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Staggering Across the 2011 Finish Line

Feb 6, 2012 Will Clemens

Predicting the weather in Boston for next week is very difficult, but you can generally bet it will hot and humid most of the summer, cold and windy much of the winter, and you should always have a contingency plan because the weather tends to not cooperate.

Predicting returns is much harder than predicting the weather, because returns can fly in the face of available logic, consensus, or, seemingly, facts. At the beginning of 2011, we all knew that the United States was politically and fiscally dysfunctional, and the very creditworthiness of our country was open to question. These fears were borne out by the two-punch debacle of the debt ceiling standoff and the US Treasuries downgrade. At a minimum, a prudent investor would underweight, if not actually avoid, US Treasuries. Other important facts we “knew”: emerging markets represented relatively better growth opportunities than developed markets, and US real estate still had a massive overhang of devaluation to work off, notwithstanding a rally in REITs.

Let’s say your prudent client had the discipline to look at longer time frames in addition to simply quarterly returns. At the end of the March, US equities led all major classes, with a 6.4% year-to-date and a 17% return over 12 months, and all asset classes had positive returns versus the start of the crisis. Meanwhile, US bonds appeared to be “pricing in” their declining desirability, with a .42% quarterly return, with long-dated Treasuries quite sensibly showing a loss for the quarter, worse than any major asset class.

A murky picture, certainly, but a prudent investor would maintain her equity position to protect against inflation and continue to gain from the post-crisis stock rebound, and would certainly avoid Treasuries, with their low yields and negative credit outlook.

And of course, what happened next? Equities dropped sharply (emerging markets the most), erasing most of the post-crisis gains. The financially-impaired US government benefitted from a flight to “quality.” Yields somehow fell further. Treasuries broke all the models with their gains, especially in long-dated bonds.

The 25% return for the quarter in long-dated Treasuries, in fact, was a higher quarterly return than anything seen in the US equity market since the start of the 1995 bull market and all the booms and recoveries since.

And finally, by the end of the year, with all the ups and downs, US equities would have produced modest gains, and we start 2012 worried about the same factors we’ve worried about since the end of 2008: indebtedness and competitiveness in developed countries, unemployment, and growth. A lot of ups and downs for a year in which, for equity investors, not much changed in the end!

Of course, the received wisdom of dumping Treasuries, buying emerging markets, etc., might eventually come true. But who knows when? In the meantime, in the face of a decade of unpredictability, what can a prudent investor do? Some investors will try to time the rotation of different assets classes.

For the rest of us, sometimes a simple answer is the best one. A simple balanced world portfolio, such as can be assembled with Vanguard funds, would have returned just above 6% per year since mid-2000, outperforming the S&P’s “lost decade”, ranking consistently above the median performance of a peer group of world allocation funds, and ranking at in the top quartile that same peer group using Sharpe Ratio.

As we stagger across the 2011 finish line, some of the simplest time-tested rules may be more true than ever: the best performing asset classes will always vary and in ways that are difficult to predict; a well-balanced portfolio is a simple way to manage risk; and maybe sometimes the best investment decision is to do nothing.

And within the profession, sometimes the best an investment professional can do is have the tools and data to explain strategies and strange markets to their customers, and work with them to have the discipline and patience to stick to their plan. Hopefully Zephyr is helping you with this daunting responsibility.

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