Invesment Basics

We have identified eight asset classes, each of which has provided strong historical returns that are not strongly correlated with those of the other seven:

 

CORRELATION TABLE*	A	B	C	D	E	F	G	H
A) Cash and Cash Equivalents	1.000
B) Short/Interm.Term Fixed Income	.177	1.000
C) Income Equities (REITs)	.001	.061	1.000
D) Large Cap Value Stocks	.037	.131	.637	1.000
E) Small Cap Stocks	.002	.011	.657	.789	1.000
F) Large Cap Growth Stocks	.022	.080	.476	.834	.829	1.000
G) International Stocks	-.023	.063	.458	.637	.601	.625	1.000
H) Gold Related Investments	-.054	.047	.087	.040	.091	.034	.209	1.000

 

*Data from Dimensional Fund Advisor Returns platform. Monthly data from 1/1979-12/2008; Default Currency USD. Asset class representation for the following chart includes: Cash= One-Month Certificate of Deposit, Short/Intermediate Term Fixed Income= Five-Year US Treasury Notes, Income Equities= Dow Jones Wilshire REIT Index, Large Cap Value Stocks= Russell 1000 Value Index, Small Cap Stocks= Russell 2000 Index, Large Cap Growth Stocks= Russell 1000 Growth Index, International Stocks= MSCI World ex USA Index (net div.), Gold Related Investments =historical GOLD price returns. Russell data copyright © Russell Investment Group 1995-2009, all rights reserved. US long-term bonds, bills, inflation, and fixed income factor data © Stocks, Bonds, Bills, and Inflation YearbookTM, Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield). MSCI data copyright MSCI 2009, all rights reserved. Certificates of deposit provided by Federal Reserve Statistical Release H:15: Selected Interest Rates. Dow Jones Wilshire data provided by Dow Jones Indexes.

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Cash and Cash equivalents are defined as short-term, highly liquid investments or declarations which are held as cash, or can be readily converted to cash for immediate use.

We cannot stress enough the importance of liquidity. The maintenance of a balance in money market funds offers maximum possible liquidity and security of principal (at least in current dollar terms). Brokers generally offer a choice of several money market funds. These include US Government or Treasury portfolios, municipal portfolios, or general money market portfolios which typically hold U.S. and foreign issues, including commercial paper, asset-backed commercial paper, CDs, variable and floating-rate debt securities, bank notes and repos.

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Short/Intermediate Term Fixed Income Assets are defined as securities where the payout of principal and interest are promised to the purchaser by the issuer in advance. The initial maturity of Short/Intermediate Term Fixed Income Assets is generally up to 5 years.

The purpose of holding fixed income securities is to increase portfolio stability. We focus on Short/Intermediate Term Fixed Income in order to optimize returns while maintaining overall portfolio balance. While other fixed income investments might provide higher returns, they do so only by assuming additional risk in the form of price volatility2, which undermines this stability. Research has shown that for investors seeking fixed income as a source of portfolio stability, the risk return trade-off generally becomes unattractive for securities with maturities that extend beyond five years. This trade-off is depicted below:

Evaluating the Maturity Risk/Return Tradeoff
Quarterly: 1964-2008

 

We can see that by extending the maturity out past five years, we are taking on much more risk (red line = standard deviation) but are compensated with only slightly better returns (green line = returns). By focusing on the shorter end of the spectrum, we are both maximizing return for unit risk taken for the fixed income asset class, while also providing important diversification benefits to the overall portfolio.

Our passive approach makes no attempt to predict interest rate changes that occur in this five-year “short end” of the yield curve. We instead adopt either “laddered” strategy, designed to provide equally-weighted dollar exposure to the yield curve, or a variable maturity approach, which is designed to capture the maximum return for any changes in the yield curve that might occur.

We also carefully control credit risk (the risk that an issuing entity will default on its obligations). We restrict our recommendations to investment vehicles that invest in bonds issued by governments (sovereign debt), government agencies, municipalities, or corporations with investment grade credit ratings.

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Real Estate Investment Trusts (equity REITs) are generally defined as a product that uses investor’s pooled capital to invest in a variety of commercial real estate ventures. By law 90% of a REIT’s taxable income must be distributed to investors.

REIT subsectors include industrial, office, retail, residential, lodging, specialty and self-storage properties. We utilize index-type mutual funds or exchange-traded funds that invest in virtually every U.S. REIT, proportionate to their relative market capitalization.

REITs have demonstrated the potential for strong capital growth over the long term, which further bolsters the case for their inclusion in a well diversified, balanced portfolio. More importantly, REITs are considered a separate asset class because of their low correlation with other asset classes. Notably, REITs are a form of equity but exhibit risk/return characteristics different from common stocks. Similarly, REITs generate a strong level of investment income, but provide returns that are distinct from fixed income securities.

This unique asset class provides a liquid means of holding real estate investments while generating a dependable source of investment income. This construct makes REITs particularly well suited for non-taxable vehicles such as IRAs and 401k accounts.

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Our approach to using equities (common stocks) as part of a well diversified portfolio is based on decades of research broadly known as Modern Portfolio Theory (MPT). This approach to portfolio construction is based in objective, empirical and continually evolving economic research conducted by academic researchers throughout the world.

This research has led us to adopt certain fundamental tenets as we design portfolios:
a) Markets are in equilibrium
b) Diversification is essential
c) Risk and return are related
d) Focus on what you can control – long term time horizon, tax efficiency and cost of implementation

As applied to equities in particular, research has uncovered some powerful underlying forces which determine a portfolio’s overall expected return, namely:

1) Equities have a higher expected return than fixed income
2) Small Company stocks have higher expected returns than large company stocks
3) Value stocks have higher expected returns than growth stocks

By using these facts to our advantage, we can structure the equity portion of our portfolios to maximize return per unit of risk taken. By avoiding “unpaid risk”, our portfolios benefit in a number of ways, including increased returns and a reduction in overall portfolio volatility.

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U.S Large Cap Value Stocks include those stocks that generally include U.S. companies with market capitalizations within the largest 90 percent of the market universe. After identifying the aggregate market capitalization break, a value “screen” can be applied; securities are considered value stocks when they have a high book value in relation to their market value (BtM).

 Over the long term (since 1927) Large Cap Value stocks have generated higher annualized returns than the overall stock market, as measured by the S&P 500 Index. This is explained by the inherent trade-off between risk and return. Value companies, being in a distressed state, carry high economic risk and have higher costs of capital than larger and financially healthy companies. When they take out a loan from a bank, they pay (and investors receive) higher interest rates; when they issue stock, they receive (and investors pay) lower prices. A firm’s cost of capital is the investor’s expected return.

Because of their inherently higher level of risk, distressed companies have higher expected returns than companies that are healthier. Research and historical results show that long-term increases in expected returns can be achieved with value exposure. Such premiums cannot be gained by stock selection or market timing, nor can it be gained through various other segmenting schemes promoted by active managers, such as “bets” on industrial sectors or individual countries.

Our research suggests that the most reliable means of identifying a distressed stock (to distinguish value from growth stocks) are its BtM or its dividend yield. We utilize index-type mutual funds and exchange traded funds that sort these stocks by BtM. For larger accounts, especially those with an explicit need for investment income (such as certain trust accounts) we utilize dividend yield as our gauge, through our “4-for-18” high-yield Dow approach, in which we purchase equities directly.

Our HYD model began by incrementally “investing” a hypothetical sum of $1 million over 18 months. Specifically, one eighteenth of $1 million ($55,000) was invested equally in each of the 4 highest-yielding issues in the Dow Jones Industrial Average each month, beginning in July 1962. Once fully invested (January 1964) the model began a regular monthly process of considering for sale only those shares purchased 18 months earlier, and replacing them with the shares of the four highest-yielding shares at that time. The model each month thus mechanically purchases shares that are relatively low in price (with a high dividend yield) and sells shares that are relatively high in price (with a low dividend yield), all the while garnering a relatively high level of dividend income.

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Large Cap Growth Stocks are defined as those stocks that are generally among the largest in terms of market capitalization and correspondingly have the lowest Book to Market (BtM) ratios.

Although Large Cap Value stocks have provided greater returns over time, most investors should have some exposure to Large Cap Growth stocks as well. Compared with value stocks, growth stocks are healthier companies with better prospects for growth in sales and earnings. Because they are safer, they have a lower cost of capital. Although this translates into lower expected returns for investors, the chart below reveals that when risk (as measured by volatility) is accounted for, the higher absolute returns attributable to value stocks disappear. It is also important to realize that there have been extended periods when growth stocks have outperformed value stocks, so investors who have no exposure to this asset class may experience years when the equity portion of their portfolio’s growth will lag that of the overall market.

All this suggests that an investor can “fine tune” his equity risk exposure through a prescribed allocation to large cap growth stocks that is consistent with his tolerance for risk.

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U.S. Small Cap stocks are defined as those stocks that are generally among the smallest 10 percent of the market universe.

Small Cap Stocks carry with them higher economic risks and thus have higher costs of capital associated with them. Smaller cap companies often have to pay higher interest rates when they take out a loan from the bank when compared to larger, more well-established firms. Similarly, when they issue common stock they receive lower prices versus larger firms. This means higher expected returns for investors.

The historical returns and volatility of the smallest deciles of market capitalization have been thoroughly studied. As indicated in the table below, small cap stocks have provided returns in excess of those of the overall stock market as measured by the Standard & Poor’s 500 Index (large cap stocks), although investors would have had to accept increased volatility in the process.

*Source: DFA, CRSP 6-10 Index (CRSP data are provided by the Center for Research in Security Prices, University of Chicago

What should make small cap stocks especially attractive, however, is not just their potential return premium; but rather the fact that the returns to small capitalization issues are not strongly correlated with those of large stocks, such as our recommended high-yield Dow shares. In the table below, we present market returns by deciles. Large stocks (decile 1) and small cap stocks (decile 10) provided the greatest “swings” in terms of gains and losses over three-year rolling periods, but most importantly, these swings were not correlated. For example between 2002 and 2004, small caps averaged 29.17% annually, while large caps returned only 1.7%. Conversely, between 1987 and 1989, small caps gained 2.82% while large caps gained 17.06%. The point is, though no one can predict these patterns of relative performance in advance, for a given level of risk they are willing to accept, investors can maximize their potential returns by holding both groups of assets.

Annual Stock Market Returns (NYSE, AMEX, NASDAQ)

	Decile 1	Decile 2	Decile 3	Decile 4	Decile 5	Decile 6	Decile 7	Decile 8	Decile 9	Decile 10
1926-28	112.73	90.85	85.86	90.98	103.42	67.95	79.03	50.53	61.41	101.76
1929-31	-60.64	-71.89	-72.70	-76.95	-74.48	-81.69	-79.52	-84.63	-86.17	-87.63
1932-34	32.69	91.23	109.83	119.81	83.79	159.55	106.00	265.88	230.92	500.57
1935-37	25.37	32.33	8.09	9.69	27.17	20.20	30.34	16.79	41.90	47.20
1938-40	21.81	17.43	19.56	30.20	51.56	41.72	34.11	28.65	20.59	-14.82
1941-43	25.05	54.23	51.00	52.39	59.20	58.64	102.64	102.70	136.32	251.24
1944-46	45.00	76.92	75.08	90.18	92.86	117.71	94.58	112.89	150.03	171.53
1947-49	29.81	26.36	28.88	19.48	19.57	15.05	15.21	5.32	6.97	17.35
1950-52	78.71	78.86	72.20	71.45	74.15	67.62	79.74	73.48	70.62	69.58
1953-55	92.73	79.04	88.69	77.50	79.09	93.84	81.88	69.60	87.61	94.36
1956-58	37.73	51.96	44.21	55.27	45.08	35.42	51.55	41.65	55.70	38.92
1959-61	42.41	47.03	53.63	50.96	51.61	44.96	47.17	49.77	50.56	40.40
1962-64	29.59	25.44	23.05	18.51	9.57	13.49	14.23	19.77	7.94	14.81
1965-67	19.21	35.78	56.04	69.69	85.75	101.80	99.24	118.52	136.72	175.67
1968-70	3.59	3.29	9.24	-8.26	-1.75	-0.23	-13.57	-11.31	-20.50	-11.05
1971-73	22.38	-1.19	1.45	-0.67	-12.39	-10.84	-19.52	-22.57	-30.55	-31.68
1974-76	14.42	43.70	60.02	62.29	79.62	69.59	82.47	97.09	85.18	98.70
1977-79	11.70	26.84	46.35	53.91	69.04	97.65	95.45	108.77	103.62	123.34
1980-82	45.58	58.87	65.23	70.51	80.87	81.55	75.30	72.37	88.24	82.41
1983-85	71.70	73.31	67.59	61.41	61.15	68.97	61.52	73.35	56.33	38.65
1986-88	42.37	42.10	46.54	46.01	34.40	27.35	27.40	22.72	13.47	3.41
1989-91	71.83	60.18	60.45	55.91	58.07	51.24	43.92	39.05	25.62	7.35
1992-94	14.37	28.77	26.66	28.78	45.06	39.75	38.28	29.66	41.16	63.25
1995-97	132.66	110.54	98.35	98.94	75.15	91.63	106.36	90.07	104.46	86.66
1998-00	45.42	35.06	35.25	25.20	17.63	22.46	11.27	21.98	10.57	-1.34
2000-03	-17.45	3.52	8.50	17.67	13.37	28.37	30.35	52.82	79.66	148.71
2004-06	29.43	55.82	51.81	46.60	49.32	44.72	53.18	54.24	37.82	50.05
2007-09	-14.72	-13.60	-14.32	-5.09	0.35	-9.75	-10.84	-9.77	-11.66	-13.76

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Lowest returns are in red, highest are in green

CSRP data provided by the Center for Research in Security Prices, University of Chicago. The S&P data are provided by Standard & Poor’s Index Services Group. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.

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International Stocks are defined as those companies that are located outside of the United States. As of December 2007 these stocks outside the US represented roughly 59 percent of world market capitalization as defined by the MSCI Provisional All Country World Index. This asset class includes companies that are domiciled in developed as well as in emerging markets. Emerging markets generally have lower per capita income than developed markets, but could also be experiencing significant GDP growth. However, this growth often comes with less overall infrastructure support and stability than more developed international economies enjoy.

International Stocks, both emerging and developed, can add important benefits to an overall investment portfolio, providing solid long-term returns while also generating returns that are generally uncorrelated with the other seven asset classes. Research has shown that the size and value effects prevalent in the U.S. stock market are also evident in overseas markets. International portfolios can be “tilted” similarly, toward small cap and value companies to more precisely customize a portfolio to match the particular risk profile of an individual investor.

Emerging market portfolios are carefully screened to include only stocks traded in countries with well-organized capital markets and ample liquidity, a good legal system and reasonable treatment of foreign ownership both with regard to taxation and any restrictions on repatriation of capital.

International Stocks*	MSCI EAFE Index	MSCI EAFE Growth  Index	MSCI EAFE Value  Index	DFA Intl Small Cap Index	MSCI Emerging Mkts. Index
Annualized Return	11.47%	9.40%	13.34%	15.58%	13.83%
Standard Deviation	17.36%	17.92%	17.41%	18.14%	24.33%

*Source: DFA – Dimensional Returns 2.0. Returns shown from 1975-2009. MSCI Emerging Market Index results shown from 1988-2009.

 

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Gold is a unique asset class. Its price often increases in value when stock and/or bond values decrease and vice versa as a result of various economic and political factors that undermine market confidence in fiat currencies. Gold’s low (sometimes negative) correlation with other assets is a useful tool in managing portfolio risk. A small allocation to gold related investments can result in a significant reduction in overall portfolio volatility without significantly reducing portfolio returns.

Perhaps gold’s most valuable attribute is that it has effectively served as a form of portfolio insurance during periods of extreme financial distress. Unlike most commodities, it has served throughout history as a form of money, and unlike fiat currencies gold cannot be devalued “at the stroke of a pen.” Its price is extremely volatile however, so we recommend that investors devote only a small portion of their financial assets to gold.|

The chart below depicts the effectiveness of gold as the only form of money that has retained its purchasing power over extended periods.

Gold ETFs allow individual investors to easily own and trade gold bullion. An ETF share represents ownership in 1/10 oz. of gold. ETFs are an excellent way to own gold as a security that is readily tradable on a major stock index. Since their inception, gold ETFs have tracked the price of gold very closely.

We also recommend gold mining stocks as a means of owning “gold in the ground.”
These high-quality gold shares also provide a number of additional advantages:

• Shares of gold mining companies provide ownership of gold “in the ground” via their vast ore reserves.
• These companies, by virtue of their ability to expand production and minimize production costs, offer the potential for share price appreciation that is independent of the gold price.
• All of our recommended mining stocks have a history of maintaining a steady dividend. Unlike gold bullion or even ETFs, mining shares offer investors a reliable stream of income.
• Unlike many highly publicized small mining companies that often hold land with nothing more than unsubstantiated claims of gold resources, the companies we have recommended are actually producing gold, and have proven, long-lived, low-cost reserves.
• Our recommended companies are carefully screened for financial stability; they are large enough so that the shares are highly liquid, their balance sheets are not overly leveraged, and they have diversified operations which can minimize political and other risks.

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