Asset Allocation: Avoid Picking Individual Stocks

I recently attended an economic presentation by Dr. Gene Fama of the University of Chicago, the leading champion of the efficient market theory and a favorite to win the Nobel Peace prize one day. Dr. Fama stated, “I’d compare stock pickers to astrologists, but I do not want to bad-mouth astrologists.”

One of the biggest mistakes individual investors make is following the advice of the media, a stock broker or money manager on individual stock picking. Why is it that every year Money Magazine selects its top stocks to beat the market and never reports on how they performed the next? Why does Fortune Magazine list different “top money managers” each year and forgets to tell you about their selections of previous years. Why does CNBC run experts with differing opinions 14 hours per day and never tracks their recommendations? The reason is that it sells magazines and ad space!

Let’s look at some of Fortune Magazine’s “All Star” stock picks in their July 2000 edition:

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In the January 2000 issue of Time Magazine, Amazon founder Jeff Bezos was declared man of the year. If you purchased Amazon in January of 2000, your stock lost 75% of its value within a year. This year’s person of the year is “you”! The ramifications of this prediction are a little scary. This phenomenon is not limited to just stock picking either. Money Magazine’s “timely” June 2005 issue touted the virtues of buying residential real estate and denied the existence of any housing bubble. According to the magazine, “These days, everybody knows someone who has made money in real estate, and rising prices have become a national preoccupation. We are a wealthier country than we have ever been, so it makes sense that we would spend more on real estate, pushing prices to new highs. After a l l , F e d e r a l R e s e r ve Chief Alan Greenspan complained of "irrational exuberance" in 1996, more than three years before the stock boom ended in tears.”

I feel truly sorry for those that followed that advice. Once a financial trend hits the main stream, it’s generally time to get out. Over the past 20 years, money managers failed to beat their market bench marks over 80% of the time. This leaves just 20% of money managers or stock pickers beating the market on an annual basis. The problem is that different managers beat the market each year.

There is very little consistency with these managers beating the market from year to year. On the occasion that one of these star managers floats to the top, so much money flows into their portfolio that it creates a drag on future investment performance. Maybe if we can locate these emerging managers, we can beat the market more consistently. So how do we find these guys? When Peter Lynch, arguably one of the best stock pickers ever, retired from his job as manager of Fidelity Magellan, he and the executives at Fidelity spent an enormous amount of time and money scouring the investment world for the best money manager. Three money managers later, Fidelity Magellan has underperformed its bench mark index by exactly the management
fee it charges. What makes us think we can pick a good portfolio manager when Peter Lynch and Fidelity cannot?

What about the great stock picker Warren Buffet? According to Buffet, he may find 2 or 3 good stock ideas every couple of years. Mutual fund companies typically hold 150 to 250 stocks. How does a mutual fund manager find 200 good ideas? I guess they simply select 2 good ideas and 198 average ideas. Buffet also inserts himself into the management of the good ideas he selects, a likely boon to his returns. This does not happen in the traditional portfolio managementindustry. So, if we can’t pick stocks that consistently beat the market and we can’t pick managers that consistently beat the market, what should investors do? Stop trying to beat the markets! Put your savings to work and earn a market rate of return. As investors, we are entitled to the market return. Anything less is our own mistake. How do we get this?

In order to answer this, we need to understand some basic facts about what the “market” is and risk. Here is a table showing the typical market asset classes and their performance over the previous ten years.

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As you can see, different asset classes perform differently from year to year. Many times one year’s winner is the next year’s loser. By diversifying among these asset classes in such a way that meets your individual risk tolerance, you can obtain market returns with an appropriate amount of risk. This can be done by purchasing index funds and exchange funds that mirror the asset classes. Now, if we simply select the asset mix that meets risk and return profiles, we can earn the market return and go play golf!

If you need help, don’t hesitate to call. This is our specialty!!!

Real Estate Corner

The real estate market softened considerably during 2006. There have been pockets of depreciation in certain parts of the country and in the higher priced homes. I have seen drops of as much as 15% from recent peaks in the same markets. However, the overall market seems to have stabilized. We have not as yet experienced a significant broad based drop in home prices.

The Mortgage Bankers Association referred to 2006 as “A Normalization of the Housing Market”. In the aggregate, residential real estate seems to have remained roughly the same as a year ago. Home sales were lower by 10%, with new homes falling by 17% and existing homes falling by 8%. (This excludes data from December 2006, which will not be released until the end of January).

According to the Office of Federal Housing Enterprise Oversight, “US Home prices rose in the 3rd quarter, but the rate of appreciation declined significantly and some areas experienced declines. Nationally, home prices were 7.73% higher in the third quarter of 2006 than they were a year earlier.” Idaho topped the list of states with an annual increase of 17.5%, while Michigan, home of Ford and GM, was at the bottom with a slight price decline.

In our local market, the average sales prices of homes in Northern Virginia declined 4% in November compared to a year ago. Homes are also taking longer to sell, averaging 85 days on the market compared to just 35 days a year ago. There were also 30% fewer home sales than a year ago. One of the most interesting phenomenons is the switch from a seller’s market to a buyer’s market. Over the past 5 years, buyers have been paying on average 2% less than the listed price. However, in 2006, this number has increased to 7%.

I expect 2007 to be a true buyers market with sellers willing to provide handsome concessions and lower prices to entice buyers. If rates move north of 6.75%, there may be some true housing depreciation. Most economists however, are still expecting a soft real estate landing with a flat market over the next 2 years.

Sector Performance Report 12/31/06

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Market Summary

2006 turned out to be a terrific year for most investors. Stocks rose more than Wall Street analysts predicted after the Fed. halted 2 years of interest rate increases while energy prices fell 22% from their high in July. The S & P 500 was up 14%, the Dow Jones Industrial Average was up 16% and the NASDAQ moved up 9% for the year. Overall, the equities market performed remarkably well in spite of pressures from higher interest rates and energy prices.

In writing this newsletter, I reviewed my predictions from last year and would like to report the results. I suggested large cap stocks with high dividends or “value stocks” would have a big year. In fact, this asset class was up 23%. I also suggested the Fed would stop raising rates after another 1/2% increase. The Fed did stop, but not until after raising short-term rates another 1%. I suggested the energy and real estate sectors were due for a correction. I was way off here. The energy sector posted a strong 21% return beating the S & P 500 by 7%.

The real estate market was mixed. Commercial real estate continued to post excellent returns while residential real estate fell considerably. As for mortgage rates, I predicted a 1/2 % increase in rates. As predicted, 30 year fixed rates mortgages did increase from 6.25% to 6.75%; however, they came back down to 6.25% ending the year where they started.

For the record, my predictions are done mainly for sport. Predicting short term economic trends is more luck than skill and my predictions should not be acted upon at home. Market timing should never be substituted for sound asset allocation and rebalancing strategies.

Expectations for 2007 That thought in mind, let’s see what may be in store for 2007. As the current economic cycle matures, I expect larger stocks to perform better. This sector has been an underperformer since the late 90’s and is due for a good year. 2007 may be the year the S&P 500 and Large Cap growth stocks out perform all other asset classes. I also expect Healthcare and Financials to be in the top US sectors. As for rates, the market is pointing to a 50 basis point drop by the Fed and mortgage rates to lower by about 1/2%