Where's the Party

By Weston Wellington

The surge in stock prices around the world in the first quarter serves as a reminder that predicting market trends can be a frustrating business. Six months ago, the outlook for stock prices appeared to be fading from grim to grimmer: Congressional leaders were wrangling unsuccessfully to craft a deficit reduction plan, Standard & Poor’s had removed its AAA rating on US Treasury obligations, and Greece appeared one step away from defaulting on its debt. Yet just when many investors least expected it, stocks staged a powerful rally: From the low for the year on October 3, the S&P 500 Index rebounded 28.1% through March 30 while the Russell 2000 Index jumped 36.2%. As the news excerpts below suggest, it is worth recalling the Wall Street adage that "bull markets climb a wall of worry."

• August 5, 2011—S&P downgrades US Treasury debt to AA+ from AAA; stocks plunge in the biggest selloff since 2008.
• September 3, 2011—Journalist: "The US economy slammed into a wall in August, failing to add new jobs for the first time in nearly a year."
• September 5, 2011—Gold reaches a record high of $1,895 per oz. (London Fix).
• September 19, 2011—Wall Street chief equity strategist: "I don’t think we’ve seen the lows for the year by any stretch. Things have to get much worse before they get better."
• September 23, 2011—Journalist: "The world economy once again stands on a precipice."
• September 26, 2011—Investor: "I don’t see anything changing in the next two or three years."
• October 1, 2011—Economist cover story: "Unless politicians act more boldly, the world economy will keep heading towards a black hole."
• October 3, 2011—US stock prices slump to their lows of the year: 1099.23 for the S&P 500 and 609.49 for the Russell 2000 Index.
• October 13, 2011—Census Bureau reports the weakest income growth over a ten-year period since records began in 1967.
• October 20, 2011—Col. Muammar el-Qaddafi killed by Libyan rebel forces.
• November 20, 2011—Consumer goods CEO: "Consumers everywhere continue to be cautious and hesitant to spend."
• November 21, 2011—US Congressional "supercommittee" fails to reach deficit reduction agreement.
• November 24, 2011—Market strategist: "Earnings growth is very quickly decelerating."
• November 28, 2011—Moody’s Investors Service warns that multiple countries could default on their debt.
• November 29, 2011—AMR Corp., parent of American Airlines, files for bankruptcy.
• December 10, 2011—Detroit’s mayor predicts the city will run out of cash by April 2012.
• January 6, 2012—Gasoline prices are at the highest point ever for a new year.
• January 18, 2012—World Bank: "Developed and developing-country growth rates could fall by as much or more than in 2008–09."
• January 18, 2012—Eastman Kodak files for bankruptcy.
• January 25, 2012—Report from Davos World Economic Forum: "Global elite fears renewed downturn."
• February 13, 2012—Journalist: "There is still plenty that could go wrong in Europe, while U.S. economic growth remains slow and corporate earnings are looking less and less robust."
• February 27, 2012—Money manager: "This is a business-as-usual overpriced market and you’ll get a zero return for seven years."
• March 2, 2012—Eurostat reports that Eurozone unemployment in January reached 10.7%, the highest in fifteen years.
• March 12, 2012—Strategist: "The stock market has effectively doubled since the March ‘09 low, and we’re still in redemption territory for equity funds."
• March 19, 2012—Journalist: "Expectations for earnings have been steadily scaled back this year, as the mood among companies has worsened."

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References

E.S. Browning, "Downgrade Ignites a Global Selloff," Wall Street Journal, August 9, 2011.

Sudeep Reddy, "Job Growth Grinds to a Halt," Wall Street Journal, September 3, 2011.

Quotation from Adam Parker, chief US equity strategist Morgan Stanley. Jonathan Cheng, "Wall Street’s Optimism Fades," Wall Street Journal, September 19, 2011.

Chris Giles, "Financial Institutions Stare into the Abyss," Financial Times, September 22, 2011.

Tom Lauricella, "Pivot Point: Investors Lose Faith in Stocks," Wall Street Journal, September 26, 2011.

"Be Afraid," Economist, October 1, 2011.

Phil Izzo, "Bleak News for Americans’ Income," Wall Street Journal, October 13, 2011.

Kareem Fahim, "Qaddafi, Seized by Foes, Meets a Violent End," New York Times, October 21, 2011.

Quotation from Jim Skinner, chief executive of McDonald’s. Jeff Sommer, "From the Mouths of Executives, Little Comfort," New York Times, November 20, 2011.

Jonathan Cheng and Brendan Conway, "Panel’s Failure Sinks Stocks," Wall Street Journal, November 21, 2011.

Quotation from David Rosenberg, chief market strategist, Gluskin Sheff & Associates. Tom Petruno, "Wall Street Gets Cautious on Earnings," Los Angeles Times, November 24, 2011.

Brendan Conway and Steven Russolillo, "No Year-End Stock Surge in Sight," Wall Street Journal, November 26, 2011.

Liz Alderman and Stephen Castle, "Dire Warnings Are Building on European Debt Crisis," New York Times, November 29, 2011.

"Nowhere to Run—The Motor City Flirts with Fiscal Disaster," Economist, December 10, 2011.

Ronald D. White, "Gas Prices Ring in 2012 at a High," Los Angeles Times, January 6, 2012.

Chris Giles, "World Bank Warns on the Risk of Global Economic Meltdown," Financial Times, January 18, 2012.

Chris Giles, "Pessimism Hangs in Mountain Air," Financial Times, January 25, 2012.

Tom Lauricella and Jonathan Cheng, "Too Late to Jump Aboard?" Wall Street Journal, February 13, 2012.

Ajay Makan, "S&P 500 at Post-Crisis Peak but Investors Remain Wary," Financial Times, February 25, 2012.

Quotation from Jeremy Grantham, chief investment strategist, GMO. Leslie P. Norton, "Not So fast: Coping with Slow Growth," Barron’s, February 27, 2012.

Brian Blackstone, "Poor Economic Data Slam Europe," Wall Street Journal, March 2, 2012.

Quotation from Liz Ann Sonders, chief investment strategist, Charles Schwab. Nikolaj Gammeltoft, Inyoun Hwang, and Whitney Kisling, "The Bull Turns Three. Where’s the Party?" BusinessWeek, March 12, 2012.

Ajay Makan, "Wall Street Braces For Hit to Soaring Markets," Financial Times, March 19, 2012.

Out of The Blocks

By Jim Parker

"And you thought 2011 was tough?" So went the headlines in December as media and market pundits, reflecting on a miserable year, saw no respite for investors in 2012. But markets have a funny way of confounding expectations.

To be sure, the reasons to be anxious were piling high as the year turned, with European politicians dithering over how to tackle a tottering mountain of sovereign debt, policymakers in the US running short of options, and emerging markets not providing the cushion that many investors had hoped for. The general view, as expressed through the media, was that there would be more muddling through in early 2012. "Buckle up!" warned the respected Barron's magazine. "For investors frightened by the stock market's volatility in the past six months and tired of worrying about places in Europe once given little thought, 2012 promises scant comfort—at least in the first half."¹

As an investor, if you had taken that advice, you might be ruing it now, as global equity markets—as measured by the MSCI World Index—have registered their best start to a calendar year in twenty-one years. The index was up by just over 10% in US dollar terms as of the end of February. You have to go all the way back to 1991 to find a better start.

Added to that is that much of the leadership for the turnaround is coming from the US, an economy that many observers just two years ago were writing off in favor of the emerging powerhouse economies in Asia. The US benchmark S&P 500 was up by 9.0% at the end of February. This is also its best start since 1991 and returns the index to the levels of June 2008, before the Lehman collapse.

The US market's strong start followed a standout 2011 in which it was one of the best-performing markets in the world. And that included most of the emerging markets.

Even Europe, the epicenter of concerns for much of the past year, has exploded out of the blocks in 2012. The Euro Stoxx 50 was up by nearly 12% over the first two months of the year, with the German market rising by close to 20% in US dollar terms.

The renewed buoyancy extended to Asia, where the MSCI Asia Pacific Index has registered ten consecutive weeks of gains, its longest uninterrupted winning streak since 1988, and powered by strength in energy stocks. Australian stocks have firmed as well, to be up 12.5% year to date in US dollar terms—although in local currency terms, the gain has been less stellar at just over 7%.

Why the change in mood? There are several catalysts for the turnaround in markets so far in 2012.

First, by the end of last year, market participants were discounting a lot of bad news, including a couple catastrophic scenarios. Fears of mass defaults in Europe and a possible breakup of the euro were seen as entirely possible.

While Europe can hardly be described as being out of the woods yet, the agreement by creditors on a new round of official funding for Greece has eased nerves, as has the European Central Bank's provision of another half-trillion euros in cheap funding to financial institutions.

Second, there have been signs of a turnaround in the US economy, at least compared to the view the market was taking a few months ago. At that time, another recession was seen to be in the cards. Since then, data has shown an improvement in the labor market, a rise in manufacturing orders, and a climb in consumer confidence.

Third, central banks are pumping out massive amounts of cheap cash—essentially printing money—to provide liquidity to the financial system and to support the recovery. As well as the ECB's latest cash injection, Japan and Britain have recently extended their so-called "quantitative easing" programs, while China has cut the reserve requirements for its banks.

Of course, just as it was wrong to extrapolate the pessimism of last year into 2012, it would be foolish to forecast that the rest of this year will resemble the first two months in tone. No one knows how markets will perform going forward, because that requires an ability to forecast news. You can always guess, of course, but we tend to think that's not a sustainable investment strategy.

The point of this is to highlight the virtues of discipline and the tendency of markets to absorb news very, very quickly and to look forward to the next thing. Unless you know what the next thing will be, you are wise to stay in your seat.

Who Has the Midas Touch?

By Weston Wellington

Over the course of a lengthy and illustrious business career, Warren Buffett has offered thoughtful opinions on a wide variety of investment-related issues—executive compensation, accounting standards, high-yield bonds, derivatives, stock options, and so on.

In regard to gold and its investment merits, however, Buffett has had little to say—at least in the pages of his annual shareholder letter. We searched through 34 years' worth of Berkshire Hathaway annual reports and were hard-pressed to find any mention of the subject whatsoever. The closest we came was a rueful acknowledgement from Buffett in early 1980 that Berkshire's book value, when expressed in gold bullion terms, had shown no increase from year-end 1964 to year-end 1979.

Buffett appeared vexed that his diligent efforts to grow Berkshire's business value over a fifteen-year period had been matched stride for stride by a lump of shiny metal requiring no business acumen at all. He promised his shareholders he would continue to do his best but warned, "You should understand that external conditions affecting the stability of currency may very well be the most important factor in determining whether there are any real rewards from your investment in Berkshire Hathaway."

As it turned out, the ink was barely dry on this gloomy assessment when gold began a lengthy period of decline that tested the conviction of even its most fervent devotees. Fifteen years later, gold prices were 25% lower, and even after thirty-one years (1980–2010), had failed to keep pace with rising consumer prices. By year-end 2011, gold's appreciation over thirty-two years finally exceeded the rate of inflation (205% vs. 195%) but still trailed well behind the total return on one-month Treasury bills (398%).

Perhaps to compensate for his past reticence on the subject, Buffett has devoted a considerable portion of his forthcoming shareholder letter (usually released in mid-March) to the merits of gold.

With his customary gift for explaining complex issues in the simplest manner, Buffett deftly presents a two-pronged argument. Like a sympathetic talk show host, he quickly acknowledges the darkest fears among gold enthusiasts—the prospect of currency manipulation and persistent inflation. He points out that the US dollar has lost 86% of its value since he took control of Berkshire Hathaway in 1965 and states unequivocally, "I do not like currency-based investments."

But where gold advocates see a safe harbor, Buffett sees just a different set of rocks to crash into. Since gold generates no return, the only source of appreciation for today's anxious purchaser is the buyer of tomorrow who is even more fearful.

Buffett completes the argument by asking the reader to compare the long-run potential of two portfolios. The first holds all the gold in the world (worth roughly $9.6 trillion) while the second owns all the cropland in America plus the equivalent of sixteen ExxonMobils plus $1 trillion for "walking around money." Brushing aside the squabbles over monetary theory, Buffett calmly points out that the first portfolio will produce absolutely nothing over the next century while the second will generate a river of corn, cotton, and petroleum products. People will exchange their labor for these goods regardless of whether the currency is "gold, seashells, or shark's teeth." (Nobel laureate Milton Friedman has pointed out that Yap Islanders got along very well with a currency consisting of enormous stone wheels that were rarely moved.)

When Buffett assumed control of Berkshire Hathaway in 1965, the book value was $19 per share, or roughly half an ounce of gold. Using the cash flow from existing businesses and reinvesting in new ones, Berkshire has grown into a substantial enterprise with a book value at year-end 2010 of $95,453 per share. The half-ounce of gold is still a half-ounce and has never generated a dime that could have been invested in more gold.

Few of us can hope to duplicate Buffett's record of business success, but the underlying principles of reinvestment and compound interest require no special knowledge. Every financial professional can point to individuals who have accumulated substantial real wealth from investment in farms, businesses, or real estate, and sometimes the success stories turn up in unlikely places.

Where are the fortunes created from gold?

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References

Warren Buffett, "Warren Buffett: Why Stocks Beat Gold and Bonds," Fortune, February 27, 2012. Available at: http://finance.fortune.cnn.com/2012/02/09/warren-buffett-berkshire-shareholder-letter/.

Milton Friedman, Money Mischief (Boston: Houghton Mifflin Harcourt, February 1992).

Stocks, Bonds, Bills and Inflation, March 2011.

Bloomberg.

Berkshire Hathaway Inc. Available at: www.berkshirehathawy.com (accessed February 21, 2012).

Cracks in the Crystal Ball

By Jim Parker

One of the mysteries of life in the financial markets is that many people still seem to believe you can build a successful investment strategy around forecasting, despite the road being littered with the corpses of those who got it wrong.

This month, twenty-four out of twenty-seven market economists polled by Bloomberg forecast that the Reserve Bank of Australia would cut its benchmark official cash rate by one-quarter of a percentage point to 4.0%, the third such move since November last year.¹

The rationale seemed clear enough. The global economy was moderating, local activity was slowing, household spending had eased, employment growth was weakening, inflation pressures had receded, and the strength of the local currency was making life tough for non-commodity exporters and import-competing businesses.

A Bloomberg journalist wrote: "The Reserve Bank of Australia is poised to respond to the nation's weakest job market in almost 20 years by lowering interest rates for a third time tomorrow, the most aggressive rate cuts since the global financial crisis."

In its own preview, the Sydney Morning Herald's reporter was even more emphatic: "A betting plunge on financial markets puts an interest rate cut today as good as certain with weak retail sales figures indicating the worst growth on record."²

Yet, the central bank confounded market expectations and kept rates on hold. The market reaction was dramatic. The Australian dollar took off like a rocket, hitting its highest levels in six months against the US dollar and rising on the cross rates. Shares eased and bond yields rose.

At this point, the very same economists who had carefully parsed the bank's language going into its decision proceeded to analyze in great detail the wording of the statement announcing that rates would stay where they were for another month.

Actually, there really wasn't that much remarkable about what the RBA said. Essentially, it had decided that, with economic growth close to its long-term trend and inflation on target, the RBA could afford to wait another month to see how events in Europe and elsewhere panned out.

Local bank economists immediately pushed out their expectations for the next policy easing to March. Some had second thoughts altogether and decided the central bank might be done on interest rates for the foreseeable future.

For everyday investors, there are a few lessons out of this episode. The first is that there is very little evidence market professionals—including the ones closest to policymakers—are any better than anyone else in forecasting the prices of securities, commodities, interest rates, or currencies.

Last August, for instance, a global bond fund manager admitted he felt like "crying in his beer" over his call in March 2011 to dump almost all of his flagship fund's US government bond holdings because interest rates were unsustainably low.³

The second lesson is that trying to time markets—picking the turn in performance of bonds versus equities or government bonds versus corporate bonds or value stocks versus growth stocks—is a pretty tough job. In fact, few (if any) people seem to get it consistently right.

The third takeout is that it really doesn't matter how strong you think the fundamental case is for an interest rate change or a lower currency or a higher stock price; events have a distinctive and unerring way of messing up your impeccable logic.

An example: In the US in February this year, strategists at some of the world's biggest investment banks capitulated on their bearish forecasts after global stocks registered their best start to a year since 1994. In a summary of recent research, Bloomberg quoted strategists at several banks as admitting they had gotten their timing badly wrong.⁴

The final message is that you don't really need any of this fundamental analysis to build long-term wealth. Markets are unpredictable because news is unpredictable.

This means the best approach is to structure a diversified portfolio that is built according to your own investment goals and risk appetite, both across and within asset classes. Occasional rebalancing of the portfolio ensures you maintain an asset allocation consistent with your risk profile. The rest is all about discipline.

This may not be a particularly exciting investment story. But it's one that works. And it doesn't require you to make forecasts about interest rates, currencies, stock prices, or economies. As we have seen, there are some serious cracks in the crystal ball.

Is China the Best Place to Invest

By Larry Swedroe

(MoneyWatch)

One of my major focuses is demonstrating that so much of the "conventional wisdom" of investing is wrong. One of the more persistent beliefs held by investors is that if you want high returns, you should invest in countries experiencing rapid economic growth.

It seems that even professor Burton Malkiel, author of A Random Walk Down Wall Street, believes the conventional wisdom, as he has been touting China as the place to invest. For example, in 2011, he stated: "Institutional investors are missing out on investing in the world's fastest growing economy; since the early 1980s China has expanded at more than 9 percent a year, after inflation." To see if the conventional wisdom is correct, let's take a look back.

Antti Ilmanen, in his book Expected Returns, reports that from 1993 through 2009, China's GDP growth rate averaged more than 10 percent. If ever there was a test that would demonstrate that high rates of economic growth translate into high investment returns, this should have been it. Yet, Ilmanen found that U.S. dollar-based investor would have earned negative returns over the period. The negative return has now been extended to 19 years as the iShares Trust FTSE China 25 Index Fund (FXI) returned just 2.1 percent in 2010, and then lost 17.7 percent in 2011.

If the Chinese example doesn't convince you that the conventional wisdom is wrong, perhaps the cumulative weight of the evidence from the following studies will: One study found that for the period 1900-2000, the real return from stocks and a country's growth rate was negatively correlated (-0.27); another study ranked 83 countries and found that the lowest growth countries outperformed the fastest growing countries by almost 7 percent a year.

The explanation is pretty simple: Markets price for risk, not growth. Countries with high projected growth rates are perceived as less risky than those with low projected growth rates. Thus, you shouldn't expect high returns from countries with high growth rates.

Invest Smarter Than an MLB Star

By Larry Swedroe

(MoneyWatch)

COMMENTARY The lawsuit by former baseball All-Star Denny Neagle against his financial advisor should serve as a warning to all investors: Working with an advisor you can trust is important but shouldn't replace your own education on financial matters.

Denny Neagle, who pitched for six teams during his 13-year career and was a two-time All-Star, and his ex-wife filed suit against their former advisor, alleging that they were supposed to be in liquid investments such as stocks and bonds, but ended up in illiquid, expensive investments such as hedge funds and private equity funds. The lawsuit also claims they now can't access large portions of their portfolio and experienced large losses on alternative investments.

What put them in this position? They claimed they were "utterly unsophisticated" when it came to finances and were looking for help.

Certainly, Neagle, who signed a $51 million contract in 2000, isn't the first athlete to run into financial troubles. For example, NFL quarterback Mark Brunell, who earned an estimated $50 million during his pro career, filed for bankruptcy in 2010; news reports blamed failed business ventures. Three-time WNBA MVP Sheryl Swoopes, who also earned an estimated $50 million throughout her playing career and endorsements, filed for bankruptcy in 2004. She told the New York Times, "Growing up not having a lot of money, I was suddenly in a position to change my lifestyle and help those around me. But I didn't surround myself with the right people. I got in a position where it was like, 'Oh, wow, what happened?' "

It's easy to write off situations like these as athletes being irresponsible. It's also easy to place the blame at their feet, saying they should know better and stop being so trusting. But you don't have to be an athlete making millions to fall into the same traps. According to the National Foundation for Credit Counseling's 2011 Financial Literacy Survey, more than 40 percent of respondents gave themselves a C grade or lower for their knowledge of personal finance. And about three out of every four agreed that they could benefits from advice and answers from a professional.

Such issues can affect all walks of life. Think of the people taken in by Bernie Madoff and Allen Stanford. Or think of Olga Kuschnieryk, an 85-year-old who worked in a forced-labor camp during World War II before coming to America. She worked at a meatpacking plant and had sent more than $330,000 to a financial advisor before discovering he was running a Ponzi scheme.

Working with an advisor or financial professional can be hugely beneficial, but that doesn't absolve you of your responsibility to know your own financial picture. What investments do you hold? How big is your portfolio? What fees are you paying? How much risk are you taking? There's a large difference between not letting someone else handle the day-to-day management of your portfolio and being completely unaware of what you have.

Embracing Imperfection

By Jim Parker

New Year's resolutions often involve making promises to ourselves we can never keep. But instead of tilting at windmills, we can often generate better results by merely resolving to be less dumb in certain areas. And money is a good place to start.

One human tendency is to judge the effectiveness of our retirement savings strategies by looking at performances on one-, two-, or three-year horizons. We do this because we are wired to be more sensitive to short-term losses than to long-term gains.

This is why much of the financial services industry and media encourage a short-term focus for an audience with a long-term horizon. This is akin to looking through the wrong end of a telescope. The thing you should be focusing on looks even farther away.

The result of this short-term mindset is that investors end up following the herd and seeking safety when opportunities are plentiful and seeking risk when opportunities are few. The less dumb thing is to maintain a level of discipline amid the noise.

Another human tendency—and one allied to our built-in loss aversion—is to be suckers for the supposedly "free" or discounted offer. Like Homer Simpson, a zero price tag makes us fall for pitches selling us stuff that is neither necessary nor good for us.

In the world of investment, it's this tendency that makes people gravitate to strategies that headline high returns without mentioning the risk, or that conveniently bury fees, commissions, and other costs. Regret lies on the other side of those decisions.

A less dumb thing is to focus on return and risk. They're related. Focusing exclusively on return can lead to rude awakenings when risk shows up. Focusing exclusively on risk can lead to disappointment when returns are delivered.

A third tendency among humans is to succumb to what behavioural scientists call "hindsight bias." Essentially, this is our habit of viewing events as more predictable than they really were. Call it the "I saw it coming" syndrome.

There is a fair bit of this around at the moment, with plenty of "experts" saying the sovereign risk crisis was completely predictable. This is strange because the overwhelming consensus among institutional investors a year ago was that fixed income would underperform in 2011. The crisis may have been predictable, but the market reaction wasn't.

The consequence of hindsight bias for investors is they tend to be forever rewriting history and forever seeking to interpret performance based on what they know now rather than what they knew a year or more before.

A less dumb thing is to accept there will always be a level of uncertainty. The future is unknowable. And all we can do as investors is to ensure the risks we take are related to an expected return, that we diversify around those risks as much as possible, and that we exercise a level of discipline amid the noise.

It's a way of embracing your imperfection, and it's a New Year's resolution you have a chance of sticking to.

Year End Review

By Weston Wellington

Equity investors around the world had a disappointing year in 2011 as thirty-seven out of forty-five markets tracked by MSCI posted negative returns. The US did well on a relative basis and was the only major market to achieve a positive total return, although the margin of victory was slim. Total return for the S&P 500 Index was 2.11%, and the positive result was a function of reinvested dividends—the index itself finished the year slightly below where it started.

Throughout the year, investors seeking clues regarding the strength of business conditions or the prospects for stock prices were confronted with ample reason to rejoice or despair. Optimists could cite the strong recovery in corporate profits and dividends, the substantial levels of cash on corporate balance sheets, low interest rates and inflation, a booming domestic energy sector, continuing strength in auto sales, and record-high share prices for leading multinationals such as Apple, IBM, and McDonald's. Pessimists could point to persistently high unemployment, slumping home prices, tepid growth in retail sales, worrisome levels of government debt at home and abroad, and political gridlock in both Congress and various state legislatures.

Although the broad market indices showed little change for the year, there were opportunities to make a bundle—or lose one. Among the thirty constituents of the Dow Jones Industrial Average, thirteen had double-digit total returns, including McDonald's (34.0%), Pfizer (28.6%), and IBM (27.3%). But losing money was just as easy: The three worst performers in the Dow were Hewlett-Packard (–37.8%), Alcoa (–43.0%), and Bank of America (–58.0%). If nothing else, the substantial spread between these winners and losers discredits the argument we often hear that all stocks are now marching in lockstep and that diversification is ineffective.

Achieving even modest results in the US market required more discipline than many investors could muster, since investor sentiment fluctuated dramatically throughout the year and the temptation to enhance returns through judicious market timing often proved irresistible.

For fans of the "January Indicator," the year got off to a promising start as stock prices jumped higher on the first trading day, pushing the Dow Jones Industrial Average to a twenty-eight-month high. Bank of America shares jumped 6.4% that day, the top performer among Dow constituents. With copper prices setting new records and factory activity worldwide perking up, the biggest worry for some was the potential for rising prices and higher interest rates that might choke off the recovery. "Overheating is the biggest worry," one chief investment strategist observed. By April 30, the S&P 500 was up 8.4%, reaching a new high for the year.

Stocks wobbled through May and June but strengthened again in July. On July 19, the Dow Jones Industrial Average had its sharpest one-day increase of the year, jumping over 200 points, paced by strong performance in technology stocks. Just a few days later, however, stocks began a precipitous decline that took the S&P 500 down nearly 17% in just eleven trading sessions. The century-old Dow Theory—a sentimental favorite among market timers—flashed a "sell" signal on August 3, and on August 5, Standard & Poor's downgraded US government debt from AAA to AA+. As investors sought to assess the implications of sovereign debt problems in both the US and Europe, stock prices fluctuated dramatically, with the S&P 500 rising or falling over 4% on five out of six consecutive trading days in early August. Rattled by the sharp day-to-day price swings, many investors sought the relative safety of US Treasury obligations in spite of the rating downgrade, pushing the yield on ten-year Treasury notes to a record low. Stock prices hit bottom for the year on October 3 as some market participants apparently lost all confidence in equity investing. A Wall Street Journal article cited a number of individual investors as well as professional advisors who had recently sold all their stocks and did not expect to repurchase them anytime soon. "I feel like a deer in the headlights," said one.

As it turned out, the article appeared in print on the second day of a powerful rally that sent the Dow Industrial Average surging over 1,500 points during the next 19 trading days, putting it back into positive territory for the year.

What can we learn from a difficult year like 2011? As Dimensional founder David Booth is fond of saying, the most important thing about an investment philosophy is that you have one. Many investors (as well as some allegedly professional advisors) apparently decided to switch from a buy-and-hold philosophy to a market timing strategy in the midst of an unusually stressful period in the financial markets. We suspect few of those adopting the change would have been able to clearly articulate their investing beliefs and why they had shifted.

Legendary investor Benjamin Graham offered the following observation nearly forty years ago: "There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he himself is a part."

Good advice then, good advice now.

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Mark Gongloff, "Investors' Forecast: Sunny With a Chance of Overheating," Wall Street Journal, January 3, 2011.

Jonathan Cheng and Sara Murray, "Stock Surge Rings in Year," Wall Street Journal, January 4, 2011.

Matt Phillips and E.S. Browning, "Tech Sends Stocks Soaring," Wall Street Journal, July 20, 2011.

Steven Russsolillo, "'Dow Theory' Confirms It's an Official Swoon," Wall Street Journal, August 4, 2011.

Damian Paletta, "U.S. Loses Triple-A Credit Rating," Wall Street Journal, August 6, 2011.

Tom Petruno, "Investors Stampede to Safety," Los Angeles Times, August 19, 2011.

Kelly Greene and Joe Light, "Tired of Ups and Downs, Investors Say 'Let Me Out'," Wall Street Journal, October 5, 2011.

Benjamin Graham, The Intelligent Investor (New York: HarperCollins 1949).

The S&P data are provided by Standard & Poor's Index Services Group.

MSCI data copyright MSCI 2011, all rights reserved.

Yahoo! Finance, www.yahoo.com, accessed January 3, 2012.

Things Change

By Jim Parker

It's that time again when harried finance editors ask reporters to call investment professionals and cobble together top predictions for the coming year. These are fun to write. But for readers, they're more entertaining a year later.

Take the late 2010 Barclays Capital Global Macro Survey of more than two thousand institutional investors. The pick for the best performing asset class in 2011 was equities (with 40% support), followed by commodities (34%) and bonds (less than 10%).¹ The consensus prediction was a 15% gain in the S&P 500 for the year to around 1,420.

As we now know, the truth turned out to be rather different. To the beginning of December and using broad indices, diversified fixed income was the best performing asset class of the year, followed by government bonds. Returns from commodities and equities were negative. The year-to-date return for the S&P 500 was close to zero. (And remember, these are the forecasts of big institutional investors.)

Barron's, meanwhile, was telling readers this time last year that smart stock pickers were "looking eastward" in 2011. The year was to be dominated by fast growth and rising inflation, and the smart thing was to reweight toward China and other tigers.²

That didn't really turn out to be such a good idea, as China had another bad year. The Hong Kong Hang Seng index was down nearly 17% to early December. The Shanghai Composite was down by a similar amount.

Conversely, the gloom around fixed income in late 2010 was all pervasive. Barron's surveyed 10 strategists and investment managers and found nearly all expected stocks to outperform bonds in 2011. "You've got to believe in outright deflation to put new money into bonds right now," said one investment banker.³

The logic might have been impeccable, but the strategy wasn't so. As of early December, US debt securities, as measured by a Bank of America Merrill Lynch index, had risen by 8.7% in 2011, their best performance since 2008.4

In other words, bond yields might have been seen as unusually low a year ago. But they have fallen even further since, and those who tried to profit by market timing or making concentrated bets elsewhere have paid a heavy price.

So if the experts can't get the broad asset class movements right, what chance on earth have they of correctly and consistently predicting individual stock or commodity performances? But year after year, that doesn't stop them from trying.

One prominent investment bank team was quoted by The Australian Financial Review last January as saying that platinum was the metal to back in 2011. As of early December, the spot platinum price was down nearly 14% for the year. On the Australian stock exchange, platinum stocks Platinum Australia and Aquarius Platinum—both recommended by the bank—had delivered total returns to the end of November of –83% and –53%, respectively.5 Ouch!

Stock picks often go wrong because forecasters base their calls on what turn out to be incorrect assumptions on macro-economic variables like base lending rates and inflation. Take the AFR Smart Investor magazine "expert panel," which in late 2010 suggested to readers moving out of international fixed income and into cash given expectations of rising cash rates in Australia.6 As it turned out, Aussie rates did not move until November, and when they did the direction was down, not up.

Currencies are another variable that defy even the most assiduous forecasters. In its 2011 outlook, published in the London Daily Telegraph in December 2010, a major British bank forecast sterling would be the best performing currency of the year.7 The banks also predicted stock markets would outperform bonds, with the FTSE 100 rising about 18%. A year later, sterling ranked only a distant fourth behind the Japanese yen, Norwegian krone, and Swiss franc, and the FTSE was nearly 6% lower.

It's a tough business, isn't it? And remember these are major financial institutions with armies of expert analysts, mountains of data, and sophisticated forecasting tools. So what is an ordinary investor supposed to do?

The first lesson might be that forecasting is hard, particularly about the future! You can do all the analysis you want, but events have a way of messing with your assumptions.

The second lesson is you don't really need forecasts to succeed as an investor. Yes, equity markets were rocky again this past year. But a properly diversified fixed income portfolio provided excellent returns. Staying diversified both across and within asset classes helps lessen the effects in down times and ensures you are still positioned to reap returns when riskier assets come back into demand.

The third lesson is that the past has gone. The news may be gloomy, but that information is in the price. When risk appetites are low, the price of safety is higher than at other times. But the expected reward for risk is higher. Conversely, when risk appetites are high, the expected rewards are lower.

It's human to feel anxious about bad news because we fear loss more than we like gains. But in this case, the loss isn't real unless you realize it, so it makes sense to stay with the asset allocation your advisor has tailored for you.

The final lesson is that nothing lasts forever. In fact, of all the forecasts ever made, the only one really worth counting on is that things change. What's more, they often change in ways we least expect.

1. "For 2011, It'll Be All About Equities," Pensions & Investments, December 27, 2010.

2. "Asian Trader: Stockpickers, Look Eastward," Barron's, December 20, 2010.

3. "Outlook 2011," Barron's, December 20, 2010.

4. "Treasuries Rise on Concern Europe Struggling to Resolve Crisis," Bloomberg, December 7, 2011.

5. "Platinum to Become the Price of Metals in 2011," Australian Financial Review, January 7, 2011.

6. "How to Rebalance Your Portfolio in 2011," AFR Smart Investor, December 17, 2010.

7. "Sterling Best Major Currency Next Year, says Barclays," The Daily Telegraph, December 10, 2010.

The 10 New Year's Investing Resolutions

By Larry Swedroe

The New Year is a time to reflect on the changes we want or need to make. The following are my recommendations for New Year's resolutions that will not only make you a better investor, but will also improve the quality of your life -- assuming you have the discipline to stick to them.

1. I'll adhere to my investment plan. If I don't have one, I'll immediately develop one.

2. I won't take more risk than I have the ability, willingness or need to take.

3. I will avoid all complex investments and won't invest in something if I don't fully understand its risks.

4. I'll ignore all market and economic forecasts, because they have no value.

5. I'll remember that just because something seems obvious now, it doesn't mean it was obvious before it happened.

6. I won't confuse strategy with outcome. If my plan doesn't return what I expected, that doesn't mean my strategy was wrong. Sometimes you win; sometimes you lose.

7. I won't react to current market trends. Instead, I'll remember rule No. 1.

8. I won't treat the unlikely as impossible, nor the likely as certain.

9. I'll take my risk in the stock market and use bonds to dampen my overall risk, if necessary. My bonds will be of the highest quality.

10. I won't confuse yield and return. If an investment has a high yield, there's a high degree of risk, even if I can't see it.

And here's a bonus resolution, which will not only help you, but probably provide some good laughs, too. I will keep a diary of my market and economic forecasts and review them at the end of the year. That will help me avoid the mistake of being overconfident of my skills.