Discover your path to Retirement Freedom at a valuable free event taking place on Saturday June 9th in Bellevue.

Learn how to enjoy a more comfortable and secure future with help from two of the Seattle area’s leading experts on retirement planning, investing, and legal issues.

Find out how to avoid huge financial mistakes and how to build an investment portfolio for your specific risk profile that is designed to provide a better return with reduced volatility with PBS host and investment advisor, Tom Cock.

Attorney Rick Gregorek from the radio show, Northwest Legal Compass, will guide your through the treacherous legal issues that can make retirement a nightmare and cause headaches for your loved ones. Rick will make these clarify these complex issues and help guide you to a future with fewer worries.

Finally, Tom will share the ways you can create a better income from your retirement portfolio with handing your hard earned money over to an insurance company.

This special morning of education and enlightenment is absolutely free and there is no obligation. It will take place at the Master Builders Association, 335 116th Avenue SE in
Bellevue at 10 a.m. on Saturday, June 9th.

All we ask is that you reserve you seat in advance using the form below. We will also make sure you get a copy of Don McDonald’s helpful book on investing and money management, “Financial Fysics” at no cost.

These are the best stock picks?

There was a time when even I believed that there was a decent possibility that great stock research could improve an investor’s chances of success. Gradually I discovered that, over extended periods, even the “experts,” such as mutual fund managers, were unable to do better than buying the entire stock market (not just the S&P 500).

In 1998, investors were enjoying impressive gains from their equity portfolios. The “hot” mutual fund managers watched record amounts of money flood into their portfolios. Every major financial publication was publishing lists of “The Best Stocks to Buy Now.” Among those was the well respected Kiplinger’s magazine.

Trying to top their competitors, Kiplinger’s went to “…the nation’s long-term, top-performing mutual fund managers…” for their top stock picks. In December, 1998 they published nine equity fund managers’ favorite stock. Given their perceived skill and access to the best research and resources, one would have reasonably expected that these stock picks stood a better than average chance of creating market beating (or, at least, no worse than market matching) overall returns over the past 13+ years.

Let’s see how they did (all purchase prices were as of 11/23/98, today’s price is from 3/20/12):

“Best” Stock 1 – Artisan International was one of the decades hottest global funds. Fund manager Mark Yockey was “confident” that this Swedish cell phone manufacturer would bounce back after plunging from $45 to $36 in a little over a year.

Looks like Mark failed to foresee Blackberries and iPhones killing the demand for plain, old cell phones.

“Best” Stock 2 – Next, Kiplinger’s turned to the manager of Seattle’s Safeco Growth, Tom Maguire. He saw great potential in the “…leading owner of golf driving ranges in North America,” Family Golf Centers.

This seems to be one area where the little guys (small, locally owned driving ranges) were stronger than the industry heavyweight. The combination of a recession and lots of debt took them down.

“Best” Stock 3 – One of the hottest managers of the 1990s was Michael Price who managed the exciting Mutual Series funds. In 1998, he believed that one of the nation’s largest firms was selling at a discount based on the value of its many pieces saying, “You’re paying almost nothing for the basic auto business.”

Maybe the reason investors were “…paying almost nothing for…” GM’s auto business was the fact that it was really worth almost nothing. Then, all it took was a major recession to make that “almost nothing” actually nothing.

“Best” Stock 4 – Robert Rodriguez of FPA Capital Fund (the “P” stands for Pacific) liked an upstart, West Coast Home Depot competitor, HomeBase. He believed (quite possibly because of a “hometown bias”) that HomeBase was up to challenge of taking on the industry giant. He also liked the fact that the stock was “much cheaper.”

Robert, as an investing “expert” should have known better than anyone that being cheaper does make a stock a bargain. HomeBase was liquidated in 2001 and shareholders lost everything.

“Best” Stock 5 – This next company was found far from the “beaten path.” Robert Perkins of Berger Small Company Value discovered a niche firm that transported oil for Shell under a long-term contract that guaranteed both operating expenses and a nice dividend for shareholders. Perkins also believed there dividend had room to increase.

While the stock price has fallen over the past few years, the result has not been terrible for long-term investors. That’s because Perkins turned out to be right. Knightsbridge did increase its dividend which meant that someone who bought the stock in late 1998 collected almost $34 in dividends, per share, over the years.

“Best” Stock 6 – Remember “tracking stocks?” These were representations of the perceived value of a wholly owned subsidiary of a large firm. In this case, Richard Lawson or Weitz Hickory Fund believed that Liberty Media, the programming division of cable giant Tele-Communication, Inc. (TCI) was undervalued stating that “Wall Street has a habit of forgetting the value in Liberty.”

After many hours attempting to recreate the convoluted pricing of Liberty and multiple mergers, acquisitions, spin-offs (including its purchase by AT&T in 1999 and split from AT&T in 2001), I gave up trying to determine the changing value of Liberty and just used the current stock price. One of the finest illustrations of the confusing nature of business transactions I have ever seen. Despite the fact that investors made some money on this stock, it was probably not worth the paperwork needed to calculate tax liability.

For those who think I’m exaggerating, take a look at the stock’s convoluted history at http://www.libertymedia.com/company-history.aspx.

“Best” Stock 7 – The late 1990s were marked by rapid growth in both the technology and communication industries. Harbor Capital Appreciation manager, Spiros Segalas was excited by the long-term prospects for what he called “one of the fastest growing big companies around.” MCI WorldCom. They had been on a building and acquisition spending spree and had just purchased the much larger firm, MCI. They looked like a winner “on paper.”

There is a problem with blindly believing what a company puts “on paper.” Sometimes people at a firm lie. In the case of MCI WorldCom, that rapid earnings growth turned out to be part of a series of lies amounting to $11 billion. That led to MCI WorldCom becoming the largest American bankruptcy to date. CEO Bernie Ebbers was convicted on multiple counts and is serving a 25-year sentence in a Federal Prison in Louisiana. Probably of small consolation to those who lost their life savings investing in this “hot” stock.

“Best” Stock 8 – The stock market was hot in 1998. It was easy to make money and make it fast through stock trading. At the forefront of the trading revolution was discount broker, Charles Schwab. They were growing rapidly and Ron Baron of Baron Asset Fund believed that they would continue to be a market leader.

Ron was right. Schwab is still the leader in the discount brokerage industry. However, a couple of bad markets in the 2000s reduced Schwab’s trading volume and earnings growth and kept the stock price from rising. When you factor in the approximate $2.60 in dividends paid since late 1998, Schwab investors have almost broken even (*price above adjusted for stock splits).

“Best” Stock 9 – With all of the electronic data being created, businesses were desperate for places to safely store it all. One of the country’s hottest fund managers, Bill Miller of Legg Mason Value liked the “competitive strides” being made Storage Technology and recommended purchase of their stock.

This turned out to be a pretty good investment. StorageTek was purchased by Sun MIcrosystems in 2005 and then, Sun was acquired by Oracle in 2010. **If a StorageTek investor had used the money from each purchase to buy into the acquiring firm, the value of that single share would be approximately $88 today.

It doesn’t look like our investing “experts” recommendations fared too well over the past 13 years, as the chart below illustrates (click on it to enlarge).

Only three of the nine “top-performing mutual-fund managers” picked stocks that made money. Four of nine picked stocks that ended up going bankrupt. The other two managers picked stocks that lost between a few percent and more than half. Overall, it was a pretty awful showing. If you had purchased 100 shares of each “top” stock pick you would have watched a bit more than $34,000 decline to less than $22,000 in 13 years. No wonder some people disparage “buy and hold” investing. If the “experts” are so horribly wrong, what chance do we mere investing “mortals” have?

While it can be argued that this is merely an anecdotal example of really bad luck, there are numerous academic studies that validate the theory that “active” stock selection is a fool’s game. Most of what passes for predictive ability vanishes when luck is factored in. Then, once the higher fees charged by “expert” fund managers are factored in, the long-term data shows that, on average, actively managed mutual funds underperform their passive benchmarks.

If you would like to see some the research on the subject take a look at these papers from the University of Chicago and the Swiss Finance Institute. Another excellent take on the subject is a brief paper written by Nobel Prize winner William Sharpe entitled “The Arithmetic of Active Management,” which uses simple math to “prove” that active investing can’t work.

Since picking the “best” stocks back in 1998 failed to make any money, how might a “buy and hold” investor have done if they placed the same $34,400 (from the chart above) in a globally diversified equity portfolio consisting of over 14,000 stocks? Remember, there were some really bad markets during that period (including the infamous “lost decade” of 2000-2010), so it would seem reasonable to expect little. However, the actual numbers are pretty astounding:

To be fair, the “best” managers picks do not include dividends. However, if we had included the reinvestment of dividends the result would have still been a large net loss in the portfolio chosen by “smart” managers. On the other hand a “dumb” passive portfolio (annually rebalanced, after fees and expenses) almost tripled in value over that same 13+ years. Even more astonishing is the fact that this unmanaged portfolio did as well as it did in a period that included two of the worst “bear” markets of the past century.  If this isn’t enough to make you steer clear of investing “experts” and active fund managers, I cannot imagine what would.

100% EQUITY PORTFOLIO INCLUDES REINVESTED DIVIDENDS AND IS AFTER FUND EXPENSES AND 0.8% ADVISORY FEE. FOR PORTFOLIO INFORMATION PLEASE VISIT VESTORY.COM AND SELECT “DISCLAIMERS.”

Investors desperately need points of reference or benchmarks to which we can compare the performance of our investments. That’s why we are constantly asking, “How did the market do today?” It’s tough to properly determine the relative performance of our investments when we compare them to the wrong benchmark.

The most popular yardsticks by which investment portfolios are measured are the ever popular (and badly flawed) Dow Jones Industrials Average (the Dow) and the blue-chip stock index, Standard & Poor’s 500 (S&P 500). For far too long the Dow has been the go-to index when the media mentions stock market performance. When you hear an announcer saying that the “market” was up or down a certain amount, odds are they are referring to this archaic conglomeration of 30 almost arbitrarily selected large US companies. The only way this would be a reasonable benchmark against which to compare your portfolio would be if you owned a relatively small portfolio of blue-chip stocks in United States companies and none of them were in the transportation or utility business (those industries have their own tiny Dow indexes).

There has been a bit of improvement as some have started to compare portfolios to the S&P 500. Even we have been guilty of that, as so many investment studies use the S&P 500 for comparison. We hate doing it, but compared to the Dow Jones 30 Industrials, the S&P 500 is a far better index against which to measure your portfolio’s performance. For those with globally diversified portfolios, the S&P 500 is sorely lacking. It only tracks the 500 largest companies in the United States. It ignores the performance of many thousands of companies, both in the US and abroad.

Trying to match your portfolio against the wrong benchmark can cause emotional turmoil that often leads to bad decisions, particularly when the comparison is made over a short period of time. Let’s take a look back at 2011, for example. For the year, the Dow Jones 30 Industrials gained almost 5%. The Standard & Poor’s 500 index posted a tiny loss. Some might infer from those figures that a more focused investment, in a few blue-chip stocks, has the potential for greater returns. To a point, they would be right. Yet, those potential returns are offset by potentially greater losses.

Concluding that owning fewer stocks in a portfolio is better would be dramatically reinforced by the one-year performance of the Dow Jones Global Total Stock Market Index (DWG). This index, which includes more than 12,000 stocks from 64 different countries, lost almost 11% of its value during 2011. Had you purchased the Dow 30, at the beginning of 2011, you would’ve made almost 5%, while owning the world (or at least a pretty big part of it) would have cost you more than 10% of your investment.

So, do you put all of your eggs in a 30 stock basket for next year or should you continue to invest globally? If next year exactly mimics this year the answer is obvious. Is it likely? No! Do you know what’s going to happen to every stock market on the entire planet next year? Don’t kid yourself.

Now, let’s broaden our perspective a bit. Using the same 3 indexes, decide which would have been a better point of reference, for a well diversified portfolio over the past 10 years.

From January, 2002 through December, 2011 the Dow Jones 30 Industrials Average rose by about 22%. Standard & Poor’s 500 stock index only grew by about 9% over those same 10 years. Meanwhile, the broader DWG index rose from 1734 to 2343, increase of almost 35%. This is due to the fact that, while the US market foundered for most of the last decade, many European, Asian, and Latin American markets flourished.

In the past year, those same foreign markets have not fared as well as the US market. Given the longer-term performance international markets, it would be foolish to remove them from a portfolio based on a single bad year. Almost as foolish as it would’ve been to bail out of the US market in late 2008 or early 2009 (when the S&P 500 was worth about half of what it is today).

We continue to strongly believe in broadly diversified global portfolios. To help you maintain your long-term perspective, it is critical that you make sure you are making proper comparisons. Comparing a globally diversified portfolio of over 15,000 stocks to the Dow 30 is worse that comparing apples to oranges. It’s more like comparing apples to the entire produce department.

The financial services industry is changing. There are fewer commission based salespeople, as the advisory model switches away from trying to predict the future. This new fee based (and we prefer fee-only) approach is centered less on delivering excess return and more on helping investors avoid outsized losses. This is explained clearly in this 2010 white paper from Vanguard (click to download pdf file):

Why Advisors

“The hardest arithmetic for human beings to master,” wrote the great American working man’s philosopher Eric Hoffer, “is that which enables us to count our blessings.”

It’s a piece of wisdom worth recalling after another year that has tested the nerve of many investors and prompted questions about what current generations have done to deserve to live in such a tempestuous stage of history.

As the year winds down (if that’s the word for it!), financial markets are gripped by uncertainty over developments in the Eurozone crisis. Each day brings fresh headlines that send investors scrambling from virtual despair to tentative optimism.

While not seeking to downplay the very real anxiety generated by these events, particularly in relation to their effects on investment portfolios, it’s worth reflecting critically on our often second-hand memories of the “good old days.”

A Brief History of the 20th Century

Nearly 100 years ago, Europe was engulfed by a war that destroyed two centuries-old empires, redrew the map of the continent, and left more than 15 million people dead and another 20 million wounded. The economic effects were significant, with widespread rationing in many countries, labor shortages, and massive government borrowing.

Just as the Great War was ending, the world was struck by a deadly pandemic—the Spanish flu, which, by conservative estimates, killed some 50 million people. About a third of the world’s population was infected over a two-year period.

A little over a decade after the Great War and the pandemic, the Great Depression cut a swath through the global economy. Industrial production collapsed, international trade broke down, unemployment tripled or quadrupled in some cases, and deflation made already groaning debt burdens even larger.

In the meantime, resentment was growing in Germany over its Great War reparations to the Allied powers. Berlin resorted to printing money to pay its debts, which in turn led to hyperinflation. At one point, one US dollar converted to 4 trillion marks.

In a new militaristic and nationalist climate, fascist regimes arose in Germany, Italy, and Spain. Under Hitler, Germany defied international treaties and began annexing surrounding regions in Austria and Czechoslovakia before finally attacking Poland in 1939.

This led to the Second World War, a conflict that engulfed almost the entire globe while Japan pushed its imperial ambitions in Asia, and Germany sought to conquer Europe. More than 50 million died in the ensuing conflict, including a holocaust of six million Jews. The war ended with the invasion of Berlin by Russian and western forces, while Japan surrendered only after the US dropped nuclear bombs on two cities, killing a quarter of a million civilians.

In economic terms, the war’s impact was profound. Most of Europe’s infrastructure was destroyed, millions of people were left homeless, much of the UK’s urban areas were devastated, labor shortages were rife, and rationing was prevalent.

While the thirty-five years after World War II were seen as a golden age in comparison, the geopolitical situation remained fraught as the nuclear armed superpowers, the Soviet Union and the US, eyed each other. The breakdown of the old European empires and growing east-west tensions led the US and its allies into wars in Korea and Vietnam.

The cost of the Vietnam and cold wars created enormous pressures concerning balance of payments and inflation for the US and led in 1971 to the end of the post-WWII Bretton Woods system of international monetary management. The US dollar came off the gold standard, and the world gradually moved to a system of floating exchange rates.

In the mid-1970s, the depreciation of the value of the US dollar and the breakdown of the monetary system combined with war in the Middle East to encourage major oil producers to quadruple oil prices. Stock markets collapsed and stagflation—a combination of rising inflation alongside rising unemployment—gripped many countries.

While the 1980s and 1990s were a relative oasis of calm—aided by the end of the cold war—there still was no shortage of bad news, including the Balkan wars, the Rwandan genocide, and recessions in the early part of both decades.

In the past decade, there have been the tragedies of 9/11; the 2004 Asian tsunami; the 2011 Japanese earthquake, tsunami, and nuclear crisis; and now, the financial crisis sparked by irresponsible lending, complex derivatives, and excessive leverage.

Another Perspective

So from this potted history, it seems fairly clear that tragedy and uncertainty will always be with us. But the important point to take away from it is that previous generations have stared down and overcome far greater obstacles than we face today. And while it is easy to focus on the bad news, we mustn’t overlook the good either.

Alongside the wars, depressions, and natural disasters of the past century, there were some notable achievements for humanity—like women’s suffrage, the development of antibiotics, civil rights, economic liberalization, the spread of prosperity and democracy, space travel, advances in our understanding of the natural world, and enormous advances in telecommunication. (Oh, and the Beatles.)

Today, while the US and Europe are gripped by tough economic times, much of the developing world is thriving. Populous nations such as China and India are emerging as prosperous nations with large middle classes. And smaller, poorer economies are making advances too.

The United Nations in the year 2000 adopted a Millennium Declaration that set specific targets for ending extreme poverty, reducing child mortality, and raising education and environmental standards by 2015. In East Asia, the majority of twenty-one targets have already been met or are expected to be met by the deadline. In Africa, about half the targets are on track, including those for poverty and hunger.

Alongside these gains, new communications technology is improving our understanding of different cultures and increasing tolerance across borders while providing new avenues for the spread of ideas in education, health care, technology, and business.

Through forums such as the G20 and APEC, international cooperation is increasing in the field of trade, addressing climate change, and lifting the ability of the developing world to more fully participate in the global economy.

Rising levels of education and health, and workforce participation also mean the foundations are being built for a healthier and peaceful global economy, dependent not on debt, fancy derivatives, and fast profits but on sustainable, long-term wealth building.

Anxiety over recent market developments is completely understandable, and it is quite human to feel concerned about events in Europe. But amid all the bad news, it is also clear that the world is changing in positive ways that provide plenty of cause for hope and, at the very least, gratitude for what wealready have. These are ideas to keep in mind when we scan the news and long for the “good old days.”

As a topic of conversation, investment is like sports. Everyone has an opinion. And the strongest opinions often come from those who spend more time in front of the TV than out on the field. Practitioners, meanwhile, are wary of anything labeled a sure thing. Indeed, it’s one of life’s ironies that the people who know the least about a subject sound the most sure of themselves. In investment, these are the ones who prop up bars telling anyone who will listen that they have found the path to certain wealth.

These pub philosophers tend either to be permanent bulls or permanent bears about the market. They have their standard story, and they adapt the facts to fit. Some of them even end up writing newspaper columns and hosting television shows.

By contrast, some of the world’s most respected and seasoned investors strike a humbler tone, having learned from personal experience about the unpredictability of markets and deciding to focus instead on those things within their control.

Take, for instance, the frequently heard line that smart investors should seek to time their entry points to markets and wait for the volatility to clear. We are hearing a lot of that right now as the European crisis dominates market attention.

Writing about this in 1979 before one of the biggest bull markets in history, Warren Buffett said: “Before reaching for that crutch (market timing), face up to two unpleasant facts: The future is never clear [and] you pay a very high price for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.”¹

Another line from the pub philosophers is that the job of an investment expert is to spot the best market-beating returns and harvest them before someone else finds out.

Asked about this in 2007, two years before his death, legendary investment consultant and historian Peter Bernstein said it was better to focus on risk than return. “The central role of risk, if anything, has grown rather than diminished,” he said. “We really can’t manage returns because we don’t know what they’re going to be. The only way we can play the game is to decide what kinds of risk we’re going to take.”²

A third perennial pub conversation is the role of stock picking in investment success. The line here is that the key to wealth building lies in painstakingly analyzing individual stocks and buying them based on a forecast or even a hunch about their prospects.

Prompted by a newspaper reporter for his opinion on that piece of conventional wisdom, Charley Ellis, long-time Wall Street observer and the founder of Greenwich Associates, said the truth was actually quite the opposite.³

“The best way to achieve long-term success is not in stock picking and not in market timing and not even in changing portfolio strategy,” Ellis said.

“Sure, these approaches all have their current heroes and war stores, but few hero investors last for long and not all the war stories are entirely true. The great pathway to long-term success comes via sound, sustained investment policy, setting the right asset mix and holding onto it.”

While that’s probably not the kind of message you are likely to hear from the instant experts who prop up your local bar, it may be a more durable and a more useful one.

Bill Miller is one of the most closely watched money managers in the industry, so it was big news when he announced his decision last week to step down as portfolio manager of Legg Mason Capital Management Value Trust (LMVTX) early next year. His departure also adds an intriguing chapter to the long-running debate regarding the value of active stock selection.

Miller’s most frequently cited accomplishment is the fifteen-year period from 1991 through 2005, during which Value Trust outperformed the S&P 500 each calendar year, the only US equity fund manager to have ever done so. His success attracted a wide and enthusiastic following: Morningstar named him Portfolio Manager of the Decade in 1999, Barron’s included him in its All-Century Investment Team that same year, and a Fortune profile in 2006 described him as “one of the greatest investors of our time.” A former US Army intelligence officer and philosophy student, his formidable intellect covered a wide range of interests, and he believed that conventional investment analysis could be enhanced with insights drawn from literature, logic, biology, neurology, physics, and other fields not obviously related to finance. His expressed desire to “think about thinking” suggested an unusual ability to assess information differently from other market participants and arrive at a more profitable conclusion.

Miller’s bold and concentrated investment style would never be confused with a “closet index” approach. Big bets on Fannie Mae, Dell, and America Online, for example, were rewarded with handsome gains (as much as fifty times original cost in the case of Fannie Mae). Unfortunately, similar bets in recent years revealed the dangers of a concentrated strategy as heavy losses in stocks such as Bear Stearns and Eastman Kodak penalized results. For the five-year period ending December 31, 2010, LMVTX finished last among 1,187 US large cap equity funds tracked by Morningstar. Considering the enormous variation in outcomes among these carefully researched ideas, Miller’s overall investment record presents an interesting puzzle: How can we disentangle the contribution of good luck or bad luck, of skill or lack of skill?

Over the May 1982–October 2011 period, annualized return was 11.28% for the S&P 500 Index and 11.76% for the Russell 1000 Value Index. Value Trust slightly outperformed the S&P and underperformed the Russell index by over 0.40% per year. A three-factor regression analysis over the same period shows the fund underperformed its benchmark by 0.08% per month.

Do these results offer conclusive evidence of the failure of active management? Not necessarily. The fund’s expenses are above average at over 1.75% and provide a stiff headwind for any stock picker to overcome. Gross of fees, the fund’s performance over and above its benchmark goes from –0.08% to 0.07% per month. This swing from negative to positive raises an interesting point that Ken French speaks to at every Dimensional conference. There are almost certainly some mistakes in market prices and almost certainly some skillful managers who can exploit them. But who is likely to get the benefit of this knowledge—the investor with his capital or the clever money manager? If stock-picking talent is the scarce resource, economic theory suggests the lion’s share of benefits will accrue to the provider of the scarce resource—just what we see in this instance.

To cloud the discussion even further, both of these results, positive and negative, flunk the test for statistical significance; in neither case can they be attributed to anything more than chance. So even with twenty-nine years of data, we cannot find conclusive evidence of manager skill—or lack thereof. This is the inconvenient truth that every investor must confront: The time required to distinguish luck from skill is usually measured in decades, and often far exceeds the span of an entire investment career.

Miller is well aware of the challenge of distinguishing luck from skill and has conspicuously declined to boast about his results, even when they were unusually fruitful. He has acknowledged that topping the S&P 500 each year for fifteen years was an accident of the calendar and that using other twelve-month periods produced a less headline-worthy result.

Commentators have said that Miller has “lost his touch” or that his investment style is no longer suitable in the current market environment. These arguments strike us as the last refuge for those who find the idea of market equilibrium so unpalatable that they search for any explanation of his change in fortune other than the most plausible one—prices are fair enough that even the smartest students of the market cannot consistently identify mispriced securities.

Where does this leave investors seeking the best strategy to grow their savings?

When asked by a New York Times reporter in 1999 to sum up his legacy, Miller replied, “As William James would say, we can’t really draw any final conclusions about anything.” Twelve years later, this observation seems more useful than ever. And investors would be wise to treat even the most impressive claims of financial success with a healthy degree of skepticism.

REFERENCES

Andy Serwer, “Will the Streak Be Unbroken,” Fortune, November 27, 2006.

Edward Wyatt, “To Beat the Market, Hire a Philosopher,” New York Times, January 10, 1999.

Tom Sullivan, “It’s Miller Time,” Barron’s, October 12, 2009.

Diana B. Henriques, “Legg Mason Luminary Shifts Role,” New York Times, November 18, 2011.

S&P data provided by Standard & Poor’s Index Services Group.

Morningstar data provided by Morningstar Inc.

Russell data copyright 2011, Russell Investment Group 1995-2011, all rights reserved.

from Dimensional Fund Advisors

In early August, Standard & Poor’s downgraded US government debt from a top-rated AAA to AA+.1 In the weeks preceding the event, some market observers expected a downgrade to result in higher interest rates and lower stock returns.

After the downgrade, yields on US government securities fell across the term spectrum as investors around the world fled to the safe haven of US bonds. US stocks experienced negative returns in the following weeks but logged positive performance from the day of the downgrade to month end.2

These events raise questions about whether changes in sovereign debt ratings impact the financial markets. The short answer is that results are mixed, and that many other factors affect a country’s cost of capital and stock market returns.

Regarding bond markets, history offers examples of major developed countries that experienced a credit downgrade without a significant rise in interest rates.3 Examples include Australia, Canada, and Japan, which lost their top ratings in 1986, 1992, and 1998, respectively.

Other research suggests that countries with high credit ratings may withstand a downgrade better than countries with lower ratings. One study looked at sovereign credit rating downgrades since 1990 and found that bond yields changed little among countries downgraded from the highest triple-A rating. However, countries with lower credit ratings (single A or below) experienced significant interest rate increases following their downgrade.4

Stock market impact

Another question is whether the US downgrade has played a role in the US market downturn—and research does not provide convincing evidence.

Below is a chart that summarizes stock market performance of respective countries before and after a ratings change. It is based upon a study of ratings changes made by Moody’s from 1983 to 2009. During the twenty-seven-year period, the ratings agency made seventy-one upgrades and twenty-five downgrades to governments in the developed and emerging markets tracked by MSCI.

The study identified the date of each change and logged each country’s market performance in the twelve months before and twelve months after the event. Each country’s market returns were compared to the respective market index and the excess return averaged for all events. (Excess return refers to performance above or below the respective market index, either MSCI EAFE or MSCI Emerging Markets, as appropriate.)

Figure 1. Equity market performance before and after Moody’s ratings changes, 1983–2009

Analysis conducted by Dimensional Fund Advisors using sovereign bond rating data from Moody’s Investors Services, “Sovereign Default and Recovery Rates, 1983–2009.” Returns are in US dollars and represent performance in excess of MSCI EAFE Index for developed markets and MSCI Emerging Markets Index for emerging markets. A positive excess return indicates market outperformance; a negative excess return indicates underperformance. The table reports the return of an equal-weighted, event-time portfolio. Past performance is no guarantee of future results.

The aggregate results show that stock markets of upgraded countries outperformed their respective market index in the twelve months before the rating change (13.83%), while stocks in downgraded countries aggregately underperformed the market index before the event. However, cumulative returns in the twelve months following a ratings change were almost the same for the upgraded and downgraded countries (3.87% vs. 3.73%).5

These results suggest that market prices reflect all available information and expectations about a country’s economic prospects—including the possibility of a ratings change. By the time a country’s debt rating is upgraded or downgraded, the market has already integrated the news into prices. Stock markets reflected positive economic developments prior to a ratings upgrade and negative developments before a ratings downgrade. After the event, markets did not appear to perform much differently, in aggregate.

Conclusion

This research underscores the importance of looking to market prices for signals about the fiscal health and prospects of a country or a company. Based on the foregoing analysis, markets appear to work faster and more accurately than ratings firms to assess a country’s financial condition and evaluate the potential impact on its cost of capital and equity market.

1. A sovereign credit rating is an assessment of a government’s ability to pay its debts. The US had held S&P’s top rating since 1941. S&P made the announcement after business hours on Friday, August 5, but word of the downgrade leaked during the day. Although timing of the announcement was a surprise, the downgrade was mostly expected, as S&P had issued a negative long-term outlook for the US in April and July. The other top credit agencies, Moody’s Investors Service and Fitch Ratings, have maintained top ratings for the US.

2. Two weeks following the downgrade, the US market, as measured by the Russell 3000 Index, logged a negative 6.82% return (August 5–19). However, from the day of the announcement to month end, the market returned a positive 1.6%. Russell data copyright ©Russell Investment Group 1995–2011, all rights reserved.

3. Tom Lauricella, “Lessons of Lower Ratings,” Wall Street Journal, July 30, 2011.

4. Ivan Rudolph-Shabinsky and Dennis Shen, “When ‘Risk-Free’ Isn’t Risk Free: The Impact of a US Treasury Downgrade”white paper, Alliance Bernstein, June 2011.

5. The twelve-month aggregate excess performance prior to the ratings change was statistically significant, while the twelve-month returns after the ratings change were not.

from Dimensional Fund Advisors

Predicting interest rate movements correctly is hard. Predicting them for a living is harder still. But getting it wrong is nowhere near as painful as the experience of those who lose their own money based on someone’s forecast.

A year ago, the Reuters news agency polled a group of people closer than just about any other community to those who actually decide rate movements. These were 16 money market dealers who do business directly with the US Federal Reserve.1

The so-called primary dealers — banks or broker-dealers — are market makers for government securities. They consult directly with the US central bank and Treasury about funding the budget deficit and implementing monetary policy.

So if you wanted an informed view about the interest rate outlook, these might be the people you would call on first, which is what Reuters did when it asked the dealers for their forecasts for Treasury bond yields three, six and 12 months ahead.

Back in late September 2010, the dealers came up with a consensus forecast for US 10-year Treasury note yields rising from 2.50 per cent to 2.70 per cent in three months, 2.80 per cent in six months and to 3.20 per cent by September 2011.

So how did those forecasts turn out? Well, after three months, the yields had already surpassed the 12-month forecast at around 3.3 per cent. Another three months on, yields had topped 3.4 per cent, again well above forecasts. But then they started coming down again and by September 2011, were close to 2 per cent.

So the expert panel misjudged the trajectory for bond yields in terms of the magnitude of the increase in the first six months and then completely got the direction itself wrong in the subsequent six months.

But it wasn’t just the sell side that misjudged the market. In February, the world’s biggest bond fund PIMCO announced it had reduced its US government-related debt holdings from 22 per cent in December 2010 to just 12 per cent in January 2011, the lowest in two years.

In March, PIMCO announced it had eliminated government related debt entirely from its flagship fund, saying that bond yields had reached unsustainably low levels given the scale of government debt obligations and the chance of a correction when the Federal Reserve ended its quantitative easing program.

But by August, PIMCO manager Bill Gross admitted he had made a mistake, telling the UK Financial Times that he felt like “crying in his beer”, so badly had he misjudged the movement in bonds in 2011.

“Do I wish I had more Treasuries? Yeah, that’s pretty obvious,” Mr Gross told the FT. “I get that it was my/our mistake in thinking that the US economy can chug along at 2 per cent real growth rates. It doesn’t look like it can.”

None of this is to impugn Mr Gross’ logic earlier this year in saying that the term risk of investing in government bonds was not worth the meager return.

But as tends to happen with forecasts, events intervene and those who maintained an exposure to Treasuries in 2011 have enjoyed solid returns in the intervening months.

The chart above compares the relative yields of US Treasuries at various maturities in January this year versus more recently in September. You can see that the curve was relatively steeper earlier this year than it is now.

The yield spread between the 10-year bond and the 1-year bonds was just over three percentage points in January. By September, this term premium had contracted to two percentage points. The change reflects news in the intervening period. Sentiment about the US economy has deteriorated in that time and investors have become more averse to taking term risk.

Put another way, when yields fall, prices rise. So those whose net exposure was relatively longer earlier in the year have enjoyed a capital gain that was not available to those who took a bet against Treasuries early this year.

Now, Dimensional’s own research has shown there is a reliable relationship between current term spreads and future term premiums. So wider yield spreads predict larger term premiums, while narrower yield spreads predict smaller term premiums.

This is why we employ a variable maturity approach, varying the allocation towards short-term and intermediate bonds depending on the shape of the yield curve.

The advantage of this approach is we are only using information available in the market at the present time. There is no need for forecasts, which no matter how rigorous the underlying analysis can come undone as events and circumstances change.

The bad news is that financial markets have a tendency of sending even the most well informed and respected forecasters a curve ball. The good news is that you don’t have to take those sorts of risks if you don’t want to.

1. POLL: Rising Bond Yields Constrained by QE, Reuters survey, Sept 28, 2011

Conventional wisdom rarely leads us to greatness or even success. Yet we continue to take the same well traveled paths, even when we see that there may be a better way.  This week the world lost someone who epitomized the quest for a better way of doing things. The wisdom and tenacity of Steve Jobs has inspired me to do things that flew in the face of tradition. The technology he created, despite having a huge influence on the way I have made a living since 1985, is secondary to the lessons he taught me about business and life. If we want to be successful, we must always question “conventional wisdom.”

What does this have to do with investing? Everything! Conventional investing wisdom says that we should be all in the market or all out. Conventional investing wisdom tells us that only “experts” know the future. Conventional investing wisdom leads us to consistently spend more and make less. Conventional investing wisdom idolizes stock pickers and market timers. In other words, conventional investing wisdom make your broker (or banker or insurance agent or…) richer and you poorer and Wall Street loves it.

Over my 25+ years in this business (which strangely coincides with my first Apple purchase), I have constantly tried to “think different” and look at investing from new directions, despite the constant brainwashing flowing from Wall Street and their willing minions in the money media. Following the facts and ignoring the hype has inevitably led me to an investing philosophy that just makes sense (much like Apple’s various operating systems). It’s an investing philosophy that is user (investor) centric, based on decades of careful study and academic research by some of the brightest minds on the planet, It is a investing method that is regularly honed, improved, and updated. In other words (and not mine), “it just works.”

Listen carefully to almost every other financial program on the air and you will find that the messages are almost all the same… Investing is synonymous with speculating, gambling. Rarely will you hear anyone sharing the investor-centric view that we impart every week on this program. Just as your mother likely admonished at one time or another, “Just because everyone else is doing it, doesn’t mean you should.”

This may be the Steve Jobs greatest legacy. To be successful in life, business, and investing, we all need to “think different.”

Finally, on a more personal note. Despite the fact that I have spent a small fortune on Apple products (starting with a Macintosh 512k in 1985), I feel I still owe tremedous gratitude to Steve Jobs, both for the powerful produsts he created to improve my productivity and product quality and the lessons he taught me about life and business. Steve – although I never knew you, I will truly miss you. Thanks iLot!

-Don McDonald