July 2009: Investment Trade-Offs

Open Client Meeting Review: July 2009

Our Outlook

We believe that the worst of the financial and economic crisis is now behind us and there will be increasing signs of recovery, albeit gradual and uneven.  The beauty of capitalism is when it gets sick, it heals itself.  But, it doesn’t happen overnight.  It would be normal (and even expected) to see a lull and/or pullback in the stock market prior to posting further gains from here.  That’s what markets do… they don’t just move in one direction.

Our portfolios are on the conservative side of our targeted stock allocation of 50-70%.  Stocks comprise roughly 45% of current portfolio allocations.  This provides us with a greater measure of safety and stability and allows us to proceed cautiously with the flexibility of adjusting our stock allocations higher.

Investment Trade-offs

Earlier this year we discussed our views regarding the classic investment trade-offs that come with choosing to invest aggressively or choosing to invest cautiously.  The trade-offs entailed two scenarios:

  1. If a sustained stock market advance had begun and was expected to continue higher, we could take a more aggressive investment stance by increasing portfolio stock allocations to gain greater exposure to the stock market.  But, if wrong and the stock market declined, we would face losing capital, or
  2. If we were not confident that the stock market would continue to rise or concerned that the market might be headed for another decline, then we could elect to be cautious by maintaining a reduced allocation to stocks.  If wrong, and the stock market climbed, we would lose opportunity.

Opportunities are much, much easier to replace than capital.

We reasoned the lesser of two evils would be to lose opportunity rather than lose capital and we proceeded cautiously.  Throughout the first half of this year the asset allocation (mix of stocks, bonds and cash) of our portfolios held a smaller portion in stocks compared to the benchmark, giving us a reduced exposure to stocks and thereby a greater measure of safety.

That worked to our benefit early in the year as the stock market plummeted, but detracted from performance in March and April when the stock market surged higher.

Another factor was in play at the same time.  The best performing stocks since the stock market bottomed on March 9th have been speculative stocks of low quality companies.  In recent months they have done better than stocks of solid, high quality companies.  The trashier they were, the bigger their gains.

The mutual fund managers we’ve selected are predominantly value oriented stock pickers that buy stocks not for their speculative potential, but for their merits as solid and profitable businesses.  They gravitate toward the stocks of good companies that can be purchased at bargain levels.

Given the same choices again, we would make the same decisions to take a cautious approach and favor quality investments over speculative companies.

Being Different

You can’t follow the crowd and expect to do better than average.  Any quest to be above average requires being different.  Being different requires a willingness to be out of sync with the crowd from time to time.  In turn, that will entail occasional periods of underperformance.

We realize that it is never pleasant to underperform, even if only temporarily and by a slight amount, but sometimes that’s the price for attaining long-term superior performance.  Our strategy will not outpace our benchmark each and every quarter, and can occasionally lag for even longer periods.  We understand and accept this as a part of the process of successful long-term investing.

 We are confident in our strategy and the investment results it produces.  We believe this is the correct path and that it will serve us well despite any temporary aberrations or setbacks along the way.

Looking Back to See Ahead

“You can observe a lot just by watching.”  -- Yogi Berra

All of the balanced mutual funds we have selected for you are managed by veteran managers with decades of investment experience.  This is not the first time they have experienced unusual conditions in the stock market and economy.  And, every one of them, notwithstanding their records of long-term success, has been out of sync with their peers at times.  We believe that their abilities for independent thinking and resistance to following the crowd are major contributors to their long-term success.

Look back at the year 1998.  The mania for internet and technology stocks was in full bloom in 1998.  The way to obtain outsized performance that year --- remember, it was temporary --- was by owning the storied stocks of the day that were perceived as having no upward limits.  The managers of your balanced funds did not get caught up in the technology mania and its aftermath.

In fact, every single one of the balanced funds you now own lagged their peer group in 1998.  And, most of them were in the bottom 10 percentile of their peer group that year!  Why?  They were independent thinkers that followed their convictions and refused to follow the crowd, regardless of whether or not it caused them to temporarily fall behind the performance of their peers.

Of course, this proved to be the correct strategy.  In the years after, their shareholders averted the “tech wreck” that followed and were well rewarded for not following the crowd.  They went on to far outpace their peers, more than making up for a temporary lull.

We’re not saying this is another 1998.  Every stock market challenge is presented a little differently.  Just as we are unlikely to ever see another 1998 in our lifetimes, we are also unlikely to ever see another 2008.  What we are saying, however, is that experienced managers who think independently and follow their convictions have a knack for coming out on top.  In our opinion, these are the fund managers most likely to post successful long-term superior track records going forward.

Our research finds that the very best mutual fund managers have well-conceived investment strategies that can be clearly and simply articulated.  We have also observed that unnecessary complexity usually ends badly (e.g., recent examples being “credit default swaps,” “structured investment notes” and other exotic derivatives that crashed and burned).

Successful investing does not need to be complicated.  It doesn’t require PhD mathematicians and supercomputers.  In the very simplest of terms, it can be reduced to four time-tested axioms:

  1. Balance,
  2. Diversification,
  3. Moderation, and
  4. Patience.

Those are the cornerstones of our investment strategy.  They are time-tested and we have no doubt that they will continue to serve us well in the years ahead.

Thank You

Our responsibilities to you are taken very seriously.  We will continue to guide your portfolios as we do our own (including our company pension plan), relying on our investment knowledge, experience and judgment.  We are determined to prevail and provide our clients with long-term favorable outcomes that will build their wealth.

Thank you for your trust and confidence in us and for your continued business. ***

Greg Schultz & Bruce Grenke
© 2009 Asset Allocation Advisors, Inc.