First Quarter 2011 Letter to Clients

Despite the fact that stocks have gained upwards of 20% since last August and are now back to levels last seen in 2007, the conventional wisdom amongst investors still seems to be oriented towards doom-and-gloom. We are not at all opposed to this, as we have long held to the old adage that “stocks climb a wall of worry.” That is exactly what we have seen these past seven months.

Nonetheless, it is interesting to note the continued assertion by the media that employing a diversified, buy-and-hold approach to investing has somehow been invalidated in the post-2008 world. One recent article in the New York Times (In This Market, Safe May Be The New Risky, February 11, 2011) highlighted this mindset, questioning whether asset allocation provides as much benefit as it did in pre-Lehman days, asserting that “…diversification has provided little benefit during the last three years.”

We would take exception to the idea that an investor with a well-diversified portfolio strategy who emerged from the worst market downturn in a century with his portfolio intact did not much benefit from diversification. We think all of those investors who lost everything they had in the stocks of Wachovia and General Motors and AIG would trade places with a well-diversified investor in a skinny minute.

Interestingly, there was a similar article in the Times nearly two years ago that we referenced in our Second Quarter 2009 client letter, and it’s worth revisiting now with the benefit of hindsight.

The article (Time for a New Strategy? May 21, 2009) contained a variety of quotes from money managers asserting that strategic asset allocation (i.e., diversifying one’s assets and not making changes based on market conditions) was no longer valid in the post-financial crisis world. As one such manager sniffed, “Many of our [clients] believe we are in a trader’s market where long-term investing should be shunned but trading opportunities should be seized.”

For the record, since that article was published on May 21, 2009, the S&P 500 has soared more than 50%. Those are gains that were there for the taking in a conventional, diversified portfolio strategy.

Unless, of course, you shunned long-term investing…

* * * * *

Let us now consider the other alternative: Investment managers who believe it is their job to “do something” when times get tough for stocks.

It is not an inconsequential group. A March 11 article in SmartMoney magazine, entitled “Is Your Adviser Running Scared?”, pointed to a recent study that found that more than 30% of investment advisors blinked during and after the financial crisis, pulling their clients out of stocks.

Here’s an excerpt:

Nearly one-third of advisers moved clients out of the stock market and into conservative investments in 2009 and the early part of 2010, according to research from GDC Research and Practical Perspectives. That includes bonds, cash and variable annuities, with bonds and cash as the most popular exit strategies.

Just to reiterate, we aren’t talking about investors here – we are talking about investment advisors. Trained professionals (theoretically) who are supposed to be the behavioral barrier between their clients’ emotions and their money. But rather than rise to the call and help keep clients focused on the long term during the financial crisis of 2008-09, fully 1/3 of investment advisors ran for the exits, selling their clients’ equity positions for bonds, cash and (shudder) variable annuities.

One advisor featured in the article had moved his clients entirely to cash in the spring of 2009, then watched, paralyzed, while the market soared 86% through 2010. When asked by the reporter why he moved his clients into cash after stocks had suffered such steep losses, the advisor said he believed more damage was coming and he wanted to “keep losses to a minimum.”

This is an extreme example of the great myth that many investment managers tout of “downside protection” – the idea that an advisor can mitigate market losses for his clients by moving to the sidelines in times of turmoil, then deftly jump back into the market once the raging seas have calmed.

Advisors who sell this dream rarely have the misfortune of moving out of stocks at the exact bottom of the market, as the aforementioned advisor did. But even those who manage to avoid the worst of a bear market and move back into stocks in time for the inevitable recovery that follows rarely deliver any real value to their clients. On the contrary, such advisors usually end up costing their clients money even as they tout their risk-avoidance strategies.

Let’s go back to the fall of 2008 and consider an example:

After the collapse of Lehman Bros. investment bank in mid-September, volatility seizes the stock market. Daily swings of 5% or more become commonplace as Congress, the Treasury and President Bush wrestle with the TARP bailout package. The bill finally passes on October 3, and most experts expect this to calm the stock market. Instead, the opposite transpires: the worst financial panic since 1929 sweeps the market, and the Dow plunges nearly 3,000 points in just four trading sessions. On October 10, the Dow reaches an intraday low of 7,700 before rebounding to close at 8,500. Only a week before the Dow had stood at 11,000.

Having seen enough of this unprecedented turmoil, Advisor A acts quickly to capitalize on the rebound and moves his clients out of the market at Dow 8,500. While the panic selloff caught him off guard, he knows that things are far from calm, and the near term outlook is likely to get worse. Being committed to “downside protection” he moves to limit his clients’ “losses.” (Ignoring the fact that, by selling his clients’ out of the market, he has turned their paper losses into real losses.)

Meanwhile, Advisor B, who has his clients in well-diversified portfolios, is committed to staying the course. He knows that making short-term guesses about the market, even when things seem as dreadful as they do in October 2008, will only cause long-term damage to their portfolios.

Rather than responding to his clients’ worst fears by succumbing to his own worst fears, Advisor B remains an island of calm for his clients in the sea of hysteria.

By March 2009, Advisor A looks like a genius. Although he didn’t see the October panic coming, at least he didn’t just sit there and watch it get worse, he tells his clients. With the Dow now below 6,500 and falling fast, Advisor A makes sure his clients are well aware that his focus on “downside protection” saved them from incurring another 25% loss they would have suffered if they’d stayed the course.

Six months later, however, everything has changed. By September 2009, the Dow, inexplicably, is back to the 10,000 level. Despite this, virtually every “expert” in the media believes this to be a false recovery; they warn that another steep downturn in the market is imminent. Nonetheless, Advisor A summons his resolve and jumps back into the pool, moving his clients out of cash and into stocks.

By the end of 2010, the Dow is back to 11,500 – above the level it was before the collapse of Lehman – and Advisor A feels vindicated.

“Yes, it’s true we didn’t capture all of the upside when the market turned around,” he says. “But we captured a lot of it. And, most importantly, we protected our clients on the downside!” He points to his stellar track record during the worst of the downturn, from October 2008 to March 2009, when his clients only lost about 23% while the Dow lost more than 40%.

Those numbers sound compelling when you put them in a brochure. But now step back and consider the big picture:

• For the whole round trip from October 2008 to December 2010, Advisor A lost around 9% for his clients by realizing part of the downside and failing to get back in for part of the upside. (Keep in mind, too, that this does not account for the very significant tax and trading costs his clients would also have incurred.)

• Meanwhile, Advisor B, who did not make any changes to his clients’ portfolios in reaction to the downturn, actually saw his clients gain about 0.5% during the same period. His clients survived the worst market downturn in a century completely unscathed without any attempts by their advisor to “protect them on the downside.”

Ironically, Advisor A will no doubt trumpet his “downside protection” abilities for years to come, while Advisor B will create no such expectation with his clients. In reality, however, Advisor B is the one who truly protected his clients, while Advisor A cost his clients money they never would have, or should have, lost if he had done the hard thing and helped them summon their resolve instead of playing to their worst fears.

Market downturns are no fun. You will get no argument from us on that point. But they are merely temporary setbacks on the market’s long-running, upward climb. Moreover, market downturns are as unpredictable as the weather, as we have seen amply demonstrated in the selloff and rapid recovery following the Japanese earthquake.

Advisors whose value proposition is “downside protection” are, essentially, offering to diminish your wealth in exchange for making you sleep better at night by appearing to be “doing something” in times of turmoil. But it is a false comfort, because once things turn around, that advisor will very likely miss some portion of the rally that ensues, and when that happens all of the supposed benefit he was providing by moving you to cash in the first place will be completely lost.