Can Investors Beat the Market?
1. Can Investors Beat the Market? WhatAstuteInvestorsNeedtoKnow By Mark J. Smith, CFP, CPA/PFS, CIMA Principal, M.J. Smith and Associates Becauseoftheextremevolatilityofthestockmarketinrecentyears,manyinvestorsandinvestmentconsultants havequestionedthevalidityofassetallocation.Inthe1990s,thestrategyofdiversifyingstocks,bondsandcash knownasassetallocationcameunderattack.WiththeinventionoftheInternet,aneconomythatneverseemed to slow down, and a fully employed workforce, there seemed to be no need for asset allocation. Growth stocks ap- pearedtobetheonlyanswerforachievingsuperiorreturns.TheStandardandPoors500Index,theworldslargest stock market index, added more technology names to its composition, and with the momentum built into this capitalization weighted index, the S&P 500 seemed unstoppable. AtM.J.SmithandAssociates,awealthmanagementadvisoryfirm,someofourclientsquestionedowningbonds, realestateinvestmenttrusts(REITs),smallcompanystocksandforeignholdingsinthelate1990s.Notonlydid these investments display lower past returns than the S&P 500, but apparently they did not present the opportunities desiredinthenewInternet-drivengoldenage. Howtimeshavechangedsincethelate90s!Thebearmarketof2000-2002andnowthebearmarketof2008have been two of the worst in history. From January 1, 2000 through December 31, 2008, the S&P 500 averaged an an- nualized return of -1.38%. This decade is on track to be the second worst in its history. Prior to the 2000-2002 period, stocks had not lost money for three years in a row since 1939-1941, and investors had not experienced a decline like 2008ssince1931.ThiscenturysbearmarketsaresecondonlytothoseoftheGreatDepression.Investorshavebeen seriously questioning their beliefs about the market as we enter 2009 and investor sentiments changed from Why arentwebeatingthemarket?toWhyshouldwebeinthemarket?Emotionshadturnedfromgreed,whenthe markets were high, to fear when the markets were much lower. Fortunately, most of our clients realize the benefits of maintaining a broadly-diversified portfolio and know the dangers of letting emotions drive their investment decisions. While diversification does not guarantee a profit nor protectagainstalossindecliningmarkets,weatM.J.SmithandAssociatesbelievethatthefutureisalways unknown. Successful investing requires the following: 1)Ownqualityinvestmentsdontspeculate 2)Bebroadlydiversifiedacrossandwithinassetclasses 3)Hiresolidinvestmentfirmstobuy/sellthespecificsecurities 4)Bepatientanddonotletemotionstakeyouoffcourse Itisthislastareawhereaninvestmentmanagementconsultingfirmlikeoursprobablyaddsthemostvalue.To provethispoint,Dalbar,Inc.,awell-respectedinvestmentcompanyresearchfirm,comparedthemarketsreturn forthe20-yearperiodendingDecember31,2007(Buy&Hold,S&P500),totheaveragereturnearnedbyactual shareholdersinequityfunds(AverageEquityInvestor)andarrivedatthefollowingshockingresult. Clients should periodically re-evaluate whether the use of an asset-based fee continues to be appropriate in servicing their needs. A list of additional considerations, as well as the fee schedule, is available in the firms Form ADV Part II as well as the client agreement.May 2009 2. CHART 1 Dalbars Quantitative Analysis of Investor Behavior Study 2008: 20-year average annual total returns as of 12/31/07Thischartrevealsthattheaverageinvestorsreturnswerefarless 12% 11.6%than the returns the market generated, and the emotions of fear andgreedareprimarilyresponsible.Theunfortunatetruthisthatthe 10%averageholdingperiodofafundisonly30months.Typicalinvestors8%purchase investments based on attractive past returns (when6%investmentsarelikelyovervalued)andwantoutwhentheydont 4.5% performordecline(whentheyarepricedless).4% 3.0%SOURCE: Dalbar. Past performance is no guarantee of future results2%Keep in mind that the Average Equity Fund Investor (as defined by DALBAR) represents theaggregate action of all investors in equity mutual funds. The return is calculated by treating ag-0%gregate industry flows as being representative of the average investor and applying these flows to AverageInflation Buy & Hold Equity Investor(S&P 500) the appropriate performance index. The rate of return investors earn is based on the length of timeinvestors actually remain invested in a fund, amount of dollars bought and sold and the historicperformance of the funds appropriate index. Indices used in the DALBAR study include the S&P500 Index for equities and a Long Term Government Bond Fund for fixed income investments.Toassesshowindividualportfolioscouldperform,comparedtothemarket,weransomereportsandchartsfroma Morningstar database we maintain. We assumed the following hypothetical diversified portfolio:Hypothetical Diversified Portfolio Real Estate Small Company Stocks 10%Stocks 10% Footnote: Disclosure below for indexes used for above asset classes Commodities This portfolio is strictly hypothetical. The weighted portfolio, and all associated returns and10% Large statistics, are not reflective of any historical advisory recommendation.Stocks 15%The investment profile is hypothetical, and the asset allocations are presented only as examplesand are not intended as investment advice. Please consult your financial advisor if you havequestions about these examples and how they relate to your own financial situation.International Investing in small cap stocks generally involves greater risks, and therefore, may not be Bonds 40%Stocks 15%appropriate for every investor.CHART 2 Annualized Returns as of 12/31/2008 1 Year3 Year5 Year10 Year Barclays Capital Government Credit Bond 15.70%5.56% 4.64% 5.64% Standard & Poors 500 Large Stocks 2-37.00-8.36-2.19 -1.38 EAFE International Stocks3 -43.38-7.35 1.660.80 Wilshire REIT 4 -39.20 -11.99 0.657.65 Russell 2000 Small Stocks 5 -33.79 -8.29 -0.933.02 S&P GSCI Commodity-46.49-15.53 -2.367.35 1. Barclays Capital Government Credit Bond - Fixed income or bond funds may pay higher rates than CDs, but their net asset values are sensitive to interest rate movementsand a rise in interest rates can result in a decline in the value of the customers investment. Individual results will vary. 2. S&P 500 is an unmanaged index of 500 widely held stocks that are generally considered representative of the US stock market. 3. The EAFE index is an unmanaged index that is generally considered representative of the international stock market. These international securities involvedadditional risks including currency fluctuations differing, financial accounting standards and possible political and economic volatility. 4. Wilshire REIT REITs have various risks, including possible lack of liquidity: devaluation based on adverse economic and regulatory changes and will fluctuatewith the value of the underlying properties. 5. The Russell 2000 index is an unmanaged index of small cap securities, which generally involve greater risk. The prices of small company stocks may be subjectto more volatility than those of large company stocks. This Chart is not representative of an individual client portfolio keeping in mind individuals cannot invest directly into an index. The above indexes are all represented in the pie chart for the Hypothetical Diversified Portfolio. 2 3. Chart 2 reveals these facts:BondshaveactuallyoutperformedU.S.andinternationalstocksduringthelasttenyears.While,thisisgenerallynotthe case long term, it is a reflection of the fear that has gripped investors during much of this decade. With interestrates the lowest they have been in history, future bond returns are likely to be lower. WhilemanyinvestorswereintriguedwiththeS&P500asweenteredthisdecade,itisnowactuallyinlastplaceinterms of performance from 12/31/98-12/31/08 compared to the others on the chart. From a contrarian point of viewand based upon numerous valuation metrics, it may actually represent one of the best opportunities today. Broadbaseddiversification,asrecommendedbyourfirm,isdesignedtoreducetheriskofthemarkets,butitdoesntal-ways do so. For example, 2008 was a very unusual year where even many balanced portfolios saw declines in excess of 20%. WhiletheinflationhedgeinvestmentsofbothREITsandcommoditiessawlargelossesin2008,theyhaveaddedsig-nificantlytotheoutperformanceoverthelastdecade.Ifthegovernmentsstimuluspackagehasitsintendedeffect,oneshould count on a reemergence of inflation, which is where these investments perform best. WhilebothsmallU.S.stocksandinternationalstockshaveoutperformedtheS&P500overthelastdecade,thishasnotalwaysbeenthecase.Duringmuchofthe90stheoppositewastrue.Bydiversifyingacrossthesethreemarkets,our firms intent is to improve overall consistency. While not guaranteed, this has generally been our experience.With all observations above, please note that past performance is no guarantee of future results and please read the other pertinent disclosures in this research report.Diversified Portfolio vs. Market Return Analysis Now lets compare the results of a hypothetical well-diversified portfolio to the S&P 500 over the last 10 years. Growth of $100,000 CHART 3 Year While both portfolios displayed ups and downs during this 10-year period, the path taken was quite different. Lets compare the actual trailing returns of both portfolios. 3 4. CHART 4 Annualized Returns through 12/31/08 1 Year3 Year5 Year 10 YearThe Diversified Portfolio (see page 2) -21.72%-2.26%2.71% 5.20%Standard & Poors 500 Large Stocks -37.00 -8.36-2.19 -1.38Note: this investment is hypothetical and the asset allocation is presented only as an example and is not intended as investment advice.Please consult your financial advisor if you have any questions about this example and how it relates to your financial situation.You cannot invest directly in an index. Individual results will vary. This investment returns and statistics presented do not reflect the deduction ofinvestment advisory fees, if applicable. Past performance does not guarantee future results. Investing involves risk and you may incur a profit or loss.For the purpose of calculating performance, the portfolio was rebalanced annually to the original model allocation.The illustration may include reinvestment of dividends and capital gains. It depicts performance without adjusting for the effects of taxations. Thehypotheticaldiversifiedportfolioexperiencedanunpleasantlossof21.72%lastyear,butbeatthemarketslossof37%.But What About Risk?Inthelate1990s,investorsfrequentlytoldushowrisktoleranttheywere.Itwaseasytoberisktolerantduringthistime,as the 1990s stock market experienced very little risk. Since then, many of these same investors have reassessed their risktolerance and have decided to make their portfolios more conservative after seeing the downside risk of stocks.Lets talk about downside risk. Chart 5 compares the losses, over the last ten years, of the hypothetical diversifiedportfolio to the S&P 500:CHART 5 Downside Risk Analysis WorstWorstWorst Chart 5 reveals that the diversified portfolio experienced significantly3 months (a)1 year (b) 3 years (c) lessdownsideriskthanthatofthemarket.Asnotedintheworst 0Diversified Portfolio three-year loss analysis, an all-stock portfolio loss of 16% per year(see pie chart on page 2)-5-3.86% would500 seen approximately half of the portfolio value eroded,S&Phave -10 while the diversified portfolios loss of 3.9% annually would have Downside Risk Analysis -15 experiencedacumulativedeclineoflessthan12%.Thediversified Worst WorstWorst -16.0% portfolio reflects attractive returns in Chart 4, when compared to the3 months (a) 1 year (b) 3 years (c) -20 Diversified Portfolio (see pie chart on page 2) returnswithanall-stockportfolio.Obviously,ittakesmuchlonger -25-23.21%-24.68%-3.12% S&P 500 to recover from a 50% loss than a 12% loss. -8.97%-30 -9.20%SOURCE: Morningstar-29.65% Footnotes (a) 9-08/11-08 (b) 12-07/11-08 (c) 4-00/3-03 S&P 500, 12-05//11-08 Diversified Portfolio -35 Beta is a measure of a portfolios leverage to the benchmark (the benchmark beta=1.0) A portfolio beta of 1.2 indicates -16.0%-19.2% that if the benchmark returns 10.0% the portfolio is expected to return 12.0%. If the benchmark returns -10.0% how- -40 -38.09% ever, the portfolio is expected to return -12.0%. Examiningthetotalvolatility(bothgainsandlosses)ofbothportfoliosoverthelasttenyears(asmeasuredbyBeta), -26.54% thediversifiedportfoliodisplaysonly48%oftheoverallvolatilityofthemarket(Betaof.48).Whenwecomparetherisk/return tradeoffs over the last ten years, we arrive at the following results:Thehypotheticaldiversifiedportfoliogeneratedgreater returns than an all-stock portfolio but with Diversified Portfolio CHART 6 (see pie chart on page 2)only 48% of the overall volatility and with signifi- 6 S&P 5005.20%cantlylessdownsiderisk.Therefore,onanabsolute 4and risk-adjusted basis, over 10 years, the hypotheti-caldiversifiedportfoliobeatthemarket!Ofcourse, 2 1.0individual results would vary and past performance -1.38%0.48 0is not guaranteed.10 Year Annual10 Year Risk (Beta) -2 Returns 12/31/0812/31/08Please contact our office if you want more updatedreturns represented in this analysis. 4 5. What Does This Mean? Wehelpourclientsrealizethattheirfocusshouldnotbeonbeatingthemarketoranyotherrelatedindex.Investors needtorecognizethattheprimaryobjectiveinthemanagementoftheirassetsistoachievetheirfinancialgoals.At M.J.SmithandAssociates,beforeanyinvestmentdecisionsaremade,aproperanalysisofretirementgoals,childrens educationfundingneeds,risktolerance,incometaxsituationandtimehorizonisconducted.Onlythenareinvestorsina position to make the most important investment decision of all, which is asset allocation. Studies continue to prove, as illustrated in this report, that how you diversify is more important than what stocks, bonds or funds you purchase. Focusing on investments before policy results is putting the cart before the horse and having a poor investment process in place.Why Use an Investment Consulting Firm? Chart 1 reveals that investors could dramatically under-perform the markets because they use a poor investment policy and let the emotions of fear and greed influence their decisions. With the significant rise in the markets since 2002, followed by the recent volatility, investors are under a lot of emotional stress and subject to make the same mistakes reflected in Chart 1. While basic investing fundamentals do not have to be complicated, astute investors recognize the significant value of using an investment management consulting firm. When seeking a wealth management firm, astute investors look for: A firm with integrity that can provide unbiased information and knowledge on not only investment-related topics, but also more comprehensive financial planning areas.Theseareasincluderetirementplanning,taxplanning,estateplanning, college funding and risk management. A firm that can align your financial goals with your financial assets and resources to determine the likelihood of successfully achieving those goals.Investmentmanagementfirmsmustsharetheuncertaintiesofthemarketsandothervariables with investors so that realistic expectations can be established. A firm that recognizes the primary focus should be on asset allocation, and that allocation decisions should be made only after a complete review of an investors need, willingness and ability to take risk. Designing a carefully laid out investment plan, only to find an investor bailing out when market volatility increases, results in potentially serious losses and unmet goals. A firm that focuses on how to reduce the tax burden on the returns of the portfolio.Theportfolioshouldbestructuredso thatlesstax-efficientfundsarepositionedinsidequalifiedandnon-qualifiedaccounts(IRAs,40l(k)s,annuities,etc.). Taxablefundsshouldbepositionedinmoretax-efficientinvestments. A firm that works on a fee-basednot commission driven approach, without hidden agendas, and has access to a large universe of top-rated investment choices. While selecting investment companies with great past performance is easy, the firm must have a disciplined monitoring process on future performance and recognize that even the best investments willfrequentlyunder-performduringcertainperiods.Investorsmustbeeducatedabouttheimportanceofknowing whentoreplaceaninvestmentandtorecognizethatthispartoftheprocessisnotanexactscience.Replacinganinvest- ment made too quickly, due to under-performance, may lead to the same results of the average investor in Chart 1. Clients should periodically re-evaluate whether the use of an asset-based fee continues to be appropriate in servicing theirneeds.Alistofadditionalconsiderations,aswellasthefeeschedule,isavailableinthefirmsFormADVPartII as well as the client agreement. A firm that has the overall accounting and monitoring systems in place to regularly evaluate the total portfolios return and to cross-check and verify that the investor is on track to achieving the goals established.Iftheinvestorisoffcourse,strategies should be discussed and reviewed so that the investor can make informed decisions on the best course of action to take. A firm that provides the discipline to regularly rebalance the portfolio as needed.Theprocessofrebalancinginvolves selling some of those asset classes that have risen the most and buying, with the proceeds, those investments that have under-performed.Aseasyasitmaysoundtosellhigh,buylow,mostinvestorsfinditverydifficulttodo. A firm that will constantly educate the investor.Onethingiscertain;changeisconstant.Investorsneedhelpfiltering through the noise of the market and dealing with the emotional aspects of world events. Mistakes, such as confus- ing the familiar with the safe, overconfidence, following the herd, having too many eggs in one basket, treating the unlikely as impossible, and purchasing products that you didnt intend to buy, need to be avoided. WeatM.J.SmithandAssociatesremainfirmlycommittedtohelpinginvestorsachievetheirfinancialgoals.Wewant to thank the hundreds of valued clients who have been with us over the last 25 years of our firms history, and we look forward to forging lasting relationships with our new clients. We welcome any questions you may have. 5 6. About Mark J. Smith and M.J. Smith and AssociatesMark J. Smith is a CERTIFIED FINANCIAL PLANNERpractitioner,aPersonalFinancialSpecialist,aCertifiedInvestment ManagementAnalyst,andaCertifiedPublicAccountant.Hewasthetop-rankednationaladvisorforRaymondJames FinancialServices,Inc.,forfourconsecutiveyears,andhasbeenrankedinthetopthreeadvisorseveryyearforthepast elevenyears.In2009BarronsmagazinenamedSmithtoitslistoftop1,000wealthadvisors.Thelistisbasedonadvisors assets under management, revenues, management practices, expertise, insight, trustworthiness and commitment to their clients.In2008,Registered Rep magazine named Smith one of the top independent broker/dealer rep- resentativesintheU.S.,rankinghim15th,basedonassetsundermanagement,outofmorethan 90,000independentbroker/dealerrepresentativesintheindustry.HewasalsoincludedinWorth magazines 2008 national list of top 250 wealth advisors, judged on expertise, insight, trustworthiness and commitment to clients.In2007,Barrons named Smith the top independent financial advisor in Colorado and number 22 intheU.S.basedonassetsundermanagement,revenuesandqualityofservice.Registered Rep namedhimoneofthetop10outstandingwealthadvisorsinAmerica,selectinghimforselected based on superior performance in money management, client service, business building, acknowledged peer recognition andrespect,andphilanthropicactivities.In2007and2008,TheWinnersCircle,anindependentadvocacyorganiza- tion,rankedSmithfirstandthird,respectively,intop-rankedColoradofinancialadvisors.Theselectionteamanalyzed quantitativecriteria,includingassetsmanagedandrevenues.Theirqualitativeresearchincludedinterviewswitheach candidates colleagues and clients and analysis of the firms team, credentials, and client service.M.J.SmithandAssociateswasnamedtoWealth Managermagazines2008TopDoglistofbestnationaladvisoryfirms servinghigh-net-worthclients.Therankingisbasedontheaverageassetsundermanagementperclient.AnaccountingmajorattheUniversityofIowa,Smithholdsabachelorofbusinessadministrationdegree.Heestablished M.J.SmithandAssociatesin1983aftergainingexperienceattheinternationalaccountingfirmDeloitte,Haskins&Sells. HealsoservedasthedirectorofincometaxesforAffiliatedBanksharesofColorado,a29-bankholdingcompany,where hewasinchargeofallincometax-relatedmattersfor37corporations.M.J.SmithandAssociatesoffersfee-basedassetmanagementserviceswithacomprehensivefinancialplanningapproach whichincludesincometaxplanning.ThefirmisaregisteredinvestmentadvisorwiththeU.S.SecuritiesandExchange Commissionandisoneofthefiveleadingofficesoutof1,366independentbranchofficesofRaymondJamesFinancial Services,Inc.,anationalinvestmentcompany. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of M.J. Smith and Associates and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. Investments mentioned may not be suitable for all investors. Past performance may not be indicative of future results. Be advised that investments in real estate and in REITs have various risks, including possible lack of liquidity and devaluation based on adverse economic and regulatory changes. Additionally, investments in REITs will fluctuate with the value of the underlying properties, and the price at redemption may be more or less than the original price paid. Commodities may be subject to greater volatility than investments in traditional securities. Investments in commodities may be affected by overall market movements, changes in interest rates, and other factors such as weather, disease, embargoes and international economic and political developments. Please note that international investing involves special risks, including currency fluctuations, differing financial accounting standards, and possible political and economic volatility. There is no guarantee that any asset alloca- tion, diversification, strategy, or recommendation will ultimately become successful or profitable nor protect against loss. Tax advice should be sought and provided by an appropriate professional. Rebalancing a non-retirement account could be a taxable event. 9635 Maroon Circle, Suite 230M.J. Smith and Associates is aEnglewood, CO 80112Registered Investment Advisor T 303-768-0007 | F 303-768-0008www.mj-smith.com