Quarterly Newsletter – April 2005

The past ten years have been a triumph for the investment method of diversification. Diversification has produced long-term results similar to those of the large capitalization U.S. growth stocks while displaying much less volatility. Enclosed is a graph showing a ten year comparison of the performance results of the U.S. growth stocks (Russell 1000 Growth Index) vs. a diversified equity model portfolio similar to the stock side of your portfolio. (A description of the contents, method and limits of the diversified model, is on the reverse side of the graph.)

The comparison is dramatic. The growth stocks soared and then plunged. The final result is a portfolio value similar to that of the diversified method. But diversification gets rid of much of the hair-raising ride. As we all know, many investors were lured into the growth stocks only after the bubble had really gotten going, and therefore suffered huge losses. Diversification would have protected them. In this example, at least, the reduced risk of diversified investing costs very little in long term return and yet produces a profound gain in peace of mind by reducing short term volatility and the chance for loss.

Why is diversification like this? Why does it produce a large increase in economic welfare at little cost? Think of a world of fifteen companies and fifteen owners. In one arrangement, each owner owns one company. In another, each owns one fifteenth of a mutual fund, in which the shares of all the companies are pooled. In the first world, it is extreme wealth or poverty. If your company does well, you win big. If it goes broke, you lose everything. The second is more moderate. If the net returns to the two systems of ownership are similar, the reduction in risk has been obtained at a low cost.

Think of the fifteen companies in the above example as being the fifteen asset classes in the diversified equity model. Non-diversified investors chose to put all or most of their money in one company (one asset class) – and in the example we are considering here, many paid the price. The price was fear of the volatility and, in many cases, actual losses due to active trading. They paid because it is very difficult to hold a single asset class portfolio throughout a period such as the one shown on the graph.

Markets are very risky. Anyone who did not know that – who thought it was as easy as pie to get rich by concentrating their portfolio in one asset class and then hanging on has, by now, surely, been disabused of that idea. Where does this risk come from? The U.S. growth stocks bubbled and then collapsed. One would think that markets would be smarter than that. Why did people keep buying and buying? What were they thinking? Were they thinking at all? Perhaps not. Perhaps they were just watching – and lusting. Watching their neighbors get rich. Watching the ticker on tv and trading. When people make investment decisions by watching the investment decisions of other market participants, rather than the world outside, then the market has become self-referential. It goes up today because it went up yesterday. Self-reference increases volatility for no reason other than its own existence. The move may start slowly, but then accelerate as speculators pile in. Suddenly some event in the real world produces large scale selling. Speculators are driven off leveraged positions. More selling is forced. And down it goes. The market of any individual asset class can be seen as a treadmill of this kind of endless volatility.

Volatility increases risks, most especially for the non-diversified investor. Volatility increases the long-term cost of capital for the society as a whole. Increased cost of capital means reduced investment and employment and thus social wealth. This is the thesis of Robert Haugen in his book Beast On Wall Street – How Stock Volatility Devours Our Wealth. He describes financial markets as self-referential. Market returns are (he claims) much more volatile than the economic realities that should drive them. He cites studies for his case in equities, in commodities, and in futures. Haugen claims that the excessive volatility of the stock market was the direct cause of the 1930s depression. The market run-up in the 1920s was caused at least in part by self-referential investing. Then the market collapsed. This turn led to a collapse in confidence, and thus in real investment, and in the banking system and finally in employment.

In a previous letter we discussed the book The Wisdom of Crowds. One of the key points of that book was that crowds (markets) can be wiser than many or all of their individual participants. But, to operate in this way, the mechanism of summarizing the opinion of the crowd had to be individualistic and independent. A self-referential crowd is the opposite of this. The crowd becomes a mob. This is what Haugen discusses. This is what happened in the growth stock mania. Our method allows us to resist it.

What about now? Returns so far this year are flat. What will the rest of the year bring? As usual, we don’t speculate. We do know one thing though – the volatility risk remains and it always will. In the 90s it was the day-trader. Now it is the hedge funds. Hedge funds create and then chase volatility. They thrive on it. They chase the short-term. And hedge fund assets have risen exponentially.

This may sound as if we are somehow opposed to hedge funds or speculation. Far from it. Speculation is the source of what might be called competitive market violence. Competition among investors means poor corporate decisions are decisively punished. It is the heart and soul of financial markets. Speculation makes markets quicker, wiser and stronger. A diversified investor, such as we are, thrives on asset class volatility. We can survive it and profit from it by rebalancing. But while speculation creates and benefits markets, it only benefits those market participants who survive it. Diversification, in our opinion, is the best way to assure that survival.

Dean & Jim