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).

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.

The US stock market has taken investors on a bumpy ride in recent years.

Market volatility has tested investor discipline and prompted some people to question their commitment to equities. While no one knows the future, looking at the past may help you gain a better view of long-term market performance and put the recent market volatility in perspective.

The above chart shows the historical distribution of US market returns since 1926. The performance years are stacked in ascending order by return range. This chart illustrates that:

• Market performance over the past two years has been severe by historical standards. In 2008, US stocks experienced their second-worst calendar return in eighty-four years. Then, in 2009, stocks rebounded strongly to deliver a return in the top quartile of the historical distribution.
• Over the long term, the market’s positive return years have outnumbered the negative return years. Since 1926, the market has experienced a positive return in almost three-quarters of the calendar years.
• Not only are the positive years more numerous, the chart shows a larger concentration of performance in the higher ranges of returns.
• The sequence of calendar returns appears random, suggesting that accurately predicting future performance is a difficult task for any investor or professional manager.

Over time, the market has rewarded investors who can bear the risk of stocks and stay committed through various periods of performance. Therefore, the best strategy is to ignore the “noise” and stick to your investment plan.

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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There is a difference between luck and skill and knowing when you are just lucky and when you are successful due to skill is of paramount importance as an investor.

For instance, let’s say you correctly called the flip of a coin five times in a row. What are the odds that you will correctly call the next flip?

Correctly calling five flips in a row might be considered a “hot streak” and lead you to believe that chances are high you can correctly call the next flip. Well, assuming it is a fair flip, there is, of course, only a 50/50 chance that you will be correct because flipping a coin is a game of known probability. The fact is the coin flip has no memory of your hot streak.

And, just like a coin flip, an investor who is on a “hot streak” may simply be lucky.

With millions of investors, odds are that some of them will make winning investments numerous times in a row.

If these winning investors were, in reality, just lucky, but they think they were actually skillful, then that is when the situation turns problematic. The lucky investor may start to think they are infallible and get stubborn when the market turns against them.

Eventually, when the lucky streak ends, it will likely mean serious losses for the investor.

The best antidote we know of to the danger of confusing luck and skill is to remain humble. When our investment strategy performs well, we are very thankful. When it doesn’t perform well, we accept this as part of the market cycle.

The investment business has an uncanny way of turning hubris into painful losses. We think humility is a safer route.

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