At the beginning of last year long-term bond interest rates were already quite low. Many “market experts” advised avoiding them, saying that they did not expect a good year for bonds. And once again market timers guessed wrong as bonds were the best performing asset class in 2011. Gold also had a good year – and it is a rare and odd time when gold and government bonds do well together –as bonds normally defend against deflation and gold against inflation. But both are sometimes seen as a defense against “the end of the world (or Europe) as we know it” and that was the fear of many people in 2011.

Market sentiment remains very pessimistic but Europe, or rather the Euro, has not ended yet. There are, of course, many famous people predicting that it will. Those predictions began in real earnest in 2011, and one can see the consequences in the volatility of the various equity markets in 2011. For instance the S&P 500 had thirty five trading days in which it closed up or down over 2%. That compares to no such days in 2005 and only two in 2006. All of this has meant a pretty busy year for us, rebalancing back and forth as market sentiment shifted. Our rebalancing was always taking the other side of the prevailing trade. When the equity markets were falling and bonds rising we sold bonds to buy equities. And when equity markets were rising and bonds were falling we sold equities to buy bonds. We spent the year buying risk when others wanted to sell it and selling risk when others wanted to buy it.

But there is a larger question. What if Europe does collapse? What would happen? Of course we have no idea. It is likely worldwide equity markets would go down a lot. But, would they stay down? And for how long? Is it a wise idea to remain invested given this gigantic uncertainty? This does seem like a level of uncertainty seldom seen in markets. Many investors are just sitting this one out until it is all resolved, as can be seen from the record levels of cash parked in safe money market funds and the constant flows all year of money out of equity funds and into bond funds. These folks would rather wait on the sidelines till the weather clears up.

And then there is a further fact. Equity returns in the U.S. have been basically flat over the past ten years. There has been a lot of volatility but the compound annual rate of return for the S&P 500, adjusted for inflation, for the last ten years is basically zero. This is a very rare occurrence and much has been made of it. Perhaps something has permanently changed and equities are not a good bet any more. This kind of thinking has driven many investors to more exotic assets or investment methods, such as commodities or gold or hedge funds.

Unsurprisingly, we do not agree with this. There is a very powerful pattern to be seen in U.S. equity returns. It is present as far back as reliable data goes – to1871. A bad ten year period of returns tends to be followed by a better (even a good) ten years. It does take ten years both ways for the pattern to appear, and it is of course not a sure thing. But it does make sense. Stock market returns measure the collective opinion of a society about the wisdom, or lack of it, of the present investment of the capital stock of the society as a whole. Ten years of poor returns is an indication that society does not think very highly of its own past investments or of its own future prospects. And democracies do not like this. They do not like to have poor prospects, and they try to do something to change these prospects. This is what political debate is about. For the last 140 years the citizens in this country have been able to change things and thus produce both better economic results and also a better performing stock market after a ten year bad period.

The future is not so bleak as to think that nothing can be done and that things will never be better again. Democracy and markets together allow that change to occur. With much of the rest of the world adopting both, one can assume that this same pattern will emerge in other countries. Therefore if the Euro fails and markets fall worldwide, we believe that society will eventually heal itself, and we will buy into the panic rather than running from it. It is a reasonable bet that markets will be higher ten years from now and ten years is a reasonable investment time horizon. Thus we will continue to rebalance in the face of this great uncertainty. Having an investment method and sticking with it is the path to success. Our method has provided you with very good returns even in the current ten year period of poor results for the S&P. Acknowledge risk and accept it as the source of return. Don’t run from it. In our opinion that is the only correct way to invest.

Later this month we will be sending you information needed to prepare your tax return. However, due to a change in the law, it will now be Schwab who will provide the schedule of realized gain and losses. We will only be sending the investment management fees you have paid us in 2011. Please call us with any questions.

Happy New Year!

Jim, Dean, John and Ryan

What does this mean for markets and what is the proper response to this?

On the one hand a European failure would cause worldwide confusion and panic. But on the other hand the equity markets, here and in Europe, are very much cheaper than they were in 2007. For the first time since the 1950’s the dividend yield on the S&P 500 is higher than the ten year Treasury yield and the European dividend yield is higher yet. This really is a generational buying opportunity – just as 2008 was. Stocks only get this cheap when people are really frightened, as they certainly are now. And please remember that the decade of the 1950’s was a more dangerous time than now – with Soviet power on the rise and the definite possibility of a nuclear war. We do need to keep some kind of perspective here – whatever may happen from this we are not going to start World War III.

This issue of cheapness and gumption – the willingness to step up and purchase when it is scary to do so – is very important. Stocks simply do not get this cheap unless people are real scared – and therefore are just not willing to buy. What we have here is a buyers’ strike. Frightened and desperate sellers have to move prices down in big steps, to induce buyers to step in – and this is what these gigantic and very fast market drops are about. Scared sellers and sticky buyers. Buyers who insist on getting a real deal, given how risky the world is now.

Stocks are cheap. But they are only cheap if you buy them, or hold the ones you already own. If someone sells them now, out of fear or regret that they had not sold them earlier – then obviously they are not buying them. This is not a deep and profound thought. It is hard to both sell and buy at the same time.

Nor are we the only people buying stocks now. One must remember that for every share sold that same share is bought by someone else. In the recent MarketWatch article “Why you should buy Europe now” a hedge fund manager, Crispin Odey, explains why he has been aggressively buying European equities:

“It may be confusing to find someone who believes that a crisis is on its way but is also happy to buy equities ahead of the crisis,…My reason is that the worries have been there so long, the causes are so obvious and the valuations are so cheap that this is a case of buying early. For me the crisis will bring resolution and with it higher prices.”

The article continues: Yet Europe today certainly passes the most obvious test for a contrarian: Everyone else is too afraid to invest. Imagine a portfolio manager trying to make the argument to an investment committee. Imagine a financial adviser trying to explain it to Mrs. Jones.

Indeed – as we are trying to do.

But – what if we have a worldwide economic collapse – caused perhaps by a general failure of the European financial system. What then? First, the odds of this are extremely low. And second, it is impossible to predict if this would be an inflationary or a deflationary event. It would doubtless be both, alternating back and forth. The European Central Bank would almost certainly respond to such a failure by aggressively printing money. It is therefore very important to understand both the power and the limits of unconventional monetary policy.

In the U.S. and Europe there are budget problems, i.e. political problems. The markets know that long-term government expenditures are unfunded. This causes investors to worry that these expenditures might eventually be paid for by simply printing money. This concern about long-term inflation risks has produced a much less aggressive monetary policy by the Federal Reserve and European Central Bank than is possible. Long-term budget control is critically important exactly because firm funded budgets put a cap on long-term inflationary expectations. With this in place a more inflationary short term monetary policy could be followed. Aggressive monetary policy is a tool not yet used.

So what does this mean for markets? As politicians deal with funding and/or cutting our long-term commitments and central banks try to walk a tight rope of just enough money creation, markets will fluctuate (sometimes wildly) between inflation and deflation fears. And what is the proper investment response to these markets? Bonds defend against deflation and stocks against inflation. Therefore, in our opinion, a diversified portfolio that is rebalanced as fears of inflation and deflation move around is the only solution to the current uncertainty. As stocks fall we will sell bonds and buy stocks.

Markets are now awash in panic. But the sweep of history is clear albeit easily forgotten in times of crisis. In 1950 only 31% of the world’s population lived in a democracy. That number is now over 58%. Democracies and new capital markets boost world living standards (and therefore returns to stock holders) and reduce war. Of course markets and market participants can and do make mistakes. But markets and democratic capitalism are the only way to manage a modern complex economy and society. Nothing happening now changes that in the least.

Jim, Dean & John

This not aiming at return, this patience, this lack of emotion, allows us to invest in a way that is very different from the average investor. A recent theory powerfully explains the importance of behaving differently than the average investor. This theory, developed by, among others, John Cochrane of the University of Chicago, says that investor emotions are the primary driver of market returns. The approach is based on the idea that, for each individual investor, emotions, risk aversion (call it stock market fear) varies. And it varies a lot. Risk aversion is greatly influenced by events in the wider economy. In bad times, such as recessions, everything financial becomes more difficult. Income falls. Layoffs happen. Replacement jobs are hard to find. Wealth declines. And it all happens at the same time. Observing this has a large impact on a person’s risk tolerance. As wealth declines, stock market fear rises and it rises much more rapidly than wealth falls. The very rise in risk aversion causes the markets to fall, which only reinforces the fear. This happens to the average investor, which means it can happen market-wide and quite suddenly. It occurs because people have a definite idea of the minimum level of future consumption they wish to have. As their invested wealth falls to a level that seems to threaten this desired minimum level of future consumption, risk aversion rises, dramatically and quickly, and straight fear forces many investors to simply sell out.

Earlier theories of market efficiency did not have this kind of systemic market-wide variation in risk aversion. Lacking it, there were many “anomalies” in markets, many ways in which markets did not appear efficient. The most dramatic of these was the size and value effects discovered by Cochrane’s father-in-law, Eugene Fama, also at Chicago (a hard working family there). Fama found that small capitalization (low priced) stocks and value stocks (cheap based on sales or assets) performed a good bit better than large capitalization growth stocks without an increase in volatility. Indeed it was two of Fama’s students, David Booth and Rex Sinquefield, who started Dimensional Fund Advisors (the firm we use for the large majority of our mutual funds) to develop a method of buying the small cap and the value stocks in an efficient way, but there wasn’t really a theory explaining why these types of equities should perform better than large cap growth stocks.

The variation in risk aversion does explain this. It’s the timing. The idea is that assets that are expected to do well in hard times will always be more in demand and will therefore have lower expected returns (people are willing to receive a lower return for expected safety). These are the high quality bonds and the large capitalization growth stocks. On the other hand, assets that are expected to do badly in hard times, to fall apart in a recession just when everything else is falling apart, i.e., the small cap stocks and the value stocks, will meet up against that rapidly climbing investor fear in a recession, and will always have to have higher expected returns before anyone will buy them. And these lower quality assets must have this higher expected return all the time, because one never knows when the next recession will arrive. And because recessions arrive less often than the market fears, these higher expected returns for the small and value stocks will often become higher realized returns.

The changing levels of stock market fear means that markets are more volatile than variation in the cash value of the stocks would seem to predict. In other words, stocks can fall below their fundamental value because of investors’ increased fear. This variation in risk aversion is exactly what allows us to believe that we might do better than the average investor, just as the disciplined free throw shooter expects to do better than the average shooter. It is variation in the risk aversion of the average investor that is the primary driver of asset prices. But you are not an average investor, nor are we an average investment management firm. Through our education, financial planning, diversification and constant repetition of these ideas we hope you can recognize your preparedness for market downturns and thus be able to resist acting on rising fear. It is exactly this willingness to hang tough, to not panic when others are panicking, that allows our clients to expect to do better than the average investor, as they – you have, in fact, done. To wit, we use an internal model portfolio to evaluate our investment performance, and the performance of that model, net of fees, for the ten years ending 12/31/2009 is substantially higher than the performance of the average Morningstar mutual fund, and very much higher than the average Morningstar fund investor. If you would like to see the comparison of your own portfolio to the Morningstar data, give us a call.

So you see, there is method in our madness. Ignore return and practice the fundamentals and an odd thing happens – you can achieve a higher return. Control your changing risk aversion and the odds rise that you will do better than the average investor.

Swish!

Jim, Dean & John

To answer the first question let’s use the last quarter as an example. Not much of note has happened since our last letter. Only the largest earthquake in Japanese history, followed by a still ongoing nuclear nightmare, revolution in the Middle East and apparently continued political paralysis in Europe – not to mention in the U.S.

And the response of the equity markets? Basically a big yawn. And why have they held up so well? Because equity markets are all about earnings – current earnings and more especially expected future earnings. To buy a stock is to buy the rights to future income. The market is not just a silly gambling game, a lottery that might just as well go down as up, an empty volatile bet. No. Buying a company is buying management, technology, brands, skills, that are all aimed at creating earnings. How high will current and future earnings be and how high should the price/earnings multiple (price) be to buy them? Future earnings are a constantly changing estimate and the price is a matter of confidence in the estimates. Pricing future earnings is all the equity markets can do and all they are interested in doing.

Equity markets are brutally volatile. As they attempt to value those future earnings, prices can move a lot! If you need a reminder of this simply look back at your Asset Class Performance Report ending March 31, 2009. At that time the market was literally priced for expected earnings lower than those produced in the depression of the 1930’s. But the disaster of the big depression did not happen, much to the surprise of the market. Earnings have held up remarkably well, and in 2011 they are expected to be as high as they were in 2007.This surprise has led to the extraordinary gains we have seen over the last two years.

The passive funds we use deliver the risk of the markets as a whole, not the isolated risk of a specific industry, location or security. The bet you are making is that world-wide capitalism (world wide earnings, let’s say) will survive and prosper over your investment time horizon. We believe all clients should have some equity exposure. The safety of this exposure depends on the safety of world markets, which is beyond knowing. But this bet does at least seem reasonable.

And what of the risk of hiring Pinney & Scofield? We think of our job as being, in large part, to prepare our clients for the above discussed volatility. This involves a proper financial plan and a discussion of volatility. The plan should be an accurate description of your financial life, leading to a portfolio with an amount of fixed income suitable to your objective ability to bear volatility (equity) risk. It also involves a discussion with you of your subjective ability to tolerate volatility. This means education. We believe that it is the very volatility of equities that leads to their higher expected returns. But we sure do understand that volatility frightens people. It is our job to persuade you that the only reasonable way to deal with this volatility is patience and discipline. As you know, we do not believe volatility can be predicted or timed. It must be accepted – and dealt with using discipline and patience. Your discipline and patience are your contributions to this mix.

We do not believe we could do this planning if we were in the selling business – in the business of selling you financial products with commissions attached. Such a method would put our interests, of making the sale, ahead of your interests. We are fiduciaries. We are required, by law, to put your interests ahead of our interests. We have always believed that the “fee only” model we use is the only way to do that. Our main tenet, as we state on our website, is honesty and integrity. We state: “we wish to maintain long-term relationships with our clients. We understand that such relationships must be based on trust. Trust occurs only when people act with utmost integrity and honesty.”

Does a frank acceptance of volatility plus the fee only model lead to safety? The last few years have felt anything but safe. It is true that neither you nor we sold during the crash. We did not run from the volatility and neither did you. Many investors did. The U.S. stock market (the S&P 500) is now about 8.5% under its pre-crash peak, set on 10-09-07. The very large majority of portfolios we manage have done a good deal better than that (adjusted for flows in or out), both because they have several asset classes and because they were rebalanced. That cannot be said for many other investors, who sold out during or after the crash and many of whom will never make back their losses.

You stuck with us and our method because you have confidence in us. Confidence born from both our investment method and our business practice choices. They are built in to everything we do. But it has been quite a ride – and it may happen again. And if it does, we will all have gone through the trial by fire before, and we can do it again. We are all more experienced investors than we were before. And experience is a powerful source of patience and discipline and thus safety.

So – yes. We believe your money is safe with us.

Dean & Jim

And what of 2011? The year has started with some considerable optimism. The second round of Federal Reserve quantitative easing, QE2, seems to be working better than expected. The production and trade statistics seem to be getting better. However, employment is not improving much, the housing market remains very weak and the European debit crisis seems unsolvable. The present calm in the markets belie these very large risks. We now know, courtesy of the “flash crash”, that financial markets are capable of gigantic moves – both up and down – almost at a moments notice. The volatility seen over the last three years is entirely new to all but a few investors – because market action like this was last seen in the 1930s. There is research indicating that a crash such as the one we have been through scars the thinking of many investors for even as long as a generation. People come to hate equities and somehow imagine that they can take “revenge” on the market by not buying. Or they are just too burned and frightened to get back in.

The recent market volatility both reflects and creates uncertainty. And this uncertainty makes ordinary living difficult. There is a tendency toward paralysis –standing still and just hoping for the best. Holding ones breath and waiting. Many investors are now doing this – refusing to put their money into markets that seem incomprehensibly volatile and speculative. But of course this is a mistake. Planning needs to be done – actively. The resources are what they are. One is the age that one is. Investing must be done. Investors who were out of equities last year are worse off for that decision. And we remain convinced that the only way to do this is with diversification and patience.

The article in last week’s Sunday New York Times about ultra fast investing shows that many people do not agree with us. The majority of transactions are now done by speed demons – investors whose holding period is measured in nano-seconds. The recovery from the 2009 bottom has been powered mostly by hot money from hedge funds – momentum traders – fast and faithless.

And how well have these fast money traders done? Have they been able to do what they say they can do – namely predict where markets will go and therefore avoid the falls while profiting from the gains? Have they been able to deliver what they promise?

Apparently not. The return statistics for hedge funds are notoriously unreliable, due to their secretive nature and due to survivor bias in the reported numbers that do exist. However, the mutual fund category called “long-short” funds are very similar to hedge funds, in that they can go short or use many other timing techniques to try to beat the market. And their numbers, because they are publicly registered, are present in the Morningstar database. And they are not good. To quote from research done by Buckingham Asset Management and reported in the article Long/Short Funds Come Up Short, “For the year through the end of October 2010, long-short funds are up 2.2 percent, compared to 7.8 percent for the S&P 500 index. For the past five years, long/short funds have an annualized return of only 0.8 percent per year, versus 1.7 percent for the S&P 500.”

The long-short funds, in other words, did worse than the S&P over the last five years, a period that includes the crash. Worse. These are mutual funds whose whole reason for existence is that (presumably) they can get out of a falling market and then jump back in when it is obvious that the market is going to rise. And how obvious was it that the market was over-valued and would soon crash in 2007, or that it was cheap and would therefore rebound in 2009? Pretty obvious – or so many pundits are saying now. So how hard should it have been to do better than this market? Pretty easy apparently. But no – not so. It was not so easy at all. These funds did not do as advertised. But your portfolio did substantially better than the S&P over the same time period. Diversification and rebalancing triumphed, once again, over timing exactly when timing should have added the most value. The fast money folks (timers) need liquidity. Long-term investors like us provide it – but we charge for it. We (or the funds we use, the DFA funds) buy what panicked short termers want to sell. And sell what they want to buy. We are on the smart side of the spread. We take the other side of panic on the downside and greed on the upside, and we are quite content to do so.

We are not geniuses here. But we do know what we don’t know. We do know that we don’t know how to time markets. The evidence is that other people don’t know either. They just don’t know that they don’t know it. Too bad for them. The future is unknown. It may well be as violent as the past. Our view is that the only reasonable thing an investor can do is to continue to plan, diversify, sit on the good side of the spread, and stick it out.

We will be sending you the information you need to do your taxes around the end of January.

Jim & Dean

Investor behavior very much reflects this lack of confidence. Money has consistently left equity funds and gone into bond funds. This has produced the result that, for the first time since the 1950s, the dividend yield on the S&P 500 is higher than the yield on the ten year Treasury bond. This shows either extreme fear or a firm conviction that corporate earning are about to fall – a lot. This would seem to be a market in which active investing – market timing – is very important. What matters is apparently to be right on the big issue – will we have a deflationary spiral downward again – or will deficit spending and easy money produce a run-away inflation. These investment outcomes would have very different effects on portfolios, and neither of them seems very wonderful.

The shock from the 2008 market collapse has not worn off. Many investors are therefore sitting on the side waiting for a clear direction before committing money to the world stock markets. To them it seems prudent to miss out on a few months or years of return in order to “know” that the market has settled down. The people who do consider buying equities often deal with their fear by active trading – being ever ready to pull the trigger at the slightest sign of market losses. This active trading is reflected in “professionally” managed money, such as in high frequency trading hedge funds. It is also present in very active trading done by some individuals, especially those using the leveraged or even double leveraged ETFs.
The average holding period for both mutual funds and also for direct equity accounts is down dramatically. According to the article, “Short Tempered Trading”, in Business Insider, the mean duration of U.S. equity holdings has fallen from 7 years in 1949 to 2 years in 1987 to 7 months by 2007 – and it is no doubt much lower than that now, with those active investors accounting for over 70% of the total equity volume. Clearly people are determined to never “get caught” again, as they believe they were in 2008. Vigilant – quick on the trigger. These are the watchwords. Larger and larger numbers of people are trying to make these predictions. The hedge funds and high frequency traders are trying to own only those assets that are going to go up, and to own them only on those days when they will go up.

But of course it has not worked out. There is this false memory – or this myth – that “everything is moving together” – that the market just goes up or down en-mass – that every day is either a ‘risk on’ or a ‘risk off’ day. When we say a “false memory” what we mean is that from October 2007 to March 2009 “everything” (i.e. all equity asset classes) most certainly did move together – and they all moved down, in a big way. The shock of this is still what people remember. They therefore conclude diversification doesn’t work. That it is dead. But the very opposite has been going on, as your report for the last 12 months illustrates. There has been a very dramatic difference in the performances of the equity asset classes, with the REITs doing the best and emerging markets the second best. International large capitalization stocks have done almost nothing.

Once again, diversification is the key. Diversification across asset classes, across inflation vs. deflation, and also across “up” vs. “down” days. The diversified investor dismisses the idea that one can be in on good days and out on bad days as pure speculation. Investing like this is not investing. It is madness. Since the bottom of the market in March 2009 diversified investors have enjoyed returns from every equity asset class of at least 70%, with some being over 175%. People who have hid out in bonds or cash have not. In March of 2009 you would not have predicted that real estate would be the best performer – not after what the bears were saying about it during the crash. We would not have predicted it either – but there it is – on top. And neither you nor anyone else can predict the day, week, or month, in which the markets will go up or go down. Some people have been knocked into an extreme version of active investing , hyper-active investing, by their memories of the crash. This kind of trading is a field day for investors like us – as the violent market action creates rebalancing opportunities. Judging by the success (or rather lack of it) of the average hedge fund and the average actively manage fund, and judging by simple common sense, this active investing has not and will not work out well. We will continue to do the opposite.

A few administrative notes. As we mentioned in our last letter, we do have a website now, and the process of transmitting data back and forth privately is much easier. We invite you to take a look – at www.pinneyandscofield.com. If you have friends who might benefit from what we do, send them to the website to learn about us. Also let us know if you would prefer to receive these letters and reports via the secure side of the web site. Dean is moving his office at the end of October. His new mailing address will PO Box 1634, Jackson, WY 83001. His office is at 320 East Broadway in Jackson. When you next visit Grand Teton or Yellowstone National Park drop in and say hello.

Please do call with any questions or comments.

Jim & Dean

The writing of the website content provided us with an opportunity to clarify how we add value for you. We believe our primary goal is to allow our clients to focus on the important things in life by knowing there financial affairs are in good order. That confidence starts from the way we organize our business, with no conflicts of interest in our fee schedule and through using an independent custodian to hold your assets. The next step is the financial plan. The plan not only allows you to know that your goals are achievable and that you are living within your means but also to be comfortable that the unexpected is also covered. By providing an objective look at your insurance coverage and emergency funds we allow you to spend time with family, work or your community without worries. Lastly our method of investing, using passive investment vehicles in a diversified and rebalanced portfolio, means you are betting on world capitalism rather than your advisor outsmarting all the other market participants.

The client login part of the website will allow us to post your most recent financial plan, meeting notes, tax returns and of course your quarterly performance reports. Hopefully this access will mean these documents are more readily available for easy reference allowing you to see what you need and get back to your life. You can also post information there for us. No more snail mail, faxing or unsecure emails with important private information. In this area you will also be able to see (although not change) what we have for your contact information. If we have an out of date email or phone you can easily contact us with the current information.

We looked for the best in security for the site and are very pleased with the results. No one logging into the private part of our site is ever on our server or directly connected to our server. Only the documents we authorize or that you post are available. When you click on a document to view it a request is sent via the server of the secure client portal to our server. An encrypted data packet containing only that file is then sent back to the secure client portal for you to view. This method will allow us to share documents easily and securely. It complies with Massachusetts’ new privacy law and is far superior to email.

The investor resource section has useful links to other websites such as Medicare, Social Security, the IRS, the organizations that grant our professional designations and fund families we use. The link to the Federal Trade Commission’s web page about identity theft is a great resource for information on protecting your on-line identity. We have also posted our past quarterly letters. This will allow prospective clients to get a feel for our advice at certain points in the markets and let you reread any that are of interest.

We are, of course, hopeful that this new resource will help spread the word about our business and bring in new clients. This helps you in at least two ways. First it gives you a way to refer people to us. Simply point them to our web site for information and options on how to contact us. Second as our business grows it becomes even more sustainable, which allows you not to worry about the future of the firm as we age.

So how does this all work? We have authorized all of the relevant documents we have for you. The performance reports included in this letter are posted. In addition all first quarter performance reports are available and any tax returns, financial plans, notes etc. that are recent are available. You will need to call us and have us activate you as a user. That will be a fairly short call to work out the particulars of your user name and password. We can issue you a temporary password that you can change upon entering the site, which we will then not know, or we can give you a password that does not change if you don’t mind us knowing it. If the password is ever forgotten just give us a call and we can reset it.

With the markets as volatile as ever, we continue to believe that focusing on the long-term picture is of upmost importance. Paying attention to the things you can control such as spending, saving, insurance protection and tax and estate planning is the way to weather the market’s storms. We are pleased to be able to offer this tool to you to help to that end. There are lots of possibilities for expansion of the site that would allow additional uses. Please look around, use it and let us know what you like and don’t like.

Dean & Jim

That may seem a bit melodramatic, but in order to be a successful long-term investor you must not miss any of the great rallies. This gigantic rally, like all before it, was in no way obvious. One year ago we were in the second worst market decline in the last 100 years. This was the scariest market most of us had ever experienced or even imagined. A literal repeat of the Great Depression, or even worse, seemed to be a real possibility. The central banking system looked like it might crack. The largest banks and insurers were failing; the “smartest” investment minds at some of the “best” run endowments were going broke; unemployment was in double digits and rising. Panicked investors fled the market in droves – and many have not come back even yet. But you stayed invested and therefore you are enjoying the current historic and gigantic rally.

Morningstar, the mutual fund rating company, recently released a study showing the investment results of the ten years ending December 31, 2009. The average compound annual return of all mutual funds during that decade was 3.18%. However, the average investor in those same funds only earned 1.68%. How is that possible? The participants moved money from one fund to another based on emotions and guesses about the future. This moving cost them 50% of their otherwise available returns (from 3.18% to 1.68%). The conclusion is dramatically clear. Market timing is hard – and for the investment public as a whole it is a loser of an activity. This is simply another example of what we have been writing about for years. The natural reaction to emotion is to act. Action in the face of strong emotion is often a good idea, but not in investing. And that is being played out again right now. In the last twelve months the S&P is up 50% while the EAFE, the international S&P 500 equivalent, is up 55%. And still the majority of the money flows are out of equities and into bonds, just as they have been for the past twelve months. The owners of that money will never make the returns back that they have now lost.

We all know that markets will continue to be volatile. We know that the natural reaction to that volatility is to do something. That is why we have an investment policy statement for each of you defining the allocation we will use and the moves that will be made when the inevitable happens. Decisions made in advance allow you to overcome the instinct to flee and instead behave in a way that makes you a long-term investor.

If you have an allocation of 50% or more to bonds you are now roughly back to the highs of your portfolio that occurred in October of 2007 (ignoring flows). Those with more stock exposure are not there yet. This rally provides both you and us an opportunity to reflect on the level of risk you are assuming and to consciously agree it is appropriate or needs changing. We believe one of the benefits of our method and service to you is that they allow you to be free of market concerns and concentrate on the important things in life. If the action of the collapse caused you blind fear, perhaps your portfolio is too risky. We will be more than happy to meet with you to discuss your experience over this last decline and recovery and make whatever changes seem appropriate. More bonds will mean lower risk. Lower risk will mean lower return in the long run but a smoother ride. Consider the difference between a lower allocation to stocks during the next big rise and thus a lower return vs. selling everything at the next bottom (out of fear or regret at not having added bonds now) and having to tell your grandchildren you missed the next great rally. However, it may well also be that our method was sufficiently stable and predictable to persuade you that you can continue to own more stock than you perhaps thought you could when the market was at the bottom. We are not making market predictions here. We are saying that the last two years have been a real good risk preference test for you and thus are well worth talking about.

As per usual, there is both a bear and a bull case. China and the other big emerging markets continue to grow. And markets generally are not particularly expensive. These are bull factors. On the other hand there has been no significant regulation reform regarding banks and derivatives, unemployment remains high and government finances are very stretched. The future seems finely balanced between inflation (stocks benefit) and deflation (bonds benefit). But the apparent need to figure that all out and react accordingly is not a need at all. The single most important determinate of your investment results will be your behavior as an investor. We stand ready to assist you in becoming a successful long-term investor by ignoring the information avalanche and making your investment decisions in advance.

In our view, the last two and a half years have been a triumph for us and our method. They have demonstrated the wisdom and strength of the way we do things better than we could have ever articulated it. If you know anyone who could benefit from this type of assistance we would welcome the chance to discuss our services with them.

Dean & Jim

But for many investors it was also the most challenging experience of their financial lives, and their ability to maintain a consistent strategy was sorely tested. The markets did not simply go up 25% during the year. Performance was bifurcated into two distinct periods. From January 1st through March 9th the rate of fall, which started in October 2007, was one of the fastest ever recorded. By March 9th world equity asset classes were 60% to 70% below the peaks set in 2007. But March 9, 2009 through year-end saw the sharpest equity market rally since 1933.

To show you the amazing violence of these moves, and the difference in performance of the various asset classes you owned over these time periods, we are enclosing a special asset class performance report. It covers three different periods: first, the drop, from October 12, 2007 through March 9, 2009; then the recovery (thus far) – from March 9, 2009 through December 31 2009; and finally the whole episode from October 12, 2007 through December 31, 2009. (If you started working with us during the period, the results shown will only cover the time you have been our client. Also for anyone with an annuity the dates have been adjusted to the end of the closest month.)

The first period shows why 2009 was so difficult. So much was going wrong in the world’s economies and markets that hedge funds, banks, even money market funds, were not safe. There was talk of a full scale nationalization of the banks, which could have set off a run on the insurance industry, an industry not protected by the Fed. Investors had to ask the dreaded question, “With these losses can I still accomplish my goals in life. Maybe I should sell out and protect what I have left.”

Changing life goals is a traumatic process. It is very difficult to voluntarily lower one’s standard of living. We tend to wait too long to make changes to our life style and as a result we must make even more drastic changes. When the market was falling 650 points in a day it was reasonable to ask, “Can I still retire, can I send my children to college, keep my charitable promises”? These questions lead one to question their investment method and decisions. “Maybe if I change the way I invest I won’t have to change my goals or life style.” In a falling market the easy choice is to sell the falling asset.

But then the recovery period (the second part of the special report) happened. Your portfolio was up between 35 and 110 percent depending on your risk tolerance and asset allocation! These are returns normally experienced over a decade. Here it happened in less than a year. And because you had a method in place, backed by a financial plan, you had not sold the falling assets but actually bought more of them. No insignificant feat in the face of such a major meltdown.

And today? Or tomorrow? Could all this happen again?

Yes – it certainly could. The fact that it has happened once probably makes the odds of a repeat higher. Are the banks of the world more stable now? Will there be meaningful regulation of derivatives contracts? Will corporations incentivize good long-term results instead of short-term profits? What is the environmental future? Will the basic trend be inflationary or deflationary? No one has the remotest idea what the answers to these questions will be – and yet financial and investment decisions have to be made. We believe our financial planning and investing methods are the best available to deal with this deep uncertainty, and we look forward to our continuing relationship with you – helping you avoid giving into the emotions brought on by the uncertainty of the future.

Now a bit of housekeeping.

First – You will soon get another letter from us marked “tax information” in red. If you do your own taxes you will have to open this and deal with it. Otherwise give it to your accountant, along with the tax reports sent to you by Schwab.

Second – we have decided to join the 20th century by having a website. We will have our basic documents, our letters, and some interesting links. We will also have a secure document exchange system. You will be able to set up your own secure mailbox password, and we will be able to exchange confidential things – taxes – budgets – securely and safely. We had hoped to have the site up by the time of this letter, but it is not ready. When it is up we will let you know.

We thank you for the confidence you have shown in us and our methods. May the New Year be happy, healthy and prosperous.

Jim, Dean, John & Ryan

How you react to those bear markets will be the primary determinate of your long-term return.

Think about that for a minute. You have control over the primary determinate of your return! It is not inflation versus deflation, the Middle East, China’s future, derivatives and their regulation or Wall Street bonuses that will be the primary determinate of your long-term return. Your behavior will be. If you react by buying as markets fall you will be taking advantage of these risks. If you react by selling you will lose.

Markets are people in action, and it is human nature to be emotional. Market participants overreact to news on both the upside and the downside. They overestimate the upside of new inventions and innovations and also overestimate the downside of the macro political or economic disasters. This will surely continue. It is your ability to remove your investment decision-making from these emotions that will determine your lifetime rate of return.

Notice that we didn’t say avoid the emotions. The fear and greed are real and very few can avoid them. However it is important to remember that we have agreed with you to have a long-term goal oriented investment method, one that made sense when the emotions weren’t present. Thus, when the emotions arise we can acknowledge them and then deliberately not act on them. The bear markets of the past all had causes and those causes were real – assassination of one President, shooting of another, Soviet missiles on our doorstep, a nuclear arms race with a country bent on our destruction, acts of terrorism, leverage not seen since the depression etc. During each of these crises there was a plausible argument for the end of markets and the world we know. The stories are always there, and the world has not ended yet. This is true now, and will be true of the next six bear markets as well.

Our task then, ours and yours, is to know that these bears are coming and to not be shocked by them. To embrace them as an opportunity to buy more shares with the dollars we have and not cringe at them and hope they go away (for if they do the higher expected returns go away as well). As financial writer Nick Murray says, “a bear market is a period of time during which common stocks are returned to there rightful owners. That is, stocks that were bid away from good investors by bad investors during euphoric times are, during major market declines, sold back by the flapper to the wise and deserving investor at fire sale prices.” We think this is a pretty good definition of the rebalancing we do. Be ready for the next bear market – it will come.

Restated. Over the long term equities must have a higher expected rate of return than either bonds or cash. They simply must, exactly because they are riskier than either bonds or cash. A sharply falling market is a chance, heaven sent, for a long term investor to buy equities at cheaper prices. Therefore stay invested and buy as markets fall. Be disciplined. The only alternative is impossible clairvoyance, an impossible and never yet demonstrated ability to time both the fall and the rebound. Your portfolio is still down from the top in October 2007, but it is up a lot from the bottom in March of this year. It is up exactly because we did not sell but rather rode the market down and rebalanced into cheaper equities on the way down. We stayed put and therefore we can now ride up the most powerful bull market since 1933. Many investors hate this recent market recovery. They just can’t stand to see it happening, because they sold out and they can’t pull the trigger to get back in. The vast majority of mutual fund flows from October 2008 until March of 2009 were into bond funds, not stock funds. That is not true of us, or of you. Buy and hold investors such as we are have done much better in this market than the vast majority of timers, and over a longer period of time buy, hold and rebalance is the only reasonable way there is to deal with savage market volatility and the emotions that come along with it. And one day markets will turn and go down again. Be prepared.

There is a branch of economics called behavioral economics. Daniel Kahneman and Vernon Smith won the 2002 Nobel Prize for their work in this area. This branch studies the patterns of (normally less than optimal) human financial decision making in the face of uncertainty and stress. What we do here is behavioral economics. We attempt to influence your decision making and investment behavior in ways that we believe are in your long term financial interest, even if they don’t feel all that good at any given moment.

Now for something completely different. There is a tax law change coming in 2010 that eliminates the income threshold for converting a traditional IRA to a Roth IRA. We have developed a process for analyzing whether or not it makes sense for you to consider this. There are many variables involved including the probability of you leaving money to heirs (individuals not charity), expectations of future tax rates, your current tax rate and the balance of your assets already in tax advantaged versus non-tax advantaged accounts. If we have not already discussed this with you, please give us a call or plan to spend some time on it at your next meeting.

Jim & Dean