design build-protect-clients (notes)

Hello, welcome, etc.

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When it comes to our financial futures, the decisions we make can have an enormous impact in the years ahead.

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The first step in creating a plan is “Design”

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A portfolio should address all three of these areas.

But there are a lot of challenges facing investors, when you design a plan, including stock market volatility

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Wall Street and the financial media are another challenge.

They can sometimes turn investing into entertainment

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That is why it is so important to focus on what really matters—your financial and life goals

A good plan should be designed around an investor’s financial AND life goals—and as this chart shows, these goals can cover a wide variety of areas.

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Once you understand what is important to you as an investor, then you can start to build an appropriate portfolio with your financial advisor.

Like the story of the three little pigs—you don’t want a straw portfolio built with whatever investments are “Hot” right now in the financial media.

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Nor do you want a “wood” portfolio which is just a collection of investments which may not work well together and don’t necessarily reflect your unique goals and needs.

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Portfolios should be built with investments that provide proper diversification, work well together and reflect the right balance or risk and potential reward for each investor’s chosen level of risk and time horizon.

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And we believe that science and academic research are critical to building a prudent portfolio. Great thinkers and economists such as Adam Smith, Frederich Hayek, Paul Samuelson, Merton Miller, Bill Sharpe, Daniel Kahneman and of course Harry Markowitz have provided us with powerful insights into how portfolios should be constructed.

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When it comes to portfolio construction, we believe investors have three key decisions they need to make. Read slide.

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From the smartphone in your pocket to the department store where you buy your clothes, many companies that are a big part of our lives are public companies that are listed for trading on a major stock exchange. Not all of them are big with well-known brand names and not all will be successful long-term. However, one of the best opportunities to grow your money over the long-term can come from making an investment in capitalism and the stock market.This chart is a good illustration of the long-term growth of US businesses over the past eighty years.

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To be an effective “shock absorber,” the portfolio should contain:• Bonds with shorter maturities that have lower correlations historically to stocks. This means the bond typically has a 3 to 5 year “lifespan” and does not go up and down in value at the same time or to the same extent as stocks. Generally, longer maturity bonds entail more risk• Higher-quality bonds that can help dampen portfolio volatility and lower the risk of a default.

The chart illustrates the risk and reward to portfolios from fixed income holdings. Of note is the lower volatility of short-term bonds that you can see represented by the standard deviation number (how much the portfolio goes up or down in a year). Note also that investors are typically not properly compensated for the additional risk of longer-term bonds.

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Now that you understand about not putting all of your eggs in one basket, by investing in both stocks and short-term bonds it just makes sense to apply diversification to the global markets. Today, more than 56% of the total market capitalization is outside of the US markets!

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This slide depicts the world not according to land mass, but by the size of each country’s stock market relative to the world’s total market .

Population, gross domestic product, exports, and other economic measures may influence where people invest. But the map offers a different way to view the universe of equity investment opportunities. If markets are efficient, global capital will migrate to destinations that offer the most attractive risk-adjusted expected returns. Therefore, the relative size and growth of markets may help in assessing the political, economic, and financial forces at work in countries.

The slide brings into sharp relief the investible opportunity of each country relative to the world. It avoids distortions that may be created or implied by attention to economic or fundamental statistics, such as population, consumption, trade balances, or GDP.

By focusing on an investment metric rather than on economic reports, the chart further reinforces the need for a disciplined, strategic approach to global asset allocation. Of course, the investment world is in motion, and these proportions will change over time as capital flows to markets that offer the most attractive returns.

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While the US outperformed almost all other countries in 2012, the long term picture still points to a need for international diversification, with the US coming in 39th out of 45 countries in terms of 10-year stock market returns.

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This is why we build asset class portfolios that typically contain over 9,000 companies in 45 countries, representing 36 currencies. While we love the great U.S companies, the science suggests that investing in thousands of stocks globally rather than a few can help mitigate the overall risk of the portfolio and may increase your return. The reason is simple: if you own a lot of companies around the world you will eliminate the “company specific risk” that comes when your portfolio is exposed to a reversal that may affect one company or one sector or even one country. Capitalism and creation of wealth is a worldwide phenomena and the countries with the highest — and lowest returns — change year by year. International stocks can be riskier than U.S. stocks and are subject to a variety of additional risks, including currency and political risks. That is why investors must carefully decide how they will allocate the equity portion of their portfolio between U.S. and international stocks.

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When you consider all you want to achieve in life — today, tomorrow and for many years to come — how hard does your money have to work to help you get there?

We intuitively understand that when a risk is unrewarded, it is rarely worth taking, just as we know that we are seldom compensated for taking no chances at all. “Nothing ventured, nothing gained” as the old saying goes. Investing involves risks regardless of what you invest in.

In 1992, academic research by Professors Ken French and Eugene Fama Sr., identifying two equity risk factors — small companies and value companies —that investors should expect to be compensated for. As an investor, you need to decide how much of these risks you are willing to take. As the chart shows, the greater the risk exposure, the greater the expected long-term return

The size and BtM – or value -- effects appear in both US and international markets—strong evidence that the risk factors are systematic across the globe.

This chart demonstrates the higher expected returns offered by small cap stocks and value (high-BtM) stocks in the US, non-US developed, and emerging markets. Note that the international and emerging markets data is for a shorter time frame.

Small cap stocks are considered riskier than large cap stocks, and value stocks (as defined by a higher book-to-market ratio) are deemed riskier than growth stocks. We believe these higher returns reflect compensation for bearing higher risk.

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This is some of the key academic research we draw upon to help us build portfolios

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This is some of the key academic research we draw upon to help us build portfolios

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This is some of the key academic research we draw upon to help us build portfolios

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This is some of the key academic research we draw upon to help us build portfolios

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To be a successful investor you need discipline and structure — and ongoing education — to manage THROUGH markets rather than TO markets. You don’t want to “guess” when it comes to investing to meet your life goals. And don’t let emotions derail your best laid plans

Rebalancing is an important step that many people neglect when they try to manage their own investments. Without rebalancing, portfolios can drift as the markets change. This drifts can add extra risk to your plan that you never intended or expected.

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As you can see from this chart, the annually rebalanced portfolio was historically less volatile over the last twenty years. It may not have soared as much during bull markets, but it didn’t decline as much during bear markets. And overall, it offered slightly better performance with less risk than the drifting portfolio.

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Investing can be an emotional roller coaster. In this age of the “24-hour news cycle” it is easy to forget the role that maintaining our investment portfolios can play in achieving our long-term goals.

As the illustration shows, at the moment of greatest potential risk, many want to invest even more money. And at the moment of greatest potential opportunity, many are tempted to sell. It can be difficult to stay focused on the long-term when the short-term consumes our thoughts and emotions.

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Just to show you how investors can sabotage their returns when they don’t take a long-term perspective, consider this chart which shows that over the last twenty years, the average investor did substantially worse than major indices.

Why the big difference? Some investors might think they know when to buy and sell. But this means they have to be right twice: picking the right time to buy and the right time to sell. That is a pretty tall order! Other investors might give in to panic or even greed and make hasty, emotional decisions. Whatever the reason, the results as a whole are shocking. The average equity investor in the study above underperformed the S&P 500 by almost 4% each and every year. A gap that large can have a real impact over time on an investor’s long-term goals – even quality of life.

Your future is too important to play games with and take unnecessary chances. We don’t believe you should gamble by trying to time markets or pick winning managers.

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Beating the S&P 500 isn’t easy. Of the 862 U.S. Equity Funds from 1998 –2007, only 420, or less than half managed to beat the S&P 500. So you might think, just invest in one of those winning managers, and you’ll do fine.

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But 5 years on, in 2012, 248 funds (almost 30%) have closed their doors, merging or going out of business.

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And—five years later--of the original 420 funds that outperformed, 70% failed to sustain their performance or closed their doors.

And a few of the underperformers even managed to beat the S&P 500. But there is no predictable pattern to any of this performance up or down. Nothing that we believe offers a sound guide to which manager to invest with for the future.

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In summary…

Read slide

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Thank you so much for joining me today. We have a couple of minutes left, and I’d be happy to answer a couple of questions.