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

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

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

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

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

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

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

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

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

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

Author Weston Wellington is a Vice President with Dimensional Fund Advisors

REFERENCES

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

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

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

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

Standard & Poor’s

Morningstar Inc.

What if you had a magic newspaper and were able to read tomorrow’s economic news today? Do you think you could successfully invest with that information?

It would make investing a lot easier, right? Well, maybe not.

Super investor Warren Buffett famously said, “If (Federal Reserve Chairman) Ben Bernanke whispered in my ear exactly what he’s going to do tomorrow, it wouldn’t change anything I’m going to do today.” The problem is it’s difficult to know how the market will interpret any given piece of information.

Take oil prices as an example. If we whispered in your ear that oil prices would fall $2 per barrel tomorrow, do you think that would be bullish or bearish for the stock market? In reality, it probably depends on the reason for the fall.

Generally speaking, falling oil prices are good for the economy because it lowers the cost of gas and may allow consumers to spend more money, which could lead to higher corporate profits. With that backdrop, if oil prices fell due to oversupply, it might be bullish for the stock market because consumers would have more money to spend.

However, if oil prices fell due to a slowing economy, some believe the stock market might sell-off because some consumers would lose their jobs and reduce spending.

So, even if you knew what was going to happen to oil prices tomorrow, you’d still need to know the “why” behind the price change to predict its impact on the stock market.

And oil is just one of many examples.

Think about the myriad of economic indicators, corporate announcements, political wrangling, regulatory actions, and other things that happen each week that could affect the stock market.

Trying to track all these factors and accurately discern their impact on the market would be futile.

What are two things people tend to buy less of when the price goes down?

Normally, people like a bargain. When we go shopping, we feel much better buying things when they’re 20% off or “Buy one, get the second at half price.”

But, there are two things that tend to buck this trend of buying when the price goes down. If fact, with these two things, people tend to buy more of them after their price has run up. Do you have your guess on what they are?

How about real estate and stocks?

According to the most recent S&P/Case-Shiller Home Price Indices, home prices on average across the U.S. are back to their summer of 2003 level, meaning, they’re the cheapest they’ve been in about eight years.

So, are Americans clamoring to buy homes? Nope.

In February, new home sales in the U.S. fell to a record low on a seasonally adjusted annual rate, according to MarketWatch. Yet, during the boom times in 2005-2006 — when prices and sales were at their peak — people were buying homes like crazy and “flipping” them, according to the U.S. Census Bureau and Standard and Poor’s.

Likewise, when it comes to stocks, history suggests that people tend to shun them when prices are down.

For example, how many Americans were loading up the truck to buy more stocks as the market was declining to its recent low in March 2009? Not many. Yet, how many felt comfortable buying internet stocks in late 1999 as their prices were zooming?

These two examples suggest that housing and stocks are two major categories that defy traditional expectations. Knowing that, being a “contrarian” investor in these assets may be a smart long-term plan.

Berkshire Hathaway released its 2010 annual report last weekend, including the letter to shareholders from Chairman Warren Buffett that is always eagerly awaited by the investment community. We are gratified to find that Mr. Buffett’s legendary ability to simplify complex issues remains undiminished and his trademark wit is as sharp as ever.

Financial journalists, eager for clues that might reveal Buffett’s thoughts on where markets are headed, focused on Buffett’s optimistic outlook for the future (“America’s best days lie ahead”) and his appetite to make further large acquisitions (“my trigger finger is itchy”).

We prefer to focus on a number of issues touched on in the letter that offer investment wisdom that should be just as useful ten years from now as it is today.

• As of year-end 2010, Berkshire held positions in excess of $1 billion in fourteen common stocks. Five of these were non-U.S. firms: BYD Company Ltd. (China), Munich Re (Germany), POSCO (South Korea), Sanofi-Aventis (France), and Tesco plc (UK). Five years ago a similar list of twelve companies contained just one non-U.S. firm, and ten years ago there were none. In his comments about the future of America, Mr. Buffett remarked that “human potential is far from exhausted” and that, despite many setbacks, the American system “has worked wonders for over two centuries.” Judging by Berkshire’s portfolio, it appears this notion applies with equal force throughout the world.
• Berkshire has willingly shouldered some unusual risks over the years. It acquired building products maker Johns Manville in 2000 despite the stigma of asbestos-related liabilities, invested over $15 billion in various financial firms in the tumultuous weeks following the Lehman Brothers bankruptcy in 2008, and once insured an internet firm against the possibility of awarding a $1 billion prize associated with a marketing promotion. Many investors might assume that such adventurous and unconventional thinking in equity assets would be matched by an equally unorthodox approach in fixed income. On the contrary, Buffett’s strategy for investing Berkshire’s cash ($38 billion at year-end) is so conservative that some might accuse him of excessive caution. We suspect any institutional money manager with a balanced account mandate who maintained most of the fixed income assets in Treasury bills despite yields approaching zero would be fired for lack of imagination. Such an approach only makes sense if the role of fixed income is to preserve liquidity and limit the potential damage associated with riskier equities, rather than to generate satisfying returns. Mr. Buffett cites an observation from financial writer Raymond DeVoe that “more money has been lost reaching for yield than at the point of a gun.”
• For those who ponder why it is that stocks are expected to provide a positive rate of return even if they pay no current dividend, one number cited in the letter offers a clue: $1 billion. That is the approximate amount of cash that shows up in Berkshire’s mailbox each month from its collection of seventy-six businesses. Mr. Buffett’s job is to invest that cash in new projects that carry an attractive rate of return, and history shows that these may come in a variety of shapes and sizes. Last year, for example, Berkshire spent $50 million to buy Alabama’s largest brick manufacturer and $22 billion to complete its acquisition of the nation’s largest freight railroad. Mr. Buffett reports that the rail acquisition is working out “even better than I expected,” and to the extent any chief executive can invest a firm’s retained earnings more profitably than we can, dividends are not just unnecessary, they are undesirable.

Since taking control of a floundering Massachusetts textile mill in 1965, Warren Buffett has assembled an extraordinary record of business success. His oft-stated goal has been to grow Berkshire’s book value at a faster rate than the total return of the S&P 500 Index, and he has certainly succeeded. While many have focused on his facility with numbers and his ability to identify attractive business opportunities, it seems to us there is a lot more to the story. Mr. Buffett may never forget a number you give him, but he also appears to be an astute judge of character and has a knack for quickly sizing up individuals whose business acumen and management style will make for a good fit within the Berkshire confederation.

What are the investment implications of this appealing story? Should we be confident that Berkshire shares will continue to outperform the market, at least as long as Mr. Buffett is at the helm?

To address this question, we should consider to what extent Mr. Buffett’s skills are already reflected in Berkshire Hathaway’s stock price and whether the S&P 500 Index is the most useful basis of comparison. Let us first acknowledge that Berkshire’s long-run price performance relative to almost any benchmark is sensational—over the last 25 years it has compounded at 16.9% per year compared to 9.93% for the S&P 500 Index with reinvested dividends. The margin of superiority relative to the S&P 500 narrows for more recent time periods, however, and disappears altogether in comparison with broader-based equity strategies. Over the last fifteen years, for example, Berkshire shares have still outperformed the S&P 500 by 276 basis points per year, but fall a smidgen behind a globally diversified Dimensional Balanced Equity Index (16 basis points). Over the last ten years, Berkshire shares have underperformed the Balanced Index by an even larger amount: 295 basis points per year. Some might be tempted to conclude from these results that Mr. Buffett’s legendary skills are waning, but if markets are working properly the numbers should come as no surprise and are no reflection on Mr. Buffett’s talents. Berkshire’s book value has grown from $48 million in 1965 to $157 billion in 2010, making it larger, by this measure, than oil giant Exxon Mobil. Mr. Buffett has gone from piloting a speedboat to commanding an aircraft carrier; the ever-increasing amount of capital Berkshire oversees makes it difficult to earn above-average returns. Moreover, Berkshire Hathaway is not a mutual fund, but a public company with a share price that reflects expectations for the future. Now that Mr. Buffett’s admirable qualities are understood and acknowledged by so many market participants, it seems likely that his perceived value is already reflected in Berkshire’s stock price, just as Apple’s current stock price reflects the genius of founder Steve Jobs.

We wish Mr. Buffett well and hope to be reading his letters for many years in the future. And investors who have a soft spot for Berkshire Hathaway shares can take comfort in the knowledge that if they own a truly diversified equity strategy, they own a piece of Berkshire.

The New Normal.

By now, you have probably read that you should prepare yourself for a New Normal in the stock market. The 2008 global market crisis and the struggling economy have left many investors fatigued. Despite two years of strong equity returns, some investors have been slow to regain market confidence. And by now, many are accepting the talk about a “new normal” in which stocks offer lower returns in the future.

The concept of a new normal is anything but new. In fact, throughout modern history, periods of economic upheaval and market volatility have led people to assume that life had somehow changed and that new economic rules or an expanding government would limit growth. What they could not see was how markets naturally adapt to major social and economic shifts, leading to new wealth creation.

Let’s look at other periods when investors had strong reasons to give up on stocks, and consider the parallels to today:

1932: The US stock market had just experienced four consecutive years of negative returns. A 1929 dollar invested in stocks was worth only 31 cents by the end of 1932. Hopes were sinking during the Great Depression, and many people felt as though the economy had permanently changed. Many investors left the market, and some would not return for a generation. Amidst what is considered the roughest economic time in US history, the markets looked ahead to recovery.

US Stock Market Performance after 1932*
Annualized
5 Years: 15.35% – Growth of $1: $2.04
10 Years: 10.07% – Growth of $1: $2.61
20 Years: 13.19% – Growth of $1: $11.92

All stock market returns based on CRSP 1-10 index.

*Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

1941: World War II was raging, and the US had just entered the conflict. The US stock market had experienced two consecutive years of negative performance, and the economy had shown signs of sliding back into depression. Although conversion to a wartime economy would revive industrial production and boost employment, investors struggled to see beyond the conflict. Many expected rationing, price controls, directed production, and other government measures to limit private sector performance.

US Stock Market Performance after 1941*
Annualized
5 Years: 18.63% – Growth of $1: $2.35
10 Years: 16.67% – Growth of $1: $4.67
20 Years: 16.29% – Growth of $1: $20.47

1974: Investors had just experienced the worst two-year market decline since the early 1930s, and the economy was entering its second year of recession. The Middle East war had triggered the Arab oil embargo in late 1973, which drove crude oil prices to record levels and resulted in price controls and gas lines. Consumers feared that other shortages would develop. President Nixon had resigned from office in August over the Watergate scandal. Annual inflation in 1974 averaged 11%, and with mortgage rates at 10%, the housing market was experiencing its worst slump in decades. With prices and unemployment rising, consumer confidence was weak and many economists were predicting another depression.

US Stock Market Performance after 1974*
Annualized
5 Years: 17.29% – Growth of $1: $2.22
10 Years: 15.92% – Growth of $1: $4.38
20 Years: 14.89% – Growth of $1: $16.07
5 Years 10 Years 20 Years

1981: The stock market had delivered strong positive returns in five of the last seven calendar years, and the two negative years (1977 and 1981) were only moderately negative. Despite these results, investors were weary from stagflation, which was characterized by high annual inflation, anemic GDP growth, and unemployment, and from fears of another economic downturn. In late 1980, gold climbed to a record $873 per ounce—or $2,457 in 2010 dollars. (By comparison, spot gold reached $1,256 per ounce in 2010.) Memories of the 1973–74 bear market lingered. A 1979 BusinessWeek cover story titled “The Death of Equities” claimed inflation was destroying the stock market and that stocks were no longer a good long-term investment.

US Stock Market Performance after 1981*
Annualized
5 Years: 18.82% – Growth of $1: $2.37
10 Years: 16.58% – Growth of $1: $4.64
20 Years: 14.54% – Growth of $1: $15.11

1987: On “Black Monday” (October 19, 1987), the Dow Jones Industrial Average plummeted 508 points, losing over 22% of its value during the worst single day in market history. The plunge marked the end of a five-year bull market. But in the wake of the crash, the market began a relatively steady climb and recovered within two years. The effects of the crash were mostly limited to the financial sector, but the event shook investor confidence and raised concerns that destabilized markets would increase the odds of recession.

US Stock Market Performance after 1987*
Annualized
5 Years: 16.16% – Growth of $1: $2.11
10 Years: 17.75% – Growth of $1: $5.12
20 Years: 11.89% – Growth of $1: $9.46

2002: By the end of 2002, investors had experienced the stress of the dot-com crash in March 2000, the shock of the September 11 attacks, and the early stages of wars in Afghanistan and Iraq. Although October 9, 2002, would ultimately mark the market’s low point, investors had endured three years of negative performance and an estimated $5 trillion in lost market value. A younger generation of investors had experienced its first taste of old-world risk in the “new economy.”

US Stock Market Performance after 2002*
Annualized
5 Years: 13.84% – Growth of $1: $1.91
10 Years: - – Growth of $1: -
20 Years: – - Growth of $1: -

2008–Today: The market slide that began in 2008 reversed in February 2009—gaining 83.3% from March 2009 through 2010. Despite two years of strong stock market returns, memories of the 2008 bear market and talk of the “lost decade” have led many investors to question stocks as a long-term investment. But earlier generations of investors faced similar worries—and today’s headlines echo the past with stories about government spending, surging inflation, deflationary threats, rising oil prices, economic stagnation, high unemployment, and market volatility.

Of course, no one knows what the future holds, which brings the concept of “normal” into question. What exactly is the status quo in the markets?

Since 1926, there have been only four periods when the stock market had two or more consecutive years of negative returns. In addition, annual returns are rarely in line with the market’s 9.67% long-term average (annualized). The most obvious normal may be that, over time, stocks offer expected returns reflecting the uncertainty and risk that investors must bear.

What’s new about that?

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.

For those who find making Investment New Year resolutions useful, here are ten investment-related resolutions, courtesy of Brad Steiman, Director, Head of Canadian Financial Advisor Services and Vice President, Dimensional Fund Advisors Canada ULC, that will hopefully result in better long-term wealth:

1. I will not confuse entertainment with advice. I will acknowledge that the financial media is in the entertainment business and their message can compromise my long-term focus and discipline, leading me to make poor investment decisions. If necessary I will turn off CNBC and turn on ESPN.
2. I will stop searching for tomorrow’s star money manager, as there are no gurus. Capitalism will be my guru because with capitalism there is a positive expected return on capital, and it is there for the taking. And for me to succeed, someone else doesn’t have to fail.
3. I will not invest based on a forecast—whether it is mine or anyone else’s. I will recognize that the urge to form an opinion will never go away, but I won’t act on it because no one can repeatedly predict the future. It is, by definition, uncertain.
4. I will keep a long-term perspective and appropriately consider my investment horizon (i.e., how long my portfolio is to be invested) when determining my performance horizon (i.e., the time frame I use to evaluate results).
5. I will continue to invest new capital and work my plan because it is time in the market—and not timing the market—that matters.
6. I will adhere to my plan and continue to rebalance (i.e., systematically buying more of what hasn’t done well recently) rather than “unbalance” (i.e., buying more of what’s hot).
7. I will not focus my portfolio in a few securities, or even a few asset classes, as diversification remains the closest thing to a free lunch.
8. I will ensure my portfolio is appropriate for my goals and objectives while only taking risks worth taking.
9. I will manage my emotions by learning about and acknowledging the biases and cognitive errors that influence my behavior.
10. I will keep my cost of investing reasonable.

Most of us find it hard to follow a sensible diet or a sensible investment strategy 100% of the time. If you must stray when managing your wealth or well-being, moderation is the key. Chocolate cake is OK, as long as it’s not for dinner every night. Speculating on a stock or two is all right as well, as long as you don’t do it with your investment capital.

Finally, just as successful athletes rely on coaches and trainers to help them achieve their goals, most investors can probably benefit from having a “financial coach” to remind them about their New Year’s resolutions and keep them on track toward a more prosperous future.

I wish you and your clients good health and good wealth in 2011.

The comments of Weston Wellington are gratefully acknowledged.

The need for retirement income doesn’t end with the onset of retirement.

A new retiree’s focus shifts from building wealth to managing and creating retirement income. One major challenge is to make the investment portfolio supply retirement income for life—through different economic and market conditions.

Experts have studied portfolio longevity to help retired investors reduce the odds of exhausting their wealth too soon and found three main issues that drive portfolio endurance:

• asset mix
• spending level
• investment time frame

Certain parts of these issues are within an investor’s control while others are not. Let’s briefly consider them.

Asset Mix

Asset mix describes the ratio of stocks to bonds in a portfolio.

This determines risk exposure and expected performance, and is an important decision investors of all ages can make. Historically, stocks have outperformed bonds and outpaced inflation over time.

So, the larger the stock allocation, the greater a portfolio’s expected return—and risk.

Keep in mind that risk and return go together. A higher allocation to equities increases the risk of experiencing periods of poor returns during retirement.

However, growth can bring higher retirement income, inflation protection, and portfolio endurance over time.

Spending Level

Portfolio withdrawal is typically described in specified dollars (e.g., $50,000 per year) or a percent of annual portfolio amount (e.g., 5% of assets each year). Neither method is ideal, however—and for different reasons. Briefly consider each one:

• Specified dollars: withdrawing a fixed amount each year and adjusting it for inflation can provide a stable retirement income stream and preserve your living standard over time. But the portfolio may survive only if future withdrawals represent a small proportion of the portfolio’s value.

• Percent of annual portfolio value: withdrawing a fixed percentage of assets based on annual asset value makes it unlikely that you will deplete retirement assets because a sudden drop in market value would be accompanied by a proportional decline in spending.

Investment Time Frame

Investment time horizon may be the hardest to estimate, especially when your horizon mirrors your lifespan.

In this case, you can only guess how long your portfolio must support spending.

Time frame forces a tradeoff between the short and long term. Retirees with a longer investment time horizon might choose a higher exposure to equities. But they may have to offset this risk by being flexible about spending over time.

Elderly retirees and others with a short time horizon may choose a less risky allocation or a higher payout rate, although they can experience rising spending levels, too.

Considerations

Planning involves assumptions about the future—assumptions that may not pan out.

Although you cannot avoid assumptions, you can ask whether they are practical and consider how your lifestyle might change if future economic and financial conditions differ from your projections.

Many investors understand the need for portfolio management.

Unfortunately, most investment professionals work very hard to make their portfolio management extremely confusing.

• They have a vested interest in creating investor confusion.
• They use jargon designed to intimidate you and make it difficult for you to understand.

But portfolio management is actually not that complicated if you stick to five key concepts for portfolio management success.

Concept One: Utilize Diversification Effectively to Reduce Risk

Most people understand the basic concept of diversification: Don’t put all your eggs in one basket. However, no matter how sophisticated you are, it’s easy to get caught in a trap. Proper diversification is a major key to successful portfolio management.

Concept Two: Dissimilar Price Movement, Diversification Enhances Returns

If you have two investment portfolios with the same average or arithmetic return, the portfolio with less volatility will have a greater compound rate of return. You want to design your portfolio so that it has as little volatility as necessary to achieve your goals.

Concept Three: Employ Asset Class Investing

Many investors feel that they could have executed better than they did during the last few years.

Unfortunately, most investors are using the wrong tools and put themselves at a significant disadvantage to institutional investors. The average investor who uses actively managed mutual funds is trying to fix a sink with a screwdriver, when they really need a pipe wrench. You need the right tools.

Almost all investors would benefit by using institutional asset classes due to:

1. Lower operating expenses
2. Lower turnover resulting in lower costs
3. Lower turnover resulting in lower taxes
4. Consistently maintained market segments

Concept Four: Global Diversification Reduces Risk

We’ve all read about the concept of a “global village”—that we’re getting closer and closer together.

Technology is creating a new paradigm in which businesses around the world are tied together, just as markets are now tied together. International investments should be a part of your portfolio.

Concept Five: Design Portfolios That Are Efficient

The process of developing a strategic portfolio using Modern Portfolio Theory is mathematical in nature and can appear daunting.  This concept boils down to one simple point: for every
level of risk, there is some optimum combination of investments that will give you the highest rate of return.

Given today’s market volatility, one of the most important things you can do as an investor is to ensure that your investment plan is current. Your plan should examine where you are now and where you need to go to
realize your financial goals, and should also identify the gaps you need to overcome.

In recent years, structured products have gained favor among retail investors in Europe and the US. Investment banks promote these securities as sophisticated tools to help investors manage downside risk, enhance returns, or achieve other investment objectives.

Sales have grown briskly since 2006, and despite a decline after the 2008 market crisis, some industry sources expect a rebound in sales and a flurry of new products in the future.

With this in mind, it may be useful to understand how the products work and to evaluate the costs, benefits, and tradeoffs before considering one in your investment strategy.

Basic design

A structured product is a contract that promises to pay a future amount based on the performance of an underlying asset, such as a stock, market index, or commodity. The payoff is typically linked to a preset formula.

Most structured products are designed to either preserve capital or enhance returns, and are typically issued as notes. The notes offer a specific payout over a designated period or at maturity, and the final payout depends on the performance of the underlying asset as well as the value of the derivatives written on it.

Since the product typically is issued by an investment bank, the investor is exposed to the credit risk of that entity.

One common product, a principal-protected note, generally offers a minimum return equal to the original investment, plus a potential return tied to performance of an underlying asset, such as a stock market index. If the index drops during the term, the investor gets his money back, but if the index rises, he may receive the upside gain, but usually only a part of the underlying asset’s gain.

Structured products can be replicated by portfolios composed of an interest-bearing instrument, such as a certificate of deposit or zero-coupon bond, equity securities, and options or other derivative securities whose performance is linked to the underlying index.

A few common characteristics of structured products are:

• Complex design: Most products have a complex design, which can make analysis of pricing, risk exposure, and potential outcomes more difficult. Some investors equate this complexity with higher potential returns, when, in fact, it may only mask high fees and risk. Worse yet, investors may not understand the range of possible outcomes. During the 2008 market crisis, some investors learned a hard lesson when the issuing firm went bankrupt or when their structured product experienced losses from poor performance of the underlying asset.
• Substantial cost: These products tend to carry a significant markup and costs that in some cases are difficult to quantify, especially if an investor lacks the technical knowledge to analyze the underlying components of the strategy.
• Replication: The payoff of virtually any structured product can be replicated in a portfolio by holding the underlying securities, then buying or selling derivatives written on those securities. In many cases, the costs associated with the replication portfolio are much lower than the structured product itself.
• Tradeoffs: In return for receiving a prescribed payout, investors must accept a tradeoff in the form of a lower return and/or limited upside potential. When evaluating a structured payout, remember that there is no free lunch in the risk-return tradeoff. To pursue higher expected returns, you must accept more risk.
• Multiple Risks: First, there are the inherent risks of the underlying security (e.g., the stock or index). Investors also are exposed to credit risk of the issuing firm. The contract is an agreement with the issuer to make a pre-determined payment in the future, and thus, it is contingent on the firm being able to deliver. Liquidity risk is another issue. Although many structured products are listed and traded on exchanges, they may be difficult to sell, especially in a volatile market.
• Tax considerations: It is also important to check tax consequences. Some instruments may have certain appeal under the current tax rule. But, often, tax consequences differ according to the investment situation (e.g., whether one buys at the issuance or in the secondary market).

Who might benefit?

One example may be an individual who currently holds restricted company stock whose value may account for a significant portion of his total wealth. Although he might prefer to diversify this exposure, company rules may prohibit a sale until some future date. A structured product might provide protection against the downside risk of the company’s stock.

Perhaps most important, investors who are considering a structured product should consider why they even need a highly structured payoff in the future—and if so, whether the payoff can be structured by other means in the portfolio. In many cases, the strategy can be replicated at a lower cost, and perhaps with less risk. Many investors would prefer an alternative that is less complex and more transparent.

And as the recent credit crisis taught many investors, it is wise to avoid investing in things you do not understand.