Investors Zig and the Market Zags

Investors pulled $2.8 billion from US stock funds in January, according to Morningstar. Investors were likely reacting to the poor results turned in by equities in 2011.

But the spurned market responded by turning in its best result for the month of January in 15 years. The Dow Jones Industrial Average rose 3.4% and the Standard & Poor's 400 gained 4.4% in January.

The lesson? Investors need to learn to remain steadfast. Successful investing does not require timing in and out of the market. Rather, successful investors develop an appropriate investment approach and remain committed to it.

Happy Valentine's Day

Two Standards

The Dodd-Frank Act (Wall Street Reform and Consumers Protection Act) was passed in the summer of 2010 in the aftermath of the global financial crisis. The bill required the Securities and Exchange Commission (SEC) to conduct a study of the standards under which investment advisors and broker-dealers provide investment advice.

The problem is that broker-dealers and investment advisors operate under different regulatory regimes and are subject to different legal standards. In its executive summary, the SEC notes that "retail investors are generally not aware of these differences or their legal implications." http://www.sec.gov/news/studies/2011/913studyfinal.pdf

Here's the issue:

Investment advisors are held to a fiduciary standard of care. They must, by law, serve the best interests of their clients. If a conflict arises between their interests and those of their clients, they must subordinate their interests to those of their clients.

Broker-dealers are held to a suitability standard of care. This standard requires broker-dealers to make recommendations that are consistent with the interests of their customers. Notice that this standard does not require broker-dealers to serve the best of their clients.

This week The Wall Street Journal provided an update on the battle over these standards: http://online.wsj.com/article/SB10001424052970204301404577171112474127468.html

Actively Managed Mutual Funds

According to Morningstar, investors pulled $8.6 billion from actively managed mutual funds in 2011. They invested $76 billion into index funds and $121 billion into exchanged traded funds, most of which are passive.

Perhaps investors are really beginning to wake up to the fact that actively managed mutual funds consistently underperform their benchmarks. While there will always be funds that do outperform, it is impossible for an investor to know, in advance, which funds will.

Investors cannot control the market. But they can control how much they pay to be in the market. Intelligent Investors practice low cost, passive investing, because it allows them to capture the returns of the markets with very little cost.

Burton Malkiel on 2012

As I review the performance of various asset classes in 2011, it is rather clear that the investment markets continue to struggle with the effects of the global financial crisis. There are very few asset classes that performed will last year.

I have read several books on the history of economic crises and the impact such crises have on the financial markets. The correlation between asset classes converges and there are often few places for investors to hide. Unfortunately, last year was no exception to this phenomenon.

Most investors have undoubtedly grown weary of watching their portfolios languish. The past several years, starting in the fall of 2007, have not been kind to investors.

I know from my self-directed reading that eventually crises end and asset classes begin to follow a more normal pattern of returns. However, the current economic crisis in Europe (and the United States) is rather acute and the deleveraging process that must precede market recovery will quite likely take longer than most expected and hoped.

The fundamentals of investing have not changed: proper asset allocation, diversification, low costs and systematic rebalancing. You might find this article by Professor Burton Malkiel in The Wall Street Journal reassuring, "Where to Put Your Money in 2012." Professor Malkiel and Richard Ellis co-authored The Elements of Investing, which I highly recommend.

Measuring Investor Risk

I have used FinaMetrica's investor risk profile for several years to attempt to assess clients' ability to accept risk. FinaMetrica's found, Geoff Davey, was recently featured in an online interview I viewed. Davey identified three distinct forms of risk that investors confront.

Required risk measures the extent to which investors must expose themselves to market volatility and losses in effort to receive the returns they need to achieve their goals. We can use standard deviation as a means of measuring this risk.

Risk capacity refers to the investors' ability to accept losses. If an investor has a $10 million portfolio, a $50,000 loss is not a big deal. The loss is just ½ of 1%. An investor with a $500,000 portfolio would have lost 10%. A very big deal.

Risk tolerance is a psychological construct. It's a personality trait. It's what FinaMetrica measures with their profile.

When I write an investment policy statement for a client, I refer to all three kinds or risk.

Fund Stars Plummet

I am always looking for evidence to support my belief that it is very difficult, probably impossible, to find mutual fund managers who will outperform their benchmark. It is not difficult to find managers who have beat the market in the past. That information is readily available through Morningstar.

The investment industry and the financial media will often celebrate fund managers who have outperformed the market for an extended period. So, I found it noteworthy that The Oregonian identified five mutual fund managers who have come upon hard times. As of the December 6, 2011, the date of the article:

Bruce Berkowitz was Morningstar's Domestic Fund Manager of the Year, 2009, and Stock Fund Manager of the Decade (2000-2009). His Fairholme Fund is down 29%. The Standard & Poor's 500 index is down 1%.

Michael Hasenstab was the Morningstar Fixed Income Manager of the Year in 2010. His Templeton Global Bond fund has lost 2.4% this year.

Bill Gross was the Morningstar Fixed Income Manager of the Decade (2000-2009). Gross runs the largest mutual fund in the world, the Pimco Total Return fund. The fund has gained 2% this year, but trails 91% of its peers.

David Herro was Morningstar's the International Stock Fund Manger of the Decade (2000-2009). His Oakmark International fund is down nearly 13% this year and is in the bottom 25% of its category.

Even the most accomplished fund investors can get derailed. Most eventually do.

The Financial Truth

Today marks the 70th anniversary of the bombing of Pearl Harbor. It was a day that, as President Roosevelt said, would live in infamy. The attack drew the United States into World War II. The war brought out the best in this country. We were galvanized, emboldened and determined to preserve the values upon which this nation was founded.

We are facing yet another great challenge, although not one that will be fought in battle fields, in the skies or on the seas. It is a struggle in which the majority of Americans are finding themselves in trouble financially. Some are in truly desperate financial straits. This short video conveys the seriousness of the matter more powerfully than I can.

Financial Truth

Please watch it and then encourage those around you to save more, spend less and borrow less.