The latest edition of our fortnightly email newsletter was sent to subscribers Tuesday 25th November. 

In this edition we consider the basics of income planning, take a look at CommSec's iPod Index, provide a summary of the movements in markets over the past fortnight and look at the link between the economic cycle and share market returns.

We are also pleased to continue with the new section looking at case studies this week looking at a couple with $1 million to invest.

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 lead article for the latest newsletter:

Financial Topic Demystified - Income Planning

A financial advice firm which follows a very similar approach to ours in the USA is Merriman Berkman Next.  You may have noted that we have made a number of references to items on their website and included their website www.Fundadvice.com as a recommended website in our email newsletter.

Today they have published a question from a concerned client along with the response from Paul Merriman, founder of the firm, - My finances are getting uncomfortable. What do I do now?  It is well worth a read.

In summary, the client asks whether it is foolhardy to keep hanging on to equities. Merriman responds by stating that:

- he does not know the future and therefore does not have a perfect answer
- he openly acknowledges that the problems facing the global economy are challenging ones without quick, easy fixes but they do now have everybody's full attention.
- he believes that the past, which is our only indicative guide, shows that diversification will be an investor's friend going forward
- it might be time to reconsider asset allocations and how much risk needs to be taken on to reach future goals
- going to cash reall is a question of the philosophy you follow - are you going to follow a buy and hold strategy going forward or follow a market timing strategy?  He suggests that market timing is actually much more of a psychological challenge as you now need to be constantly evaluating when to sell and when to buy

Merriman's conclusion is that every investor has two primary jobs - to manage your risk and to manage your emotions.

Both are being put to the test in the current climate and it is important to be talking through both with your financial advisor if you are questioning either.

Regards,
Scott Keefer

It would be an absolute understatement to suggest that 2008 has been a difficult year for investors and their financial advisors.  These difficulties have confirmed to us the importance of regular dialogue with clients regarding their specific portfolio as well as more generally about investment markets.  It has also highlighted to us the importance of being totally available for client questions and discussions.  We both comment that these phone discussions, meetings and email discussions are the best part of our work.

It is hard to give prospective clients a sense of what this ongoing communication involves so we have tried to provide a few more details on our Portfolio Management Service & Fees page outlining the communication we have had with our clients over the past 12 months.  For those interested, a summary of these points of contact follow:

November 2007 - Provided a copy of an article written by Alan Kohler and discussed the topics of international share investments including currency hedging, the non acceptance of commissions, the problem of ownership bias, avoidance of hedge fund investments and an explanation of why we use wraps.

December 2007 - Provided an article providing insights into why we build investment portfolios the way that we do.

January 2008 - Provided copies of a couple of articles along with thoughts on on the current market volatility, income planning, cash & fixed interest part of portfolios, the importance of discipline and the risk of overreaction, the resilience of sharemarkets, the Australian advantage of income and a look at property trusts.

February 2008 - Provided thoughts on the following topics - importance of cash and fixed interest investments, the strength of company earnings in the sharemarket (PE ratio), the growth of company earnings, the risk of selling share investments or changing strategy, whether stock picking or "normal" managed funds provide a better return in the current environment, and avoiding the financial collapses that seem common.

March 2008 - Discussed an article written by Ross Gittens,  looked at the underperformance of an alternative "value" investment approach taken by Clime Capital, discussed the issue of companies and investment schemes under stress, and pointed out that sometimes the best investments are the ones you don't make.

March 2008 - Held client seminar looking at current market movements and our response to the current situation.

April 2008 - Sent out March quarter portfolio reviews.

June 2008 - Discussion of the following topics - recent broker consensus reports on the Australian share market, Vanguard's quarterly report on investment markets, what else you could be investing in and why we were not recommending these products, a number of articles looking at our investment approach, upcoming income distributions, 3 booklets produced by Vanguard on realistic sharemarket expectations, index investing and investing for income, and implementation of our fee reduction program.

July 2008 - Discussion of the following topics - scenario planning if the share market were to fall a further 30%, expert stock picks and their subsequent performance, and commentary on investment performance within portfolios.

August 2008 - Sent out 2007/08 income report and included a discussion of whether we should be using unlisted assets in portfolios along with an article putting the current market situation into perspective.

Early September 2008 - Discussion of the following topics - performance for the quarter so far including the impact of the fall in the Aussie dollar, look at earnings growth following the annual reporting season, an article produced by Dimensional looking at how their trusts had held up over the year ending June 30, Vanguard's Australian Sharemarket Volatility Chart, an article looking at past quotes regarding "unprecedented" events that tested investor confidence and an update of our referral program and KIVA lending.

Late September 2008 - Discussion of the following topics - market commentary, our investment philosophy, Macquarie Bank and our approach to reduce costs of the bsuiness and in turn costs for clients.

Late September 2008 - Held client seminar and teleconference looking at the credit crisis and our response to these developments.

October 2008 - Sent out September quarter portfolio reviews along with a discussion of the problems in markets, the government guarantee of bank deposits and looking at a recent article written by Warren Buffett.

Regards,
Scott Keefer

In the latest edition of the Sound Investing podcast, published by FundAdvice.com, Paul Merriman, Tom Cock and Don McDonald discuss stock pickers failing during bear markets, why you should buy stocks now, and myth or reality - professionals beat amateurs at investing.

One warning, the radio show is 51 minutes in length and will use up 47MB of download.

If these constraints are not a problem, I recommend you take a look at the latest podcast - Sound Investing - November 14, 2008

For those who have limited time and/or limited download capability the following is a brief summary of the more relevant material that was covered:

Stock Pickers Fail During Bear Markets

The presenters discuss a recent piece of research conducted by the Vanguard group which shows that in 3 of the last 6 bear markets since 1970 the majority of active managers have failed to beat the relevant market index.

Paul Merriman comments that investors do need to become active, actively taking responsibility for their investments by making changes to decrease expenses, turnover and taxes and to get into asset classes that are in your best interests.

Why should you be buying shares now?

The presenters comment on a recent article written by Knight Kiplinger suggesting now is a great buying opportunity and a wise approach is through dollar cost averaging.

Pau Merriman commented that we can not absolutely depend on the past as a guide to the future.  However, in 1973-74, if you adjusted the losses for inflation a 40/60 strategy has experienced almost the same losses as now.  After 73-74, a diversified portfolio over the next 2 years provided a 34% per annum return.  After October 1987, a diversified portfolio provided a 24% per annum return over the next two years and after the declines of 2001-02, a diversified portfolio provided returns of 25% per annum over the next 2 years.  Finally, after the 1929-32 period the next two years saw a compound rate of return of 23% per annum over the next two years and 47% per annum over the 4 years after 1932.

The key point, investors with staying power won the day.

Back to the Basics

Don McDonald reminds listeners not to invest in investments which you do not understand.

Merriman's Simple Steps

Paul Merriman listed his simple steps to success:

• Own the right asset classes
• Own the right amount of equities and fixed income investments
• Control expenses
• Control hidden charges
• Know your risk tolerance
• Know how to take money out in a low risk way
• Have enough information so that you understand your investments
• Allow markets to do their thing

Myth or Reality: Professional investors have an advantage over amateurs

The presenters suggested that the proxy for professional investors were mutual funds (actively managed funds in our language).  From 1980 to 2005 mutual funds provided investors a compound annualised rate of return of 10%.  If an investor had invested in the S&P 500 they would have received a 12.5% compound rate of return.

The conclusion an average amateur investor who invests in an index fund is likely to be more successful than professional investors.

Regards,

Scott Keefer

Last Saturday, 15th November, Scott Francis joined Warren Boland's "Weekends with Warren" program on 612 ABC Brisbane.  The major topics covered were:

1. The Four Factors Weighing on Share Markets
2. The Role of Interest Rates
3. The Difficulty of Forecasting

Click on the following link to be taken to a summary of the material covered in the segment - Four Factors Weighing on share Markets / Interest Rates / Difficulty of Forecasting

Any introductory economics course will have at its heart theories surrounding the business / economic cycle.  The basics of this theory is that economies go through cycles moving from periods of expansion into contraction and then back to expansion.  The basic point of economic policy is to try to smooth out these cycles so that we do not have too strong growth leading to high price increases (inflation) or stong contraction leading to high levels of unemployment.

A lot of the talk in the media is whether we are moving towards or are already in one of those contractionary periods.  The technical term is a recession and the technical definition of a recession is a continuous period of two quarters (6 months) of negative growth.

Unfortunately we can only be sure about whether we have had a recession after the fact.  But even if we knew where we were on the economic cycle how does this flow through to the investment world?

A small article in today's Australian newspaper discusses an investor's perspective of the recession debate - "Future strategy easy in retrospect".  The original article was written for the Wall Street Journal by David Gaffen.

In the article Gaffen points out that investors start discounting an economic recovery about halfway through a recession which prompts a rise in stocks that continues as the economy picks up steam.  However two pieces ofthe puzzle are missing:

1. When has the recession started?
2. When is it going to end?

He suggests that many believe that a recession began in the US somewhere around the first quarter of this year.  In the 16 periods of economic contraction in the US since 1919, the average length of the contraction has been 13 months.  And the conclusion he makes is that the US recession is at or even past the halfway point.  (To add some further perspective, the two worst recessions of recent times began in November 1973 and July 1981 and both ran for 16 months)

Based on this analysis , have markets already priced in the recession and shouldn't we be jumping in boots and all into equity markets?

Unfortunately, Gaffen goes on to point out that the recession this time might be worse than average and we may not make halfway for another few months yet.

Whichever way you lean on the recession, this discussion provides an interesting perspective and some hope that the worst of the declines at least might be behind us.  We will never know until years down the track.

Regards,
Scott Keefer

An article written by Scott Francis has been published in the ASX Investor Update Email Newsletter for November - Strategies for volatile times.  A copy can also be found on the ASX website.

The key points from the article are:
- The risk of timing markets
- Building an effective asset allocation

Scott concludes by providing an example based on a couple about to retire with $700,000 of assets.

In his latest article written for Alan Kohler's Eureka Report, Scott discusses Warren Buffett's recently released official biography - The Snowball.

Scott takes away 5 key factors emerging from Buffett's disciplined approach to investing:

1) He is an exceptionally intelligent investor
2) His use of the margin of safety
3) He is a dedicated entrepreneur
4) He uses minimum borrowings
5) The snowball effect

Click on the following link to read Scott's analysis - Warren Buffett's textbook on investing ... and life.

A natural reaction of late, especially since the strong falls on share markets across the world through October, has been a flight to safety namely cash.  The Australian government guarantee of cash deposits has solidified at least one area of the market.  This looks pretty attractive when most other asset values, even residential property based on data out today, are falling or have already fallen significantly.

Unfortunately, interest rates on these cash deposits are also falling.  Central banks around the world (whole heartedly supported by their respective governments) have cut interest rates in what has been viewed as a coordinated response to the looming downturn in the global economy. (Some would say slashed but I think emotive language such as this coming out of the media has been less than helpful and is in a small degree responsible for the scale of the falls on markets.  I'll get off my soap box now.)

The economic theory behind these moves is that through reducing interest rates, access to credit becomes more accessible and at the same time fewer resources are needed to pay back outstanding debt.  This in turn leads to more money being freed up by and for consumers and companies to spend in the real economy.  This in turn leads to higher levels of economic growth.  The economic term to explain this policy move is loosening monetary policy.  The sooner this is done the better as economic theory suggests the time lag between a cut in interest rates and for this to lead to a stimulation of the economy can be up to 18 months in duration.  Let's hope the impacts are felt sooner rather than later!!

These reductions in interest rates flow on to the rates paid by institutions for customers to loan them money by depositing their money with the bank or other financial institution.  These rates paid by banks and the like in Australia are still comparatively high compared to other developed parts of the world, thinking particularly of Japan and the USA, but are starting to fall.

As rates fall it makes the decision to hold cash that touch more difficult.   In a Eureka Report article published early in October - Yields the new king? - Scott Francis pointed out that the yields (or income) on Australian shares and listed property trusts are making these asset classes look a whole lot more attractive compared to cash deposit interest rates, especially when taking into consideration franking credit benefits. 

Nicole Pedersen-McKinnon provided a similar angle in her article published in the Sydney Morning Herald and dated the 26^th of October - Cash is safe but it isn't king - where she in particular referred to the dividend yields of 8% or more being offered by the big four banks.  The big assumption here is that company dividend payments will at least remain steady.  There is some doubt as to this but so far the big banks, the part of the market which has suffered the most from the credit crisis so far, have at worst maintained dividends (ANZ) or in other cases continued to increase.  What this is telling investors is that if you buy shares in the banks now and held them like holding a term deposit, the income returns - the money coming into your bank account - would be 8% compared to what could soon be 6% or even in the 5% range for cash deposits after a few more RBA cuts.

Now of course the growth side of owning shares, taking the big 4 banks as an example, have been anything but stellar over the past 12 months.  If you might need to access the capital contained in a bank account or a share investments there is real risk in buying shares as the underlying investment may still fall in value.  But if you have a buy and hold strategy, for the long term, you would have to think that asset prices are pretty compelling at present levels.

A third piece of commentary on the problem with holding cash over the long terms is that inflation is a killer and eats into the returns from cash.  Warren Buffett makes this case in his article - Buy American.  I am. - which I have referred to in a previous blog posting.  Growth assets, such as shares, also have a growth component and their income tends to grow over time, both providing a hedge against the impact of inflation.

As Nicole Pedersen-McKinnon suggests in the conclusion to her article - buying bank shares (or any shares) is not for the faint hearted but dipping the toes in and taking a conservative, measured approach through techniques such as dollar cost averaging might make some sense.  However in my view this should only be contemplated by buy and hold long term investors in consultation with their financial advisor and in relations to their current portfolio allocations, as the share market might just keep falling in value and/or dividends might not hold up over the coming year.

Regards,

Scott Keefer