March 3, 2003

Investors were relieved by the start of the war, and the markets surged 12% only to give back half of those gains by the end of March. The questions then became- how long will this go on, and how much will it cost? Five years ago, the federal government had a budget surplus of $54.3 billion. During the first 11 months of 2002, it had a deficit of $209.7 billion.

Research shows that in the 12 months following the end of a bear market, a fully invested portfolio returned an average of 47%. If you missed the first six months of the recovery by waiting on the sidelines in cash, the return was reduced to 11%. There's a lot of cash sitting on the sidelines according to Bloomberg: $2.3 trillion is sitting in money market funds or the equivalent of 23% of the value of U.S. stocks.

Investors tend to pick a fund on the basis of its past performance and dump it when it gets in trouble. And managers will get into trouble. Cambridge Associates looked at managers who were in the top quartile in total return ten years ago. Of those, 98% subsequently underperformed for at least three years in a row, relative to others who follow a similar style. And 685 of them fell into the bottom quartile three years in a row. So there has got to be more than just past performance when deciding on investing in a mutual fund for the long term. Some (not all) of the components I look for- Sharpe ratio, Beta, performance and style consistency, trailing return history, peer group ranking, portfolio manager interviews, portfolio manager disciplines, organizational strength and research capability.

Do not confuse dumping an underperforming fund with rebalancing. Investment research has long shown the benefit of rebalancing. During the past 25 years, rebalancing at least once a year on a portfolio with a target split of 60% stocks and 40% bonds cut the risk of the portfolio by nearly 20%, according to Ibbotson. Investors understand the importance of rebalancing but have a hard time doing it. Their research shows the benefits of rebalancing are nearly identical whether it take place monthly, quarterly, twice a year, or just annually (as I have done). Annually is the best way to go to avoid generating lots of short-term gains or losses.

In recent research, John Ameriks, an economist with the TIAA-CREF Institute along with researcher Andrew Caplin and John Leahy of New York University, have analyzed survey responses for TIAA- CREF participants and found a strong correlation between planning and wealth. Individuals who plan have significantly higher wealth than those who don't. They also have individual characteristics or personality traits that are related to planning and saving. They suggest that people with a "propensity to plan" tend to maintain personal budgets and save more than those who don't. They also hypothesized that the mere monitoring of spending tends to result in lower spending. I have personally found this to be true in my practice.

When the bull market was hot, so were index funds. There are, however, inherent flaws in the indices and the funds that track them. Because the S&P 500 Index is weighted by market capitalization, stocks like Microsoft, General Electric, and Intel, accounted for more than 20% of the index. When they collapsed, so did the S&P 500 Index. That's why I like a blend of active and passive fund managers. Over the past 12 months, says Morningstar, 53% of actively managed mutual funds, outperformed the indices. That may not be spectacular performance, but it is a lot better than in 1998, when index funds beat 80% of their actively managed peers.

"Some people know the cost of everything but the value of nothing" -Oscar Wilde

-Fern Alix LaRocca CFP® EA