Notes, Views, and the Occasional Provocation March / April 2008  

The Credit Crisis of the 2000's follows a seeming modern trend of at least one financial catastrophe each decade. Unfortunately, it is this trend that trips up so many investors – both individual and institutional – inducing them to buy high and sell low, over and over again, as they succumb to the siren song of "this time it really is different" in the equity markets. One investor who has not succumbed is David Swensen, famed chief investment officer of the Yale University endowment. Thus, our first article highlights the recent market turbulence, and the second article highlights Mr. Swensen's example of how to successfully navigate it.

Please feel free to forward the newsletter to anyone who might enjoy reading it, and please send along any questions or comments you may have. We love hearing from you.

Warm regards,

Milo Benningfield



2008 – Tough Start
It seems to be a rule that we must have a major financial catastrophe at least once each decade. Now it's the credit crisis of the 2000's, which has made 2008 a tough start for the equity markets. But there is some room for optimism. more

Antidote to Panic – Investment Policy
For the past twenty-two years, the Yale University endowment has generated an annualized rate of return of over 16% with famed chief investment officer David Swensen at its helm. One of the endowment's clearest advantages is Mr. Swensen's ability to maintain a consistent investment discipline. more

BFA Notes & Media Quotes
A few notes on goings-on at the firm and recent media quotes. more





2008 – Tough Start
It seems to be a rule that we must have a major financial catastrophe at least once each decade. Recent ones include the Arab oil embargo and rampant inflation of the 1970's; the savings-and-loan crisis that began in the 1980's; the 1990's emerging-markets meltdown that threatened global finance, and the maniacal dot-com boom and bust. Now it is the credit crisis of the 2000's. Last month the crisis nearly caused the collapse of Bear Stearns, one of the world's largest investment banks, which, in turn, led to a bailout by the Federal Reserve in a move that had not been seen since the Great Depression.

Understandably, January through March 2008 was the worst quarter for both U.S. and foreign stock markets in the past five and a half years. Large U.S. company stocks dropped almost 10%; large foreign companies dropped almost 9%.1

The declines were widespread, affecting all ten major market sectors:

S & P 500 Sector Performance – First Quarter 2008
Sector Percentage Change
Consumer Staples -2.78
Materials -3.55
Industrials -4.47
Consumer Discretionary -6.25
Energy -7.53
S & P 500 -9.92
Utilities -10.68
Healthcare -11.94
Telecom Services -14.55
Financials -14.67
Technology -15.53

Even investment legends had trouble navigating these waters. Fund manager Bill Miller, whose Legg Mason Value Trust fund had beaten the S & P 500 Index for fifteen years in a row up until two years ago – the longest winning mutual-fund streak alive when it ended – lost a whopping 20% in the first quarter 2008.2

No one can say what will happen next for the markets, but as one commentator notes, “there is some room for optimism,” since the market may have already discounted a lot of the bad news coming out of the financial sector and broader economic data:

The S & P 500 has fallen for five consecutive months. The last time that occurred was October 1990 in the middle of another banking crisis, which was brought on by the failure of more than 1,000 savings and loan banks. Over the next twelve months the S & P 500 rose 33.5%, despite the fact that the economy was in a recession from July 1990 to March 1991.3

Some positive factors right now include:

  • Because the dollar is weak, U.S. exports are strong.
  • The world economy is diversifying beyond the U.S. as new markets in China, India, and Brazil emerge as potential offsets for more developed economies.
  • The U.S. and foreign governments are helping to restore confidence in the financial markets by providing various kinds of support.
  • Private equity firms are offering cash to financial firms, suggesting that the Federal Reserve's recent efforts to calm the credit markets may be paying off.

Indeed, Warren Buffet apparently believes in the markets' future prospects. Berkshire Hathaway's 2007 annual report revealed that the company has sold 15- or 20-year put options on the S&P 500 and three foreign indexes, effectively betting the markets will rise over that time.4

Thus, while what happens next in the markets is uncertain, now is as risky a time as any to bet against them for long-term portfolios. If history is any guide, however, over the next several months we'll see many investors do just that, locking in their losses and moving to the sidelines just in time to miss the next market recovery.

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Antidote to Panic – Investment Policy
For the past twenty-two years, the Yale University endowment has generated an annualized rate of return of over 16% with famed chief investment officer David Swensen at its helm. This beat every other major school in the country as well as the 12% return of the S & P 500 Index over the same period. Yale has a lot of advantages over individual investors: an indefinite investment horizon, freedom from taxes, and an asset base of over $20 billion that gets some of the best investment deals in the world.

But one of the endowment's clearest advantages is Mr. Swensen's ability to maintain a consistent investment discipline:
[O]nce he likes an investor, Mr. Swensen tends to hang in, even in tough times. Yale weathered a 13 percent loss one year on funds invested with Water Street Capital, a hedge fund run by Gilchrist Berg. "I was a little bit shaky but David said to me, 'We really value the relationship and we want to put more money with you,'" Mr. Berg recalls.5
This discipline derives from Mr. Swensen's belief that formal investment policy, not market movements should dictate how a portfolio is managed, with particular emphasis on the portfolio's policy allocation:

In many ways, establishing policy asset allocation targets represents the heart of the investment process. No other aspect of portfolio management plays as great a role in determining a fund's ultimate performance, and no other statement says as much about the character of a fund. . . . Without a disciplined, rigorous process for setting asset allocation targets, effective portfolio management becomes impossible. 6
Focusing on investment policy and consistency sounds unassailably wise. But portfolio decisions made during a "serene and blessed mood" often look like pure folly when markets turn topsy-turvy, as now. Formal policy, in fact, is often one of the first things thrown overboard as investors attempt to save the ship, even though, as Mr. Swensen notes, it's one of the surest ways to sink the ship, since it "exposes portfolio managers to the damaging whipsaw of buying high and selling low."7

Several studies have documented the buy-high-sell-low phenomenon that wrecks many individual investors. For example, a study by Boston research firm Dalbar, Inc. revealed that from 1984 through 2002, the average equity-fund investor earned an annualized return of only 2.6% by piling into funds at market tops and bailing at the bottoms. Meanwhile, over the same period the S & P 500 Index returned 12.2%. In other words, during the greatest bull market of the twentieth century, the average equity-fund investor underperformed the U.S. equity market by an astounding 10%. 8

Lack of discipline isn't limited to individual investors. After the market crash of 1987, the Yale Investment Committee itself almost succumbed to abandoning policy. The committee had just reaffirmed the university's investment policies a few months earlier, but suddenly called an emergency meeting and criticized Mr. Swensen for having rebalanced the endowment portfolio to restore the equity allocation after stock prices had plummeted — a rebalancing move that ultimately made the endowment millions.

Immediately after the crash, however, one committee member called the previously approved asset allocation "on the far edge of aggressiveness," citing the "bleak short-term prospects for equities," and argued that the equity allocation should be reduced. He feared the university would "get little credit" for maintaining an aggressive equity allocation if Swensen was right about stocks, but would have "all hell to pay" if he were wrong. Another member questioned whether "[recent] increases in historical volatility made stocks less attractive on a relative basis."9

As Swensen noted, the committee members' fear nearly sank the Yale long-term investment discipline just when the endowment needed it most:

By questioning – after the fact – assumptions that had been examined recently as part of the annual policy target review, four months earlier, committee members exposed Yale to the risk of an untimely reversal of strategy.10
How can we resist the temptation to abandon long-term investment strategies in times of market distress? It's not easy. Financial crises feed on themselves, creating a streak of negative news lasting weeks and months, often with daily disclosures of financial mismanagement or fraud. Investors worry, "If we didn't know half the story yesterday, who's to say we know everything today?"

It helps to remember that when financial crisis strikes, the real story for individuals often has less to do with macroeconomic events than with their own poor choices.11 For example, a recent Wall Street Journal article discussed how many baby boomers were deferring retirement, profiling several "victims" of the combined housing slump and falling stock prices. But a closer look reveals a number of self-inflicted wounds:
  • An IBM executive put retirement on hold, in part, because he lost 20% in his 401(k) and IRA accounts in the first quarter 2008. The accounts must have held some aggressive bets, because they severely underperformed the U.S. market during the same period: the S & P 500 Index declined less than 10%, and a globally diversified 60/40 balanced portfolio declined less than 5%.12
  • Similarly, a Hewlett-Packard executive's mutual-fund portfolio declined 12% in January 2008, but the S & P 500 Index fell only 6%, and even more volatile small-company stocks in the Russell 2000 Index declined less than 10%.
  • Finally, a Florida dentist and his wife deferred retirement after their real-estate investments plunged in value. But their properties were two speculative condo purchases they had hoped to "flip" within two years, not income properties.13
It also helps to remember that scary news reports often reveal little about how our own financial circumstances may be affected. For example, take the recent recession talk. Hardly an article mentions "recession" without including words like "fear" and "alarm." But for most of us the reality is far less concerning. As the joke goes, "a recession is when you lose your job, a depression is when I lose mine." The statistical truth behind the joke is that in most recessions, unemployment – which tends to hover around 4% even during robust times – rarely tops 10%. Thus, even in most economic downturns, more than nine out ten people keep their jobs, muddle through, and end up just fine.

Also, because a recession is such a broad economic event, it may tell us little about the economic details affecting our lives. A recession is commonly defined as two quarters of decline in Gross Domestic Product, or GDP. GDP, in turn, sums up all business investment, consumer spending and government activity, amounting to a number almost too big to imagine, currently about $14 trillion in the United States. Hidden within this number can be huge discrepancies in the magnitude and severity of a recession in local and regional markets and different industries.

Finally, a recession is always called after the fact, meaning that economically, the sun is already out before we can tell that there was, in fact, a storm. Little wonder that the "recession watch" articles largely amount to data without a purpose.

Parsing rhetoric from fact in dour news reports fortifies our ability to adhere to sound investment policy and withstand volatile market waters. Indeed, during such times, investment policy is often all that stands between us and being on the wrong side of J.P. Morgan's observation years ago: "bear markets return stocks to their rightful owners" – i.e., those investors who fully appreciate the risk of stocks and have the time and patience to wait for their rewards.

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BFA Notes & Media Quotes
Website Revision
We recently updated BFA's website to better describe our services, including personal-trust services, and provide more detail regarding the types of clients we serve. The website also now has a "Newsletter" section that archives previous email newsletters and provides a form to subscribe. You can see all the changes here:
www.benningfieldadvisors.com.

Recent Media Quotes
Financial Advisor Magazine, March 1, 2008
Milo was quoted in David Drucker's article, "Blueprint for Success," which discussed the various resources that have made it easier to start a fee-only investment-advisory business than it was twenty years ago. Among them are industry studies and practice-management resources that allowed BFA to "start from the beginning with a paperless office, saving enormous cost and aggravation" and "helped [Milo] map out future business growth and a team-based approach to client service." Read the article.

That's it for now. Thank you for reading. Please look for our next newsletter in June. Until then, yours truly,

Milo Benningfield




1 U.S. large-company stocks are represented by the S & P 500 Index, foreign developed-country stocks by the MSCI EAFE Index.

2 "Legg Mason Fund Hits 26-Year Low," Washington Post, April 6, 2008.

3 "1st Quarter 2008: Market Review," Seeking Alpha, John D. Frankola.

4 "Warren's Well-Paying Weapon," Fortune, February 29, 2008.

5 "For Yale's Money Man, a Higher Calling," New York Times, February 18, 2007.

6 Pioneering Investment Management, David F. Swensen (The Free Press 2000), p. 329.

7 Pioneering Investment Management, p. 3.

8 Dalbar's precise figures have been debated, but no one disagrees that the average individual investor grossly underperforms their mutual-fund returns because of buying high and selling low. See, e.g., Winning the Loser's Game, Charles D. Ellis (McGraw Hill, 4th ed., 2002), p. 42 ("During the 15 years from 1982 to 1997 mutual funds averaged approximately 15 percent in annual returns. However, mutual fund investors averaged only 10 percent.")

9 Pioneering Investment Management, p. 329-30.

10 Pioneering Investment Management, p. 330.

11 Weston Wellington, Dimensional Fund Advisors, April 3, 2008 internal commentary, "Can You Afford to Retire?"

12 The balanced portfolio is represented by the DFA Global 60/40 Portfolio Class I (DGSIX).

13 "Americans Delay Retirement As Housing, Stocks Swoon," Wall Street Journal, April 1, 2008.

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