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Blog Posts
 
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Letter to Clients: 4th Quarter 2012

Dear Clients & Friends,

As we enter October, we are now three quarters through a very eventful 2012 both in the marketplace, and here at DV Financial.

Over the past quarter, we released our new website www.dvfin.com along with a few new services.

  • Live client portal – our secure client website has been a huge success. It provides a place for you to collect all your financial data; not just the assets we manage for you. The real value to you is the collaboration this supports since we are both seeing the exact same information. Behind the scenes is some powerful financial planning software so we are prepared to quickly answer any financial questions you may have, and the data we use will always be up to date! We have been adding a few clients every week into the system, but only for those who want to use it. DV Financial pays for the system. There is no cost to you. Please let us know if this is something you would like to enjoy.
  • Quarterly Economic Updates – In the past I had posted quarterly economic commentary to our blog. With our website upgrade this is now available in an email format. It is free and easy, just go to the website and sign up under "Free Economic Update". This is not a marketing campaign and you do not even be asked for anything except your email address (which will not be used for any other purposes than to send you four emails a year). The most recent update went live on October 10th. Look it over and if you like what you see, sign up for the next update in January.

In the markets, this year has been a tale of three distinct quarters. In the first quarter we saw the strongest start for the stock market since 1988, driven by a reduction in fears about Europe and stronger economic data in the U.S.

The second quarter gave many of those gains back, due to escalating concerns about the European currency union and slowing global growth, accompanied by discouraging data on employment. We also saw a slowdown in China and India, putting downward pressure on the prices of oil, other commodities, and stocks in general.

This past quarter we saw markets bounce back, as the U.S. Federal Reserve Board and the European Central Bank (ECB) put measures in place to stabilize economies and to boost growth prospects. In particular, European confidence was boosted by the ECB's announcement that it would backstop Greece, Spain, and other countries whose economies are struggling.

Here is a summary of global market performance in 2012 to date, all in U.S. dollars. It's of note that the global "flight to safety" over the past 12 months has led to a stronger dollar, depressing returns outside the U.S. when denominated in the dollar. It is now hard to recall that when we suffered our own fiscal crisis just a few short years ago, some pundits wondered if the U.S. dollar would be replaced as the global currency standard.

Guidance from a Wall Street Legend

Of course, looking back is always the easy part of investing – looking forward is more challenging. Barton Biggs entered the investment industry in 1961 and in 1973 joined Morgan Stanley, where he served as chief global strategist from 1985 until his retirement in 2003. He was named 10 times to the All-America research team and was voted Wall Street's top global strategist each year from 1996 to 2000. Among his claims to fame:

  • He predicted the bull market that began in 1982 and warned investors about Japanese stocks prior to their collapse in 1989.
  • In an interview in July 1999, he identified a bubble in the U.S. market and advised investors to sell tech stocks.
  • He correctly called the bottom in U.S. stocks in March 2009.

Biggs wrote extensively on how investors can prosper in volatile markets. Three of his themes are especially relevant today:

  • Why owning stocks is essential for most investors
  • The challenges of investing rationally in an irrational world
  • The psychological makeup of successful investors

Why owning stocks is essential

One insight from Biggs relates to why almost all investors need to own equities at some point in their investing lives:

The history of the world is one of progress and as a congenital optimist, I believe in equities. Fundamentally, in the long run you want to be an owner, not a lender.

Biggs also discussed the trap of making short-term safety your only investment consideration and sacrificing higher returns for lower volatility:

Warren Buffet said it best when he said he would always pick an investment strategy that over five years would give him a 12% compounded annual return, but that was volatile, over one that promised him a stable 8% return.

Rational investing in an irrational world

Biggs also wrote widely on the challenges of being caught up in the emotions of the market and the tendency to root our investment outlook in the immediate past rather than what is happening today and what may happen tomorrow.

This is no different from military officers who attempt to prepare for the next war by applying the lessons learned from the last one, without recognizing that the context has become entirely different. Biggs' comment helps explain peculiarities such as massive inflows into government bonds during a period of all-time low rates, leading to a virtual certainty of capital losses when interest rates rise.

As investors, we always have to be aware of our innate and very human tendency to be fighting the last war. We forget the Mr. Market is an ingenious sadist and the he delights in torturing us in different ways… Mr. Market is a manic depressive with huge mood swings and you should bet against him, not with him, particularly when he is raving.

Biggs went on to refer to a comment by Warren Buffet about investing – that it is like being in business with a partner who has a bipolar disorder:

When your partner (with a bipolar personality) is deeply distressed, depressed, and in a dark mood and offers to sell his share of the business to you at a huge discount, you should buy it. When he is ebullient and optimistic and want to buy your share from you at an exorbitant premium, you should oblige him. As usual, Buffet makes it sound easier than it is because measuring the level of intensity of the mood swings of your bipolar partner is far from an exact science.

The psychological makeup of successful investors

As a result of the strong emotions at play, many money managers find it hard to stick to their strategies. Here is what Biggs had to say about the importance of immunizing yourself from the psychological effects of the swings of the market:

The investment process is only half the battle. The other weighty component is struggling with yourself and immunizing yourself from the psychological effects of the swings of the market, career risk, the pressure of benchmarks, competition, and the loneliness of the long distance runner.

And Biggs offered one final piece of advice about knowing yourself and your foibles that will particularly resonate with those of you who remember the tech boom of the late 1990's. While this advice is oriented to investment professionals, it applies to individual investors as well:

At the extreme moments of fear and greed, the power of the daily price momentum and the mood and passions of "the crowd" are tremendously important psychological influences on you. It takes a strong, self-confident, emotionally mature person to stand firm against disdain, mockery, and repudiation when the market itself seems to be absolutely confirming that you are both mad and wrong.

What this means for your portfolio

We face two major events as we bring 2012 to a close. The first is the obvious Presidential election. The second is the upcoming Fiscal Cliff; the expiration and effect of the Bush era tax cuts. As we sit here in October, weeks away from the election, most of the attention is directed there. But I believe the Fiscal Cliff has far more short-term significance to investment portfolios than deciding who will occupy the White House.

Left to its own, the Fiscal Cliff represents the single largest tax increase in history. All aspects of our tax code will be effected… ordinary income tax rates, capital gains, dividends, capital gains, payroll taxes, estate taxes, and even some new taxes courtesy of the law commonly referred to as ObamaCare.

No rational, patriotic citizen disputes that we need to make some changes. Even Congress agrees that change is necessary. They just can't seem to agree on what needs changed and who should foot the bill. None of this is a surprise. I am not revealing any privileged information. All of this is well known, but I do not believe the fiscal cliff is fully priced into the markets. I believe the market expects that after the election some kind of compromise decision will be reached, most likely in the 11th hour. Remember how well that worked when the government almost shut down over increasing the debt ceiling in 2011? Who knows? It may happen if all the political dots line up just right.

While I do ultimately believe a compromise will be reached, I do not know if it can be done during a lame duck session of Congress. If we fall off the fiscal cliff, the market may not react well. So what are your choices?

If you are a long term investor and you have time on your side, why should you change anything? You may see a sharp decrease in your portfolio values, but since you understand the cause it should be palatable. Once compromise is achieved, the market should soon restore that value which was "misplaced".

If you do not have a long term investment horizon and you are concerned about a significant decline in your portfolio, perhaps you need to reconsider your asset allocation. The 21st century has taught us a lot about risk tolerance, or perhaps more accurately our lack of risk tolerance. Removing volatility is a legitimate investment goal as your timeline grows shorter, but understand that "price" of safety is diminished returns.

Yet others will choose to take this insight and become aggressive by increasing their cash position before the market reacts, and then attempting to buy back in once prices have fallen. While this sounds perfect in theory, there are a couple obstacles to making it work in reality. First, how will you know when the prices are done falling? Or will you set a point which is "low enough" to buy back in? How will you feel if a compromise is reached before prices fall and the market reacts by shooting straight up? Now you will be sitting in cash and forced to buy back in at higher levels than when you sold? Finally, remember the Biggs quote. Are you a "strong, self-confident, emotionally mature person to stand firm against disdain, mockery, and repudiation when the market itself seems to be absolutely confirming that you are both mad and wrong"?

Only time and history will prove one course of action to be better than any other. More important than choosing the "best" option, is choosing the one which fits you regardless of the result.

At the beginning of the month I published a list of year end considerations on our facebook page and blog which I encourage you to review.

If that list, anything in this note, our new client portal, or any other issue is of concern or raises questions for you about your financial plans, please give me a call. I am honored to serve as your financial advisor and appreciate your trust and confidence. My staff and I look forward to continued service for you.

Sincerely,

Art Dinkin, CFP®