First Quarter Review 2008

The following is a guest post from Marotta Asset Management.

The first quarter of 2008 made the difference between well-designed portfolios and poorly designed portfolios obvious. Check your quarterly statement to see which category describes your portfolio.

You may hesitate to change your investment strategy even if you suspect performance is suboptimal. Perhaps you believe your current investment mix went down so much simply because of the markets and will go up when the markets rebound. But this assumption is faulty.

Systemic problems, not market volatility, explain why some portfolios performed extremely poorly in the first quarter. If your asset allocation was unbalanced, you took the brunt of the drop because you are invested primarily in U.S. large-cap stocks. An unbalanced portfolio will continue to be unbalanced and gyrate randomly rather than progressing steadily toward your goals.

Furthermore, if your underlying investments are laden with fees, they will continue to be even after the markets rebound. It may be difficult to see you are paying too much in hidden fees and expenses when the markets are going up. But when they go down, excess fees add insult to injury and exaggerate your losses.

We design portfolios using six asset classes, three for stability and three for appreciation. The three for stability are (1) short money (maturing in less than two years), (2) U.S. bonds and (3) foreign bonds.

1. Short money, such as cash, money market and CDs, continues to be the riskiest investment since 2002. Cash can be dangerous. When our currency decreases in value, we experience inflation and the purchasing power of our dollars is compromised. Having the same number of dollars doesn't do you any good if they won't buy as much as they used to.

The Federal Reserve lowered the rate of federal funds from 4.25% to 2.25% this quarter. It lowered the discount rate (the rate at which a limited number of institutions can borrow directly from the Fed) from 4.75% to 2.25%.

As a result, the dollar continued to slide in value, deteriorating several percentage points in the first quarter. The Euro rose about 3.4% against the dollar. The U.S. Dollar Index, measured against a broader basket of currencies, dropped about 5.3%. Even the Japanese yen rose over 8%. Finally, the price of gold went from $840 an ounce, past $1,000 and back down to $916, ending up over 9%.

This loss of the dollar's purchasing power means that losses in all other categories were compounded. Not only did the U.S. stock market lose value in dollars, but the remaining dollars were worth even less. Three of the six asset classes protect you directly against a falling dollar, and more than half your portfolio should be in these investment classes.

2. The second asset class in stability is U.S. bonds. The Lehman Aggregate Bond Index was up 2.17% in the first quarter. Annualized, that would produce an 8.68% return. Treasury inflation-protected bonds provide some protection against a dropping dollar and appreciated 5.18% in the first quarter.

Having the right balance of stability to appreciation (fixed income to equities, or bonds to stocks) is important for a portfolio's behavior.

Adding bonds to an all-stock portfolio can actually boost returns over the long term. When an all-stock portfolio performs poorly, you just have to wait for it to rebound. But when a portfolio is stable and the stock side bounces down, the natural process of rebalancing sells bonds at their high and adds to stocks at their low. This contrarian move helps the portfolio as a whole rebound more quickly by adding to the stock side when it is down.

Even in a very aggressive portfolio, bonds provide a stable store of value waiting for a market correction. This "dry powder," or cash on the sidelines, can be invested into the markets after a drop to help your portfolio rebound quicker.

3. Foreign bonds, the third asset class in stability, protect you better against the weakening of the dollar. They did very well in developed countries, appreciating nearly 10%. But emerging market bonds were flat. A mix of mostly developed countries and a third in emerging market bonds would have produced a return of around 7%.

The three additional asset classes for appreciation are (4) U.S. stocks, (5) foreign stocks and (6) hard asset stocks. U.S. stocks did the worst.

4. The Dow was down 7.55%, the S&P 500 was down 9.44%, the Russell 2000 lost 9.90% and the NASDAQ lost 14.07%. The average daily volatility in the first quarter was 1.21% compared with a historical average of 0.75%.

Value stocks lost less than growth with small value doing the best, only losing 5.28%. Oddly enough, small growth did the worst, losing 14.40%. Small- and mid-cap stocks have soundly outperformed large cap over the past five years, so your portfolio should tilt toward small and value.

Technology stocks did the worst this quarter. The sectors that lost the least were consumer services and consumer goods.

So U.S. stocks were definitely down. But if your U.S. stock losses were approaching 10%, one of three things is probably wrong with your portfolio: You have all U.S. large cap stocks, you are overly invested in volatile funds or your excessive fees are dragging down your investments. You can view the expense ratio on every fund you own at www.morningstar.com.

5. Many foreign markets fared even worse. Emerging markets were down 11%. Britain's FTSE was down 11%, France's CAC was down 16.3%, and Germany's DAX was down 19%. The EAFE foreign index, however, was only down 8.91%.

The 11 countries we recommend with the most economic freedom fared better than average, only losing 8.23% for the quarter. Overall, your foreign investments should have done slightly better than your U.S. investments. We believe foreign stocks provide better country diversification and also protect your investments against the devaluation of the dollar.

6. The third asset class for appreciation is hard asset stocks, which include companies that own and produce an underlying natural resource, such as oil, natural gas, precious metals (particularly gold and silver), base metals such as copper and nickel and other resources such as diamonds, coal, lumber and even water.

These stocks exhibit a unique set of characteristics: They have a low correlation with other stocks and bonds and they appreciate with inflation.

Gold and oil both hit record highs in March. They then fell 12% and 11%, respectively, in just three days. Crude ended the quarter up 5.9%, gold was up 10.3% and natural gas was up 30.9%. These commodity prices affect the long-term price of hard asset stocks. With the gyration in prices, hard asset stocks have been much more volatile than normal and lost 4.89% this quarter.

Asset allocation means always having something to complain about, but it also means always having something to be glad about. The S&P 500 was down nearly 10%, but a well-balanced portfolio should be down much less. Don't assume that everything is down the same. Some portfolios just can't overcome having all their assets in large-cap U.S. growth stock funds with excessive expenses. And because they are poorly designed, these portfolios won't rebound as quickly with the markets.

Take the time to compute your first quarter's returns and determine if your investments are designed to meet your goals. It's an excellent opportunity to review your asset allocation and investment selection.

Comments

[rwh]

We try to maintain a 60/40 allocation and were down 4% the first quarter. We're a little light on TIPS, making up less than 3% of the portfolio. I'm not sure if we'll increase that exposure. Inflation could gear up, or the FED could start moving interest rates up.

You made this statement: "Three of the six asset classes protect you directly against a falling dollar, and more than half your portfolio should be in these investment classes."

Which 3 asset classes are you referring to?

[Zook]

"Three of the six asset classes protect you directly against a falling dollar, and more than half your portfolio should be in these investment classes."

Never heard of this...As a 20-something, I simply don't believe this is even in the ballpark of a recommendation I would be interested in...MORE THAN HALF of your investments should be in cash, CD's, MM and various Bonds? Yeeesh.

This is just flat out bad advice for the typical blog reader of FMF...

Sounds kind of like market timing...

[Rod Ferguson]

rwh - I believe that would be foreign bonds, foreign stocks and asset stocks.

I would disagree with Marotta somewhat, however. My current ratio is 75/25, with the majority in foreign asset stocks, foreign equities, metals and foreign currencies. The remaining 25% is domestic stocks, money markets and cash, and I'm about to drop that to 10% and increase my metals and asset stocks positions; I'm almost to the point where my Cost Average as referenced in silver and gold has reached parity with prices (and Dr. Copper looks to be saying that base metals are about to go up again) - both are a sign for me to buy :) In the first quarter, I gained about 7%; foreign equities were down, currencies up, metals up, asset stocks slightly up, cash down, money markets level and domestic stocks slightly down.

[Zook]

He was referring to #'s 1-3 as the 50+ percent allocation not your hand selected choices.

[rwh]

How can short money, i.e. cash, protect against a declining dollar?

[Zook]

I am really interested in hearing more on how an across the board 50+ percent in bonds/cash/CD's is something I should be looking into for my portfolio.

I would really LOVE for Marotta...Just ONE time to come on here and go a bit more in depth...

[Rod Ferguson]

Zook - Neither cash, US bonds or US stocks could be classified as "protection against a falling dollar" as all three are dollar denominated. US asset stocks (the author doesn't distinguish between foreign and domestic stocks in this class) can be viewed as a dollar hedge only due to the general inverse corrolation between asset prices and dollar value - and that isn't all that consistent and has only been a condition fairly recently.

I see how you could come to that conclusion, though. The author injects the comment about three dollar hedges in the middle of a description of three "stable" and three "growth" classes. I'd call it an editorial mistake; it should have been mentioned separately under it's own heading.

[Zook]

I get ya Rod...I don't think that is what he meant however unless the article was written by a new language learner...

If the article reads that way (and it does) it should be taken down IMMEDIATELY.

[Sue]

This letter is designed (and timed) to scare people into pulling out of their investments and switching to this asset management company. Shame on them.

[FMF]

Zook --

I don't take down posts simply because they are unpopular (or even inaccurate.) This is the author's point of view. He's entitled to it and you're entitled to disagree.

[Zook]

Fair enough.

What Rod is suggesting is that the article has a MAJOR mistake. I don't believe it does and I do believe that Marotta or someone else should come on here and explain this post. I do believe Marotta is suggesting exactly what is stated in this post with no editorial errors.

Suggesting that your portfolio should have over 50% in CD's, CASH and bonds, across the board, is on its face, foolish. It smells like really bad market timing into CASH/bonds of all things. Yikes.

The article reads to me as market timing and I disagree that there is any "mistake" as Rod suggests. This is shameful and basically churning an account.

[FMF]

Zook --

As I said on a different post today, this blog is about presenting different financial perspectives (even if many people (most?) don't like a few here or there.) Besides, if it's just me ranting on every post, you all get bored, don't you? ;-)

[Zook]

Agree.

However, if I submit an article to you that states the year is 2006, it is a mistake worth noting and fixing. If there are errors, it isn't about perspective, it is about fixing them to make sense to the reader.

I don't think this should be pulled. Rod seems to think the article is one big editorial mistake. I on the other hand think Mr. Marotta believes this crap and would love to hear more.

[Jake]

"Short money, such as cash, money market and CDs, continues to be the riskiest investment since 2002."

Anyone who thinks that TBills and CDs are riskier than equities, junk bonds, hedge funds, private equity, venture capital, subprime mortgages, etc, has just failed investments 101 and should not be listened to regarding things financial.

[Jake]

"Adding bonds to an all-stock portfolio can actually boost returns over the long term."

I get his point about rebalancing, but I'd love to see any example of a period spanning 30+ years in which a 80% stock / 20% bond portfolio rebalanced annually would outperform a 100% stock portfolio. I would be shocked if there was a single one in the USA in the last century.

[Jake]

" But if your U.S. stock losses were approaching 10%, one of three things is probably wrong with your portfolio: You have all U.S. large cap stocks, you are overly invested in volatile funds or your excessive fees are dragging down your investments."

Sorry for multiple posts, but WOW... He posts this right after giving the return characteristics for several stock categories... and the numbers HE PROVIDES show that if you invested in index funds with NO EXPENSES and split equally between the S&P 500 and the Russell 2000 -- in other words, between large and small caps -- you would have lost over 9.5%! That's certainly approaching 10%, right? What if you had a 10% weight in a small cap growth index fund and had 0.15% expenses, you'd be over 10% right there.

[Rod Ferguson]

Zook - I never said the whole article was an editorial mistake, just the insertion of the "Three of the six asset classes protect you directly against a falling dollar" in the middle of talking about "stable" and "growth" classes. Imagine that statement as a verbal aside; when you are talking to someone, people can usually sort those out pretty easily when you observe body language and hear vocal tone, but when you write it down it becomes downright confusing without the help. That's why editors exist - they, by not being inside of your head, only read what you've written and can point out when things that make perfect sense to you make no sense to them so you can correct the mistake before you publish. Upon re-reading the article, I think he didn't have an editor at all; I think he just wrote it stream-of-consiousness and published.

Now, that's not to say that I agree with the author on the rest of the article. As FMF points out, he has his point of view. I disagree with some of it - especially the weightings he suggests - but it's his point of view based on the data he's accumulated. I hold cash (and I'm pretty bearish on the US at this point) because I can't predict the future and I do not wish to put all of my eggs in one basket; that's how wealth is lost.

[Zook]

Well I just got through pounding my head against a wall.

The point we are discussing is the lynch pin of the entire article. The rest is standard "stuff". This isn't verbal. This is written and it happens to be Marotta's 167th piece on the site. I would assume the guy writes what he means, no?

Rod: There isn't any mistake. This guy believes that you should have over 50% in the first three asset classes and that is exactly how it reads. You can't pick a sentence and say it applies to something other than what the author conveys. You are taking your own opinion and inserting in here.

And again, for the 4th time. If that is the intent of the author as you suggest, the article has a major mistake and should be taken down.

[rwh]

Jake:

I don't know if there is data that an 80/20 stock/bond portfolio will outperform a 100% stock portfolio over 30 years but there is plenty of data that blended or balanced portfolios are significantly less volitile.

I don't think you can take a 30 year "snapshot" of a portfolio. How many people stay fully invested in stocks for a 30 year period? If you do, or plan to, you are much braver then me.

Last year Kiplinger's published a study that showed over any 10 year period back to 1926 a 60/40 portfolio returned over 80% of a 100% stock portfolio with about 20% of the volatiltiy.

[Michael Blackburn]

Zook: I took the "three out of six" comment the same way Rod did. It makes no sense whatsoever to say that CDs and Bonds are a dollar hedge. However, knowing he wasn't talking about those two assets, I skimmed down to find which of the six he's talking about. Not exactly what you're looking for in reader behavior.

However, I agree with Rod (again) that suggesting 50% of your assets should be in foreign bonds, foreign stocks and commodities is most certainly a terrible, terrible recommendation. It's market timing, it's chasing performance, it's just a bad idea. It's my opinion (and admittedly, I don't have a fancy asset management firm) that you should base your investment decisions strictly on the timeframe for using the money, and your time available to manage your assets. Unless it's your job to pay attention to the market, pay no attention to the market.

What's more, and this is to FMF, this advice is counter to your own sensible, non-ideological, no-foolishness approach which has brought you your audience. I approve of you bringing in guest bloggers. I would recommend replacing this particular one. It's not that "he's entitled to his opinion, and I'm entitled to disagree." It's that his articles are poorly conceived and then poorly written. You can say in the comments that you're not responsible for the content, but the fact is that if it's on your site, it's there because you put it there.

[FMF]

Michael --

1. I hear you. I understand the last part of what you're saying in particular.

2. I'm not replacing this post -- that's contrary to the spirit of this site. I HATE it when sites put up one thing, then change/delete it without notice, so once something goes live here, it's live for good unless it's deemed to be illegal, slanderous, etc.

3. As I said on another post, I've written Mr. Marotta and asked him to come and address these issues. If he does, then I think it will make for some good conversation. If he doesn't, I'll need to re-evaluate how much (and what part of) his stuff I publish in the future.

4. Occasionaly, there will be stuff here that people don't like (stop by on a Sunday if you want a good example of that.) That's ok to me. I can't think of any site where I like 100% of what's said, though I have many sites I frequent regularly.

For those of you interested, I suggest you follow this post over the next few days to see if Mr. Marotta decides to comment or not.

[David John Marotta]

Author post (from David John Marotta):

Thank you for reading the column and for your comments.

Sorry to have confused matters. In editing I lost the explanation behind this sentance:

"Three of the six asset classes protect you directly against a falling dollar, and more than half your portfolio should be in these investment classes."

The three asset classes (of the six) that protect against a falling dollar are:
3. [unhedged] Foreign bonds
5. Foreign stocks
6. Hard Asset stocks

It was inserted as a comment under short money because many people wrongly believe that cash, money market and CDs are without risk. The risk is a drop in their purchasing power and in retrospect it has been the riskiest of the asset classes over the past few years.

Again, I apologize for the confusion. The column was way over the word limit and the details were trimmed from that paragraph.

Regards,

David John Marotta

[Michael Blackburn]

FMF: Agreed. I don't think you should take anything down. We all appreciate that this is your world and we are but small fuzzy marsupials. I particularly appreciate the way you actually live up to the dictates of your creed, including that you spread the Good News.

Mr. Marotta: Thanks for coming out. I see now the thought process behind your statement, and why you placed it in that section. It is absolutely correct that calling cash "without risk" is inaccurate (most marketing materials I see nowadays specify "without market risk").

If I may address your writing style, my primary critique is that something about your tone made your Q1 recap read as either a recommendation for Q2 (in my opinion, not a good idea) or a "you shoulda done this" (which reads as unhelpful at best). If you intend to discuss two topics, recapping the past quarter and making recommendations for the second, you must make them more distinct, perhaps seperate posts.

As the son of an English teacher, these comments are intended simply as feedback on the writing, not the content of the post, which is not my area of professional expertise.

[Jake]

"I don't know if there is data that an 80/20 stock/bond portfolio will outperform a 100% stock portfolio over 30 years but there is plenty of data that blended or balanced portfolios are significantly less volitile. "

Yes, this is true, and would have been an excellent point if it was what Marotta was saying.

[David John Marotta]

Author post (From David John Marotta):

"If you intend to discuss two topics, recapping the past quarter and making recommendations for the second, you must make them more distinct, perhaps separate posts."

I accept the criticism that I was trying to do too much in the article. It started twice as long as the published version, but I really didn't want to spend more than one column on rehashing the past quarter so I edited it down.

Most people don't review their portfolios very carefully. Few know with any precision how their own portfolio did. So when the nightly news says it was a down quarter and their portfolio is down their analysis stops there.

But down portfolios (even more than up portfolios) are an opportunity to see how well your portfolio is constructed.

There is down and then there's *really* down.

The S&P500 was down -9.44% in the first quarter, but a more balanced portfolio might only have been down 4% (money under our management was down 4.08% after all fees and expenses). Some portfolios, because they are both poorly allocated and laden with high fees and expenses are down much more than 10%. It is easier to hide excessive fees when the markets are going up.

So I accept the criticism that the intent was to make people who have unbalanced portfolios with excessive fees dissatisfied with the financial advice they are receiving. It is difficult to suggest that you should check your returns to see if you are being taken advantage of without coming across as fear mongering, but much of the financial services world does not sit on your side of the table and has no legal obligation to act in your best interests. You would be better off learning enough to do it yourself from sites such as freemoneyfinance.com

If you are looking for a financial advisor, I recommend finding a NAPFA advisor in your area through napfa.org (All these advisors are in competition with me so this is like Macy's recommending Gimbles) NAPFA advisors receive no commissions and have take a fiduciary oath to act in their client's best interest.

I also work with the NAPFA Consumer Education Foundation (NCEF) trying to help consumers get good objective financial advice. I view the column as a format to give away advice, not solicit clients. Most of our clients live in the Charlottesville Virginia area.

Regards,

David John Marotta

[Mike H]

This article gives some very interesting analysis of the advantages of a widely diversified (low correlation) portfolio (particularly when withdrawing funds during retirement). I recently came across a link to this on another blog but thought it might tie in with this discussion. The charts on pages 5 and 6 of the article are of particular note. (Be warned that it is rather dry reading.)

http://www.indexuniverse.com/component/content/article/3220.html?issue=121&magazineID=2&Itemid=11

It's not quite the 80/20 scenario mentioned above, but seemed relevant enough to mention.

[Michael Blackburn]

Interesting thought, and in the part of your comment directed to me, well stated. I'd suggest keeping your blog posts as tightly focused. When editing next time, pay less attention to your word budget, but be absolutely ruthless in excising commentary or thoughts that do not immediately support your thesis.