Last week we came across an “Economic and Policy Watch” update prepared by a major investment bank that reviewed recent government proposals to address the nation’s funding crisis. Titled “It Just Gets Worse,” the report chided policymakers for actions that “look like a poor cover for loose money, rising inflation, and fiscal problems,” and warned that “government financing needs are corrupting monetary policy.” As a result of these ill-advised tactics, the bank had turned “more negative” on the outlook for financial stability and saw “little hope of improvement in the inflation/currency mix.”

Amidst the barrage of news coverage from dozens of sources probing the US debt/default/downgrade issue, such a conclusion might seem unremarkable. We found it of interest because the focus of the report was not the US Treasury but the government of Indonesia, and it appeared over a decade ago, on July 16, 2001.

Indonesia’s sovereign debt rating at that time placed it firmly in the “junk” (non-investment grade) category: B3 from Moody’s and single-B from Standard & Poor’s. Although Moody’s upgraded Indonesia to a B2 rating in 2003 and to Ba1 in early 2011, at no time over the past decade was Indonesia deemed to merit an investment grade rating.

What has been the experience of equity investors in Indonesia since this report was published? The Jakarta Composite Index closed at 415.09 on January 16, 2001, while the Dow Jones Industrial Average finished that day at 10,652.66. On Wednesday, the Jakarta Composite closed at 4,087.09 and the Dow at 12,592.80. If the Dow Jones Average had kept pace with Indonesian stocks over the past decade, it would be over 104,000 today.

Investors in Indonesia have had their share of ups and downs over the years, and markets fell even harder than the US during the financial crisis, with a peak-to-trough loss of nearly 60%. But the recovery was sharper as well: The Jakarta Composite recouped all of its losses by April 2010, and the all-time high on July 22 this year was 45% above the high-water mark of early 2008.

For the ten-year period ending June 30, 2011, total return as computed by MSCI was 29% per year in local currency and 33% in US dollar terms. At no point throughout this period did Indonesia have an investment grade rating for its sovereign debt, and outside observers continue to find fault with the country’s troublesome level of corruption, primitive infrastructure, and unpredictable regulatory apparatus.

We are not suggesting that investors should dismiss the effects of a US government credit downgrade. US Treasury securities are so widely held around the world that any potentially destabilizing event is worrisome. Nor are we suggesting that investors focus solely on countries with low credit ratings. Just as a broadly diversified portfolio includes companies with high and low credit quality, investing in countries with both high and low ratings is equally sensible.

Some might say the strong performance of Indonesian stocks over the past decade was at least partly attributable to the nation’s improving credit profile, even if it remained at a relatively low level. The US, in contrast, appears to be deteriorating. Our point is that a low credit rating in and of itself is not necessarily a death sentence for equity investors. Citizens of triple-A countries behave much like those living in single-B territory—they eat, drink, shop, get stuck in traffic jams, chatter on mobile phones, and check their Facebook pages. (Indonesia claims the second-largest number of members in the world.) Companies doing business in either location generate cash flows, and investors do their best to evaluate what those cash flows are worth. A triple-A sovereign debt rating is no guarantee of superior equity market returns, and a “junk” rating is no assurance of failure. A diversified strategy will have exposure to both.

Author Weston Wellington is a Vice President with Dimensional Fund Advisors

Research assistance by Victoria Choi.

Ray Farris, “It Just Gets Worse,” ING Barings Economic and Policy Watch, July 16, 2001.

“Global Credit Research,” Moody’s Investors Service, March 2004.

“Missing BRIC in the Wall,” Economist, July 21, 2011.

Securities data provided by Bloomberg.

MSCI data copyright MSCI 2011, all rights reserved.

Yahoo! Finance, finance.yahoo.com (accessed July 25, 2011).

By now, you may have noticed that consumer financial magazines such as Money, Smart Money and Fortune have published their 2011 Investor Guides.  These guides provide you with all the needed information to make informed decisions with your investments and outsmart the markets.

If only that were the case. Let’s rewind the clock and review their results for 2010.

Money Magazine told us that small company stocks would suffer, since they perform better in the early stage of a bull rally. Because of this, Money urged readers to focus on high quality blue chip stocks.

And the 2010 results were:

• Russell 1000 index (large stocks): 16.10%
• Russell 2000 index (small stocks): 26.85%

Contrary to Money Magazine’s prediction, small stocks outperformed large stocks in 2010 by a wide margin.

Money also recommended ten large company stocks to capitalize on the upcoming outperformance. Unfortunately for the readers who followed the advice, the picks had an average price-only return of 6.3% versus 16.10% for the Russell 1000 index.

Smart Money also picked up on this trend, recommending large stocks over small stocks. They offered 12 stock picks to take advantage of the trend.

Smart Money’s 12 stock picks produced an average price-only gain of 7.5% for the year versus 16.10% for the Russell 1000 index.

Fortune Magazine had a different outlook claiming, in their words, “Making judicious stock selections will be crucial in what is likely to be a topsy-turvy year.”

Fortune recommended ten different stock picks for their readers. And, although Fortune had a great performer in Salesforce.com (up 78.9%), the average price-only return for their picks was 1.75% versus 16.10% for the Russell 1000 index.

That’s not what we would call judicious stock selections.

Comically, in the same issue of Fortune there was a useful article on the appeal of a simple index fund approach: “Stock picking, whether you do it yourself or pay a pro to do it for you, is a mug’s game,” they wrote. “You’re better off buying and holding a cheap, diversified, and consistent index fund, which passively invests in the stocks listed on a broad market benchmark.”

Good advice, but we know it won’t be long before catchy cover stories such as “Top Ten Stocks for the Year Ahead” are crowding the magazine racks once again.  To be sure, last year’s results offer another example of how easy it can be to miss the rewards the capital markets have to offer.

“5 Wall Street Heavyweights say it’s time to GET BACK INTO STOCKS.”

That was a recent headline from the USA Today. These “heavyweights” want you to get back into stocks. NOW!

My immediate question is, why didn’t this headline run in March, 2009, before the S&P 500 index advanced 77.84% (03/01/2009 through 12/31/2010)? Shouldn’t these “heavyweights” have let us know this was going to happen? They can predict with certain accuracy the future movement of markets, right?

Wrong! No one can predict the future! But the “heavyweights” want you to think they can. So does the financial media.

We think it borders on the ridiculous that articles like this go to print year in and year out.  Perhaps USA Today forgot about the 2008 edition, when the paper asked the “best minds” in the financial services industry for their thoughts on how the S&P 500 would perform during the year.

In 2008, all nine experts predicted the S&P 500 would increase – meaning none of them managed to predict even the relative direction of the index, much less the exact year-ending value. And, not a single one predicted the financial meltdown.

Two of the “experts” from 2008: Abby Joseph Cohen (Goldman Sachs) and Richard Bernstein (Merrill Lynch) reappeared on the USA Today 2010 expert forecasting panel.

In 2008, Cohen predicted the S&P 500 would close at 1,675 and Bernstein predicted it would close at 1,525.  To give you an idea of how wrong they were, the S&P 500 began 2008 at 1,468 and ended at 885.  Cohen predicted an increase of 14.2%. The S&P 500 declined -39.7%.

Why in the world should readers care what these folks think will happen next year?  We don’t.

The financial media is pleased to report that the best performing mutual fund of the decade is Ken Heebner’s CGM Focus fund.

Through the end of January, 2010, the mutual fund annualized 18.03%, easily outpacing the S&P 500’s annualized return of -0.55%.

Did you miss these returns? Not to worry, because the typical investor in the CGM Focus mutual fund also missed out on the returns. Unfortunately, there is a big difference between investment returns and investor returns.

The financial media always focuses on investment returns. In other words, what did a specific investment return? In this case, the media focuses on the great track record the CGM Focus mutual fund had over the last decade.

Of course, the media rarely focuses on investor returns. In other words, how did the typical investor perform in the same investment? Luckily, Morningstar calculates dollar-weighted returns, which represents the returns real investors receive based on buying and selling.

Here are the 10-year annualized results through the end of January, 2010:

• CGM Focus: 18.03%
• Typical CGM Focus Investor’s return: -13.73%

How can this be? How did investors lose money in the best performing stock fund of the decade?

Simple. Poor investor behavior.

Most investors make buy and sell decisions based on past performance. As the financial media was happy to point out, CGM Focus returned 80% in 2007.

Believing this trend would continue, investors poured a whopping $2.6 billion into the fund in 2008.

Then, in horror, investors watched as the fund tanked -48.2%. Disappointed with the results, investors yanked more than $750 million out of the fund.

The typical CGM Focus investor missed all the gains in 2007 and captured all the losses of 2008.

Don’t fall victim to poor investor behavior and media hype. Understand there is a difference between investment returns and investor returns.

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With the dawn of a new decade arrives the financial media’s recommended investments.

Articles with attention grabbing titles such as “10 Stock Investments for the Next Ten Years” entice readers with promises of market beating returns.

But should you follow media’s investment recommendations? Consider the following articles published ten years ago.

In August, 2000, a Fortune magazine article presented “10 Stocks to Last The Decade.”

How would these ten stocks have performed if you spread your investments equally among each pick versus the market and a fully diversified portfolio*?

• Fortune’s 10 Stock Investments:  -44.21%
• S&P 500:  -7.26%
• Diversified Portfolio: +81.04%

Time period – August, 2000 through November, 2009.

Fortune’s stock picks drastically underperformed both the market and a fully diversified portfolio.

A second article by The New York Times asked for Buy and Hold picks from “10 very smart, very successful investment professionals…”

So how did these stock picks fair versus the market and a fully diversified portfolio?

• New York Times:  +25.17%
• S&P 500: -4.29%
• Diversified Portfolio:  +84.35%

Time period – February, 2000 through November, 2009

The New York Time’s picks beat the market but it seems a passively managed diversified portfolio drastically outperformed these “very smart, very successful investment professionals…”

Think twice before rushing out and investing your money in any of the media’s picks for the next ten years!

Having a financial plan and a fully diversified portfolio based on this plan is the best bet when investing for your goals and future.

*Fully Diversified Portfolio:
Dimensional US Adjusted Market 2 Index: 30%
DFA Equally Weighted Emerging Markets Index: 5%
Five-Year US Treasury Notes: 40%
Dimensional International Market Index: 25%
Rebalanced annually

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Rarely do you see a headline in a mainstream newspaper containing the three words, “Yale,” “Harvard,” and “Losers,” but that’s exactly what happened last week in The Wall Street Journal.

The Journal certainly wasn’t talking about the Universities’ academic prowess or even their athletic exploits; rather, it was the disappointing performance of their once invincible endowment funds.

The value of their endowments each dropped by 30 % for the 12 months ending June 30, 2009. By comparison, a typical plain-vanilla endowment allocation of 60 % stocks and 40 % bonds lost only 13 % during that period, according to the Journal.

What’s newsworthy about these losses is that Yale had pioneered an unorthodox approach to endowment investing that worked spectacularly for years (and was copied by Harvard), but like many investment ideas, it eventually ran into a brick wall.

Under the leadership of David Swensen, Yale’s portfolio mix changed dramatically by increasing the exposure to alternative investments.

For example, the allocation to private equity rose from 3.2 to 20.2 %; real assets – timber, real estate, and the like, rose from 8.5 to 29.3 %; and hedge funds went from zero to 25.1 %. To accomplish this mix, the allocation to domestic stocks and bonds dropped from 71.9 to 14.1 %, according to a March 2009 article from Portfolio.

Essentially, Swensen argued that endowment funds should avoid traditional stocks and bonds and, instead, invest in higher yielding and less liquid assets that more closely match an endowment fund’s long-time horizon.

So keep in mind – even the best and the brightest such as Swensen eventually stumble, if only temporarily.

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A recent Wall Street Journal article epitomizes the new “conventional wisdom” that asset allocation failed in 2008.

It is true that correlations among major asset classes have increased in recent years giving the impression that asset allocation no longer works.

During the 2008 financial crisis all major equity asset classes experienced severe declines. Even commodities, which historically had exhibited low correlations to equities, dropped dramatically.

This does not mean that diversification and asset allocation failed.

• High-quality fixed income securities, i.e. U.S. Government bonds, of all maturities were a safe haven and had returns ranging from 1.6% to 25.8% percent in 2008.*
• Financial and economic shocks are rare occurrences, and investors must understand that they are part of the risk of investing in equity markets. Correlations historically have increased during economic shocks but returned to more normal levels as economic conditions normalized.
• Asset allocation depends on individual circumstances. If one has a high overall risk tolerance and a very long investment time horizon, accumulating shares during bear markets may be a wise strategy.

The major problem is, so many articles in the financial press are devoted to attempting to avoid investment losses. These articles make it seem that market timing can work for most investors. Many nervous investors needlessly adjust portfolio holdings, usually to their long-term detriment, in an attempt to grab the current “trend.”

In reality, alternatives like market timing, short selling, and stock picking have historically tended not to work as claimed for most money managers.

Your best bet for financial success is to stick to your plan and your appropriate asset allocation.

*Source: DFA Returns 2.0; One-month T-Bills and Long Term Government Bonds, respectively.

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This question has been coming up a lot lately in the media and some academic journals. Thinking Modern Portfolio Theory died last year is based on the misconception that Modern Portfolio Theory will guarantee against a loss.

That is simply not the case. What MPT believes is diversification to a portfolio, which over the long term can potentially reduce a portfolio’s volatility versus a single asset portfolio.

According to a recent article in Investment News:

• MPT does not guarantee against a loss
• Fixed income helped reduce the amount of loss in many portfolios last year
• Many advisors are finding that their clients had too much equities and not enough fixed income for their risk tolerance

Remember, when investing in a diversified portfolio, you will experience negative returns periodically.

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According to a recent article in CNN Money, only if you attempt to sort out the handful of winners from the rest of the market.

As the article points out, the majority of indi­vidual securities tend to post negative returns over the long run.

In fact, research by Dimensional Fund Advisors found that from 1980 to 2008, the top-performing 25% of stocks were respon­sible for all the gains in the broad market, as represented by the University of Chicago’s CRSP total equity market database.

As for the bottom 75% of stocks in the U.S. market, they collectively generated annual losses of around 2% over the past 29 years.

So what can you do?

According to the article, diversify as broadly as you can. With a small list of stocks, it’s easy to miss out entirely on the top 10% performers. Doing so would have cut your annual returns to 6.6% from 10.4% over the past 29 years.

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From the January, 2000 Smart Money Magazine:

“The Underachiever’s Club – Thanks for Nothing: Sixteen mutual funds reopened to new investors in 1999. But returns for these three make you wonder why they bothered.”

The three mutual funds highlighted in Smart Money’s “Underachiever’s Club” were:

• Lord Abbett Small-Cap Value
• Neuberger Berman Genesis
• Vanguard Windsor

The Smart Money article focused on each fund’s market underperformance since reopening – a period of only six months! Six months is hardly enough time to judge an investment or investment strategy.

Of course, it’s easy to find winners and losers using hindsight. The problem was, this article highlighted these funds as losers although they were on the verge of outperformance.

Look at the subsequent five-year (2000-2005) compound returns for each of Smart Money’s “underachievers” versus the general market.

• Lord Abbett Small-Cap Value: 17.05%
• Neuberger Berman Genesis: 17.44%
• Vanguard Windsor: 7.62%
• S&P 500: -1.13%

Investing based on tips from the financial media is dangerous to your wealth and will not help achieve your goals.

Finding an advisor you trust and developing a plan with that advisor will!

*This article does not represent a recommendation to buy or sell the mentioned funds. Past performance does not guarantee future results!

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