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Quarterly Market O

Fourth Q

 

Outlook &

Quarter of

 

& Strateg

f 2013 

gy Letter 

 

January 20014 

     

 

Executive

The yedelivedeclinasset

We hasluggprofitare scnot be

The su

investhave oinclud

Stable

experdrag,”that, areturnpercerebala

Unfor

persoroarindramainoppcomp

The b

comforebalaexpenmore

e Summary

ear 2013 witnered a stellar ynes. Years likeclass perform

ave been conish economicability have im

crambling to celieve it is sen

uperior perfotments, despioften performde overseas in

e portfolios coiencing large ” which can halthough the n, even for thont. Diversificaancing can he

rtunately, mannal loss thres

ng back, they atically increa

portune timespound return o

asic principleortable risk prance the portfnses as low ascomplex, esp

nessed strikingyear, while USe the last one

mance is highl

cerned for soc & earnings gmproved in recatch up with nsible to eithe

rmance of USte attractive v

med better thanvestments, a

ompound mofluctuations. ave a significaS&P 500 hadose who manation, the incl

elp to mitigate

ny individualsshold, people then scrambl

ase the volatil. As a result,on their inves

s of successfurofile, one thafolio periodics possible. Wpecially for hu

g disparities iS Treasury bo make investoy variable fro

ome time abogrowth. Fortuecent monthsa rising mark

er chase the m

S markets ovevaluations. Aan those in thre less volatile

ore effectively Excessive po

ant negative i an average aaged to stay lusion of incoe the effects o

s do not stay iabandon once to rebuild tity of their po, they have sastments over t

ul investing arat can be maially to maintahile these pri

uman beings.

n the returns nds and otheors wish they m year to yea

ut the mismaunately, the g. Retail inves

ket. Regardlemarket higher

er the past yealonger histor

he United State and offer su

y, and may proortfolio conceimpact on retannual return invested thro

ome-generatinof volatility dr

invested whence-loved assetheir portfolio

ortfolios by buacrificed nearlthe past twen

re simple: (a)ntained throuain target allonciples are st

to various finer interest-sen

had bet morear, and chasin

tch between lobal econom

stors who havess of the actior or to retreat

ar has dimmerical perspectites. Well-diveuperior risk-ad

oduce higher ntration in risturns. Many iof 11 ½ perc

ough turbulenng assets in arag.

n times are tots and flee to

os after prices uying into andy five percent

nty years.

) maintain a wugh a range oocations; and raightforward

nancial assetsnsitive assets e on the winn

ng winners is a

rapidly risingmic cycle and ve been underons of other it from it in fea

ed enthusiasmive reveals thersified portfodjusted return

long-term resky assets crenvestors are

cent since 192nt markets—wa portfolio, an

ough. Once to cash. When

have risen. Md selling out otage points o

well-diversifiedof market env(c) keep fees,

d, their practic

Pa

. US equities experienced s

ning horse. Ya futile exerci

markets andcorporate rinvested in stinvestors, we ar.

m for overseasat foreign assolios, which ns.

eturns than thates “volatilitysurprised to l

28, its compouwas only 9 ½ d regular

hey reach thethe market c

Most investorof positions a

of annual

d portfolio wiironments; (b, taxes and ce is consider

age | 1

sharp et, se.

tocks do

s sets

hose y earn und

eir comes rs at

ith a b)

rably

     

 

Page | 2

-20

-10

0

10

20

30

40

Sour

Introduct

The year 2equities dgovernmeof US Treastock marreturns goperformanthose who

Not surprbonds (TIP5%; US mstocks, onperformed

Everythin

Years like may not wyear to threasons m

0

0

0

0

0

0

0

US Equity Int'l Equity

Figure 1. Bench

rce: Bloomberg

tion

2013 witnesseelivered a ste

ent bonds fellasury and morket took the oing back to 1nce fell into tho held US stoc

isingly, other PS) declined bortgage-back

nly developedd in line with

ng That Goes

2013 make inwin big the nee next. Chasi

most individua

High YieldBonds

Int'l RealEstate

US Est

hmark Asset Clas

ed striking disellar year, risin by a whoppi

ortgage-backeFed’s decision1993…1955…1he bottom 1%cks, or as poo

interest-sensby 9%; emergked securities foreign equithistorical tren

Around…

nvestors wish ext year. As Fing the winneal investors ea

Realtate

MunicipalBonds

Int'l TIPS

ss Returns

sparities in theng by 33% in tng 9% as the

ed securities. n in stride. Th1928…even to% of results ovor for holders

sitive assets loging market b

and investmety markets prnds, buoyed b

they had betigure 2 illustr

ers from year tarn substantia

S CorporateBonds

MortgageBonds

NRe

e returns to vtotal return teFederal ReseGiven genera

he S&P 500’s o 1878! By cover the past cof US Treasu

ost ground as onds fell by 6ent-grade corroduced sizabby improving

t more on therates, asset clato year is a fually lower retu

Naturalsources

EmergingMkt Equity

Int'l Bon

Q4 2

various financerms (includinerve began toally improving2013 gain pu

ontrast, the Ucentury. Few ury bonds.

interest rates6%; developedrporate bond

ble gains, risincredit fundam

e winning horass performanutile exercise, urns than the

nds EmergingMkt Bonds

US TsyBonds

013 12m

ial assets (Figng dividends) scale back itsg economic fuut it in the topS Treasury mayears have be

s rose: US infd country bons fell by 2%.

ng by 24%. Hmentals.

se—and forgnce is highly vand one of thbroad marke

US TIPS

gure 1). US ). By contrasts large purchaundamentals,p 10% of annuarket’s een as good f

flation-protecnds declined Apart from Uigh yield bon

et that same variable from he principal t indices.

t, US ases the ual

for

cted by

US nds

horse one

     

 

Notwithstmarket vaupper reathat rely ovaluationsmarket mhas been combinat

We have b2011—agdecade owglobal ecoindex, Figdispropor5). Foreig

Regardleshigher or

tanding the cualuations are sches of the te

on long-term s to the replacargin debt is customary. Aion that natur

been concernainst a mere wes to lower onomy is on aure 3), has imrtionately invegn investors h

ss of the actioto retreat fro

urrent widespstretched. Prierritory exploaverage US ccement cost oat record leve

Against this frrally worries m

ned about valu12% rise in eainterest rates a firmer footin

mproved in recested in bondave barely pa

ons of other inm it in fear. W

pread enthusiaice-earnings rred during pa

corporate earnof capital), areels, sentimentothy backdro

many investor

uations for soarnings. Moreand taxes—g

ng, and US cocent months. ds, are still scraarticipated in t

nvestors, we dWe prefer to

asm for US eqratios (as wellast bull markenings) and “Toe similarly elet is bullish, an

op, the Federars and market

ome time. Theeover, most ogains that canorporate profi Moreover, mambling to cathe rally, but

do not believeprudently reb

quities, many as price-boo

ets. Cyclicallyobin’s Q” (wh

evated. Specund investors aal Reserve is tt watchers.

e US stock mof the earningnnot be repeaitability (as pr

mutual fund inatch up with aare expected

e it is sensiblebalance expos

investors perok and price-sy-adjusted P/Ehich comparesulative activityre holding farightening liqu

arket has gaings improvemeated. On the proxied by our nvestors, who a rising stock to join, even

e to either chasures back to

Pa

rceive that stosales) are in thE ratios (i.e., ths market y is high; stocr less cash thauidity—a

ned 70% sincent over the ppositive side,“Goldilocks” remain market (Figutually.

ase the markelong-term ta

age | 3

ock he hose

k an

e late past

the

res 4-

et rgets.

     

 

Page | 4

Chasing t

the Wave

20%

30%

40%

50%

60%

70%

Jan-1986

Equ

Source: Invest

Figure 4. Equ

-50

-30

-10

10

30

Jul-07

Figure 3. Un

* Institute for S* Institute for S

Jan-1990 Jan-

uity as % of Total Mu

tment Company Institute

uity Allocations Fo

Jul-

nited States: Go

Goldilocks Index*

Supply Management NSupply Management N

-1994 Jan-1998

utual Fund Assets

e

ollow a Rising Mar

-09

oldilocks Index

* (left scale)

New Orders Index/PricNew Orders Index/Pric

8 Jan-2002

S&P 500 Index (rig

rket

Jul-11

x vs S&P 500

S&P 500 (3mma

ces Paid Indexces Paid Index

Jan-2006 Ja

ht scale)

Jul-

a, % change q/q, 6 mo

an-10 Jan-14

-13

onths later)

0

200

400

600

800

1000

1200

1400

1600

1800

2000

4

-30%

-20%

-10%

0%

10%

20%

30%

     

 

It may be causes yolarge wagbelieved, gridlock, tnotch mas500’s 201anticipateshould ha

For whatein 2014 thterm returbecause fgreater thprobabilit

The superinvestmenabout stabthe US. Itpractices aand risks ainvestmen

tempting to ur steed to ster on one hoat the beginnthe fiscal stalessive gains. P3 closing leve

ed a gain of “jave predicted

ever it’s (not) what they expecrn to US equitorecasts usua

he likelihood tties, not a pre

rior performannts. Whether bility in the emt was only a feand dysfunctiall across the nt strategy en

0%

10%

20%

30%

40%

Jan-1984Source: Inve

Figure 5. Th

bet on the fastumble and brse. As in rac

ning of 2013—emate, and goPrevailing foreel at 1534—a ust” 13%, welit; markets ar

worth, marketcted for 2013ties. Even so,

ally are wrongthat prices, noscription for i

nce of US mait be banking

merging markew years ago ional governmworld econo

nhances prosp

Jan-1988 Jan-estment Company Institute

he Great Rotation Is

stest stallion; reak its leg…i

cing, picking w—when investoovernment specasts of the mfull 20% beloll below wherre inherently u

t pundits exp: 6-7%. Thes, there is a go

g. The furtherot returns, willinvestment st

rkets over theg problems inkets, many invthat America

ment, seemedmy, as well as

pects for long

-1992 Jan-1996

s Underway

yet there’s aln which case,

winners in invors were besi

pending sequemajor banks aw where it ene the market unpredictable

ect the US stose forecasts aood chance thr an asset is trl revert to histtrategy.

e past year ha Europe, slowvestors perce, with its over

d most troubles great oppor-term return

Jan-2000 Ja

Fixed Income as %US Ten-Year Treas

ways the risk , you might w

vesting is notoeged with woester—that thand brokeragnded up. Evefinished the y

e.

ock market tore sensible, in

hat they will brading from ittorical norms

as dimmed enwing growth ineive opportunrleveraged coed. The realitrtunities. Maiwhile dampe

an-2004 Jan-200

% of Total Mutual Fusury Bond Yield (rig

of a lurking pwish you had noriously difficorries about Whe US stock mge houses pegn the most buyear. There’s

o earn roughlynsofar as theybe wrong—ants long-term fs. This is a sta

nthusiasm forn China, or reities to be be

onsumers, corty is that therntaining a gloning portfolio

0

1

2

3

4

5

6

7

8

9

10

08 Jan-12

und Assetsht scale)

Pa

pothole that not put such ult. No one

Washington market would gged the S&Pullish forecastno reason an

y the same rey match the lod not simply fair value, theatement abou

r overseas enewed worrieetter and saferrupt financiale are problemobally diversifo risk.

0

age | 5

a

P t nyone

eturn ong-

e ut

es r in

ms fied

     

 

Page | 6

Portfolio

Figure 6 sdebt, as cthe US maOver the lof dynamdiversifiedconcentra

Portfolio vmeasure othe averaginvestmenowner neethose whoretiremenhave highmay abanmust be deasier for that neces

50

150

250

350

1997

Figure 6

Globalizatio

hows the histompared to aarkets performlong term, theic markets—td portfolio waated strategie

volatility is anof volatility is ge return. Vont horizon, theeds to cash it o operate on t income nee

h expected retdon the strat

designed withmost people ssary cash can

1999 20

6. Cumulative Return

Globally Diversified

US-Only 60/40 Stock

on => Portfo

torical return a globally-divmed better, weir cumulativetheir total retuas less volatiles, with import

n abstract constandard dev

olatility is ofteere is a greatein—thereby tshort investm

eds. Over longturns. Howevegy before ga

h their owner’sto live with.

n be raised w

01 2003

n to US-Only vs. Glob

Portfolio

k/Bond Portfolio

lio Diversific

to a US-only ersified portfo

whereas at othe returns haveurns were virte. Indeed, wetant implicatio

cept, one thaviation: the pen considereder probabilityturning a pap

ment horizonsger horizons,

ver, if a portfoaining the bes risk tolerancAdding less-vithout incurrin

2005 2007

bally Diversified Inv

cation

investment polio with the s

her times the e been very siually identicall-diversified ons for long-

at is unfamiliaercentage dis

d to be synony that a volatilper loss into a or who are dprincipal risk

olio’s fluctuationefit of thosece in mind, anvolatile and/ong a permane

2009 2011

estment Portfolio

portfolio compsame equity sglobally diverimilar. Indeed

al. The key dportfolios areterm returns.

r to many peospersion of da

nymous with rle asset will ban actual loss.drawing fromk diminishes, sons are unco

e high returnsnd why broador uncorrelateent loss of pri

2013

prised of 60%share. Duringrsified portfold, up until 20difference is the always less v

ople. The moaily or monthrisk since, ovee trading at a. This is partictheir portfolio

since volatile mfortably larg

s. For this readly-diversified ed assets to a incipal.

% equity and 4g certain periolio did better.13—after 15 yhat the globavolatile than m

ost common ly returns aro

er a fixed a discount whcularly true foos to meet assets typicalge, the investson, portfolio strategies areportfolio ens

40% ods . years lly-more

ound

hen its or

ly tor os e sures

     

 

Figure

Year 1

Year 2

Year 3

Year 4

Arithm

Geome

Cumu

The Torto

A more suvolatile is the financ

This conceor portfolsimple exayear, the sthat 40%

This may swith identcompoun

The more compounasset’s ret

The reasothe risk (acuriosity—oil drillingin mainstraverage aNote that returns cleoutliers th

e 7. Simple

metic average

etric average

lative return

oise and the H

ubtle, but no an asset (or p

cial equivalent

ept, known asio’s arithmetiample. Suppstock gains 40gain is comin

seem like an otical average rd return that

volatile the ad returns. Asturn, squared.

n volatile assnd performan

—a phenomeng rights, or tecream investmnd compoundthe median r

early are not—hat create vola

vs Compoun

(simple) retur

(compound) r

n

Hare

less importanportfolio’s) rett of the race b

s volatility drac average retu

pose you own0%. The averg off a smalle

obvious examreturns, but dwinds up in y

asset, and thes an approxim. It rises nonl

ets have highnce drag) of hnon that mattchnology stocents such as d returns for returns within—because theatility drag, an

nd Returns (in

rn

return

nt, advantage turn profile, tbetween the t

ag, is represenurn and its ge

n Apple stock,age return mer base. If you

mple, yet mostdifferent volatyour bank acc

longer the timation, volatili

inearly with v

h expected retholding themters only for hcks. On the colarge-capitalizthe S&P 500,

n each asset ce averages arend dampen co

n %)

of diversificathe more constortoise and t

nted mathemeometric avera which experiay be zero, buu started with

t people don’ilities, will hav

count. A seco

me horizon, tty drag is one

volatility (Figu

turns is becau. You might t

high-octane inontrary, the ezation US stoUS Treasury lass are quitee influenced bompound ret

Asset A

8.0

8.0

8.0

8.0

8.0

8.0

36.0

tion is superiosistently its gathe hare: stea

atically by theage return. Itiences a sharput you have nh $100, you n

’t grasp its cove different coond illustratio

the greater is e-half times t

ure 8), and its

use investors think that volnvestments sueffects of volaocks. Figure 9

bills and US Te consistent ovby outlier yeaturns.

A

or compoundains compounady often triu

e difference bt can be illustp decline of, snot recouped ow have $84.

onsequence: ompound retun makes the p

the impact ohe standard deffects comp

need to be coatility drag is uch as speculatility drag are9 below showsTreasury bondver time. How

ars, such as 20

Pa

Asset B

30.0

-5.0

15.0

-8.0

8.0

6.9

30.7

ding. The lessnd over time. mphs over sp

between an asrated with a say, 40%. Theyour loss, sin

two investmeurns—and it ipoint clear:

f volatility ondeviation of th

pound over tim

ompensated fmerely a finaative real esta

e readily appas the annual ds since 1928wever, averag013. It is thes

age | 7

s It’s

peed.

sset

e next nce

ents s the

he me.

for ancial ate, arent

. ge e

     

 

Page | 8

Many inveaverage ainvested thpercentagbut when volatility d

Volatility dIncome-gstability inportfoliosthey exhibportfolio a

Note that bills, reducharacteriencompassensitivityportfolio, without a with a por

0

2

4

6

8

10

12

14

0.00

Redu

ctio

n in

Com

poun

d Re

turn

Figure 8. Vo

estors—even nnual return hrough turbulge points per

compoundeddrag looms la

drag on moreenerating ass

n their returns by enhancing

bit little price assets with w

even a modeces volatility istics dampenssing not only

y to economicsuch as emergreat deal of

rtfolio’s other

0.10

olatility is a Drag

sophisticatedof 11.5% sinclent markets—year over thed over the 30-rge (nearly 20

e stable assetssets such as bs, by virtue of g the compouvolatility, thehich they are

est amount ofdrag conside

ns a portfolio’y different assc factors—therging market f risk—providr investments.

0.20

Standard D

d ones—are suce 1928, the co—was only 9 ½e past hundred-year life of a0%) relative to

s, such as US bonds (or real f their fixed counding of retuy contribute ilowly (or eve

f diversificatiorably. That iss fluctuationsset classes, bue greater is thestocks, interned these asse. Diversificati

0.3

Deviation of Asset or Po

urprised to leompound ret½ %. The volad years. That retirement po this decade

Treasury billsestate, or div

oupon or steaurns. Indeed,income whichn negatively)

on, i.e., a simp because com

s. The more faut also geograe reduction in

national real eets are kept inon is the prov

30

rtfolio

earn that althoturn, even for atility “haircut may not souportfolio, is moe’s lower avera

s and bonds, ividend payingady dividend. , the advantagh smoothes re

correlated.

ple 50/40/10 bmbining assetar-reaching thaphies, investn volatility. Aestate, or comn proper propverbial free lu

0.40

ough the S&Pthose who mat” has averag

und like a lot iore than 80%age equity ret

is smaller, at ag-stocks) exhi These investges of bonds eturns, and th

blend of US ss with differehe diversificattor classes, ins

Adding “exoticmmodity futureportion and arunch in invest

P 500 delivereanaged to stayed two in any given y

%. Moreover, turns.

about 5%. bit greater tments benefiare three-fol

hey diversify o

tocks, bonds nt risk and retion—struments andc” assets to a es, can add rere little correlating.

ed an ay

year,

it d:

other

and turn

d

eturn ated

     

 

Stocks an

In sum, wvalued USbetter to iequities (p(by virtue in the sunplace in a (albeit moattractivenequities (b

In love, asdisaster. Amarket vocomplacehistorical

Figure

Median192819642004

Arithm192819642004

Geome192819642004

nd Bondage

hile it may beS equities to ainvest in othepotentially, reof being utte

n. And, yes, thportfolio: as

odest) return, ness of bondsby virtue of th

s May West saAlthough the

olatility of the nt at a time wnorms, the hi

9. Annual R

n Return8-20134-20134-2013

metic Averag8-20134-20134-2013

etric Averag8-20134-20134-2013

e tempting to a portfolio thaer assets that eal estate). It erly unloved, shere will be bo a hedge agaand as a mea

s relative to stheir greater vo

aid, too muchre is no obviopast few yea

when latent vogh-flying, hig

Returns to U

S&P 500

13.31%14.22%13.31%

ge Return11.50%11.29%9.10%

e Return9.55%9.89%7.34%

double one’sat already hasstand to benealso makes sesuch as emergonds. Even ininst disappoin

ans of portfoltocks over theolatility) could

h of a good thous trigger fors should notolatility is highghly-concentr

US Assets sin

T-Bills

3.24%3.23%3.20%

3.57%5.11%1.56%

3.53%5.07%1.54%

s bet on the ws a large servinefit from the sense to includging market sn a rising intenting economio diversificate longer termd suffer more

hing can be wr a big declint be viewed ash. If and wherated tradition

nce 1928

T-Bonds

3.45%3.61%3.63%

5.21%6.97%4.69%

4.93%6.56%4.27%

winning horseng of them) itsame forces tde some assetstocks). Theserest rate envi

mic outcomestion. Rising in

m. Even so, in e in the transit

wonderful. Hoe in the US sts a panacea—en lofty US eqnal portfolio m

50/40/10

9.10%9.15%9.10%

8.19%8.95%6.58%

7.68%8.55%6.40%

e (i.e., to add mt is not prudethat have beets that are atte will eventuaronment, bon, as a source

nterest rates mmany reason

tion to higher

owever, in invetock market, t

—investors havquity valuationmay be hit the

Pa

more highly-ent to do so. n supporting tractively valually enjoy theinds have theirof consistent may diminish nable scenarior rates.

esting it can bthe subdued ve become ns revert to e hardest.

age | 9

It is US

ued ir day r

the os,

be a

     

 

Page | 10

Annual avera20-year10-year

Compound re20-year10-year

Figure 10. Q

Staying th

As noted during turmarkets aflee to casthe volatilprices havreturns—a

The Dalbareturns fro

Over the pbelow thetheir bondstrategy. selling ouannual coinvestmencontext. Adecades—same erro

                  1 These esInstitute (Iunrealized

age return

eturn

QUAIB Survey of I

he Course

above, volatilrbulent timesre falling. Onsh. Excessivellity. When thve risen. For ta shortfall tha

ar Corporationom stock, bon

past twenty ye 8% compoud allocations, In effect, invet of positions

ompound retunts. Figures 4At the beginn

—precisely whor with stocks

                       stimates are imICI), and take d capital gain

EquityFunds

9.088.71

4.256.05

nvestor Returns

ity drag erod. Unfortunatence they reachly concentratee market comthis reason, inat is exacerbat

n’s Quantitatind, and asset

ears individuand return of tearning a far

estors dramats at inopportuurns on their e4 and 5 above

ning of 2013, ren fixed-incoas they scram

                   mputed from account of sa

s, dividends, i

Bond AFunds

2.961.57

0.981.17

Individual Inv

es long-term ely, most indivh their personed portfolios

mes roaring bandividual inveted by high m

ive Analysis ofallocation fun

al investor eqthe US stock mlower return

tically increaseune times. Asequity investme illustrate thiretail investor

ome valuationmble to catch

data on mutuales, redemptinterest, tradi

Asset Alloc.Funds

6.644.58

2.292.38

vestor Returns

returns evenviduals have anal loss threshare a commoack, they thenstor results h

mutual fund fe

f Investor Behnds since 199

uity returns cmarket. Sadlythan could h

ed the volatilis a result, theyments, and fivis counterprors held their hs were least aup with a risi

ual fund holdtions and exchng costs, sale

vs.

60/40Blend

6.635.85

2.944.10

for those wha hard time mhold, people aon reason indin scramble toave been subees and exces

havior (QAIB) 93.1 These re

compounded y, individualsave been obtity of their poy sacrificed n

ve and a half pductive behav

highest allocaattractive. Noing equity ma

ings collectedhanges. The

es charges, fee

S&P 500 USTr

9.898.72

8.147.03

Index

ho manage tomanaging theabandon onceividual investo

o rebuild their bstantially lowss trading cos

reports indiviesults are sum

at an annual fared even w

tained with a ortfolios by buearly four perpoints on thevior in the cution to bond

ow investors aarket.

d by the Invesestimates capes and expen

S 10Y 60/easury Ble

7.07 8.75.64 7.4

6.65 8.25.31 7.1

x Returns

o stay investedir emotions we-loved stockors can’t stom portfolio afte

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