What we are getting asked about

The most common questions that we are being asked about in client meetings are about municipal bonds, interest rates and inflation (fixed income investments in general).

Interest rates: They are currently at all time lows, based on the past 5-10 years or over a much longer time period, such as 30-50 years. However, predicting the short term direction of interest rates (such as will they be higher 3 months from now), is nearly impossible to predict.
Implication: When we structure our client’s fixed income portfolio’s, we do not make investment decisions based on our “predictions” about future interest rates. We make purchasing decisions on the current rates that are available, with the intention to hold the investments to maturity (not buying them to trade them in 6 months or 2 years, based on our “bet” of the direction of interest rates).

Municipal bonds:
We view fixed income investments as an area to minimize risk. This should be the foundation of your portfolio, with the objective of preserving your investment, while getting a safe interest rate return.

Due to the greater rate of defaults, we do not purchase corporate bonds. The risk of default and not getting your principal back is not worth the additional small amount of annual interest that you would receive. Others may disagree with this philosophy, but it has enabled our clients to sleep well.

We believe in holding individual municipal bonds or certificates of deposits, as long as they are FDIC insured. When selecting municipal bonds, we are extremely particular about what sectors the bond is in. As much of our investment philosophy is based on academic data and research, so to is our fixed income strategy. For municipal bonds, sectors such as housing, healthcare and industrial development have far greater default rates than other areas, such as school districts, highways, and public transportation. You may have never even heard of these statistics or had it brought to your attention by another financial advisor. In our purchasing criteria, we only buy top rated municipal bonds in certain sectors, that have the lowest historical default ratio.

We also advise our clients to diversify nationally, and not hold bonds in just one state. While this may cost some small amount of additional state taxes, the benefit of diversifying your fixed income investments is well-worth the cost. Again, this helps you to sleep well at night.

Inflation, interest rates and bond funds:

As discussed in this and other posts, we cannot predict future inflation rates or interest rates. We do know, however, that interest rates are at a historical low, and it is very likely that inflation will rise at some point in the future. If either of these events occur, the value of bond funds will decrease, and for some bond funds dramatically. If you are holding intermediate or long-term bond funds, of corporate, government or municipal bonds, and interest rates rise, you’ll be faced with a permanent loss in the value of your bond fund.

For this reason, we feel it is critical that investors be very selective and hold only individual fixed income investments, not bond funds. We feel there is the potential for huge bond fund losses, at some point in the future, when interest rates rise. These losses could be similar to losses incurred in the tech bubble. This would be almost more tragic, as bond fund holders feel that their investments are intended to be safe. However, interest rate risk will negate the perceived safety of these fixed income investments.

If you have significant bond fund holdings, we would be pleased to review them and provide you with our thoughts and recommendations.

What’s Going On?

The stock markets have dropped significantly in recent weeks. What are our thoughts?

Through the end of April, 2010, there had been a significant difference between the performance of US stocks markets (positive) and International stock markets (negative). The difference, depending on the asset class, was between 5-20% (meaning the best performing US asset class may have had a 20% better return than a poor performing international asset class).

Quick thoughts on that? Diversification is always working. It is impossible to know which asset class will outperform another. These are themes that we continuously focus on.

Other events have further caused significant gyrations in the worldwide stock markets and commodities. The economic crisis in Greece and potentially other countries in Europe are certainly the root of much of the markets’ declines during 2010. While in late 2009 indications of problems in Greece were beginning to appear, it is events such as these that provide further evidence of how difficult it is to make accurate market predictions and investment decisions based on “having a crystal ball.”

Late in 2009, most forecasters were predicting greater inflation in the US, based on governmental spending that was causing even greater budget deficits. So…..the Wall Street Journal blared last week in a huge headline that the most recent inflation statistics were at a 42 year low!

Most economists predicted rising interest rates and higher mortgage rates for 2010, to correspond with the expected rise in inflation along with the Fed’s moves to stop purchasing mortgage backed securities in spring, 2010. So….interest rates have declined during 2010 and mortgage rates have decreased, not increased.

Gas prices have dropped, based on expected declines in economic activity, stemming from the problems in Europe. Few would have predicted this decline, as no one could have predicted the oil spill. One would think the oil spill would cause reduced oil supplies, which would increase the price of gas. For now, that has not happened. At the same time, the reduction in gas prices will help to limit or reduce other inflationary factors.

The impact to our clients and our investment strategy?

We are focused on long term investing, not short term market predictions and reactions to short-term market activity. We are not changing our investment strategy based on these market movements. As part of a client’s long term investment plan, we may view the market decline as an opportunity to BUY stocks, if a client’s allocation to stocks has decreased below their planned allocation to stocks. In other words, as disciplined investors, we would recommend buying low (even though we don’t know whether the market will go higher or lower in the short term).

The key are the discussions that we have with our clients, both when we develop their investment plan and possibly now, when they may be concerned about the recent market declines. As we did during the declines of 2008 and 2009, we talk and discuss the markets. We listen. We counsel our clients to focus on their goals. As part of the plan we developed, the money that is allocated to stocks is not expected to be needed for many years. If this is so, then the movements of today become less of an issue.

Although we clearly are concerned about many of the economic problems throughout the world and in the US, we remain optimistic and positive for the long term. Our economy and the world are resilient and that solutions and innovations continue.

Client Letter: A Great Story

This is the letter that we sent to our clients in mid-April:

As spring has arrived with thoughts of warmth and renewal, we thought this would be a great opportunity to share a wonderful story, which is interwoven with many lessons and insights, which we can all learn from.

A 100 year old woman died in a northwest Chicago suburb in January, leaving her entire fortune of $7 million to her college alma mater, Lake Forest College. Orphaned at age 12, Grace Groner got her college degree and went to work as a secretary for Abbott Laboratories, where she worked for 43 years. When she began working at Abbott, she purchased 3 shares for $60 each in 1935.

So what happened to that $180 investment over the last 75 years?

  • With dividend reinvestments, and no sales, her 3 shares grew to over 100,000 shares, worth approximately $7,000,000. This was an annual return of 15.13%.
  • Compare this return to other asset classes and what the result would have been:
    • US Treasury bills – $3,046 (3.84% annualized)
    • S&P 500 – $210,000 (10.87% annualized)
    • US small value stocks – $6,900,000 (15.75% annualized)
      • Note the phenomenal difference in compounded effect of just a few % points of increased return, over a very long time horizon!
  • Our investment strategy generally emphasizes small and value stocks, both US and globally, over a more traditional US growth stock bias, which would be represented by the S&P 500. Note the tremendous performance difference in these two asset classes since 1935.
    • Further, as we did not believe the amount of the difference ($210,000 vs. $6.9 million), we re-calculated the figures to prove it ourselves!
  • Groner’s strategy, which we would never recommend (hers was the absolute opposite of the broad global diversification we advocate), did require many of the fundamental behavioral concepts that are necessary for successful investing: patience, discipline and the ability to weather the periods of bad performance of the stock market (or her one stock).
  • She did not sell, even though Abbott lost 1/3 of its value in 1937.
    • Though she paid $60 a share, the price did not again exceed the mid-50s from March 1937 through March 1944. Would you have been as patient with a single stock or your entire portfolio?
    • She endured plunging stock prices in 1962, 1970, 1974, 1982, 1987, 1990, 2002 and 2008. Yet, she did not sell.
  • Can you predict a great growth stock in advance and have the patience to hold on, over long periods of underperformance?
    • During the 1950s, most stocks did quite well, as measured by the Dow Jones Industrial Average, which more than tripled. Abbott only increased 22.7%.
      • Would you maintain your holding in such a “losing” stock when “everything else” is doing much better?
      • Would you continue holding an asset class, when others are doing much better?
  • Groner was truly lucky, based simply on where she was born and chose to work.
    • For the 50 year period ending in 2009, only seven stocks had higher returns than Abbott in the entire US stock universe.
    • Unless she had worked at or invested in Altria Group (formerly Phillip Morris), Kansas Southern, Loews, Walgreen, Radio Shack, Dover or Johnson & Johnson, she would not have done as well.
    • If she had worked at many other companies which were in the DJIA at the time in the 1930s, such as DuPont, National Steel, Chrysler, General Motors, US Steel, Woolworth or Sears, her investment would not have grown to be nearly what it eventually became. It certainly would have been very different outcome.

So while this woman is truly to be admired, and her alma mater will benefit wonderfully, we do not advocate her investment philosophy.

We do advocate and admire her long term approach, her discipline to stick to her plan (even if we disagree with it) and her ability to be resilient and maintain her stock position, during long periods of stock market declines and uncertainty. Those values and behaviors resulted in her tremendous financial success. We hope you are able to follow those traits, as it will do you, your family, and your beneficiaries well over the long term.

Sources: Chicago Sun Times, LA Times, Dimensional Fund Advisors, Center for Research in Security Prices (based at the University of Chicago).