Quarterly Newsletter – December 2000

Our last letter about Nortel and what might happen if the company were to post disappointing earnings or revenue growth was prescient. On Oct. 25 Nortel did in fact disappoint, and the stock got clobbered. It is down to 41 from a high of 89 in mid summer.

Very obviously the markets are under stress right now. Increased uncertainty has lead to falling asset prices and increased volatility. It is difficult to describe or imagine the carnage in the dot.com stocks in the recent few months. A year ago this was the “can’t lose” sector in the stock market, with stocks going up by gigantic amounts. Recently the total opposite has been true. Yahoo, the blue chip of the sector, is down from 250 to 32. Priceline has fallen from 106 to 2. And Pets.com, like many others, is bust and gone forever.

We would ask you to recollect your own emotions and thoughts during the recent dot.com events. Were you tempted to “chase the winners”? Were you upset that your portfolio was not more loaded with the hot internet stocks? And now – with the markets falling and doom and gloom all over the investment press, how do you feel? Do you feel frightened – ready to “sell the loser”?

Investor psychology, your emotions, your behavior, is the key to your success or failure in investing. We have discussed this before, but it is a deep and difficult subject. The Boston financial consulting company Dalbar publishes a study called the “Dalbar Quantitative Analysis of Investor Behavior.” They find that the temptation to over-trade, to try to time the market, to try to predict and pick the winner, is gigantic and disastrous. Based on an extensive statistical analysis of cash flows into and out of equity mutual funds from 1984 through 1998, Dalbar estimates that the average investor holds mutual funds for an average of only three years. They also estimate that from 1984 to 1998 the average American mutual fund investor earned merely 7% per year.

Consider what that 7% number means. The following is a list of asset classes and their annual returns from 1984 to 1998:

US Large Growth: 17.18 % US Small: 11.02 %
US Large Value: 17.05 % US Small Value: 15.21 %
MSCI Europe 19.06 % UK Small Cap: 12.49 %
MSCI Pacific: 9.62 % Japanese Small: 7.83 %

Obviously any one of these is better than 7% per year. According to Dalbar, the average investor danced from one asset class to another, hoping to pick the next years winner, and in the process managed to under-perform a simple buy and hold strategy in even the lowest performer.

The temptation to over-trade comes from human nature. In any period of time, different asset classes have different performance results, and “picking the winner” seems an important and easy thing to do. The recent periods of volatility can exaggerate this desire to time the market and guess what it will do next. Such efforts are profoundly unwise. The effort to predict leads to the poor results Dalbar describes. The opposite strategy, our strategy, is to hold all the asset classes, winners as well as losers, and to rebalance periodically. In the 1984-1998 time period, our strategy, if applied using the asset classes listed above, would have produced a return of about 14.5 % per year before fees. This return is twice as high as that achieved by the average investor.

Our basic service is to implement a buy and hold investment strategy that takes advantage of differences in asset class performance in a logical and peaceful way. Because our method is peaceful, it leads to the behavior Dalbar identifies as the central key to investment success – buy and hold investing.

The point bears repeating. The Dalbar study indicates that the average equity mutual fund investor earned 7% per year from 1984 to 1998. This result was a direct consequence of the temptation to over-trade. The service we perform is to protect our clients from themselves and from investment services such as Morningstar, Barron’s or CNBC, all of which advocate market timing and performance investing. We do this by establishing and maintaining diversified and rebalanced portfolios of risk-factor funds. We are very sure this method will lead to investment performance that is better than average.

We are pleased to announce that Dean has successfully completed all requirements of the Chartered Financial Analyst program and is now a CFA charterholder.

Our year end tax reports showing realized gains and losses, percent US Government income and state capital gain holding periods will be sent in late February. These can be used to prepare your year 2000 returns.

We wish you Happy Holidays and a wonderful New Year.

Jim & Dean