By Richard L. Kesner, President
The CommonWealth Group
November 2006Record highs on the Dow Jones Industrial Average and a year to date return of over 12% have clients smiling. The S&P 500 is approaching double digit returns and everyone is happily looking forward to more increases. We are starting to get interesting telephone calls from clients asking to be more aggressive and to capture more of these returns.
I need to caution everyone that markets (have we forgotten already) do go in both directions, and that when we see upward movements like the past quarter we are also likely to experience a correction. For those clients with cash sitting on the sidelines we will ask them to be patient as the managers will hold the cash, even increase it by taking profits and look to reinvest during opportunities like a correction.
We continually tell clients that short-term performance is a loser’s game, and the measurement of a manager’s effectiveness is not during the bull market runs, but in the bear market corrections. Short term performance is the speculators trap and chasing returns is not in our philosophy nor should it be with any serious investor.
ABSOLUTE RETURN STRATEGY
We do a lot of due diligence on the manager’s selected for client portfolios. The decision to hire a manager is based on the fit with the client’s overall philosophy. However, our first criteria for selection are downside market capture ratio and downside deviation. We want managers who protect principle and the reason for this is an application called “Siegel’s Paradox.”
“Sigel’s Paradox” is an application that states that equivalent magnitudes of negative and positive returns are actually not equivalent. Simply stated, a gain of 10% does not offset a loss of 10%. In order to get even the portfolio needs to gain 11%; or a loss of 50% requires a 100% gain to GET EVEN.
While the above may seem obvious to some, many investors do not understand the impact that losses have on the overall portfolio. We believe that losses are the most important thing to avoid while investing, and a grievous loss almost certainly precludes the possibility of a large return.
Consequently we are constantly researching managers in an attempt to identify those who can avoid future adverse conditions.
ASSET ALLOCATION
Second on the list of importance after manager selection (in our view) is asset allocation. This is an easy concept to understand as it means diversification of the portfolio into different investment sectors, like Large Cap, Small Cap, International or Fixed Income. Asset Allocation not only protects the portfolio against huge negative returns, but also allows for more protection through diversification of security selection and style.
The problem is that most investors look at asset allocation and immediately focus on the manager that is doing the worst for the short-term time period. We look at manager performance also, but we look at the performance of the manager vs their peers and vs the appropriate benchmarks. If as in the past quarter the small cap managers are underperforming the large cap managers it is noteworthy only if the manager in the portfolio is substantially underperforming their peers and comparable index. If that were the case we would have a dialogue with the manager to find out why the performance was lacking, we could visit the manager at his office, and we would determine if this underperformance would continue to affect the long term performance of the portfolio.
If our analysis determined that the underperformance was due to market conditions we would recommend putting additional funds with the manager who was not doing well. This would be like buying stocks on sale and it would benefit the portfolio in the long term.
Conclusion
Hopefully from the above you can determine that we are interested in (a) capital preservation and long-term positive returns. We do not want to chase returns, hire the hot manager of the month or move into the sector which has the best returns. That is a prescription for failure. The prescription for success is to develop a long-term plan with long-term goals and to stick to it.
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