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Letter to Clients: 2nd Quarter 2011

"It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so" -Mark Twain

 

April 2011

 

Dear Clients & Friends,

My quarterly letters typically contain an overview of what has happened in the market over the past quarter and an outlook to where I think we may be heading. This quarter, I am going to bypass the market review and instead take a closer look into how recent world events have made a financial impact.

In his Market Commentary on April 12, 2011, Scott Marcouiller, Chief Technical Market Strategist for Wells Fargo Advisors wrote "Event risk came back into the spotlight in Asia as aftershocks hit Japan. This was followed by a rise on the nuclear accident rating to the highest severity level. The effect of the quakes on stocks was progressively less but still a threat. Meanwhile, Portugal became the third Eurozone country to be granted a bailout. Speculation is that Spain could be next. In North Africa and the Middle East, there were more clashes and deaths in hot-spot countries. Not to be outdone, oil prices climbed above $112 per barrel and served to drag out stocks' current sideways action."

Everything in his commentary is absolutely true, but entirely meaningless to investors who plan to be in invested for years.

In investing, Black Swans are low-probability, high-impact events. The Black Swan theory was chronicled by Nassim Nicholas Taleb in his popular 2007 (revised 2010) book, "The Black Swan." Taleb writes about extremely rare or highly improbable events that have a major market impact, positive or negative, which surprise even the experts.

The enormity of the tragedy in Japan has saddened the world. We have never seen a triple disaster such as this with an earthquake, a tsunami and a nuclear disaster all hitting one country at the same time. Like many others, we are hoping and praying the Japanese people will receive the support and resources they need for a speedy recovery. As humans, we are keenly aware of the pain and suffering these tragic world events inflict upon our collective community.

Earthquakes, tsunamis and energy disasters are high-probability, high-impact events, especially these days. While the human devastation is horrendous, the economic cost is negligible over time and quickly priced into the stock markets. Unfortunately, disasters happen more often than we think (and are apt to remember). Here are just a few from the past decade alone:  

  • September 11, 2001, attacks on the World Trade Center and Pentagon
  • 2003 European heat wave (40,000 deaths)
  • 2004 Tsunami in Sumatra, Indonesia (230,000 deaths)
  • 2005 Kashmir, Pakistan earthquake (80,000 deaths)
  • 2008 Myanmar cyclone (140,000 deaths)
  • 2008 Sichuan China earthquake (68,000 deaths)
  • 2008 Derivatives roil the world's banking system and financial markets
  • 2008 Failure of Lehman brothers and the sale/liquidation of Bear Sterns
  • 2009 30% drop in US home prices
  • 2010 Port-Au-Prince Haiti, earthquake (315,000 deaths)
  • 2010 Volcanic eruptions in Iceland shut down 100,000 transatlantic flights
  • 2010 Russian heat wave (56,000 deaths)
  • 2010 BP Gulf of Mexico oil spill
  • 2010 Market flash crash (1000 point drop in the Dow Jones)
  • 2011 Surge of unrest in the Middle East
  • 2011 Earthquake, tsunami and nuclear disasters in Japan

So what do we learn? Time and time again, for investors anyway, we know that Black Swan events do not matter much when it comes to the economy, and even nuclear disasters (thankfully we've only had a few) aren't material to the markets. Panic selling has been the downfall of many investors with numerous studies illustrating the losses when the panicked seller bails out of the market. Perhaps this explains why the average investor has underperformed every asset class over the past 20 years while barely beating inflation. In other words, the average investor's portfolio has made only negligible gains in purchasing power over the past 20 years.  

Barry Ritholtz expresses a valid point about investor reactions to Black Swans. When asked what investors should do now, his answer is always the same: "The time to look for the emergency aisles and where the exits are located is before takeoff, not after the wings fall off the plane. You must have a plan in place to deal with unanticipated events, a just-in-case things head south scenario."

It's that very reason why regular reviews of your financial and investing plans are so vital. Does your plan take into account the random events that happen all the time? You should be aware of your risk tolerance level and financial situations at all times. And that brings us right back to the importance of regular reviews.

And how do we make sure that you don't panic? A recent New York Times article, When to Buy or Sell? Don't Trust Your Instincts, starts off wonderfully: "Anyone watching television commercials could easily conclude that trading stocks is something a baby can do from a crib." It goes on to explain that the baby in us usually buys or sells at the worst possible time. Part of my job, as your advisor, is to make sure that you do not overreact to irrational tendencies.

I am your resource; here to discuss your situation and explain your options. James Montier of GMO LLC Mutual Funds, author of several books on behavioral finance, has put forward seven immutable laws of investing:

  1. Always insist on a margin of safety
  2. This time is never different
  3. Be patient and wait for the fat pitch
  4. Be contrarian
  5. Risk is the permanent loss of capital, never a number
  6. Be leery of leverage
  7. Never invest in something you don't understand

Together, we use these seven laws to build a financial plan which best fits you and your needs. We have always experienced unanticipated events and always will. Investors with a long-term view of investing understand this. The risk-controlled approach to investing may not be "fun" in the short-term; but all the evidence at hand suggests that over time it will serve you well, getting you to your goals with the least amount of stress and distress along the way.

Are you on Facebook? As of recently so is DV Financial! Be sure to stop by and "like" our Facebook page. Following DV Financial is a quick and efficient way to keep up with pertinent financial information without being overwhelming.

Last quarter I closed by saying there was no reason to believe the markets will not continue to gyrate, and they certainly have. Yet my confidence in my tools and abilities to guide you through these turbulent times remains extremely high. Let Sue or I know anytime you have questions. We are here to serve you and appreciate your trust. It is a responsibility we take seriously with great pride. Thank you.

Sincerely,

Art Dinkin, CFP®