Quarterly Newsletter – March 2003

It seems that every day the market dives – lower and lower. Over the past twelve months the
S&P 500 and the NASDAQ are down 23%. The Dow Jones Industrial Average is off 28%. But remember – when the TV shouts, “the market is down 180 points!” – the TV is shouting about the Dow or the S&P 500. The TV is NOT shouting about your portfolio!

Your portfolio contains many asset classes. As shown in the enclosed Asset Class Performance Summary, over the last year your portfolio has not fallen 28%! (Check the report now – and note the difference. We will wait right here till you get back.) Small stocks, bonds, REITS, foreign stocks, all have done better than the S&P 500. And so has your portfolio. (If you have been with us less than a year, check your Portfolio Performance Summary. The story is the same.)

The TV – the newspapers – all these investment “experts” – they all play on your emotions. They shout – “buy buy” when markets are rising. “Sell sell” when markets are falling. But your portfolio is diversified and robust. Robustness is better than emotions.

The prospect of war looms. Reflecting the uncertainty, markets are now more volatile than any time since the 1930s. Fear – cold hard fear – prices itself in. Given this, we wish to pose what may seem to be an academic question, but which is really not. Are markets efficient? Do they accurately reflect all available information all the time? Or do market participants overreact to short-term events? Do they assume the current trend will last forever and thus bid stocks above and below rational efficient prices?

This is a major debate within the community of researchers on financial market behavior. It would seem imperative to know the answer to this question, especially given the current world political situation, before setting investment policy. It stands to reason that the appropriate investment response to these two different market views would be diametrically opposed. If markets are efficient then market timing and stock picking services will fail. If markets are subject to swings beyond rational pricing then investors armed with the mathematical and psychological skills should be able to add value beyond the market return.

The efficient market hypothesis comes in various forms (weak to strong). Strong efficiency claims that the market behaves as if all market participants have access to all the available information affecting prices, have the knowledge to utilize that information and the psychological make-up to follow through on the recommendations generated. Weak efficiency claims that the above description is true for most investors most of the time. Either way, market efficiency implies that market timing cannot generally succeed. The proponents of this view include people associated with Dimensional Fund Advisors such as Eugene Fama and Ken French and other highly acclaimed academics such as Burton Malkiel, Bill Sharpe and Roger Ibbotson.

The other side of this argument is the behavioral finance side. This side denies market efficiency. Behavioral finance research indicates that most investors, individual or professional, do not have access to all the information, do not have the mathematical expertise to evaluate the information and above all do not possess the psychological skills to implement the trades.

Behavioral finance finds that market participants, both individual and institutional, act with systemic biases – biases such as loss aversion, myopia and overconfidence. The behavioral finance camp also has well known and prestigious followers – including the last two Nobel Prize winners in economics: Daniel Kahneman and Vernon Smith. Their argument gets a big boost from the last 5-10 years of market activity. The rising market of 1995-1999 brought out the emotion of greed, and the greed caused active (market timing) investors to over-commit to growth stocks. The falling markets of 2000 to the present have induced sharp fear – and led to disgorgement of the battered growth stocks and a flight to safety. Active investors are over-confident, they rely on small samples, they buy and sell too often and at the wrong times.

But here is the twist. Regardless of your belief in efficiency or not and regardless of the actual truth of efficiency or not (which of course cannot be determined) the best investment policy is THE SAME. And you will not be surprised to learn it is diversify and rebalance.

It is fairly easy to come to the conclusion that if markets are efficient a diversified portfolio of Factor or Index funds makes sense. No timing – no prediction – just sit still and let the markets do their thing.

But what of markets bubbling and collapsing due to investor emotions? The Noble Prize winners have described investor behavior that is irrational and sub-optimal. This behavior makes markets more volatile than the changing patterns of corporate earnings or dividend payments warrant. A disciplined method of diversification and rebalancing is just the right way to take advantage of the market madness generated by the runaway emotions of active investors.

Let’s get back to the current political situation. Either the market has correctly priced securities based on all information about the Iraqi and Korean situations and questions about what will happen if the war goes badly (well) don’t matter. Or market participants will overreact, volatility will rise, and rebalancing will pay off. The investment lesson is the same either way. Again we urge – patience – discipline – and diversification.

We wish to remind you that, as described in our letter of Dec. 13, 2002, we are switching to a calendar quarter billing cycle. This switch means that the current bill covers the four months of March, April, May and June. Our next bill and letter will be issued July 15.

Jim & Dean