LFM&P
Linnard
Financial Management & Planning, Inc.
Registered Investment Advisor
January
1, 2007
The several months since the last issue of Outlook & Trends have borne out our suggestion that the financial markets were strong and seemed to be following the four-year presidential election cycle. As this issue is written, there are no over-hyped media stories to clarify or crises to explain. Instead, we have instead taken this opportunity to present a story at the end of this letter that compares common financial approaches to a sailing voyage. It shares several conclusions that we have distilled over years of separating fact from often-repeated financial fiction.
In each of the last two January issues, we have updated you on the results of our MarketAwareSM risk management approach. They are also included again this January on the enclosed sheet. The results continue to show that it has been possible to achieve good investment returns while simultaneously managing risk through asset allocation.
On
March 20, 2007, David will be presenting another class through the
Concord-Carlisle Community Education program. This one is entitled “Asset
Allocation and Your Investment Results”. Asset allocation is the primary
factor that determines the results your investments will achieve. Since many
people’s financial future is strongly influenced by their investment results,
asset allocation exerts a major influence on financial health. If you would like
to find out more about what it is and why it is important, please join us. You
can get registration information at http://ace.colonial.net
or call (978) 318-1540.
Economy
This type of
economy is often referred to as “Goldilocks”, named after the baby bear’s
porridge that is “just right” -
not too hot, and not too cold. Unemployment remains low at 4.5%. The growth rate
of consumer prices has dropped back to just below 2% along with lower oil
prices, giving the Fed little immediate reason to raise interest rates. The real
domestic economy grew at an annual rate of 2% during the third quarter, which is
below normal and also less than the prior quarter’s measurement of 2.6%, but
corporate profits continue to rise strongly at the same time. The 30% annual
profit increase recorded by the government’s Bureau of Economic Analysis is
the strongest since 1984. Although analysts are suggesting that this rate will
moderate to 9.7% by this time next year, continued profit growth is expected to
be helpful to equity investments.
The
economic dark spot continues to be home construction and sales, which is the
sector that helped to reduce the economy’s overall growth rate when mortgage
interest rates increased. The median existing US home sale price dropped 3.5%
over the last year. The South led the decline with a 7% drop, followed by the
East’s 5.2%. Home sales may be stabilizing, however, as sales of existing
homes have increased slightly and the number of months worth of houses offered
for sale has leveled off.
Financial
Markets
In comparison to real estate, the stock market (as measured by the S&P 500) turned in a better than average year, returning 15.7%. Bonds only returned about 2.1%. Bonds and stocks together would have produced an overall gain of about 8.7% in a typical balanced portfolio consisting of Exchange Traded Funds (ETFs). A similar account that contained regular open-end mutual funds would have gained about 7.8%, slightly less than the ETF approach, reflecting higher mutual fund management fees. Stock gains came during the last half of the year when the Fed stopped raising interest rates, leading the usual upturn in the four-year presidential cycle by several months. The relative out-performance of equities versus real estate was just the opposite of our experience during the first several years of the decade. This is a good time to look back and recognize that the path to wealth is not paved with only stocks, bonds, real estate or commodities. Each is just a different type of asset that will have good times and bad. In our view, successful investing comes from maintaining awareness of economic and market conditions and a long-term commitment to the investing process, but not being inflexibly married to a single investment or asset class.
An Allegory
Let
us tell a fictional story about three sailing ships for hire in a harbor on the
east cost of the US. All three were very similar, very capable ocean-going
vessels.
The
person who hired the first ship had no particular destination in mind, and after
an enjoyable morning's sail down the coast a storm began to brew. The novice
traveler became fearful and demanded that the ship return to the safe harbor. He
gained some experience from his sail, but accomplished nothing else for his time
and expense.
A
second voyager hired the next ship with the intention of crossing the ocean and
reaching England. Although he had a firm destination in mind, this person
decided to economize and sail by himself. He was successful and prosperous in
his own trade, but his seafaring knowledge was limited. He had believed the
shipbroker, who told him that with this very special ship, he need not worry
about high winds and storms. He should just keep half of the sails raised at all
times.
He could lash the wheel and the ship would steer itself in a
northeasterly direction while he slept comfortably in his cabin. Unfortunately,
when the inevitable storms appeared, our naive sailor was mercilessly tossed
around, without the knowledge or ability to lower the sails or reset the
ship’s direction. Although the ship survived, our traveler was glad to get off
alive four months later and, not wanting to sail again, decided to make do by
living in Brazil where he had landed, far from his intended destination.
Another
traveler, who had no more knowledge about sailing than the first two, hired the
third ship. He also wished to reach England, but he realized that to do so
effectively, the ship needed a captain and a crew. He hired a captain who kept
the ship on course during good weather and bad by charting their position and
adjusting their direction. During good weather and favorable winds, the captain
hoisted all the sails and made excellent progress. When the crew spotted bad
weather on the horizon, the sails were furled and the ship gracefully rode out
the storms. They reached England in two weeks.
In
this story, the ship is analogous to your mutual fund or 401(k) retirement plan.
It is a vehicle that is only capable of transportation. By itself, it has no
direction-setting or decision-making capability. It cannot automatically steer a
course to your life destination. It does not protect you from adversity. There
are other lessons as well:
1)
You must identify your goals and be committed to your course in order to
get anywhere at all.
2)
Although the industry may tell you to ignore economic conditions and just
endure the market storms, following this advice can lead to underestimating
risks and a bumpy ride.
3)
Making one course decision, then going to sleep, is a recipe for winding
up far from your goal.
4)
Know the difference between a shipbroker and a hired captain.
5)
When the success of your journey is at stake, economizing on expertise
may wind up costing much more.
6)
Ongoing
management can lead to a straighter path, a smoother ride, and a more enjoyable
journey
To learn more about LFM&P investment management and financial planning services, our client goal-centered financial philosophy, and to better understand the value we can bring to your financial life, we encourage you to contact us or look at our website, www.linnardfinancial.com.
Average
Results of the MarketAwareSM Approach
through December, 2006
LFM&P’s
MarketAwareSM approach seeks to reduce your investment risk by
adjusting your asset allocation to reduce equity exposure during times when
stock prices are over-valued or price trends are falling. The ability to
recognize and reduce risk during unfavorable times can permit the acceptance of
somewhat more risk during other periods, preserving market gains while retaining
a client-appropriate average risk exposure.
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The charts below show the actual average results achieved in LFM&P’s managed portfolios, adjusted for new deposits and withdrawals, during the full period from LFM&P’s incorporation in April 2002 through December 31, 2006. They compare actual LFM&P results with those of large well-known mutual funds, Fidelity Magellan (thinner red line representing stocks) and Fidelity Government Income (thinner purple line representing bonds), as a proxy for the results that a typical mutual fund investor might expect using a market “unaware” approach. Also shown is the return of a moderate risk, “balanced” asset allocation of the stock and bond funds (heavier green line), which is a typical mixture for many investors.
Although
you should recognize that past results may not be indicative of the future, the
charts indicate that there has been validity in the MarketAwareSM approach.
Risk management through asset allocation adjustment does not necessarily imply
performance reduction. Over the last 4 3/4 years, an average LFM&P-managed
portfolio has posted higher returns with less risk than any combination of the
typical stock or bond mutual funds shown.*
A portion of LFM&P’s additional returns during this period
resulted from the ability to recognize asset classes that were performing well,
another benefit of maintaining an awareness of market conditions.
*This historical graph does not suggest future profitability. Future market conditions will be different and returns are unpredictable. It is possible to lose money even with a risk management focus. “Largest Loss” is calculated based on month-end prices. At some future time, the LFM&P largest loss drawdown is expected to increase. Since fees and taxes are different for each client, they are not included in any of the returns shown.