Market Commentary

From Your Risk Manager

January 2007

"The essence of investment management is the management of risk, not the management of returns." – Benjamin Graham

One of our favorite things about our work is that everyone, from our clients to ourselves, wishes for virtually the same core result when it comes to their investments: high returns with low risk. Sometimes this is expressed as a form of thinking about one's future: "How can I build my wealth for retirement aggressively without losing money?" Or, sometimes it is expressed as wanting to beat the market without ever going down with it.

It does not behoove us to ignore this yearning for low risk. Both our experience and much behavioral research shows us that fear of regret and fear of loss drive investment decisions more than any other factor. Fear can induce bad decisions, so the impact of fear is material from an investment perspective. One need only look at the data: while the S&P 500 returned 13.0% on average over 20 years ending in 2004, consumers investing in stocks averaged a measly 3.5%1 We think it makes sense to want to avoid the pain of loss, but we want our clients to participate in returns akin to those of the broader market. We think helping clients avoid fear and pain is the true goal of risk management. In turn, as Benjamin Graham, a noted 20th century investor who managed money through the Depression, states, risk management is the essence of investment management.

We also know that our clients need market-like performance in order to grow the value of their assets over time after taxes, inflation, and fees. In order to accomplish this growth while paying attention to risk, we research and work with fund managers who balance their discipline of investing for growth with efforts to preserve capital. In other words, they pay a lot of attention to downside risk in a dedicated attempt to avoid losing money. While it is unlikely that a stock-based portfolio could avoid any loss in a given year over a long period of time, we believe achieving your portfolio's long-term growth goals while limiting volatility in your portfolio (and therefore stress related to investments) is nonetheless an achievable goal. The catch to this strategy is that over shorter periods, when the market is strong, you are likely to have lower performance than broad market indexes. We believe we can reduce volatility while maintaining strong long-term returns - but it is not possible to always have market-beating returns with lower risk. Our strategy targets market-beating returns only when the market is down.

There are periods in the market when we think that it is appropriate to take more risk, because the opportunities are large and the assessed downside is more limited than it has historically been. For instance, until the third quarter of last year, we had long advised clients to take on more risk with heavy weightings in international stocks. These stocks were cheap, foreign countries' balance sheets were improving markedly, and the world economy excluding the U.S. was growing like gangbusters. Taking this risk paid off. Currently, we have many clients overweight U.S. pharmaceutical stocks for similar reasons. The stocks are cheap, their business fundamentals are strengthening, we are entering a phase in the U.S. economic cycle where they historically have performed well, and they are nearing the end of what since World War II has been usually a 7- to 10-year cycle of being out of favor amongst professional investors and our overall body politic.

In the broader markets now, however, we see plenty of reason for caution. We therefore have been building more significant bond positions during recent months within your mostly growth-oriented portfolios. We are at a point in the U.S. economic cycle where interest rates are likely to next go down, making bonds likely to outperform cash and also possibly stocks. However, as we think there is a small possibility that the Fed next raises rates due to worries about inflation, instead of lowering them, we have kept bond positions tilted to the short end of the maturity spectrum to avoid the potential for the long-bond price declines that would ensue if interest rates rise.

On the international front, while we have been wrong about the near-term price action in the U.S. dollar, the dollar's rapid decline still has us as concerned, because volatility in the value of the U.S. dollar tends to destabilizes international asset values. In the U.S., we wonder why the stock market has not discounted the possibility that we have already entered a recession, with the weak business results that come with a recession - particularly as the bond market's inverted yield curve shows that bond investors, at least, have figured this out. We think the unprecedented amount of private equity capital that has flooded the market is in part propping up stock prices that now carry a takeover premium. In addition, many publicly traded companies are increasing their leverage in order to ward off unwanted advances from private equity firms. Overall, volatility in the U.S. stock market has been low and there aren't many bears in sight. These signs of complacency and contentment worry us because we think they are disconnected with underlying fundamentals. Perception may be more important than fundamentals in the short term, but we know from experience that the fundamentals will dictate stock prices eventually.

We now know our call to become more cautious in the third quarter of 2006 was early, as the equity markets have continued to perform strongly both in the U.S. and overseas. We are also confident that the direction we have taken your portfolios will stand you in good stead for the coming one to three years, and your portfolios will continue to participate in the significant growth opportunities available in the capital markets, even as we have trimmed the sails for the coming period.

As always, call with questions or to set up an appointment to review your portfolio.

This is a general assessment of client portfolios and does not reflect the specific circumstance of every client.

1 Dalbar, Inc., Quantitative Analysis of Investor Behavior, update published April 1, 2004.

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