We have had a few weeks away from the office but are starting to wind up the springs for what will certainly be another "interesting" year for investment markets.  In preparation for a new year it is natural to be looking for those special tips to claw back some of those losses from 2008.  But be warned, forecasting is just another layer of risk for your portfolio.  For us, it is a layer of risk for which investors are not consistently rewarded for taking on.

Today's Australian newspaper provided further evidence of the risks involved with following forecasters.  It included a frank admission that the panel of 8 expert stock pickers they turned to at the end of 2007 have produced tips that underperformed the All Ordinaries index for the year - Stock pickers looking for new crystal balls.

The figures had the aggregate of the panelist recommendations providing declines of just over 50% while the All Ords index has fallen by 45%.  Not a huge difference, but for us every percentage point is important.

One point the article does not make is that investors would have been even better served by investing into developed world international markets.

It will be interesting to see the forecasts that are made for 2009.  As the article suggests in the opening paragraph, it might actually be better to listen to the advice and do the opposite.  Better still, why not employ an index based approach, diversify your portfolio across a range of asset classes - cash, fixed interest, Australian shares, international shares and listed property.  Please take a look at our Building Portfolios page for more details.

2008 has highlighted again that nobody really knows what is going to happen in the year ahead, a better strategy is to take away this forecasting risk from your portfolio.

In his latest article written for Alan Kohler's Eureka Report, Scott writes about the financial advice model employed by Storm Financial.  He specifically criticises the inappropriateness of this financial advice provided by Storm and the devastating impact for some clients.

Click on the following link to read Scott's thoughts - Storm's doomed model

In his latest article written for Alan Kohler's Eureka Report, Scott writes in conjunction with JamesThomson's piece - Investors caught in tropical Storm.

Scott specifically looks at the double gearing strategy reportedly used by Storm.

Click on the following link to read Scott's thoughts - A fatally flawed model

Glancing through the financial media this morning I came across a very interesting article on the Wall Street Journal website - The Stock Picker's Defeat.  The article looks at the terrible year for the Legg Mason Value Trust in the USA.  The fund manager is William H. Miller who is dubbed in the article as the era's greatest mutual fund manager.  This has been bestowed on him because every year from 1991 to 2005, his value trust outperformed the broad S&P 500 Index in the USA.

Unfortunately 2008 has been a devastating year for the trust and its investors.  According to Morningstar, investors have lost 58% of their money over the past year, 20 percentage points worse than the declines of the S&P 500 Index.  Some might think that this is not so bad given the outperformance over 15 years up to 2005.  Unfortunately that outperformance has now been wiped away.  A graph included with the article clearly depicts this and Morningstar now has the fund amongst the worst performing in its class for the last one, three, five and ten year periods.

This is another example of the dangers of an active manager style approach to investing.  Fund managers do have periods of outperformance.  This may be through some skill on the part of the manager or more likely just the function of probability and chance.

Even if there is such a thing as skill on the part of fund managers, another problem faced by investors is the ability to find such a manager that is going to out perform in the long run going forward.  This article suggests that investors who have come to the Legg Mason Value Trust party later in the course of events most likely have under performed the index return.

This index return, over the long run, is what we refer to as the return investors deserve to be getting from investing in the share market.  Putting it at risk by following an active style manager is a risk we believe is not rewarded over the long term.

On our website we have developed pages and a downloadable document which outlines our Research Based Approach to investing.  One section of that material includes research that has been conducted which finds no evidence that choosing a managed fund that had outperformed in the past would provide above average returns into the future.

If you are interested in finding out more about our approach and the research which underpins it please take a look at our Building Portfolios and Research Based Approach pages of our website.

Regards,

Scott Keefer

The latest edition of our fortnightly email newsletter was sent to subscribers Wednesday 10th December. 

If you would like to be added to the mailing list please click the following link to be taken to the sign up page - The Financial Fortnight That Was Sign Up Page.

The following is the market news section for the latest newsletter:

ASX P/E Ratio and Dividend Yields

An interesting article was published in today's sport section of the Courier Mail.  It outlined the results from the Brisbane Lions (AFL club) AGM.  (I must be totally up front from the outset that I am an avid Carlton Blues fan and therefore could be seen to have a bias against the Lions.  However, as long as they are not playing Carlton I am a Brisbane supporter.)

The interesting part of the article for us financial boffins was the devastation in value of the club's equity portfolio.  It had fallen from a value of $5,026,093 at the 31st of October 2007 to a current value of approximately $2,006,911.  This equates to a fall of 60%.  The article reported that the portfolio was made up of Australian shares.

To put this in perspective, the ASX200 accumulation index had declined 40% decline over that period.  The ASX200 Listed Property sector fell 55%.  The MSCI World Index (ex Australia), a measure of the rest of the international share markets apart from Australia, saw a decline of 23.2% over the same period in Australian dollar terms.

This data shows up two key concerns with the Brisbane Lions approach:

• Active Management
• Lack of diversification

The active management approach that has been followed by the Brisbane Lions has come up well short compared to the less glitzy but much more dependable index style approach.  No one likes to see negative returns in their portfolio but if you are going to have negative returns I would much prefer a 40% decline compared to a 60% decline.

The past year has also shown up the concern of holding an undiversified portfolio of investments.  The Australian share market over the past 5 years to the end of 2007 had provided significantly better returns compared to international markets.  Thanks predominatly to the fall in the Aussie dollar exchange rate some of those gains have been reversed and it has been much better to be invested in international investments over the past 12 months.  Holding a diversified portfolio including Australian shares, international shares and listed property in our opinion serves clients much better in the long term.

In the long run we would expect that Australian shares, international shares and listed property to provide very similar returns for investors.   Holding this kind of a diversified portfolio therefore smooths out portfolio returns over time while still providing a similar or even better return than holding an individual asset class.  This smoothing effect is much more palatable for investors.  If you hold an index style approach you add even further diversification in your portfolio.

I love watching the Brisbane Lions play but I for one won't be following their investment approach!

Regards,
Scott Keefer

Users of our website, through our User Voice feedback forum, have requested that we regularly update the graphs outlining the performance of the Dimensional trusts that we use in building portfolios for clients.  In response to this feedback we have updated these graphs to reflect performance up to the end of September 2008.

Commentary:

Unsurprisingly, the graphs show strong negative monthly returns over November for all sections of Australian and international markets. In particular, the Australian Small Company and the global Emerging Markets trusts have seen the strongest falls.

Over the long run, the graphs continue to clearly show the existence of the risk premiums (small, value and emerging markets) that the research tells us should exist:

Australian Share Trusts - 7 Year returns

International Share Trusts - 7 Year returns

NB - These premiums are higher than what we would expect going forward.

Please click on the following link to be taken to the graphs - Dimensional Fund Performance Graphs.

For anyone new to our website, it is important to point out that we build investment portfolios for clients based on the best available academic research.  Take a look at our Building Portfolios and Our Research Based Approach pages for more details.  In our view, this research compels us to use the three factor model developed by Fama and French.  In Australia, the most effective method of investing using this model is through trusts implemented by Dimensional Fund Advisors (www.dimensional.com.au).  We do not receive any form of commission or payment from Dimensional for using their trusts.  We use them because they provide the returns clients are entitled to from share markets.

However, academic theory is nothing if it can not be implemented and provide the returns that are promised by the research.  Therefore, we like to provide the historical returns of the funds that we use to build investment portfolios.

Please let us know if you have any feedback regarding these graphs by using the Request for More Information form to the right or via our User Voice feedback forum.

Regards,

Scott Keefer

A number of users of our website have requested that we post links to relevant financial media commentary.  In this endeavour we today post a link to a useful resource recently published by BT.

The questions in the blog title were discussed in a webcast by Stewart Brentnall, Head of Investment Solutions at BT Financial Group, and Crispin Murray, Head of Equity Strategies at BT Investment Management and posted on the BT website - Why Should I Keep Investing?

We do not subscribe to the BT approach to investing but we do think that the points discussed during the webcast are consistent with our thoughts on current markets and provide another useful perspective during what is a difficult time.

Any feedback you have on this webcast or on our website in general would be appreciated.  Please click on the following link to be taken to our feedback site - Feedback Forum.

Regards,
Scott Keefer

Jim Parker, a Regional Director from Dimensional Fund Advisors Australia, has posted another interesting piece on his Outside the Flags commentary made available to financial advisors who use Dimensional funds as a part of their recommended portfolios.

The commentary looks at the difficulty of predicting turning points in the market (timing) based on the economic cycle.

Regards,
Scott Keefer

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Safety first is the name of the game for many investors right now. And with wild day-to-day swings in the markets and hugely divergent performances by securities within the same asset class, who can blame them?

Tolerance for risk is at extremely low ebb, a development reflected in the fact that yields on risk-free assets are at historic lows?in the case of US Treasury bills at levels not seen since World War II.

Yet this risk-averse behaviour masks one of the paradoxes of investment.

In good economic times, when comfort levels are high, the expected return from risk assets is less favourable. In those times, the cost of our willingness to take a risk is a lower expected return.

Correspondingly, in tough economic times, when risk aversion rises, the expected return from risk assets goes up. In these times, the cost of our reluctance to take risks is not capturing the higher expected returns on offer.

So those now harbouring the bulk of their portfolios in Treasury bills, cash-like instruments or sovereign bonds are forgoing the opportunity to get the full benefit of the bounce in risk assets when it comes.

So why not wait till the economy recovers? The problem there is that the equity market tends to price in a turn in the cycle before it is evident. So by the time the news media proclaims an economic downturn to be over, the market usually has already accounted for it.

This is what financial economists mean when they say the market is a discounting mechanism. It absorbs new information very quickly. In other words, by the time you start worrying about it, it is already in the price.

The numbers back this up.  (Source: National Bureau of Economic Research for peak and trough months; Professor Kenneth R. French's website for market risk premiums.)  For instance the average monthly risk premium of the US equity market over T-bills from April 1960-December 2007 is 49 basis points. That's a 6 per cent annualised return over the risk free asset.

But now look what happens around the peak and trough of the economic cycle: In the three months after the peak of an expansion, the average equity risk premium has been -1.52 per cent. But in the three months after the trough of the cycle, the average risk premium was +1.87 per cent.

What this means is that the market tends to price in turning points in the economic cycle before these are confirmed. This explains the difficulty of successfully timing the market and reinforces the benefits of staying disciplined in your chosen asset allocation. (Bear in mind that turning points in the cycle are usually only identified 6-18 months after they occur.)

Inmoo Lee, 'Risk Premiums Across Business Cycles', Dimensional Fund Advisors

While the market volatility we have seen this year has been hard to take, this has to be set against the unusually low volatility of the preceding years. The experts also tell us that history suggests we can expect further volatility.

The good news is that periods of high volatility have no predictive power in relation to future returns. Neither is there any predictive power in periods of "high cross-sectional dispersion", when securities in a given asset class have very dissimilar performance in a given month. We are in such a period now.

It's also worth keeping in mind that when markets are so choppy and fickle, diversification is even more important. That's because the sort of volatility you would experience in a portfolio with just a few stocks during settled markets will be evident in a very well diversified portfolio in wildly variable markets.

So the lessons from all this are twofold: Firstly, diversification both across and within asset classes is always important, but even more so at times of instability. Secondly, during tough economic times, risk premiums rise to compensate investors. While volatility can be hard to stomach, there's no evidence that this is a leading indicator of future negative returns.

Ken French is one of the academic gurus behind the Three Factor Model approach to investing. We incorporate this approach into our recommended portfolios.  (Take a look at our Building Portfolios page for more detail on this).  He is also Director of Investment Strategy for Dimensional and the Carl E. and Catherine M. Heidt Professor of Finance at the Tuck School of Business at Dartmouth College.

Ken has recently discussed current market conditions in an online forum with Henry Blodget on Yahoo! Finance. In the three video segments below, Professor French comments on buy-and-hold investing, active vs. passive management, and the role of commodities in a portfolio.

I strongly encourage you to take the time to watch these three small videos:

Buy and Hold vs. Timing the Market

Stock Picking vs. Index Investing

Commodities and Your Portfolio

Regards,

Scott Keefer

This week, Scott Francis & I conducted a presentation for members and friends of the Institute of Electrical and Electronic Engineers.

The presentation looked at:

In his latest article written for Alan Kohler's Eureka Report, Scott looks at opportunities for investors, particularly those with a time frame of at least 10 years.

Scott specifically looks at the following opportunities:

1) Investing regularly into shares
2) The mortgage is cheaper
3) Salary sacrificing
4) A great time to start building a passive income stream

He concludes by providing a glimpse of his own strategy.

Click on the following link to read Scott's thoughts - Double or nothing