portfolio. Investing may not be quite as easy as it was through the 80’s, 90’s, and 00’s (through 2007); markets may be more volatile and provide lower returns for a while. You should absolutely invest for the long-term, but depending on your situation, short-term swings can have a dramatic effect on your standard of living. As investors get close to and enter retirement, they should be sure to plan for large market swings and potentially lower returns for a while. Not that I’m a fan of John Maynard Keynes, the late economist, but I do like this particular quote: “The market can stay irrational longer than you can stay solvent.”   -Cory S. Colquette, MBA, CPA/PFS  

The last discussion called “Markets Work” we talked about market efficiency.  Effectively, you can’t outsmart the market by stock/bond selection or market timing.  So, how do we invest then if the market is efficient?  Some would say put all your money into an index fund (like the S&P 500) and leave it alone.  While that is better than the typical “stock picker” mentality, there is still a better way.  Financial science has identified certain risk factors or dimensions that drive portfolio returns.  Exposure to these risk factors will increase a portfolio’s expected return over time.  That’s another way of saying, the more risk you are willing to take on, the higher your expected return.  That’s assuming you are taking on the right type of risk. So far, we’ve identified three dimensions that have a large effect on portfolio returns – 1) the market factor, 2) the size factor, and 3) the value or book to market factor.  The market factor basically shows that stocks are riskier than bonds, and thus, have a higher expected return.  There are many time periods though, such as the last 10 years, where this does not occur – bonds outperform stocks.  That’s why we call it a “risk factor” – over time though, stocks tend to generate higher returns, and typically by a wide margin. Next is the size factor – this is large cap companies (Wal-Mart, Microsoft, etc.) versus small cap companies (companies you’ve never heard about).  Over the long-run, small cap companies tend to have a higher expected return than bigger companies.  This idea is fairly intuitive, but many investors portfolios are still dominated by large cap companies; typically in mutual funds that basically track the S&P 500 (but cost much more than an index fund). Lastly, the value factor – this is somewhat counter-intuitive.  Most people think that the “growth” companies (Microsoft, Home Depot, etc.) will generate the highest returns because they are growing faster than other companies.  Statistical evidence shows that just the opposite is true.  Typically “value” companies (lower priced, higher book to market value) generate higher returns than do growth companies. Hopefully this helps explain the dimensions of portfolio returns.  Check out our Investment Philosophy for more explanation of our beliefs about capital markets, and feel free to contact us for additional information. Also, there is more information on the dimensions of returns here: http://www.dfaus.com/philosophy/dimensions.html