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Can Investors Beat the Market?


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Can Investors Beat the Market?

  1. 1. Can Investors Beat the Market? What Astute Investors Need to Know By Mark J. Smith, CFP®, CPA/PFS, CIMA® – Principal, M.J. Smith and Associates Because of the extreme volatility of the stock market in recent years, many investors and investment consultants have questioned the validity of asset allocation. In the 1990s, the strategy of diversifying stocks, bonds and cash— known as asset allocation—came under attack. With the invention of the Internet, an economy that never seemed to slow down, and a fully employed workforce, there seemed to be no need for asset allocation. Growth stocks ap- peared to be the only answer for achieving superior returns. The Standard and Poor’s 500 Index, the world’s largest stock market index, added more technology names to its composition, and with the momentum built into this capitalization weighted index, the S&P 500 seemed unstoppable. At M.J. Smith and Associates, a wealth management advisory firm, some of our clients questioned owning bonds, real estate investment trusts (REITs), small company stocks and foreign holdings in the late 1990s. Not only did these investments display lower past returns than the S&P 500, but apparently they did not present the opportunities desired in the new Internet-driven golden age. How times have changed since the late 90s! The bear market of 2000-2002 and now the bear market of 2008 have been two of the worst in history. From January 1, 2000 through December 31, 2008, the S&P 500 averaged an an- nualized return of -1.38%. This decade is on track to be the second worst in its history. Prior to the 2000-2002 period, stocks had not lost money for three years in a row since 1939-1941, and investors had not experienced a decline like 2008’s since 1931. This century’s bear markets are second only to those of the Great Depression. Investors have been seriously questioning their beliefs about the market as we enter 2009 and investor sentiments changed from “Why aren’t we beating the market?” to “Why should we be in the market?” Emotions had turned from greed, when the markets were high, to fear when the markets were much lower. Fortunately, most of our clients realize the benefits of maintaining a broadly-diversified portfolio and know the dangers of letting emotions drive their investment decisions. While diversification does not guarantee a profit nor protect against a loss in declining markets, we at M.J. Smith and Associates believe that the future is always unknown. Successful investing requires the following: 1) Own quality investments—don’t speculate 2) Be broadly diversified across and within asset classes 3) Hire solid investment firms to buy/sell the specific securities 4) Be patient and do not let emotions take you off course It is this last area where an investment management consulting firm like ours probably adds the most value. To prove this point, Dalbar, Inc., a well-respected investment company research firm, compared the market’s return for the 20-year period ending December 31, 2007 (Buy & Hold, S&P 500), to the average return earned by actual shareholders in equity funds (Average Equity Investor) and arrived at the following shocking result. Clients should periodically re-evaluate whether the use of an asset-based fee continues to be appropriate in servicing their needs. A list of additional considerations, as well as the fee schedule, is available in the firm’s Form ADV Part II as well as the client agreement. May 2009
  2. 2. CHART 1 Dalbar’s Quantitative Analysis of Investor Behavior Study 2008: 20-year average annual total returns as of 12/31/07 This chart reveals that the average investor’s returns were far less 12% 11.6% than the returns the market generated, and the emotions of fear and greed are primarily responsible. The unfortunate truth is that the 10% average holding period of a fund is only 30 months. Typical investors 8% purchase investments based on attractive past returns (when 6% investments are likely overvalued) and want out when they don’t 4.5% perform or decline (when they are priced less). 4% 3.0% SOURCE: Dalbar. Past performance is no guarantee of future results 2% Keep in mind that the Average Equity Fund Investor (as defined by DALBAR) represents the aggregate action of all investors in equity mutual funds. The return is calculated by treating ag- 0% gregate industry flows as being representative of the average investor and applying these flows to Average Inflation Buy & Hold Equity Investor (S&P 500) the appropriate performance index. The rate of return investors earn is based on the length of time investors actually remain invested in a fund, amount of dollars bought and sold and the historic performance of the fund’s appropriate index. Indices used in the DALBAR study include the S&P 500 Index for equities and a Long Term Government Bond Fund for fixed income investments. To assess how individual portfolios could perform, compared to the market, we ran some reports and charts from a Morningstar database we maintain. We assumed the following hypothetical diversified portfolio: Hypothetical Diversified Portfolio Real Estate Small Company Stocks 10% Stocks 10% Footnote: Disclosure below for indexes used for above asset classes Commodities This portfolio is strictly hypothetical. The weighted portfolio, and all associated returns and 10% Large statistics, are not reflective of any historical advisory recommendation. Stocks 15% The investment profile is hypothetical, and the asset allocations are presented only as examples and are not intended as investment advice. Please consult your financial advisor if you have questions about these examples and how they relate to your own financial situation. International Investing in small cap stocks generally involves greater risks, and therefore, may not be Bonds 40% Stocks 15% appropriate for every investor. CHART 2 Annualized Returns as of 12/31/2008 1 Year 3 Year 5 Year 10 Year Barclays Capital Government Credit Bond 1 5.70% 5.56% 4.64% 5.64% Standard & Poor’s 500 – Large Stocks 2 -37.00 -8.36 -2.19 -1.38 EAFE International Stocks 3 -43.38 -7.35 1.66 0.80 Wilshire REIT 4 -39.20 -11.99 0.65 7.65 Russell 2000 – Small Stocks 5 -33.79 -8.29 -0.93 3.02 S&P GSCI Commodity -46.49 -15.53 -2.36 7.35 1. Barclays Capital Government Credit Bond - Fixed income or bond funds may pay higher rates than CDs, but their net asset values are sensitive to interest rate movements and a rise in interest rates can result in a decline in the value of the customer’s investment. Individual results will vary. 2. S&P 500 is an unmanaged index of 500 widely held stocks that are generally considered representative of the US stock market. 3. The EAFE index is an unmanaged index that is generally considered representative of the international stock market. These international securities involved additional risks including currency fluctuations differing, financial accounting standards and possible political and economic volatility. 4. Wilshire REIT – REITs have various risks, including possible lack of liquidity: devaluation based on adverse economic and regulatory changes and will fluctuate with the value of the underlying properties. 5. The Russell 2000 index is an unmanaged index of small cap securities, which generally involve greater risk. The prices of small company stocks may be subject to more volatility than those of large company stocks. This Chart is not representative of an individual client portfolio keeping in mind individuals cannot invest directly into an index. The above indexes are all represented in the pie chart for the Hypothetical Diversified Portfolio. 2
  3. 3. Chart 2 reveals these facts: • Bonds have actually outperformed U.S. and international stocks during the last ten years. While, this is generally not the case long term, it is a reflection of the fear that has gripped investors during much of this decade. With interest rates the lowest they have been in history, future bond returns are likely to be lower. • While many investors were intrigued with the S&P 500 as we entered this decade, it is now actually in last place in terms of performance from 12/31/98-12/31/08 compared to the others on the chart. From a contrarian point of view and based upon numerous valuation metrics, it may actually represent one of the best opportunities today. • Broad based diversification, as recommended by our firm, is designed to reduce the risk of the markets, but it doesn’t al- ways do so. For example, 2008 was a very unusual year where even many balanced portfolios saw declines in excess of 20%. • While the inflation hedge investments of both REITs and commodities saw large losses in 2008, they have added sig- nificantly to the outperformance over the last decade. If the government’s stimulus package has its intended effect, one should count on a reemergence of inflation, which is where these investments perform best. • While both small U.S. stocks and international stocks have outperformed the S&P 500 over the last decade, this has not always been the case. During much of the 90s the opposite was true. By diversifying across these three markets, our firm’s intent is to improve overall consistency. While not guaranteed, this has generally been our experience. With all observations above, please note that past performance is no guarantee of future results and please read the other pertinent disclosures in this research report. Diversified Portfolio vs. Market Return Analysis Now let’s compare the results of a hypothetical well-diversified portfolio to the S&P 500 over the last 10 years. Growth of $100,000 CHART 3 Year While both portfolios displayed ups and downs during this 10-year period, the path taken was quite different. Let’s compare the actual trailing returns of both portfolios. 3
  4. 4. CHART 4 Annualized Returns through 12/31/08 1 Year 3 Year 5 Year 10 Year The Diversified Portfolio (see page 2) -21.72% -2.26% 2.71% 5.20% Standard & Poor’s 500 – Large Stocks -37.00 -8.36 -2.19 -1.38 Note: this investment is hypothetical and the asset allocation is presented only as an example and is not intended as investment advice. Please consult your financial advisor if you have any questions about this example and how it relates to your financial situation. You cannot invest directly in an index. Individual results will vary. This investment returns and statistics presented do not reflect the deduction of investment advisory fees, if applicable. Past performance does not guarantee future results. Investing involves risk and you may incur a profit or loss. For the purpose of calculating performance, the portfolio was rebalanced annually to the original model allocation. The illustration may include reinvestment of dividends and capital gains. It depicts performance without adjusting for the effects of taxations. The hypothetical diversified portfolio experienced an unpleasant loss of 21.72% last year, but beat the market’s loss of 37%. But What About Risk? In the late 1990s, investors frequently told us how risk tolerant they were. It was easy to be risk tolerant during this time, as the 1990s stock market experienced very little risk. Since then, many of these same investors have reassessed their risk tolerance and have decided to make their portfolios more conservative after seeing the downside risk of stocks. Let’s talk about downside risk. Chart 5 compares the losses, over the last ten years, of the hypothetical diversified portfolio to the S&P 500: CHART 5 Downside Risk Analysis Worst Worst Worst Chart 5 reveals that the diversified portfolio experienced significantly 3 months (a) 1 year (b) 3 years (c) less downside risk than that of the market. As noted in the worst 0 Diversified Portfolio three-year loss analysis, an all-stock portfolio loss of 16% per year (see pie chart on page 2) -5 -3.86% would500 seen approximately half of the portfolio value eroded, S&P have -10 while the diversified portfolio’s loss of 3.9% annually would have Downside Risk Analysis -15 experienced a cumulative decline of less than 12%. The diversified Worst Worst Worst -16.0% portfolio reflects attractive returns in Chart 4, when compared to the 3 months (a) 1 year (b) 3 years (c) -20 Diversified Portfolio (see pie chart on page 2) returns with an all-stock portfolio. Obviously, it takes much longer -25 -23.21% -24.68% -3.12% S&P 500 to recover from a 50% loss than a 12% loss. -8.97% -30 -9.20% SOURCE: Morningstar -29.65% Footnotes (a) 9-08/11-08 (b) 12-07/11-08 (c) 4-00/3-03 S&P 500, 12-05//11-08 Diversified Portfolio -35 Beta is a measure of a portfolio’s leverage to the benchmark (the benchmark beta=1.0) A portfolio beta of 1.2 indicates -16.0% -19.2% that if the benchmark returns 10.0% the portfolio is expected to return 12.0%. If the benchmark returns -10.0% how- -40 -38.09% ever, the portfolio is expected to return -12.0%. Examining the total volatility (both gains and losses) of both portfolios over the last ten years (as measured by Beta), -26.54% the diversified portfolio displays only 48% of the overall volatility of the market (Beta of .48). When we compare the risk/return tradeoffs over the last ten years, we arrive at the following results: The hypothetical diversified portfolio generated greater returns than an all-stock portfolio but with Diversified Portfolio CHART 6 (see pie chart on page 2) only 48% of the overall volatility and with signifi- 6 S&P 500 5.20% cantly less downside risk. Therefore, on an absolute 4 and risk-adjusted basis, over 10 years, the hypotheti- cal diversified portfolio beat the market! Of course, 2 1.0 individual results would vary and past performance -1.38% 0.48 0 is not guaranteed. 10 Year Annual 10 Year Risk (Beta) -2 Returns 12/31/08 12/31/08 Please contact our office if you want more updated returns represented in this analysis. 4
  5. 5. What Does This Mean? We help our clients realize that their focus should not be on beating “the market” or any other related index. Investors need to recognize that the primary objective in the management of their assets is to achieve their financial goals. At M.J. Smith and Associates, before any investment decisions are made, a proper analysis of retirement goals, children’s education funding needs, risk tolerance, income tax situation and time horizon is conducted. Only then are investors in a position to make the most important investment decision of all, which is asset allocation. Studies continue to prove, as illustrated in this report, that how you diversify is more important than what stocks, bonds or funds you purchase. Focusing on investments before policy results is putting the “cart before the horse” and having a poor investment process in place. Why Use an Investment Consulting Firm? Chart 1 reveals that investors could dramatically under-perform the markets because they use a poor investment policy and let the emotions of fear and greed influence their decisions. With the significant rise in the markets since 2002, followed by the recent volatility, investors are under a lot of emotional stress and subject to make the same mistakes reflected in Chart 1. While basic investing fundamentals do not have to be complicated, astute investors recognize the significant value of using an investment management consulting firm. When seeking a wealth management firm, astute investors look for: • A firm with integrity that can provide unbiased information and knowledge on not only investment-related topics, but also more comprehensive financial planning areas. These areas include retirement planning, tax planning, estate planning, college funding and risk management. • A firm that can align your financial goals with your financial assets and resources to determine the likelihood of successfully achieving those goals. Investment management firms must share the uncertainties of the markets and other variables with investors so that realistic expectations can be established. • A firm that recognizes the primary focus should be on asset allocation, and that allocation decisions should be made only after a complete review of an investor’s need, willingness and ability to take risk. Designing a carefully laid out investment plan, only to find an investor “bailing out” when market volatility increases, results in potentially serious losses and unmet goals. • A firm that focuses on how to reduce the tax burden on the returns of the portfolio. The portfolio should be structured so that less tax-efficient funds are positioned inside qualified and non-qualified accounts (IRAs, 40l(k)s, annuities, etc.). Taxable funds should be positioned in more tax-efficient investments. • A firm that works on a fee-based—not commission driven— approach, without hidden agendas, and has access to a large universe of top-rated investment choices. While selecting investment companies with great past performance is easy, the firm must have a disciplined monitoring process on future performance and recognize that even the best investments will frequently under-perform during certain periods. Investors must be educated about the importance of knowing when to replace an investment and to recognize that this part of the process is not an exact science. Replacing an invest- ment made too quickly, due to under-performance, may lead to the same results of the average investor in Chart 1. Clients should periodically re-evaluate whether the use of an asset-based fee continues to be appropriate in servicing their needs. A list of additional considerations, as well as the fee schedule, is available in the firm’s Form ADV Part II as well as the client agreement. • A firm that has the overall accounting and monitoring systems in place to regularly evaluate the total portfolio’s return and to cross-check and verify that the investor is on track to achieving the goals established. If the investor is off course, strategies should be discussed and reviewed so that the investor can make informed decisions on the best course of action to take. • A firm that provides the discipline to regularly rebalance the portfolio as needed. The process of rebalancing involves selling some of those asset classes that have risen the most and buying, with the proceeds, those investments that have under-performed. As easy as it may sound to “sell high, buy low,” most investors find it very difficult to do. • A firm that will constantly educate the investor. One thing is certain; change is constant. Investors need help filtering through the noise of the market and dealing with the emotional aspects of world events. Mistakes, such as confus- ing the familiar with the safe, overconfidence, following the herd, having too many eggs in one basket, treating the unlikely as impossible, and purchasing products that you didn’t intend to buy, need to be avoided. We at M.J. Smith and Associates remain firmly committed to helping investors achieve their financial goals. We want to thank the hundreds of valued clients who have been with us over the last 25 years of our firm’s history, and we look forward to forging lasting relationships with our new clients. We welcome any questions you may have. 5
  6. 6. About Mark J. Smith and M.J. Smith and Associates Mark J. Smith is a CERTIFIED FINANCIAL PLANNER™ practitioner, a Personal Financial Specialist, a Certified Investment Management Analyst, and a Certified Public Accountant. He was the top-ranked national advisor for Raymond James Financial Services, Inc., for four consecutive years, and has been ranked in the top three advisors every year for the past eleven years. In 2009 Barron’s magazine named Smith to its list of top 1,000 wealth advisors. The list is based on advisors’ assets under management, revenues, management practices, expertise, insight, trustworthiness and commitment to their clients. In 2008, Registered Rep magazine named Smith one of the top independent broker/dealer rep- resentatives in the U.S., ranking him 15th, based on assets under management, out of more than 90,000 independent broker/dealer representatives in the industry. He was also included in Worth magazine’s 2008 national list of top 250 wealth advisors, judged on expertise, insight, trustworthiness and commitment to clients. In 2007, Barron’s named Smith the top independent financial advisor in Colorado and number 22 in the U.S. based on assets under management, revenues and quality of service. Registered Rep named him one of the top 10 outstanding wealth advisors in America, selecting him for selected based on superior performance in money management, client service, business building, acknowledged peer recognition and respect, and philanthropic activities. In 2007 and 2008, The Winner’s Circle, an independent advocacy organiza- tion, ranked Smith first and third, respectively, in top-ranked Colorado financial advisors. The selection team analyzed quantitative criteria, including assets managed and revenues. Their qualitative research included interviews with each candidate’s colleagues and clients and analysis of the firm’s team, credentials, and client service. M.J. Smith and Associates was named to Wealth Manager magazine’s 2008 Top Dog list of best national advisory firms serving high-net-worth clients. The ranking is based on the average assets under management per client. An accounting major at the University of Iowa, Smith holds a bachelor of business administration degree. He established M.J. Smith and Associates in 1983 after gaining experience at the international accounting firm Deloitte, Haskins & Sells. He also served as the director of income taxes for Affiliated Bankshares of Colorado, a 29-bank holding company, where he was in charge of all income tax-related matters for 37 corporations. M.J. Smith and Associates offers fee-based asset management services with a comprehensive financial planning approach which includes income tax planning. The firm is a registered investment advisor with the U.S. Securities and Exchange Commission and is one of the five leading offices out of 1,366 independent branch offices of Raymond James Financial Services, Inc., a national investment company. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of M.J. Smith and Associates and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. Investments mentioned may not be suitable for all investors. Past performance may not be indicative of future results. Be advised that investments in real estate and in REITs have various risks, including possible lack of liquidity and devaluation based on adverse economic and regulatory changes. Additionally, investments in REITs will fluctuate with the value of the underlying properties, and the price at redemption may be more or less than the original price paid. Commodities may be subject to greater volatility than investments in traditional securities. Investments in commodities may be affected by overall market movements, changes in interest rates, and other factors such as weather, disease, embargoes and international economic and political developments. Please note that international investing involves special risks, including currency fluctuations, differing financial accounting standards, and possible political and economic volatility. There is no guarantee that any asset alloca- tion, diversification, strategy, or recommendation will ultimately become successful or profitable nor protect against loss. Tax advice should be sought and provided by an appropriate professional. Rebalancing a non-retirement account could be a taxable event. 9635 Maroon Circle, Suite 230 M.J. Smith and Associates is a Englewood, CO 80112 Registered Investment Advisor T 303-768-0007 | F 303-768-0008