My wife’s favorite movie is When Harry Met Sally. We own it on VHS and DVD and I’m sure we will own it on whatever platform comes next. In one scene, Sally (Meg Ryan) is berating Harry (Billy Crystal) over lunch for a string of meaningless relationships and onenight stands. Harry tries to defend himself by suggesting that his dates have all “had a good time.” Then Sally suggests that Harry’s dates may have only been pretending to have a good time. Harry denies that anyone could fool him, and Sally reminds him that it is simple math: most women have at some point pretended to be having a good time, while no man believes that this has ever happened to him. Then Sally demonstrates faking a good time, which is followed by the most famous line in the movie, in which a customer at another table says, “I’ll have what she’s having.”

I was reminded of this scene twice in this quarter. The first time was when one of my loyal readers pointed out that two quarters in a row I had referenced the same study from DALBAR, which says the average equity investor has gotten only a 3.51% average annual return over the last 20 years. Thanks to this insightful observation I have now referenced it three quarters in a row in the hopes I can get a second reader to pay attention. I was also reminded of this when visiting one of my institutional clients. This client has more than 16,000 participants in their 401(k) plan and their record keeper helped us with a study that showed that 91% of those participants are underperforming the professionally managed portfolios available to them. There are a lot of Harry’s out there who accept the fact that most people need help, but surely it couldn’t happen to them. Well, as Sally said, it is simple math. That is why it is so important that you take my advice from last quarter and find out what the actual time-weighted return of your total portfolio really is. If you don’t really know what return you are getting it is easy to fool yourself into thinking that you are not part of the 91%. That the average return numbers don’t apply to me, they only apply to those average people.

Once you do know what your return is then you have to compare it to something meaningful. You need a benchmark. Most people use some sort of market benchmark, such as the S&P 500. Standard & Poors (S&P) has a committee that selects 500 of the most prominent companies in the US that it believes best represent the entire economy. The index tracks the movement of the stock prices of those 500 companies weighted by their respective market capitalization. In other words, larger companies have a greater impact than smaller companies. There is nothing wrong with using market indices to judge your portfolio’s performance. We use them ourselves to make sure we are doing a good job for our clients. I would suggest that this is the best way to judge professional money managers. (The S&P 500 is not always the best index to use when judging a manager but that is another subject) However, market indices are not the best measure for you to use for your personal purposes. We suggest that investors need to calculate their personal required return. What rate of return do you need to achieve in order to reach your investment goals? Your portfolio should then be managed in a fashion that gives you the greatest probability of achieving those goals.

This concept is exactly what we mean when we say that we are bringing institutional discipline to our individual clients. Institutional investors are pension funds, endowments and foundations. If you were a company and your portfolio was a pension fund, you would hire an actuary who would calculate what rate of return you must achieve over time in order to pay out all the retirement benefits that you have promised to your employees. You would, or at least should, then manage the assets in a way that best covered your liability.

A good example of this is American Airlines. They just won the Best Corporate Plan Sponsor of the year award from PlanSponsor Magazine. They have been able to maintain their pension plan while most other airlines have been using bankruptcy courts to get out of the promises that they once made to their employees. What was the difference at American Airlines? While other pension plans were trying to outperform the market in the late 1990’s American was focused on achieving their required rate of return. This meant that while other pension plans were buying high-flying tech companies at valuations that no prudent investor could ever justify, William Quinn, who manages the American Airline pension fund was sticking to investment basics. He took a lot of heat then, but now we can see how it turned out. Adriana Posada, who works for Quinn, says, “One thing we have never done is jump on the bandwagon with everyone else. It has served the plan well.” It can also serve you well.

Many investors we talk to understand the concept of required rate of return when they are saving for retirement. If I contribute X% of my salary to my 401(k) and get X% return on average than I will have enough to money to be able to retire comfortably. What they don’t understand is that this concept goes on into retirement as well.

Just as with the pension fund, you need to manage your portfolio in retirement much the same way you did when you were working. In retirement the mistakes tend to be different. Younger investors try to jump on the bandwagon and get rich quick, which usually leads to disaster. Retirees usually don’t do this. They are too wise to make those mistakes. They make all new ones.

The most common mistake we see in retirees is an obsession with producing income. They feel that because they are retired they must have a portfolio that produces income, as opposed to returns from capital gains. They confuse income with safety and capital gains with risk.

Earlier this year I was at a dinner with Richard Bernstein, the Chief Investment Strategist for Merrill Lynch. He told a story about how Merrill had underwritten Brazilian Highway Bonds. The bonds were sold in what they refer to as tranches or blocks, with each tranche representing a section of highway. The bondholders would be paid back through tolls collected on the highway. They were selling tranche seven which represented the seventh section of the highway. There was no guarantee that the sixth or eighth section of highway would ever be built, nor was there a guarantee that there would not be a free road running parallel to this toll road. Yet, they sold out in a day. Retirees are obsessed with income-producing securities and in this low interest rate, low dividend environment they are unknowingly taking on entirely too much risk in order to get that income.

Retirees need to think in terms of building a portfolio that will maximize the probability of achieving the required return throughout their retirement. For example, if a retiree needs 6% of her portfolio as income and believes inflation will average 3%, then she needs to get a 9% return (6% income + 3% for inflation). She should build a portfolio that maximizes that probability with the least amount of risk. That is what we do for our clients.

It doesn’t matter if you are saving for retirement or already there. The right benchmark for your portfolio is your personal required rate of return.

CHUCK OSBORNE, CFA, Managing Director

~The Right Benchmark

How do you know? To measure success you have to know what you are measuring against. All success is relative. We’ve all heard the story of the two hikers walking through the woods. They come across a very angry and hungry grizzly bear. The first hiker looks at the second hiker and asks, “What are you going to do?” The second hiker says, “I’m going to run.” The first hiker asks, “Do you really think you can out run a grizzly?” The second hiker responds, “I don’t have to out run the bear, I just have to out run you.”

Success is relative to your competition. The Ohio State Buckeyes thought they had the best team in college football, because they looked like world-beaters relative to the competition in the Big 10. On the other hand, the Florida Gators looked like a lucky team who won in spite of themselves playing in the SEC. However, after cruising to a 41-14 victory in the BCS Championship Game, it is now obvious that Florida had been measured against a much harder benchmark than Ohio State.

If it is that difficult to see who the best football team is, then how are you supposed to figure out how your investments are doing? Let’s break it down into steps. The First step is to actually calculate your total rate of return. If you are an Iron Capital client then this is pretty easy, because we show your total return on your statement. But for most investors this is not as simple as it might seem. If you are like most investors your portfolio is spread over multiple accounts and the statements you receive typically do not show the rate of return.

Most people I know look at their statements and if the account balance is up they are happy, and if the account balance is down, they are sad. However, they do not know their actual rate of return. Some are a little more analytical and they will look at each holding, and mentally note, “this one is up roughly 10%, that one is down,” etc. Perhaps they even have had one holding double or more, and they extrapolate from that how well they have done as a whole. William Goetzmann and Nadav Peles published a study on this subject in the Journal of Financial Research in 1997. Goetzmann and Peles asked a group of investors two basic questions: 1) What was the return of your portfolio last year? 2) By how much did you beat the market? On average the group overstated their returns by 6.22% and overstated their out-performance of the market by 4.62%. This overstatement is due to a condition that psychologists call cognitive dissonance.

Put simply, people want to have a positive self-image. Any information that damages that self-image is rejected, and if it can’t be rejected it is accommodated by a change in beliefs. For example, last week I had lunch with a colleague who informed me in certain terms that Ohio State would not only win but that they would win by a large margin. When I spoke to my colleague after the game, he started talking about the long break between the end of the season and the bowl games and rationalized that if the game had been played earlier it would have been different, etc. My friend can’t deny what happened but he can change his belief about the circumstances. Before the game the long break was not an issue, but now that the facts are in it must have been the issue, because it just isn’t possible that my friend could actually have been wrong. That is cognitive dissonance.

When investors suffer from cognitive dissonance they tend to remember their good investments and forget their poor choices, and as a result they overestimate their performance. This is what Goetzmann and Peles found. This also explains the often-quoted Dalbar study, which states that the average equity investor earned a 3.51% average annual return from 1984-2003 while the S&P 500 earned a 12.98% average annual return for the same period. That average investor probably believes his return was much higher, because he has blocked his bad investments out of his memory.

Nothing strips away cognitive dissonance like the brutal honesty of math. Calculating performance for one time period, say last year, is not that difficult. If you did not add or take out money from your portfolio, you simply take your ending balance (total of all accounts) minus your beginning balance then divide by the beginning balance. For example, if you ended with $1,157.90 and started with $1,000, your return was (1,157.9 – 1,000) / 1000 = 0.1579 or 15.79%. That is easy. However, if you are like most people then you did have cash flows into and/or out of your portfolio, and those must be adjusted in order to find your return. This is where the math gets tricky.

If you have a business calculator or know your way around an Excel spreadsheet you can calculate the internal rate of return (IRR). The problem is that this gives you a money or cash-weighted rate of return. In other words, your return is going to depend on when exactly these cash flows took place. Moreover, we are eventually going to compare this return to some benchmark, and the benchmark is not affected by these cash flows. Your relative success could be overstated or understated depending on when you put money into your portfolio and/or took it out. There is an important distinction here: when I refer to cash flows, I am not referring to the investment decision of investing in equity versus cash. These investment decisions are exactly what we are trying to measure. Instead, I am referring to actually adding additional funds to your total portfolio and/or taking funds out of your portfolio for spending needs.

What you need to do, and what both the CFA Institute and the SEC (the government agency not the football conference) require, is to measure your portfolio’s time-weighted return (TWR). TWRs are calculated by subtracting the beginning market value from the ending market value and then dividing by the beginning market value for each sub-period. A new sub-period begins each time there is a cash flow. The sub-period returns are then geometrically linked together to calculate the return for the entire period. Don’t worry, I am not about to try to explain calculating the geometric mean, but any investment adviser should be able to do this for you. If your adviser can’t calculate this then call us and we will be glad to help you.

Once you have calculated your actual total return, you are ready for step two. The second step is to know the benchmark by which you should be measured. The S&P 500 is the most popular market proxy for stocks, and if you are investing in stocks and bonds you probably need to blend that benchmark with a bond benchmark like the Lehman Brothers Aggregate Bond Index. Both can be found on web sites such as Morningstar.com. However, your real benchmark return should be the minimum required return to achieve your investment goals. Calculating that is a topic for another newsletter.

Wishing you investment success,

CHUCK OSBORNE, CFA, Managing Director

~Measuring Success

THE OTHER DAY I came home from playing golf, and my wife came home from the mall. She asked if I wanted to see what she got, and not being stupid, I said, “Of course Honey.” Then she showed me a pair of blue jeans, which she was very excited about because she had found a great deal. It was at this point that I made my crucial mistake: I asked what she paid for the jeans. Yes, I do know better than to do this, but she was so excited about her savings that I figured this couldn’t be so bad. She excitedly told me that she got these wonderfully cool jeans for the bargain price of $98.00.

After recovering consciousness, I responded with, “You paid what for a pair of blue jeans?” She calmly told me, “Only $98.00.” Then she started to educate me on designer jeans in the Year of Our Lord 2006. Evidently I’m lucky, because other people actually spend as much as $300.00 or more for a pair of jeans. They actually cost more if they come with holes already in them. I always thought you were supposed to earn the holes in your jeans by working or playing football, etc., but in our pampered society, why should you get all sweaty breaking in a pair of jeans when you can pay someone else to do it for you?

I do understand paying up for fine clothing. I understand paying a premium for craftsmanship or fine fabrics, but my wife just paid $98.00 for $10.00 worth of blue denim. The fact that people are actually willing to pay more did not help me. Then I realized something. My wife did not pay $98.00 for a pair of jeans. She paid $20.00 maximum for the jeans, and she paid $78.00 to fit in with her fashionable friends. Don’t misunderstand, I’m not being judgmental, I am merely stating a fact. My wife is human and she wants to fit in with her peers.

I do the same thing. Not with blue jeans, I am immune to that particular strain, but we all have something that we do that may not seem completely logical, but we do it in order to fit in with our peers. It may be the kind of golf clubs we play with, the rifle we hunt with, the car we drive, where we eat, the way we wear our hair. One could go on forever. The fact is that humans are social creatures and we all have the desire to fit in with our peer groups.

So what does all this have to do with investing? Everything. Don’t get me wrong, it is important to understand how to read financial statements and economic indicators. It is important to understand correlation, asset allocation and portfolio construction. In other words, it is important to understand the science of investing. However, it is equally important to understand the psychology of investors, or, shall we say, the art of investing. As one of my mentors used to say, “To understand the market you simply have to understand the human emotions of fear and greed.” Greed drives the market up as the masses see their friends making money and start buying in order to fit in, forcing the market even higher. Then some of the smart people will start to sell to take profits, making the market drop, and the crowd, afraid of losing their gains, or perhaps more importantly no longer fitting in, starts selling in mass, driving the market down. Fear and Greed are more powerful in investing than any economic indicator or fundamental valuation.

Last month I was having a discussion with some analysts from Legg Mason Value Trust. This is the fund managed by Bill Miller, who has beaten the S&P 500 Index 15 years in a row. They have been spending a lot of time trying to understand the human side of investing, or what many now call ‘behavioral finance.’ They have discovered that the average investor has a psychological need to own whatever has done best over the last five years. They don’t merely desire to own these assets, they need them. That is strong stuff.

There is an industry group called DALBAR that has published a study on the returns of mutual fund investors vs. the mutual fund in which they invest. They have been publishing this study for years with little change, the most recent results out last year with data through 2003. According to DALBAR, the average mutual fund investor received an average annual rate of return of 3.51% from 1984 through 2003. The market as measured by the S&P 500 Index for the same period had an average annual return of 12.98% and the average large cap mutual fund had an average annual return of 11.33%. How do investors get only 3.51% while the funds themselves returned 11.33%? Simple: according to our friends at Legg Mason, investors have a physiological need to invest in what has done best over the last five years. That means they buy these funds when they are at their high.

Unfortunately for our average investors, that is only the beginning of their downfall. Then other psychological needs start to surface. John Nofsinger, Ph.D., Professor of Finance at Washington State University and author of the Psychology of Investing, calls this next emotional trap, ‘the disposition effect.’ Basically human beings fear regret, which often follows the purchase of stocks (as well as blue jeans), and seek out pride. So how does this manifest itself in investing? The average investor tends to hold onto losers far longer than the professional would. The average investor also sells winners far sooner than they should. When I first read this I did not believe the good professor. In fact I was sitting at the bar of a restaurant in Chicago’s O’Hare airport when I read this, and just then, two guys sat down next to me. One of them saw that I was reading a book on investing and decided for me that I would rather talk to him than continue to quietly read my book. He explained to me (I’m not making this up) that he had a fail-proof strategy for winning on Wall Street. When he buys a stock, if it goes down he holds it until it gets back to even and then he sells, but if it goes up he sells immediately, thereby locking in his gains.

On the surface this strategy may make sense to you. After all, if he holds onto the losers until they come back he hasn’t “lost” any money, and if he locks in the gain then he has “made” money. However, what he has done is created a portfolio of losers, selling all the winners and holding onto the losers. This follows what DALBAR found. They saw that investors bought the funds that had done best, and therefore were destined to fall out of favor and do poorly. Then investors held on to those losers for a long time, until they finally gave up and again invested in what had done best over five years.

So how do you avoid this trap? Having a disciplined investment process is the greatest defense against these emotional traps. In the words of my Financial Markets professor, geeks rule the world! Geeks, like me, don’t try to fit in with the crowd. We stick to what is logical and what actually makes money. Remember that it is okay to pay for cool blue jeans, but when it comes to investing, being cool usually leads to being broke.

Your friendly neighborhood investment geek,

CHUCK OSBORNE, CFA, Managing Director

~Fitting In

I was sitting at home the other night with my wife and we rented a movie I had not seen in a long time. It was the 1997 hit “Men In Black” featuring Tommy Lee Jones and Will Smith as secret agents policing alien activity here on earth. The existence of these aliens here on earth of course had to be kept top secret to avoid a panic. Agent J (Will Smith) thought the MIB should just let everyone know about the aliens – after all, as he said, “People are smart, they can handle it.” Agent K (Tommy Lee Jones), who was older and perhaps wiser, responded, “A person is smart. People are dumb, panicky, dangerous animals, and you know it.” How profound. Agent K could have had a very lucrative career on Wall Street.

When it comes to investing, the individual investor may be intelligent, but the market? The market is a dumb, panicky, dangerous animal, and you should know that. This year has been a classic example. In the first quarter, the market took off like a rocket for no real reason, and to make matters more confusing, it was led by the most overvalued, lowest quality sectors. In the second quarter, the market corrected based on inflation fears. The fear of inflation was treated by the market as a shocking surprise. (Evidently, too many market gurus live in Manhattan and never drive their own cars.) The only surprise about core inflation rising is that it took this long to start happening. Higher energy prices eventually will impact other prices in the market. This should not be a surprise even to Wall Street. So, what is really going on? Unfortunately, the market is just irrational, at least in the short-term. The market tends to overreact, and then correct. This is the essence of the “market cycle”. The irrational behavior of the market is not new. Robert Shiller, the Yale professor and best selling author of “Irrational Exuberance” (a title he stole from former Fed Chairman Alan Greenspan), wrote extensively about how irrational the market can be. The famous economist John Maynard Keynes once warned, “The market can stay irrational much longer than you can stay solvent.”

So what is an investor to do? I believe we should hold on to the knowledge that eventually the market does get it right. In the long-term the market does a good job of valuing assets fairly. In the short-term we should always remember Keynes’ warning. This is why having a well-defined investment discipline is so crucial.

One of the most common mistakes we find when we take over portfolios for our new clients is that often there is no discernable investment strategy in place. We usually find a random hodgepodge of holdings with no evidence that anyone ever thought about overall portfolio construction and/or risk management. Individual investors tend to make investment decisions in a vacuum. For example, when I am at a party and someone starts asking me investment questions, it is usually something along the lines of, “What do you think about Dell?” or “Should I buy GM bonds?” I used to tell them the truth – that it depends on what the rest of your portfolio looks like, and that you have to decide not only whether to buy but also how much to buy, in what account you want to buy and what to sell in order to buy. However, I have found that telling the truth at cocktail parties often means you will be drinking alone, so now I just try to change the subject.

Portfolio management is much more than just making decisions on investing in this asset and/or that asset. Portfolio management involves creating a whole portfolio where every part has its function and making decisions is based on a sound investment philosophy and controlling risk. Controlling risk is arguably the most important element in portfolio management, yet most investors do not really understand what it means. When you talk to most investors about controlling risk, they start talking about buying investments that are conservative when considered on an individual basis, but what we are talking about is much more dynamic than that. Controlling risk entails thinking about each investment in terms of your overall portfolio.

The portfolio management process should begin with a declaration. You should put in writing a carefully considered investment policy statement, which should include your objective. Where are we going? Most of our clients do not invest for the sake of investing. They are investing to fund their retirement or their children’s education, or in some cases just to have more money than their neighbors. Whatever the motivation there is a goal, and that goal greatly impacts how the portfolio should be managed.

Once we know what the goal is, we can determine the return required to achieve that goal and the amount of risk we are both able and willing to take in order to achieve that return. Then, and only then, can we build a strategic asset allocation that gives you the highest likelihood of achieving your return objective based on long-term relationships of various assets. While constructing this long-term strategy you must do something that is incredibly difficult: you must completely ignore what is happening in the market today. Don’t worry, we will eventually get around to today’s environment, but not yet. First we have to look at long-term market relationships and the big picture questions like how much equity exposure should I have long-term, how much international, how much real-estate, and how much in bonds? Only once we have made these decisions can we intelligently look at what is going on today.

Once you know how much equity exposure you want in the long-term, then you can review what is going on today and decide if right now you should be over-weighted, have more exposure than your long-term strategy calls for, or underweighted. If you are not sure, then go back to your long-term strategy. This structure gives us a framework from which to make rational decisions in an irrational market. We can then control the amount of risk you take by asking one simple question: what happens if we are wrong?

That is the key to controlling risk. It sounds so simple, yet most investors just are not willing to consider the possibility that they could be wrong. It’s too painful. Yet if you invest money long enough, you will eventually be wrong, but that doesn’t have to be a bad thing. If you consider your mortal nature before pulling the trigger, make sure that the odds are in your favor for being correct and that if you do happen to be wrong then it won’t hurt your overall portfolio too badly, than you will be okay in the long-term. This year, the market has been irrational and we, who pride ourselves in making rational decisions, have been wrong about many things, but our performance has still held up. How can that be possible? It is possible because at Iron Capital we heed Mr. Keynes’ warning and do all in our power to keep our clients solvent while the market is irrational.

Have a great summer,

CHUCK OSBORNE, CFA, Managing Director

~Irrational Behavior

Investing outside the United States has always been a somewhat scary proposition. I remember my first real exposure to international investing like it was yesterday. One morning when I was a young analyst at INVESCO, my boss stormed into my office and asked if I had a passport. I stammered, “Yes”. He asked, “Is it current” and I sheepishly said, “I think so.” He said – and this I will never forget – “You’re going to Poland!” Then he disappeared out my door as abruptly as he had entered. I sat there for a moment in shock, and then got up went down the hall to his assistant and politely asked her if I was ever coming back.

It was scary. This was a different world, different culture, different political environment and a very different market. However, the fundamentals of investing remained constant, and that young analyst did pretty well.

For most Americans investing overseas is still a mysterious and somewhat scary issue. When we inherit portfolios from our client’s previous advisors, a lack of international exposure is one of the biggest issues we find. People tend to stick to domestic stocks for a couple of reasons. First, they are more comfortable investing at home in their local surroundings and in familiar companies. The same reasoning causes 401(k) participants to invest heavily in their own company’s stock if given the chance. They are familiar with the company and that gives them more confidence.

Secondly, some believe that investing overseas is somehow less than patriotic, and shows a lack of confidence in our country. On the contrary, nothing seems more patriotic to me than owning the rest of the world. If more Americans invest in Toyota, for example, Toyota will eventually become an American owned company. Still, some people remain politically averse to investing overseas and we certainly respect that, but those who feel this way are limiting their opportunities.

More than half of the world’s invested capital resides outside of the United States. We live in a global marketplace. I am not saying it is good, nor am I saying it is bad, I am merely stating that globalization is a fact of life. Investing internationally provides access to those global opportunities.

Investing internationally also provides diversification. Everyone has heard that they should diversify their investment portfolio, but few people really understand what that means. Diversification is achieved by investing in assets that have a low correlation to one another. In other words, their prices do not move in the same direction. International markets have a low correlation to our market and therefore exposure to them can reduce the overall risk of the portfolio. This is even true of emerging market investing, which while very volatile as a stand alone investment, can actually reduce the volatility of a diversified portfolio.

Globalization and diversification are good general reasons for always having some exposure overseas. However, as our clients are aware, we are not just mildly exposed to international markets; we have a large international position in our portfolios. This has been a great boon to our clients as over the last year the international index MSCI EAFE is up 24.94% in dollar terms versus the S&P 500 which is only up 11.73%. Emerging markets have been even better with the MSCI Emerging Markets index being up 47.98% over the last year.

So how did we know? Unfortunately, it isn’t because we have a crystal ball. Investing is all about process, and it is our process that led us to venture beyond our borders. When investing, you want to buy low (when securities are undervalued) and sell high (when securities are overvalued). Value led us overseas.

According to Morningstar, the price to earnings ratio on December 31, 2005 for the MSCI EAFE international index was 16 as compared to 17.3 for the domestic S&P 500. In other words, it cost you $16 for every $1 of earnings overseas and $17.3 for every $1 of earnings here at home. It sounds simple doesn’t it? Well unfortunately it’s not that simple. The international market has been undervalued relative to the United States for a long time, yet it underperformed dramatically in the 1990’s. In the market an undervalued asset can stay undervalued for a long time. Timing matters and in our process we look not only for value but for signs that the market is beginning to recognize that value.

So, we saw an undervalued asset class and took advantage of it with some fortunate timing. But, is international still a good place to be? We believe the answer is yes. The global economy is strong. Japan is doing better than it has in more than a decade. China is growing at over 9% a year and India is right behind. Europe is a laggard, but that is not all bad. Stock market prices reflect the consensus opinion of what is going to happen in the future. If what actually happens matches expectations the markets will not move dramatically. Market prices make large moves due to surprises, down for negative surprises and up for positive surprises. In other words, it is possible that China grows very fast, but not as fast as people thought, and that Europe grows slowly but not as slowly as people thought, and you make money in Europe and lose money in China. Sometimes low expectations can be a wonderful thing.

~Have Passport, Will Travel