Separating Myths From Truth The Story Of Investing

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The investment myths are what we have traditionally believed to be appropriate methods for giving investment advice. When we talk to a stockbroker or financial advisor about investments we may ask them questions such as:

1) What stock or investments do you like? This is the 1st myth: stock selection.

2) Who is your favorite manager? This is the 2nd myth: Track record investing.

3) Where do you think the market’s going? This question speaks to the 3rd myth: market timing, or when to get in and out of the market.

4) The 4th myth is one that nobody really likes to talk about much, and that is the true costs of investing.

What we may not realize is that what we are really asking for is a prediction about how our investments will do in the future.

If this is what we are asking for in most forms of investment advice, doesn’t it make sense to find out if it actually works?


We are going to begin separating the myths from the truth by first dispelling some traditional investment myths. Then I will begin telling you the the true story of investing. And at the end of this presentation I will be offering you a huge opportunity to take action based on all of the discussions we have recently had.

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  • The Point: Tell them what you’re going to tell them. We are going to begin separating the myths from the truth by first dispelling some traditional investment myths. Then I will begin telling you the The True Story of Investing. And at the end of this presentation I will be Offering you a Huge Opportunity to take action based on all of the discussions we have recently had.
  • The Point: Set up investing myths The investment myths are what we have traditionally believed to be appropriate methods for giving investment advice. When we talk to a stockbroker or financial advisor about investments we may ask them questions such as: What stock or investments do you like? This is the 1 st myth: stock selection. Who is your favorite manager? This is the 2 nd myth: Track record investing. Where do you think the market’s going? This question speaks to the 3 rd myth: market timing, or when to get in and out of the market. The 4 th myth is one that nobody really likes to talk about much, and that is the true costs of investing. What we may not realize is that what we are really asking for is a prediction about how our investments will do in the future. Transition: If this is what we are asking for in most forms of investment advice, doesn’t it make sense to find out if it actually works?
  • The Point: Define stock selection and the myth. The first myth is related to stock selection. Stock selection can be defined as choosing stocks that are believed will do well in the future or beat other stocks or beat the market in general. The myth about stock selection is that there is some investment advisor who can consistently and predictably add value to your portfolio by exercising “superior skill” in individual stock selection. Survey: Ever owned a fund that closed or merged? What happens to the returns data for the fund that gets killed off? [IT DISAPPEARS!] So what would happen to the average numbers if we looked at ALL the data – for “live” funds and “dead” funds? That’s just what we decided to do after 2007 – be bought a $25,000 database from the Center for Research in Securities Prices out of the University of Chicago, And here’s what we found >>>
  • Just looking at one year for example, 2009, we found that there were 26,905 funds open. That’s over 3 times as many funds as there are stocks in the US Market. Here’s the astonishing truth about what’s happening behind the scenes. Going back to 1923, there were a total of 43,668 funds “born”. Well, if there were about 27 thousand funds open at the end of 2009 and over 43k born – how many had to get killed off? OVER 16,000! So, what happened to the funds that didn’t make it? Why do you suppose the Mutual Fund industry killed them off? An even more alarming question is this: what happened to the returns statistics for the funds that ended up in the trash heap?
  • How many advertisements do you see on CNN for the mutual funds that lost forty percent that year? I’d guess not many. That is because when the funds really underperforms significantly, they are quietly closed and merged into more successful funds. Doing this allows the mutual fund companies to post better returns and in essence hide the fact that the bad performers even existed.
  • This is the average return of the worst 200 mutual funds that have since been closed. NEGATIVE -77.7%! And yet, they slip quietly out of the statistics, never to be heard from again. Let’s take a look at what happens to returns when we use ALL the data to look at a true average [The Transition Point: How Much $$ is Lost to Active Management]
  • When we put ALL the data in to the analysis – including the data that mutual fund companies are trying to sweep under the rug by closing and merging poor-performing funds – here’s what we found.
  • In the last slide we were simply comparing the ALL mutual funds in the Survivor-Bias Free Average Mutual Fund database total with the S&P 500. Look what happens when we compare the Average Fund with a specific mix of assets categories, ranging from 25% equity all the way up to 100% equity, that tend to have complimentary risk/return characteristics and dissimilar price movement. Now, you may be thinking: “This is just an AVERAGE of all funds. I’m not going to use and AVERAGE fund manager. I’m going to find a BETTER THAN AVERAGE fund manager.” So, what would be the method we would use to identify the mutual funds that will end up being in the top half of the average rather than the bottom half? How would we find them? [The Transition Point: Get the Audience to suggest “History” or “Track Record” as the method for selecting managers]
  • The Point: Define Track Record Investing and myth. The second myth deals with track record investing, which is the use of performance history to determine the best investments for the future. The myth is that finding the funds or managers that did well in the past is a reliable method of indicating which funds will do well in the future. Transition: So, let’s see if seeking out the best performers is a reliable method for finding the best investment performance.
  • The Point: Set up the Top 30 funds guessing game. So, if we’re going to search for the best managers, should we use a short track record or a long track record? LONG? The 10-year history should be helpful, right? Let’s start by looking at a ten year period from 1990 to 1999. This is a list of the top 30 mutual funds during this period. Compared to “All Funds,” the S&P and the US Market as a whole, these 30 funds delivered significantly higher return. Which funds do you think the financial professionals were recommending in January 2000? That’s correct. It looked like a list of these funds. Here’s a little known fact that mutual fund companies probably don’t want you to know about that 10 year period. Out of the entire universe of mutual funds that were open January 1, 1990, only 760 had a 10 year track record at both the beginning and END of the 10-year period. Now let’s see how these top 30 funds did in the following 10-year period. Did they repeat the performance? No. Actually, they underperformed both the Average Fund, the S&P Index and the Market as a whole. What’s worse, once you realized they weren’t doing as well as you had expected them to do, there were another 1,100 funds out there to choose from in your search for an alternative. And, here again, we see the same curious phenomenon in the survivorship of mutual funds. Only 1,847 funds with 10 years of history managed to stay open from the beginning of 2000 through the end of 2009. As we saw on a previous slide, even after “killing off” some 16 THOUSAND funds there were still over 27 THOUSAND funds in existence in 2009. Now, how many do you suppose will still be alive 10 years from now? And how in the world would we be able to identify the best ones IN ADVANCE ? Oh, and remember what happens to the returns statistics for the funds that “die”? Transition: Here’s part of the trouble with this study. Most folks don’t sit still for 10 years with their mutual funds. In fact, statistically the average investor’s holding period is just under THREE YEARS. So, let’s see what this study looks like in a 5-year time period.
  • Here’s a similar study using 5-year time windows and what we find is a similar result. Take a look at 1990 to 1994. The top 30 Funds’ Average Return was an extraordinary number – over TWICE what the market as a whole or the S&P returned. Now that we’ve identified these amazing fund managers after their extraordinary 5-year run, look what happens from 1995 to 1999. Do they repeat their past performance and deliver twice what the market did in returns? No they didn’t. In fact, what did they do? Meanwhile, we had nearly 3 times as many mutual funds to choose from as replacements. Transition: Here’s the point >
  • The Point: Define Market Timing and myth 3 The third investment myth is about market timing. Market timing is any attempt to alter or change the mix of assets in a portfolio based on a prediction or forecast about the future. The myth is that mutual fund managers are able to utilize market timing to effectively predict up and down markets. Transition : So, how easy is it to get in and out of the market at the right time?
  • DALBAR is an independent research firm that does massive studies on Investor Behavior – the real results that investors get. In 2009, they concluded a 20-year study of tens of thousands of brokerage accounts for investors who have over $100,000 invested – so not just small, inexperienced folks. And here’s what they found: During the time period, the S&P 500 Index returned how much? 8.20% What was the Average Equity Fund Investor’s return during the same period? 3.17% And, if that’s not bad enough, here’s where the rubber meets the road – to find out what the REAL return in terms of purchasing power, what do we have to do with the Inflation number? SUBTRACT IT, right? So, net of inflation how’d we do? [Run thru the math]
  • The Point: Market Timing is a risky proposition. Missing the market’s top-performing days can prove costly. This chart shows how a $10,000 investment would have been affected by missing the market’s top-performing days over the 20-year period from January 1, 1990, to December 31, 2009. For example, an individual who remained invested for the entire time period would have accumulated $48,546 over the period, while an investor who missed just the 10 top-performing days during that period would have accumulated only $24,235 – ABOUT HALF AS MUCH!. Now, realize that we have 5,040 trading days, if you only miss 10 of the best ones, you get less than what you would have traditionally earned in a simple T-Bill. It isn’t difficult to see that market timing is a very risky proposition when it comes to your long-term wealth being out of the market can be just too expensive. Transition: The frightening part is that market timing can be disguised by many investment professionals and many investors don’t even know it’s there. When it’s disguised it’s called “tactical asset allocation.”
  • The Point: “Tactical Asset Allocation” is market timing in disguise. We have seen the research on market timing and believe that it’s dubious at best. But now many investment professionals will tell you that they don’t believe that market timing works, but what they can do is put together a diversified portfolio with international stocks, US stocks and bonds and small stocks using a concept called “tactical asset allocation” to change the mix based on information about which markets are underpriced. This should send a real red flag. This is market timing, because they are changing the mix of the assets based on a prediction or forecast about the future. Now, most people have been taught to think of market timing as two assets, getting 100% out of cash, and 100% out of stocks, and visa versa. Have you ever seen the movie where they play Russian roulette, and they put bullets in the gun? Is it more dangerous when you have two bullets or six bullets? The first model had two bullets to choose from, cash or stocks. It didn’t make it any easier by trying to allocate between 6-15 asset categories and try to pick and choose between them, and change the mix based on their forecast. They made it even harder. So don’t be fooled. “Tactical asset allocation” is also a simple form of market timing in disguise. Transition: Market timing has been analyzed by the best and brightest academic minds.
  • The Point: Smart people know market timing doesn’t work. Charles Ellis wrote a book, which was required study material for investment advisors. He said, “The evidence on investment managers’ success with market timing is impressive - and overwhelmingly negative.” Transition: So now we’ve seen that traditional investment strategies of stock selection, track record investing, and market timing have all been proven empirically to NOT be effective investing methods. They aren’t predictable, they aren’t repeatable and they’re forms of speculation. And there’s still one more myth to dispel.
  • The Point: Define cost and investing myth. The fourth and last myth is related specifically to the costs of investing. Costs of investing are any fees incurred by investors to buy, sell and own stocks or mutual funds. The myth is “What you don’t see can’t hurt you.” Transition: So, what aren’t we seeing when it comes to costs in our investment portfolios?
  • The Point: Set up costs conversation. Now we are going to examine the real costs of investing. I am going to tell you about some costs of investing that you, and even your investment professional, may or may not know about. They include the bid/ask spread, wrap fees and mutual funds . Unfortunately, most investors are unaware of the true costs they are paying for their investments. Transition: First, we’ll talk about bid/ask spread.
  • The Point: Trading stocks costs more than you think. Bid/Ask spread has to do with how stocks are traded in the real world. If I get on the phone and called a major wire house right now, and say “I want to buy 100 shares of (any large company) stock.” The person on the other end might say, “You can buy that stock for $50 a share. And my commission is $25.” Then if I turn around and say, “Wait a minute. I don’t want to buy, I’m sorry, I want to sell 100 shares”... I’m not going to be able to sell them for the same 50 they just quoted me. I might only be able to sell it for $49.50. Now, where does the difference between what I can buy for and what I can sell for go? I know you’ve seen all these guys running around the floor of the exchange with those little tickets on commercials,etc. Those guys are called market makers and specialists. You might think that I get to sell my shares of stock directly to you, but that isn’t quite how it works. I have to sell my shares to the person on the floor of the exchange, which in effect works for the large brokerage firms. They take a profit off the top, and they turn around and sell it to the next investor. So every time a stock changes hands, they are taking a profit that goes to the brokerage houses or wire house that controls those markets. Whether you are an individual investor, or whether you are a big mutual fund, you’re still paying the bid/ask spread costs. By the way, these costs are NOT listed in the prospectus nor are they included in the expense ratio of your mutual fund. If you want to find out what’s really going on you need to have your portfolio analyzed using a system that can extract what these average costs are and show them to you in black and white. We’ll talk more about that in a few minutes. Transition: So let’s find out what those costs add up to in various investment options.
  • The Point: Size makes a difference in costs. In large stocks, such as the those in the S&P or Fortune 500 companies, the cost runs about 3 bp. So, if we want to do what we call a round trip, sell out of one stock and buy another, that is 5 bps to sell, 5 bs to buy, plus approximately ½% in commissions - that is about .60%. A medium sized company can easily run up to 19bps. So a round trip is about 19bps to sell and 19bps to buy - that’s .38% plus commissions, that’s about .88%. Now, have you ever seen one of those commercials on TV or the radio, where they say they won’t charge you any commissions at all? How do they do that? Usually, those offers are exclusively for very, very small companies. And the spread on a small company can be as high as 6.26%. 6.26% to sell, plus 6.26 % to buy , that’s 12.62% - well, thank you for not charging me a commission! It is so important to understand how that works. These big brokerage companies don’t buy advertising spots during the Super Bowl off little commissions. They do this from making markets, that is how they make the money. Transition: So bid/ask spread is an expensive and unseen cost of investing, but it takes away value from the portfolio every time it happens. Now, let’s look at how this cost affects brokerage wrap accounts.
  • The Point: No load mutual funds are expensive. I’m sure you’ve heard and read the term “no load” mutual funds. You have probably owned a mutual fund or two, so let’s see what the term “no load” really means... The cost to the consumer of no load mutual funds: “What you can’t see can hurt you.” This is right out of Charles Ellis’s book, How to Win The Loser’s Game . He says, “The key question under the new rules of the game is this: how much better must an actively trading manager be to at least recover the cost of the portfolio turnover? The answer is daunting. Total transaction costs, which are commissions plus the spread between the bid and the ask side of the market of 2% to buy and 2% to sell are certainly not high estimates.” In no load mutual funds total expense ratio average 1.19%. Add again Trading and bid/ask costs, which are a huge 4.17% average. When you add it all up it can easily cost 5.36% of your investment money, inside of a so-called “no load” mutual fund. “ No load” mutual funds are not load-free as you might expect. Transition: So those are the myths that pervade investing. Now, before you say, “Well, forget it – it’s too complex, nothing works, and I just want to stash my money under a mattress somewhere, let’s sum up these myths and look at the truth of investing.
  • The Point: Review myths and set up the Truth. What we have done up to this point is dispel four myths of investing: Stock Selection Track Record Investing Market Timing All of which we have proven do not consistently and predictably work. And, then we’ve found that what we can’t see can hurt us because there are Costs of Investing that extract a huge return out of our investment portfolio. Transition: Now I’m going to tell you the exciting, refreshing, true story about investing.
  • The Point: FMPT set up. Free Market Portfolio Theory, otherwise known as FMPT, is an investment approach firmly grounded in the academic research of the last 50 years. Together these concepts form a solid, disciplined, and diversified investment strategy. Transition: There are three academic components of Free Market Portfolio Theory.
  • The Point: Identifying the three components of FMPT. These three components are: Free Markets Work Modern Portfolio Theory The Three-Factor Model Now, don’t be scared off by the complicated language because we’re going to break each one of these down and simplify what it really means. Transition: But before we do that, let’s meet the people who have pioneered these concepts.
  • Point: Nobel prize winners, authors, and leading academics have created this theory. Over the past 50 years there has been much research in the field of economics and specifically the field of investments. This research is conducted through some of the leading universities in the country, including Yale, Stanford and, most notably, the University of Chicago, which has been the home of the research for more Nobel Prize winners in the field of economics than any other institution. The notable researchers in the field have been: Nobel Prize Winner 1990, Harry Markowitz Nobel Prize Winner 1990, Merton Miller (Their concepts helped to define Modern Portfolio Theory which we will discuss more later) Co-authors of Stocks, Bonds, Bills and Inflation , Rex Sinquefield and Roger Ibbotson Father of Efficient Market Theory and the Three-Factor model, Eugene Fama Co-founder of the Three-Factor model, Kenneth French Based on the studies of these brilliant individuals it is possible to become a successful, wealthy investor by avoiding the traps of traditional investment methods. Transition: Now we’ll examine what these distinguished people have come up with as we learn more about each of the three components of Free Market Portfolio Theory.
  • The Point: Set up Free Markets Work The first component is Free Markets Work, first developed by Eugene Fama in 1965. In his Ph.D. dissertation, Fama said “In an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.” Transition: To understand this theory better, we’ll need to analyze two ways of looking at the market: One that markets are efficient, the other that markets are inefficient.
  • Point: There’s another side to the story. To understand free markets let’s explore the inefficient market approach. This means that markets consistently misprice goods and services. Therefore, it would be reasonable (if that were true) and possible to take advantage of the mispricings and pass value on to the investor by increasing returns and avoiding losses in investments. People who believe the market is inefficient would utilize those three traditional investment strategies we just talked about. Transition: On the other hand, let’s see what market efficiency has to tell us.
  • The Point: Market efficiency explains traditional investing myths. There is another view of the market, and it’s based on the efficient market hypothesis. This view tells us that, based on supply and demand, the free market is the best determinant of market prices. All available information is factored into the current price. Only new and unknowable information and events change pricing into the future. The randomness of the market makes it impossible for any individual or entity to consistently predict market movements and capture additional returns unrelated to risk. This view would appear to be consistent with the studies we saw earlier dispelling traditional investment myths. In fact, it explains why active managers aren’t able to consistently and predictably beat the market, because efficient market hypothesis says nobody can. Transition: There are people in both camps. Some think the market is efficient and others that it is inefficient. Most people (specifically investors), have never really thought about it. It is tremendously important as an investor for you to define this belief structure for yourself. Most investors have never had this opportunity. They simply use the latest investment strategy, or the one their neighbor used, successfully. But I know that once you are clear about your belief, what you truly believe, it will tell you how you need to manage your money.
  • The Point: Beliefs dictate actions. So, there are two completely different ways of looking at the world. In this age of grays, this decision is black and white. Attempting to believe a little bit of both and taking actions based on this murky belief will, without a doubt, give you disappointing performance on your investments. You simply can’t have it both ways. Because, if you think that markets are inefficient, then you must continue trying to take advantage of these inefficiencies through stock selection and market timing. On the other hand, if you believe that markets work, then the appropriate action is to try to find something else, something that works better. Transition: Market efficiency is the first component and belief system upon which Free Market Portfolio Theory is based. So, let’s look at what the academics discovered, as far as a better way to invest, when you believe the market is efficient.
  • The Point: Set up Modern Portfolio Theory. So now we’ll look at the 2 nd component of Free Market Portfolio Theory and that is Modern Portfolio Theory. Transition: Developed using the concepts of Markowitz, Sharpe and Miller, Modern Portfolio Theory examines portfolio performance based on risk and return. This theory won these three men the Nobel Prize.
  • The Point: Introduce Harry Markowitz. This is Dr. Harry Markowitz, the pioneer of Modern Portfolio Theory, whose doctorate paper written in 1952 won the Nobel Prize in 1990. It took nearly 40 years for computer technology to advance to the point where his theories could be proven. Like Albert Einstein who wrote the black hole theory on the back of an envelope, but it wasn’t until 40 years later that a black hole was actually discovered in space by the Hubble telescope. Mr. Markowitz, like Einstein, was truly ahead of his time. Transition: He is the one who figured out how to use the Efficient Frontier to look at risk and return.
  • The Point: Explain The Efficient Frontier. This is Markowitz Efficient Frontier. It is a hypothetical graph that illustrates an optimal portfolio return for any given level of risk. For example, we can take an investor who has 100% of their money in the S&P 500 and say, you have a historical rate of return of around 10%, and you have an historical volatility of around 19%. If you’re comfortable with that level of return, why don’t we move you straight across this graph to pick up essentially the same return with one half of the volatility. Or, if you are comfortable with that volatility, we can just move you straight up the graph, pick up an extra 2% to 3% rate of return per year without any additional volatility in your portfolio. Using what is called the Free Market Investment Analysis, we are able to plot where your current investment portfolio falls on this Efficient Frontier. Transition: So how do we create an optimal portfolio considering that we don’t want to employ traditional investment strategies?
  • The Point: Asset allocation is the key to successful investing. To do that, let’s look at the determinants of portfolio performance. This study shows that 91.5% of a portfolio’s investment return is gained through the allocation of the asset classes. In translation, what mix of asset classes did you pick? Again, we see that utilizing the methods of market timing and stock selection do not add value to the return of an investment portfolio. This means that you need not worry about which individual stocks you own, but rather, how each type of security is represented in your portfolio and how these investments work together. Transition: Which brings us to the idea of correlation…
  • The Point: Correlation is the cornerstone of diversification and you can get higher return with less volatility. So, what is correlation? Correlation is the relationship between two investments – let’s take a look at how similarly or dissimilarly they behave in the market. Utilizing investments with low correlations is one of the best ways to reduce risk in your portfolio. Finish this statement for me ... If you want extra return in your investment portfolio, you have to take more .... what?(PAUSE AND LET THEM RESPOND) Risk. Right? But that is wrong! In his research Harry Markowitz also proved that you could combine different assets within a portfolio which will offset one another because of their correlation relationships. What we’re looking for are assets with dissimilar price movements, so that when one goes down, the other has good potential of offsetting it with an up period. (USE HAND MOTIONS, ONE HAND UP, THE OTHER DOWN - MOVE TO OPPOSITE POSITION) Dr. Markowitz measured the likelihood of various asset categories moving dissimilarly. It is possible to have two assets that, by themselves, look fairly volatile, but when you combine them in this way in a portfolio, you actually increase the rate of return and reduce the volatility. Correlation is the cornerstone of diversification. Transition: Let’s look at building a portfolio using the benefits of correlation.
  • The Point: How to use correlation. Here is how to increase returns and lower volatility. The lower the correlation between two asset categories, the less similar they are. Look at the S&P 500. If we invested 100% in Large US stocks, we would have had an average return of about 10.02%, and a volatility factor of about 18.32%. Let me backtrack and explain some terms: have you ever heard someone say, “Well you should always consider risk in the investment process?” But they rarely show you how to measure it. They don’t show you a way to compare risk in one investment to an alternative. They just refer to it in conceptual terms. Well, academics measure risk mathematically and it is called standard deviation. All you have to do is remember that standard deviation is a form of volatility. The higher this number is, the higher the volatility. When we begin to diversify our S&P 500 portfolio, we add 30% Large International stocks. We actually increase our return, but our volatility is reduced. If we continue in the diversification process by adding 10% into Small International, we increased the rate of return to 10.96%. Look what happens to volatility. It’s about 15 basis points less than our original portfolio. So with this very simple hypothetical example, we’ve been able to add almost 1% return to the portfolio, with no additional volatility over the same period of time. Transition: So, Free Market Portfolio Theory tells us that there’s an efficient market hypothesis which says that prices are rational and there’s Modern Portfolio Theory which also shows us how to use correlation to create an investment portfolio with less risk and more return. Let’s check out the 3 rd component of Free Market Portfolio Theory…
  • The Point: The Three-Factor Model identifies three sources of risk that the market rewards. The 3 rd component of Free Market Portfolio Theory is the Three-Factor Model, developed in 1990 by Kenneth R. French of Yale University and Eugene Fama, who we talked about earlier. Together they determined which sources of risk the market systematically rewards with higher returns. The three factors are: The Market Factor The Size Factor, and The “Value” Factor This model takes the relationship between risk and return even further than Modern Portfolio Theory because it makes it possible to calculate expected returns based on these risk factors. The Three-Factor Model explains 97% of the variability of returns. Transition: We will examine each risk factor briefly…
  • The Point: Invest in equities. The first factor is called the Market Factor. It tells us that it is inherently riskier to invest in the stock market than it is to invest in fixed income instruments. Because there is more risk involved, stocks provide a higher rate of return than fixed income instruments. Pretty simple: the market rewards you for investing in equities. Transition: What else does the market reward us for?
  • The Point: Small companies are riskier than large companies. The second factor is the Size Factor because it takes into consideration the size of the company in which you are investing. When investing in the stock market, small companies give a larger expected rate of return than large companies due to the fact that there is more risk involved with these small companies. Transition: So the market, historically, will reward you for investing in equities, specifically small companies. Now, let’s look at the 3 rd factor.
  • The Point: Companies in distress are riskier and offer higher returns. The third factor is called the Value Factor. It refers to the extra risk exposure, and the extra risk premium, of investing in high book-to-market-value stocks. Now, high book-to-market (value) stocks are companies which have a lower market price than other companies relative to their size. These types of companies, which are usually experiencing some kind of financial distress, and usually their earnings are down. Therefore, they are riskier and offer a higher return to the investors. So the Three-Factor Model tells us that the market rewards investors for taking risks, especially in equities, a little bit more for small companies, and even a little bit more return for distressed companies. Transition: So, the Three-Factor model tells us that the market rewards investors for taking risk, especially in equities, a little bit more for small companies and even a little bit more return for distressed companies.
  • The Point: Summarize The Truth: FMPT The truth is that you can be a successful investor using the Free Market Portfolio Theory, which is made up of Free Markets Work, Modern Portfolio Theory and The Three-Factor Model, and this process eliminates the need to rely on the traditional myths of investing. Transition: So now let’s review what we learned today.
  • How can we create a diversified portfolio? Typically, the recommendation is to own a collection of equity mutual funds, or individually managed stock accounts. So first, let’s look at what the typical investor does under the advice of a broker or on his own. If we look at the time frame from 1990–2009, based on a study done by the Dalbar group, which measured actual investor behavior, we see drastically different results from the published return of the mutual funds as a whole. The annualized rate of return for investors investing in equity-based mutual funds, from 1990–2009, was a dismal 3.17%. This is very discouraging. What happened? Was the market that bad over the time period covered or was something else going on?
  • The answer can be found with other data from the Dalbar study. The average investor’s holding period was only slightly more than 3 years for the 20 year period covered by the study. So, rather than buying a fund and holding it for the long-term, what happens is that the average investor chases market performance in the following way: the investor buys a mutual fund or collection of funds based on some ranking system and/or the advice of a broker. These funds, which have had superior performance over a period of time, are likely to be heavily invested in one or two market segments and not greatly diversified. When these market segments go sour, the investor sells the fund(s) and buys ones which are currently performing better. We call this phenomenon, Changing the Market. And, as evidenced by the Dalbar study, this menu works. Also contributing to the extremely low annualized return for investors over the 20 year period are hyperactive stock picking and attempts to time the market – both systems of changing market performance.
  • So how can we improve this? Had investors stayed fully invested in, say S&P 500 stocks, over the 20 year period rather than chasing the market, the annualized rate of return would have been 9.67% - THREE TIMES THE RETURN - with about 10% less volatility than the average investor. This is shown in Portfolio 2. So just by making the move of owning a broad market index of S&P 500 stocks, and not timing or playing with the portfolio, we increase our return exponentially with less volatility.
  • The next thing we're going to do to the portfolio is to include some fixed income. Previously, when discussing the market factor, we said that an important decision facing an investor is the percentage of the portfolio invested in fixed income versus equities. In this example, we are going to use 40%, with 20% in five year government bond portfolios, and 20% in 1 year fixed income. Placing 40% of the portfolio into these fixed income assets dramatically reduces the volatility from a standard deviation of 18.78% to 11.66%—that’s nearly 40%! Even so, it has very little impact on the expected return (see Portfolio 3).
  • The next way that we're going to improve the portfolio is, we're going to add some international stocks. Here instead of having 60% in US large companies, we're going to move 30% into the European, Australian and Far East funds (EAFE) index. Stocks in this index represent the largest stocks on a global basis outside of the US. The impact of this Global Diversification (Portfolio 4) adds about 20bps in expected return for only 6bps in additional volatility. Pretty good trade off. What’s more, it increased the probability of benefitting from geo-political diversification.
  • Now, we’ll alter the portfolio to address the Factor Number 2 = the size factor by including some U.S. Small Cap and International Small Cap stocks. Based on the percentages shown in Portfolio 5, there is a dramatic increase in expected return for the nominal trade off in the impact on volatility.
  • Finally, we’ll adjust the portfolio to address the value factor. By adding 7.5% U.S. small cap value stocks and 7.5% U.S. large cap value stocks and adjusting the percentages across the other equity categories as shown in Portfolio 6, we obtain an annualized rate of 11.34% with the standard deviation of 12.25%. How does that compare to the Average Investor’s return in Portfolio 1? How does it compare to the all-S&P 500 Portfolio 2? So, without using any of the failed methods of traditional investing: picking stocks, timing the market or using a manager’s track record we’ve engineered a portfolio with better returns and reduced risk.
  • The Point: To set up the 20 Must-answer questions. The problem with this discussion is that many times it creates more questions than answers for investors. Many of the answers you need, you have to reach on your own. Now I’m going to give you 20 questions that you must be able to answer if you want to someday achieve peace of mind about your investments. The questions should be relatively easy and they all have either a “yes” or “no” answer. The catch is that the answer must be 100% yes, otherwise it is a “no.” Transition: So, let’s find out your answers.
  • Have you discovered your true purpose for money, that which is more important than money itself. Yes or no? Now, it's not enough to know that money is not the most important thing in life. To actually get a yes to this question, you have to be able to know, for you, what is the most important value that you hold. That which is more important than money, and that which is more important than everything else in life.
  • Number two is really straight forward, are you invested in the market? Meaning, do you have stocks, equities, or do you have at least equity-based mutual funds? Most people easily get a “yes” to this question, because most people today have some money in the market whether it's in their 401K, their pension plan, or their personal investments.
  • Number three: Do you know how market’s really work? I talk to investors all the time, and they have money in the market, but then when it comes to understanding the underlying dynamics of how the market works, they don’t know. It can be very disconcerting to have a portion of your wealth invested in a way that you don’t really understand.
  • Number four: Have you defined your investment philosophy? Now we all know that whether it's religion, or education, science, history, that philosophy is imperative to making solid decisions. There are basically two investment philosophies. One is that markets work. That through the process of supply and demand, the market sets a price that’s impossible for any one individual to consistently predict or forecast what's going to happen next. That a free market, like Adam Smith said, sets the best possible price and takes all the plans and knowable information and prices it into the pricing system today. That is the basic philosophy and foundation for the free enterprise system in America today. There is another investment philosophy, and that is that markets fail. That markets consistently and predictably mis-price things and that there’s one brilliant individual, or brilliant committee, that can tell you what the real price is, and that they can maximize the wealth to an economy, or to an individual investor. That is the basic premise that was developed by Carl Marx, and the basic premise that Socialism was built on. So once you're able to identify what you're investment philosophy is, then you're able to design strategies that are going to be supportive of that philosophy. Most people end up strategizing before they really even understand what the basic philosophies are, and which one they truly believe. So number four: Have you defined your investment philosophy?
  • Number five: Have you identified your personal risk tolerance? Do you have an academic number, and have you thought about it and cognitively, consciously made a decision of how much and what type of risk you want in your portfolio. Or, have you had more of a smorgasbord approach where one year this investment looks good, and another one, this one looked good, and over the years, you’ve just kind of haphazardly built a portfolio that you don’t know what the risks are?
  • Number six: Do you know how to measure diversification in your portfolio. Do you have a specific number that you can identify that tells you how well, or how poorly, you’re diversified?
  • Number seven: Do you consistently and predictably achieve market returns? To be able to answer “yes” to this question, means that you have to know historically over the last sixty years, what market rates of return have actually been. These are the benchmarks that you want to look at as you build your portfolio going forward, because most people don’t know what historically markets have done, they have no idea whether they consistently achieve market returns, or dramatically under perform. I can tell you statistically that by far, the vast majority of investors consistently and predictably under perform market rates of return.
  • Number eight: Have you measured the total amount of commissions and costs in your portfolio? Many of those costs can be hidden and we talked about that earlier.
  • Number nine: Do you know where you fall on the Markowitz Efficient Frontier? Let me explain what it is. Markowitz who won the Nobel Prize in 1990, determined that once you build a portfolio you can actually identify how much volatility a portfolio has based on historic rates of return, and then you could use modern statistics and analysis to create a portfolio that has a maximum expected return for any level of risk that you're willing to take on It's critical to be a successful investor, to know where you fall, so that you can look at what rates of return you're getting, for what risk you're taking.
  • Number ten: When it comes to building your investment portfolio, do you know exactly what you're doing, and why?
  • Number eleven: Are you working with a financial coach, versus a financial planner? A financial coach focuses you on helping to answer the twenty ‘must-answer’ questions that we're talking about today, and help solve the chronic problems that commission-based brokers, and commission-based financial planners create.
  • Twelve: Do you have a customized, life-long game plan to guide all of your investing and spending decisions? What it is, is a way of looking at what all the things that are valuable to you, all of your life goals, all of your assets, and actually planning out what you want to do with your life and with your money, so that when it comes to the end, like Ebenezer Scrooge when he's looking at his grave stone, that when you come to the end, you can say that you lived a life without regret.
  • Number thirteen: Do you have an Investment Policy Statement?
  • Fourteen: Have you devised a clear cut method for measuring the success or failure of your portfolio? What do you have? Where is your measurement tool to know if your portfolio is actually doing what it's supposed to do?
  • Fifteen: Do you fully understand the implications and applications of diversification in your portfolio, and how to build it in?
  • Sixteen: Do you have a system to measure portfolio volatility?
  • Seventeen: Are you aware of the incentives brokerage firms and the financial community have when selling commission-based products? Let’s face it. The large financial Institutions have a vested interest to get investors to trade more than they should. That is the bottom line, and there's somewhat of an unholy alliance that the financial institutions have with the large media outlets, ala TV, radio and written press, to keep you gambling and speculating with your money. Because that’s what sells ads on TV. That’s what gets magazines placed, and also, you'll find built-in conflict of interest that the very people that are buying the ads during the news programs, are the same people that are talking as the experts on the program. If you're not gambling and speculating with your money, the brokerage firms are out of business, the news programs go off the air, and there are people that make a lot of money promoting speculating and gambling with your hard earned money.
  • Eighteen: Do you know the three warning signs, the three specific signs that you are gambling and speculating with your money? It's very difficult for most people to know if they're speculating, or if they're prudently investing, because they have no way to distinguish those two activities, especially when so much of the world leads you to believe you're prudently investing, when in reality all you're doing is gambling with your money.
  • Number nineteen: Can you identify the cultural messages and personal mind sets about money that destroy your peace of mind? Many of the mind sets and beliefs that we individually take on about money, are not things that we developed when we were fifty-five, or thirty-five, or even fifteen. Many of the ideas and mind sets that we adopted about money come from our childhood, maybe when we were five.
  • And number twenty: Are you ready to shift your personal experience of money and investing from a scarcity mode, to an abundance mode? What I find is that people that are suffering from portfolio losses, the lack of diversification, the excess of cost, the commission bias built into the planning and brokerage process, are continually in a state of scarcity. Not enough time. Not enough money. Not enough peace of mind. Not enough clarity, focus and capability to move forward into the future, and their in a very diminished state. This is the only question out of all twenty, that you have to be able to answer “yes” to, to make progress. Are you ready to begin to shift your experience of your portfolio, of your money, from a scarcity mode to an abundance mode? And if you can answer “yes” to that, then you're ready to take the next steps to create abundance in your life.
  • The Point: To show the participants where they fall on the IQ spectrum. So, if you follow the score chart here, you get five points for each question that you answered “yes” to. How many people answered “yes” to all twenty questions? (If any raise their hands – “That’s very impressive”) How many got a 65-80%? Great job you are Better Investors . How many got a 45-60%? You are among the Common Investors – it’s not unusual. If you got a 25-40% you may be a bit discouraged by the investment process and may have had some unpleasant experiences. How many of you, let’s see by hands, are the 0-20%, I bet you’re feeling really frustrated with the whole idea of investing. Transition : No matter where you fall on the spectrum, there is good news here for you today. By separating the myths from the truth of investing you will be able to increase your score and gain some hope for further growth.
  • Separating Myths From Truth The Story Of Investing

    1. 1. SEPARATING MYTHS FROM TRUTH The Story of Investing
    2. 2. <ul><li>Dispelling the Traditional Investing Myths </li></ul><ul><li>Telling the True Story of Investing </li></ul><ul><li>Opportunity to Achieve True Peace of Mind </li></ul>SEPARATING MYTHS FROM TRUTH
    3. 3. DISPELLING THE MYTHS Myth : A story made up to explain a phenomenon beyond the science of the day.
    4. 4. TRADITIONAL INVESTING MYTHS MYTH 1: Stock Selection MYTH 2: Track-Record Investing MYTH 3: Market Timing MYTH 4: Costs of Investing
    5. 5. MYTH 1: STOCK SELECTION THE MYTH: Investment advisors can consistently and predictably add value by exercising “superior skill” in individual Stock selection. Stock Selection : Choosing stocks based on a belief they will do well in the future.
    6. 6. Total Number of Funds Open 2009 26,905 Total Number Born 43,668 Total Number Killed 16,763 Survivorship Bias For illustrative purposes only. Mutual fund data provided by CRSP Survivor Bias Free Mutual Fund Database. CRSP data provided by the Center for Research in Security Prices, University of Chicago. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS AND INVESTORS MAY EXPERIENCE A LOSS. * There were 257 funds opened and 47 funds closed in which the year was undisclosed. Year Number of Funds Number of New Funds Number of Dead Funds 1982 1034 205 24 1983 1221 212 25 1984 1455 253 19 1985 1798 360 17 1986 2233 459 24 1987 2726 528 35 1988 3096 450 80 1989 3308 330 118 1990 3596 474 186 1991 4080 599 115 1992 4924 1017 173 1993 6540 1776 160 1994 8430 2123 233 1995 9486 1548 492 1996 10,724 1745 507 1997 12,352 2160 532 1998 13,940 2075 487 1999 15,938 2046 48 2000 17,636 2562 864 2001 19,027 2292 901 2002 20,337 2328 1018 2003 21,112 1816 1041 2004 22,112 1847 847 2005 23,344 2287 1055 2006 25,036 2675 983 2007 2008 25,609 26,711 2050 2391 1477 1289 2009 26,905 1570 2307 Year Number of Funds Number of New Funds Number of Dead Funds 1923 1 1 0 1924 4 3 0 1925 5 1 0 1926 6 1 0 1928 10 4 0 1929 16 6 0 1930 17 1 0 1931 21 4 0 1932 37 16 0 1933 46 9 0 1934 48 2 0 1935 57 9 0 1936 59 2 0 1937 62 3 0 1938 71 9 0 1939 78 7 0 1940 86 8 0 1941 87 1 0 1944 93 6 0 1945 98 5 0 1946 103 5 0 1947 113 10 0 1948 117 4 0 1949 131 14 0 1950 137 6 0 1951 142 5 0 1952 152 10 0 1953 163 11 0 Year Number of Funds Number of New Funds Number of Dead Funds 1954 183 20 0 1955 186 3 0 1956 205 19 0 1957 222 17 0 1958 241 19 0 1959 267 26 0 1960 281 14 0 1961 273 25 33 1962 285 12 0 1963 295 10 0 1964 311 16 33 1965 329 18 0 1966 357 28 0 1967 387 30 0 1968 460 74 1 1969 552 100 8 1970 600 71 23 1971 615 47 32 1972 612 32 35 1973 606 30 36 1974 593 34 47 1975 587 25 31 1976 609 47 25 1977 635 53 27 1978 647 38 26 1979 674 52 25 1980 726 72 20 1981 853 143 16
    7. 7. For illustrative purposes only. Mutual fund data provided by CRSP Survivor Bias Free Mutual Fund Database. CRSP data provided by the Center for Research in Security Prices, University of Chicago. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS AND INVESTORS MAY EXPERIENCE A LOSS.
    8. 8. The Worst 200 Dead Mutual Funds - 77.7 % AVERAGE RETURN For illustrative purposes only. Mutual fund data provided by CRSP Survivor Bias Free Mutual Fund Database. CRSP data provided by the Center for Research in Security Prices, University of Chicago. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS AND INVESTORS MAY EXPERIENCE A LOSS.
    9. 9. Average of all US Equity funds available in the CRSP Survivor- Bias Free US Mutual Fund Database, data ending Dec. 2009 S&P 500 Index and CRSP Market Index data obtained from DFA Returns software 12/09 Past performance is no guarantee of future results and investors may experience a loss. Wealth Lost to Active Stock Picking $1,186,385 $3,153,845 $3,046,830 $1,967,465
    10. 10. Average of all Mutual funds available in the CRSP Survivor- Bias Free U.S. Mutual Fund Database, data ending Dec. 2009 Hypothetical Portfolios based on data in endnote 8. Past performance is no guarantee of future results and investors may experience a loss. $1,114,360 $2,838,165 $4,772,578 $7,258,361 $9,327,620
    11. 11. MYTH 2: TRACK-RECORD INVESTING Track-Record Investing : The use of performance history to determine the best investments for the future. THE MYTH: Finding funds that did well in the past is a reliable method of indicating which funds will do well in the future.
    12. 12. Track Record Investing All Funds Average Return Top 30 Funds Average Return S&P 500 Index CRSP 1-10 Index Total # of “Surviving” Funds 1990–1999 Total # of “Surviving” Funds 2000–2009 1990–1999 14.89 27.15 18.89 18.87 760 2000–2009 2.11 -4.43 1.21 1.95 1,847 For illustrative purposes only. Mutual funds data provided by CRSP Survivor-Bias Free Mutual Fund Database, includes funds that are U.S. Equity mutual funds. The S&P data are provided by Standard & Poor’s Index Services Group. CRSP data provided by the Center for Research in Security Prices, University of Chicago. Indices are not available for direct investment, therefore their performance does not reflect the expenses associated with the management of an actual portfolio. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS.
    13. 13. Track Record Investing Top 30 Funds Average Return All Funds Average Return S&P 500 Index CRSP 1-10 Index Number of “Surviving” Funds 1990–1994 18.77 9.40 8.69 9.04 569 1995–1999 21.66 22.24 28.55 27.42 1,524
    14. 14. A manager’s ability to pick stocks in the past has ZERO CORRELATION with his/her ability to do so in the future.
    15. 15. MYTH 3: MARKET TIMING Market Timing : Any attempt to alter or change the mix of assets based on a prediction or forecast about the future. THE MYTH: Money managers are able to utilize market timing to effectively predict up & down markets.
    16. 16. DALBAR Research Study Results <ul><li>As the chart below clearly indicates – The Average Investor earns significantly less than the market indices, and investors that time the market actually lose money over the period measured. </li></ul><ul><li>DALBAR, Inc., Quantitative Analysis of Investor Behavior, 2009 </li></ul>CATEGORY 1990-2009 Annualized Return S&P 500 Index 8.20% Average Equity Fund Investor 3.17% Inflation 2.80%
    17. 17. WHY MARKET TIMING DOESN’T WORK $48,456 8.21% $32,157 6.01% $24,235 4.53% $18,967 3.25% $15,213 2.12% $12,406 1.08% $10,193 .10% January 1, 1990–December 31, 2009 5040 Trading Days Source: ChartSource, Standard & Poor’s Financial Communications. Stocks are represented by Standard & Poor’s Composite Index of 500 Stocks, and unmanaged index that is generally considered representative of the U.S. stock market. Past performance is not a guarantee of future events. Based on initial investment of $10,000.
    18. 18. <ul><li>“ Tactical Asset Allocation” </li></ul><ul><li>is Market Timing in Disguise </li></ul>BEWARE: MARKET TIMING
    19. 19. CHARLES D. ELLIS “ The evidence on investment managers’ success with market timing is impressive - and overwhelmingly negative.” Charles D. Ellis, Investment Policy , 1993 Charles D. Ellis is a managing partner of Greenwich Associates, the leading consulting firm specializing in financial services worldwide. B.A. Yale, M.B.A (with distinction) Harvard and Ph.D. New York University
    20. 20. MYTH 4: COSTS OF INVESTING Costs of Investing : Fees incurred by investors to buy, sell, and own stocks or mutual funds. THE MYTH: What you don’t see can’t hurt you.
    21. 21. <ul><li>Bid/Ask Spread </li></ul><ul><li>Mutual Funds </li></ul>THE COSTS OF INVESTING
    22. 22. Bid/Ask Spread BUY Price $50.00 Market Maker $.50 Spread SELL Price $49.50
    23. 23. BID/ASK SPREAD What Your Broker Won’t Tell You Source: Reuters Trading Systems (Feb. 11, 2009) The Bid/Ask Spread as a percent of price is a conservative estimate of actual trading costs. This estimate is almost 125 times as great for the smallest market segment as for the largest market segment (6.26 vs 0.05). Market Cap Range ($Millions) Average Price Percent Spread 18,610-389,027 42.96 0.05 2,733-18,472 31.89 0.15 976-2,731 27.59 0.19 243-975 14.78 0.48 61-242 8.63 1.71 10-61 3.20 6.26
    24. 24. CONSUMER “NO LOAD” MUTUAL FUNDS “ The key question under the new rules of the game is this: How much better must a[n]...[actively trading]... manager be to at least recover the cost of...[portfolio turnover]? The answer is daunting.” Source: Charles D. Ellis Investment Policy - How to Win the Loser's Game , 1985 1. Mutual fund trading plus bid/ask spread cost taken from Investment Policy - How to Win the Loser’s Game , 2nd Edition by Charles D. Ellis (1993) p.8-9.
    25. 25. <ul><li>The Myths </li></ul><ul><ul><li>Stock Selection </li></ul></ul><ul><ul><li>Track-Record Investing </li></ul></ul><ul><ul><li>Market Timing </li></ul></ul><ul><ul><li>Costs of Investing </li></ul></ul><ul><li>Next… </li></ul><ul><ul><li>The Truth </li></ul></ul>SO FAR…
    26. 26. THE STORY OF INVESTING: FREE MARKET PORTFOLIO THEORY
    27. 27. <ul><li>Free Market Portfolio Theory is: </li></ul><ul><ul><li>An investment approach firmly grounded in the academic research of the last 50 years. </li></ul></ul><ul><ul><li>A disciplined approach to capturing market returns while managing volatility. </li></ul></ul>WHAT IS FREE MARKET PORTFOLIO THEORY?
    28. 28. THE COMPONENTS OF FREE MARKET PORTFOLIO THEORY <ul><li>COMPONENT 1: </li></ul><ul><li>Free Markets Work </li></ul>COMPONENT 3: The Three-Factor Model COMPONENT 2: Modern Portfolio Theory
    29. 29. LEADING ACADEMICS WHO CONTRIBUTE TO FREE MARKET PORTFOLIO THEORY <ul><li>Harry Markowitz: Nobel Prize Laureate, 1990, University of Chicago </li></ul><ul><li>Merton H. Miller: Nobel Prize Laureate, 1990 - Robert R. McCormick Distinguished Service, University of Chicago </li></ul><ul><li>Rex Sinquefield: Co-author Stocks, Bonds, Bills and Inflation , MBA, University of Chicago, BA, St. Louis University </li></ul><ul><li>Roger G. Ibbotson: Co-author Stocks, Bonds, Bills and Inflation , Professor of Finance, School of Organization and Management, Yale University </li></ul><ul><li>Eugene F. Fama: Robert R. McCormick Distinguished Service, Graduate School of Business, University of Chicago </li></ul><ul><li>Kenneth French: Professor of Finance at the Tuck School of Business, Dartmouth College </li></ul>
    30. 30. <ul><li>Free Markets Work </li></ul>COMPONENT 1: “ In [a free] market at any point in time the actual price of a security will be a good estimate of its intrinsic value.” - Eugene F. Fama , “Random Walks in Stock Market Prices,” Financial Analysts Journal, September/October 1965 .
    31. 31. <ul><li>The market fails to price goods and services appropriately. </li></ul><ul><li>It is possible for some individuals to identify in advance which prices are inaccurate. </li></ul><ul><li>Underpriced or overvalued markets can be forecast or predicted. </li></ul><ul><li>By taking advantage of these mispricings either in stocks or market sectors, it is possible to both increase returns and avoid losses in investments. </li></ul><ul><li>People with this view would utilize traditional investment myths and speculate with their assets. </li></ul>FREE MARKETS FAIL
    32. 32. <ul><li>Based on supply and demand the free market is the best determinant of market prices. </li></ul><ul><li>All available information is factored into the current price. </li></ul><ul><li>Only new and unknowable information and events change pricing. </li></ul><ul><li>The randomness of the market makes it impossible for any individual or entity to consistently predict market movements and capture additional returns unrelated to risk. </li></ul><ul><li>People with this view would utilize free market investment strategies. </li></ul>FREE MARKETS WORK
    33. 33. BELIEFS DICTATE ACTION <ul><li>FREE MARKETS WORK </li></ul><ul><li>Focus on capturing market returns </li></ul><ul><li>Utilize asset-class or structured funds </li></ul><ul><li>Diversify prudently </li></ul><ul><li>Identify your risk tolerance </li></ul><ul><li>Eliminate traditional investment strategies </li></ul><ul><li>Work with a financial coach who shares your market belief </li></ul><ul><li>FREE MARKETS FAIL </li></ul><ul><li>Pursue traditional investment strategies </li></ul><ul><li>Stay connected to all sources of financial information </li></ul><ul><li>Read every investment article you can find </li></ul><ul><li>Work with a financial professional who shares your market belief </li></ul>
    34. 34. <ul><li>Modern Portfolio Theory </li></ul><ul><li>Diversification Works </li></ul>COMPONENT 2: Nobel Prize Winners, 1990 Harry Markowitz William Sharpe Merton Miller
    35. 35. DR. HARRY MARKOWITZ As a graduate student in economics at the University of Chicago in the 1950's, Dr. Markowitz won acclaim for his studies on portfolio design and risk reduction. These concepts were later crucial for the development of Modern Portfolio Theory. Nobel Prize Winner 1990
    36. 36. MARKOWITZ EFFICIENT FRONTIER Maximizing Expected Returns for Any Level of Volatility 6 8 10 12 14 16 18 20 6 8 10 12 14 16 One Year Standard Deviation (Volatility) Annualized Compound Return Growth Aggressive S&P 500 Conservative Moderate
    37. 37. DETERMINANTS OF PORTFOLIO PERFORMANCE 1.8 2.1 4.6 91.5 1.8 2.1 4.6 91.5
    38. 38. ASSET CLASS CORRELATION Example Portfolio Time Value Investment A Investment B Portfolio 50/50 Combined Portfolio
    39. 39. INCREASE RETURNS AND REDUCE VOLATILITY Source: DFA Returns Software 12/09 Return(%) Simplified Example Of Low Correlation Benefits January 1971–December 2009 (in $U.S.) Standard Deviation Past performance is no guarantee of future results and investors may experience a loss. Large U.S. 100% S&P 500 Index 1,7 10.02 18.32 70% S&P 500 1,7 30% EAFE 1,5 Large U.S. EAFE 18.14 10.29 70% S&P 500 1 ,7 20% EAFE 1 ,5 10% Int'l Small 1 ,3,4 Large U.S. EAFE Small Int'l 18.15 10.96
    40. 40. <ul><li>The Three-Factor Model </li></ul>COMPONENT 3: Source: Fama, Eugene F., and Kenneth R. French, 1992 “The cross-section of Expected Stock Returns”, Journal of Finance 47 (June), 427-465 Eugene Fama & Kenneth French <ul><ul><li>Factor 1: The Market Factor </li></ul></ul><ul><ul><li>Factor 2: The Size Factor </li></ul></ul><ul><ul><li>Factor 3: The “Value” Factor </li></ul></ul>
    41. 41. <ul><li>Equities are riskier than fixed income. </li></ul><ul><li>Equities historically provide a higher rate of return. </li></ul>FACTOR 1: THE MARKET FACTOR 1926–2009 S&P 500 1,7 T-Bills Annualized Return 9.81 3.66 Standard Deviation 20.51 3.08 Source: DFA Returns Software, 12/09 Past performance is no guarantee of future results and investors may experience a loss.
    42. 42. <ul><li>Small companies are riskier than large companies. </li></ul><ul><li>Small companies historically provide a higher return than large companies. </li></ul>FACTOR 2: THE SIZE FACTOR Source: DFA Returns Software, 12/09 1926–2009 S&P 500 1,7 U.S. Small Co. Annualized Return 9.81 12.07 Standard Deviation 20.51 39.21 Past performance is no guarantee of future results and investors may experience a loss.
    43. 43. <ul><li>High book-to-market (value) stocks are riskier than low book-to-market (growth) stocks. </li></ul><ul><li>High book-to-market stocks historically provide higher return than low book-to-market stocks. </li></ul>FACTOR 3: THE VALUE FACTOR Source: DFA Returns Software, 12/09 July 1926–2009 S&P 500 1,7 U.S. Lg. Value 1,2 Annualized Return 9.88 11.82 Standard Deviation 19.23 25.31 Past performance is no guarantee of future results and investors may experience a loss.
    44. 44. <ul><li>Free Markets Work </li></ul><ul><li>+ Modern Portfolio Theory </li></ul><ul><li>+ The Three-Factor Model </li></ul><ul><li>= Free Market Portfolio Theory </li></ul>THE TRUTH
    45. 45. BUILDING A BETTER PORTFOLIO AVERAGE INVESTOR EQUITY PERFORMANCE
    46. 46. CREATING A DIVERSIFIED PORTFOLIO Portfolio 1 100% Equity Mutual Funds 1990–2009 Portfolio 1 3.17 20.10 Annualized Return (%) Annualized Standard Deviation (%) 60% 40% Actual Investor Results 100% Equity Mutual Funds Dalbar Investor Results Research for period 1990-2009 Portfolio 1- Data from DALBAR, Inc. Quantitative Analysis of Investor Behavior, 2009 Past performance is no guarantee of future results.
    47. 47. <ul><li>Average Holding Period—3.11 Years * </li></ul><ul><li>Track-Record Investing—Chasing the Market </li></ul><ul><li>Hyperactive Stock Picking </li></ul><ul><li>Market Timing </li></ul>WHY ARE THE RETURNS SO LOW? *Data from DALBAR, Inc. Quantitative Analysis of Investor Behavior, 2009, 20-year period
    48. 48. CREATING A DIVERSIFIED PORTFOLIO Basic Passively Invested Portfolio S&P 500 Index 1973–2009 Annualized Return (%) Annualized Standard Deviation (%) Portfolio 1 * 3.17 20.10 Portfolio 2 9.67 18.78 Portfolio 1 100% Portfolio 2 100% Equity Mutual Funds 100% S&P 500 <ul><li>Portfolio 1- Data from DALBAR, Inc. Quantitative Analysis of Investor Behavior, 2009; 1990-2009 </li></ul><ul><li>Return and Standard Deviation data from DFA Returns Software updated through 12/31/09 </li></ul><ul><li>Past performance is no guarantee of future results. Asset Allocation and diversification strategies cannot insure a profit or protect against a loss. </li></ul>
    49. 49. CREATING A DIVERSIFIED PORTFOLIO Including Fixed Income Assets in the Portfolio 1973–2009 Annualized Return (%) 60% 20% 20% Annualized Standard Deviation (%) Portfolio 1 * 3.17 20.10 Portfolio 2 9.67 18.78 Portfolio 3 9.35 11.66 S&P 500 Index Portfolio 1 100% Portfolio 2 100% Portfolio 3 60% 20% 20% Equity Mutual Funds 5-Year Government Portfolio One-Year Fixed Income <ul><li>Portfolio 1- Data from DALBAR, Inc. Quantitative Analysis of Investor Behavior, 2009; 1990-2009 </li></ul><ul><li>Return and Standard Deviation data from DFA Returns Software updated through 12/31/09. </li></ul><ul><li>Past performance is no guarantee of future results. Asset Allocation and diversification strategies cannot insure a profit or protect against loss. </li></ul>
    50. 50. CREATING A DIVERSIFIED PORTFOLIO Including Non-U.S. Assets in the Portfolio 1973–2009 Annualized Return (%) 30% 20% 20% 30% Annualized Standard Deviation (%) Portfolio 1 * 3.17 20.10 Portfolio 2 9.67 18.78 Portfolio 3 9.35 11.66 Portfolio 4 9.55 11.72 S&P 500 Index Portfolio 1 100% Portfolio 2 100% Portfolio 3 60% 20% 20% Portfolio 4 30% 20% 20% 30% Equity Mutual Funds 5-Year Government Portfolio One-Year Fixed Income EAFE Index <ul><li>Portfolio 1- Data from DALBAR, Inc. Quantitative Analysis of Investor Behavior, 2009; 1990-2009 </li></ul><ul><li>Returns and Standard Deviation data from DFA Returns Software updated through 12/31/09. </li></ul><ul><li>Past performance is no guarantee of future results. Asset Allocation and diversification strategies cannot insure a profit or protect against a loss. </li></ul>
    51. 51. CREATING A DIVERSIFIED PORTFOLIO Adding Small Cap Stocks 1973–2009 Annualized Return (%) 20% 15% 20% 15% 15% 15% Annualized Standard Deviation (%) Portfolio 1 * 3.17 20.10 Portfolio 2 9.67 18.78 Portfolio 3 9.35 11.66 Portfolio 4 9.55 11.72 Portfolio 5 10.82 12.62 S&P 500 Index Portfolio 100% Portfolio 2 100% Portfolio 3 60% 20% 20% Portfolio 4 30% 20% 20% 30% Portfolio 5 15% 20% 20% 15% 15% 15% Equity Mutual Funds 5-Year Government Portfolio One-Year Fixed Income EAFE Index U.S. 9-10 Small Co. Int’l Small Cap Stocks <ul><li>Portfolio 1- Data from DALBAR, Inc. Quantitative Analysis of Investor Behavior, 2009;1990-2009 </li></ul><ul><li>Return and Standard Deviation data from DFA Returns Software updated through 12/31/09. </li></ul><ul><li>Past performance is no guarantee of future results. Asset Allocation and diversification strategies cannot insure a profit or protect against a loss. </li></ul>
    52. 52. CREATING A DIVERSIFIED PORTFOLIO Adding High Book-to-Market Stocks Annualized Return (%) 20% 20% 7.5% 15% 7.5% 7.5% 15% 7.5% Annualized Standard Deviation (%) Portfolio 1 * 3.17 20.10 Portfolio 2 9.67 18.78 Portfolio 3 9.35 11.66 Portfolio 4 9.55 11.72 Portfolio 5 10.82 12.62 Portfolio 6 11.34 12.25 S&P 500 Index Portfolio 1 100% Portfolio 2 100% Portfolio 3 60% 20% 20% Portfolio 4 30% 20% 20% 30% Portfolio 5 15% 20% 20% 15% 15% 15% Portfolio 6 7.5% 20% 20% 15% 7.5% 15% 7.5% 7.5% Equity Mutual Funds 5-Year Government Portfolio One-Year Fixed Income EAFE Index U.S. 9-10 Small Co. Int’l Small Cap Stocks U.S. Small Cap Value U.S. Large Cap Value 1973–2009 <ul><li>Portfolio 1- Data from DALBAR, Inc. Quantitative Analysis of Investor Behavior, 2009; 1990-2009. </li></ul><ul><li>Return and Standard Deviation data from DFA Returns Software updated through 12/31/09. </li></ul><ul><li>Past performance is no guarantee of future results. Asset Allocation and diversification strategies cannot insure a profit or protect against a loss. </li></ul>
    53. 53. THE 20 MUST-ANSWER QUESTIONS FOR YOUR JOURNEY TOWARD PEACE OF MIND Directions: Answer each question “Yes” or “No.” Your Answer must be 100% “Yes” to qualify as “Yes.”
    54. 54. QUESTION 1 Have you discovered your True Purpose for Money, that which is more important than money itself?
    55. 55. QUESTION 2 Are you invested in the Market?
    56. 56. QUESTION 3 Do you know how markets work?
    57. 57. QUESTION 4 Have you defined your Investment Philosophy?
    58. 58. QUESTION 5 Have you identified your personal risk tolerance?
    59. 59. QUESTION 6 Do you know how to measure diversification in your portfolio?
    60. 60. QUESTION 7 Do you consistently and predictably achieve market returns?
    61. 61. QUESTION 8 Have you measured the total amount of commissions and costs in your portfolio?
    62. 62. QUESTION 9 Do you know where you fall on the Markowitz Efficient Frontier?
    63. 63. QUESTION 10 When it comes to building your investment portfolio, do you know exactly what you are doing and why?
    64. 64. QUESTION 11 Are you working with a financial coach versus a financial planner?
    65. 65. QUESTION 12 Do you have a customized lifelong game plan to guide all of your investing and spending decisions?
    66. 66. QUESTION 13 Do you have an Investment Policy Statement?
    67. 67. QUESTION 14 Have you devised a clear-cut method for measuring the success or failure of your portfolio?
    68. 68. QUESTION 15 Do you fully understand the implications and applications of diversification in your portfolio?
    69. 69. QUESTION 16 Do you have a system to measure portfolio volatility?
    70. 70. QUESTION 17 Are you aware of the incentives brokerage firms and the financial community have when selling commission-based products?
    71. 71. QUESTION 18 Do you know the three warning signs that you are gambling and speculating with your money versus prudently investing it?
    72. 72. QUESTION 19 Can you identify the cultural messages and personal mind-sets about money that destroy your peace of mind?
    73. 73. QUESTION 20 Are you ready to shift your personal experience of money and investing from a scarcity mode to an abundance mode?
    74. 74. <ul><li>85-100: Amazing Investor Congratulations! You are among the most educated, diligent and confident investors. You have experience in the investment markets and understand what it takes to be successful. Now is the time to support your current knowledge with discipline and educational reinforcement. </li></ul><ul><li>65-80: Better Investor As a Better Investor, you have been around the block a time or two and maybe had some less than successful investing experiences. Now is the time to expand your knowledge about investing and begin to make some solid choices about your financial future. To achieve this, seek answers to the questions you missed. </li></ul><ul><li>45-60: Common Investor You are not alone. Like many investors, you may frequently find yourself uncertain and confused about how to make the right investment choices. If you don’t already have an Investor Coach that you trust completely, now is the time to build a relationship to last a lifetime. </li></ul><ul><li>25-40: Discouraged Investor It’s easy to feel discouraged when you have been doing what you thought were the right things with your money without success. You may have followed all of the advice that you’ve read in financial magazines and newspapers, yet you are not getting the exponential results you had expected. </li></ul><ul><li>0-20: Frustrated Investor Flustered and confused, you may wonder where to begin – how is it even possible to wade through all of the information that you are being bombarded with on a daily basis. Sort through the chaos and find a path that is right for you. </li></ul>SCORING: Give yourself 5 points for every “Yes” answer.
    75. 75. THE OPPORTUNITY Learn more about what this means for you
    76. 76. <ul><li>No reinvestment of dividends or other earnings were included in the calculations. No commissions or fees have been deducted from the market performance figures because the intent is to show the benefits of diversification of asset classes and not to indicate the results Matrix would have achieved if it managed a client’s funds. If an investor invested in mutual funds designed to reflect asset class performance, the investor would, in effect, be paying an advisory fee to the mutual fund manager and brokerage commissions because these fees and commissions would be relected in the mutual fund’s expenses that are deducted from the value of each share of the mutual fund. If, in addition, an investor engaged an investment advisor to manage the assets, the investor would pay an investment advisory fee to this manager. If an investor also utilized the services of a separate custodian, the investor would pay additional fees to the custodian. The returns of the hypothetical asset class mixes frequently exceeded the results of Matrix clients’ portfolios with similar investment objectives for the period Matrix has managed clients’ funds from 1991 to present. This difference is due to differing allocations over the time periods shown. These allocations differed because of different asset classes used, new research applied, and because of deduction of commission. Also, it is not possible to invest in an index. Past performance of markets is no guarantee of future performance and clients may experience a loss. </li></ul><ul><li>US Large Value = U.S. Large Cap Value Portfolio: </li></ul><ul><ul><ul><li>July 1926-March 1993: Fama-French Large Cap Value Strategy. Simulates Dimensional’s hold range and estimated trading costs. Courtesy of Fama-French and CRSP: deciles 1-5 size, (.7) BtM. </li></ul></ul></ul><ul><ul><ul><li>April 1993-Present: U.S. Large Cap Value Portfolio net of all fees. </li></ul></ul></ul><ul><li>DFA International Small Company Strategy/DFA International Large Company Strategy: </li></ul><ul><ul><ul><li>January 1970-June 1998: 50% DFA Japanese Portfolio, 50% DFA U.K. Portfolio net of all fees. </li></ul></ul></ul><ul><ul><ul><li>July 1998-September 1989: 50% DFA Japanese Portfolio, 20% DFA UK Portfolio, 30% DFA Continental Portfolio net of all fees. </li></ul></ul></ul><ul><ul><ul><li>October 1989-March 1990: 40% DFA Japanese Portfolio, 30% DFA Continental Portfolio, 20% DFA UK Portfolio, 10% DFA Asia/Australia Portfolio net of all fees. </li></ul></ul></ul><ul><ul><ul><li>April 1990-December 1992: 40% DFA Japanese Portfolio, 35% DFA Continental Portfolio, 15% DFA UK Portfolio, 10% DFA Asia/Australia Portfolio net of all fees. </li></ul></ul></ul><ul><ul><ul><li>January 1993-March 1997: 35% DFA Japanese Portfolio, 35% DFA Continental Portfolio, 15% DFA UK Portfolio, 15% DFA Asia/Australia Portfolio net of all fees. </li></ul></ul></ul><ul><ul><ul><li>April 1997-March 1998: 30% DFA Japanese Portfolio, 35% DFA Continental Portfolio, 15% DFA UK Portfolio, 20% DFA Asia/Australia Portfolio net of all fees. </li></ul></ul></ul><ul><ul><ul><li>April 1998-Present: 25% DFA Japanese Portfolio, 40% DFA Continental Portfolio, 20% DFA UK Portfolio, 15% DFA Asia/Australia Portfolio net of all fees. </li></ul></ul></ul><ul><li>4. DFA International Small Company Portfolio: </li></ul><ul><ul><ul><li>January 1970-September 1996: DFA International Small Company Strategy. </li></ul></ul></ul><ul><ul><ul><li>October 1996-Present: DFA International Small Company Portfolio net of all fees. </li></ul></ul></ul><ul><li>EAFE Index: Courtesy of Morgan Stanley Capital International. Europe, Australia, and Far East Index net dividends ($). </li></ul><ul><ul><ul><li>January 1969-Present: EAFE Index Including gross dividends ($). </li></ul></ul></ul><ul><li>6. US Small Co = CRSP 9-10 Index: Courtesy of Center for Research in Security Prices, University of Chicago. Small Company Universe Returns (Deciles 9 &10) all Exchanges. </li></ul><ul><ul><ul><li>January 1926-June 1962: NYSE, rebalanced semi-annually. </li></ul></ul></ul><ul><ul><ul><li>July 1962-December 1972: CRSP Database, NYSE & AMEX, rebalanced quarterly. </li></ul></ul></ul><ul><ul><ul><li>January 1973-September 1988: CRSP Database, NYSE, AMEX & OTC, rebalanced quarterly. </li></ul></ul></ul><ul><ul><ul><li>October 1988-Present: CRSP Index (NYSE & AMEX & OTC). </li></ul></ul></ul><ul><li>S&P 500: Courtesy of Roger G. Ibbotson and Rex A. Sinquefield, Stocks, Bonds, Bills, and Inflation: The Past and the Future , Dow Jones, 1989. Ibbotson Associates, Chicago, annually updates work by Roger Ibbotson and Rex A. Sinquefield. Used with Permission. All rights reserved. The S&P 500 is an unmanaged market value-weighted index which measures the change in aggregate market value of 500 stocks relative to the base period 1941-1943. This index does not incur fees and charges typically associated with investing and values would be lower if such fees and charges were taken into consideration. Individuals may not invest directly in an index. Past performance is not a guarantee of future results. </li></ul>ENDNOTES
    77. 77. <ul><li>6. US Small Co = CRSP 9-10 Index: Courtesy of Center for Research in Security Prices, University of Chicago. Small Company Universe Returns (Deciles 9 &10) all Exchanges. </li></ul><ul><ul><ul><li>January 1926-June 1962: NYSE, rebalanced semi-annually. </li></ul></ul></ul><ul><ul><ul><li>July 1962-December 1972: CRSP Database, NYSE & AMEX, rebalanced quarterly. </li></ul></ul></ul><ul><ul><ul><li>January 1973-September 1988: CRSP Database, NYSE, AMEX & OTC, rebalanced quarterly. </li></ul></ul></ul><ul><ul><ul><li>October 1988-Present: CRSP Index (NYSE & AMEX & OTC). </li></ul></ul></ul><ul><li>S&P 500: Courtesy of Roger G. Ibbotson and Rex A. Sinquefield, Stocks, Bonds, Bills, and Inflation: The Past and the Future , Dow Jones, 1989. Ibbotson Associates, Chicago, annually updates work by Roger Ibbotson and Rex A. Sinquefield. Used with Permission. All rights reserved. The S&P 500 is an unmanaged market value-weighted index which measures the change in aggregate market value of 500 stocks relative to the base period 1941-1943. This index does not incur fees and charges typically associated with investing and values would be lower if such fees and charges were taken into consideration. Individuals may not invest directly in an index. Past performance is not a guarantee of future results. </li></ul><ul><li>35- Year performance figures taken from Dimensional Fund Advisor, Inc. (DFA) Returns software 12/07. Some data provided to DFA by the Center for Research & Security Pricing (CRSP), University of Chicago. Asset Classes defined as: Consumer Price Index for inflation, CRSP 30 day bill index for Treasury Bills, CRSP Long-term U.S. Government Bond Index for Long-Term Government Bonds, S&P 500 Index for U.S. large stocks, CRSP 9-10 Index for U.S. small stocks, Morgan Stanley Europe, Australia, Far East (EAFE) Index for international large stocks, and the international small stock index created by DFA using CRSP data. CONSERVATIVE, MODERATE, GROWTH, & AGGRESSIVE These results are based on the performance of 30 day T-Bills, Dimensional’s One-Year Fixed Strategy [1972- July 1983 – Simulated CD Fixed Income Strategy (maximum maturity 1 year) Aug. 1983 – DFA Fixed Income Portfolio returns net of all fees (weighted average maturity under 1 year)], Dimensional’s Five-Year Government Portfolio [Average maturity: Under Five Years, 1953-May 1987 – Simulation using U.S. Government Instruments (maximum maturity five years) June 1987 – DFA Five Year Government Portfolio net of all fees], S&P 500 Index, CRSP Large Value Index, CRSP (Center for Research & Security Pricing) 9-10, CRSP 6-10, CRSP Small Value Index, EAFE Index, and Dimensional’s Small International Index (1970-June 1988 – 50% Japan, 50% United Kingdom. July 1988- September 1989 – 50% Japan, 30% Continental, 20% United Kingdom, October 1989 – March 1990 -40% Japan, 40% Continental, 20% United Kingdom, 10% Asia-Australia. April 1990 – December 1992 – 40% Japan, 35% Continental, 15% United Kingdom, 10% Asia-Australia. January 1993 to present – 35% Japan, 35% Continental, 15% United Kingdom, 15% Australia.], and assume the asset allocation among these indices as shown under “Conservative”, “Moderate”, “Growth”, and “Aggressive” in the chart entitled Allocation of Sample Asset Class Mixes. </li></ul><ul><li>All investing involves risk and costs. Your advisor can provide you with more information about the risks and costs </li></ul><ul><li>associated with specific programs. No investment strategy (including asset allocation and diversification strategies) can </li></ul><ul><li>ensure peace of mind, assure profit, or protect against loss. </li></ul>ENDNOTES

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