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| Our Investment Philosophy |
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Our approach to developing and managing
investment portfolios is predicated on certain fundamental
assumptions with regard to the factors that most influence
investment success; among these factors are the following:
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Asset Allocation
The returns to a portfolio will be more influenced
the particular mix of investment classes than by any
other single factor. A study by Brinson, Hood, and
Beebower showed that 94% of the variation of returns
among institutional portfolios could be attributed
to the asset allocation decision, while 4% was
attributable to individual security selection, and
2% to market timing decisions. Asset class
categories consist of things like money markets,
bonds, domestic large company stocks, domestic small
company stocks, international large and small
company stocks, real estate securities, and emerging
market securities, among others. When we develop
your investment policy, it includes specific targets
for each of these categories. |
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Value Criteria
Numerous studies have demonstrated that stocks
trading at low multiples of their book value per
share offer higher returns in the long run. If one
particular market segment is to be favored over
another, therefore, it makes sense to overweight
value stocks over so-called growth stocks (i.e. low
price-to-book ratio stocks versus high price-to-book
ratio stocks). We typically give client portfolios
exposure to the broader markets supplemented by
additional investments in value stocks; we never
make specific allocations to growth stocks. |
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Size Criteria
It has also been demonstrated that the size of a
company influences its expected return, with smaller
companies offering higher returns than larger
companies over the long run. A well-diversified
portfolio will have a significant allocation to
smaller-company stocks. |
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Fees and Expenses
The future returns to any individual investment, or
asset class, are not under our control. We can,
however, exert prior control over the degree to
which those returns are reduced by ongoing fees and
expenses. Investments with low ongoing expense
ratios, therefore, should be favored over
investments with relatively high expense ratios,
without regard to whether or not the investment
vehicle was able to overcome its high expenses in
the past. |
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| Asset Allocation |
| Asset allocation is the single most important
decision for any portfolio, having been shown to explain as much
as 94% of the variation in returns between institutional pension
portfolios. |
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| As noted previously, asset classes represent
broad market segments with distinct characteristics. For
example, there would be no point in distinguishing between large
and small company stocks if these two asset classes behaved
identically (they don’t). In fact, the more dissimilar two asset
classes are, the more desirable it is to combine them in a
portfolio. The chart below illustrates the annual returns to
U.S. large cap stocks (S&P 500 Index), overseas small cap stocks
(DFA International Small Cap Value Index), and a 50/50 blend of
the two from 1982 through 2006. |
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| You can easily see that combining the two
indexes smoothes out the highs and lows and provides a more
predictable pattern of returns. Due to the impact of
compounding, a portfolio with “smoother” returns will grow
larger than one that exhibits bigger swings. |
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| US Small Cap Value Stocks |
20.0% |
22.6% |
$62.27 |
| International Small Cap Value Stocks |
20.6% |
26.5% |
$60.28 |
| 50/50 Blend |
20.3% |
19.2% |
$75.37 |
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| There are two lessons to be found in this
example: first, we should assess the attractiveness of different
investment alternatives in combination, rather than
individually, and second, it is important to seek different
investment alternatives when considering potential building
blocks for our portfolio. Clearly, diversification
matters. |
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| Value Investing |
| We follow a value-oriented investment style.
This means that we tend to favor equity investments – stocks and
stock mutual funds – that are trading at discounts to the market
as a whole as measured by the price-to-book ratio. These are
stocks of out-of-favor companies that have often fallen in value
or lagged the general market in the recent past. One value
strategy you may have heard of is called “Dogs of the Dow”
because it involves buying the “dogs” or under-performing
members of the Dow Industrial Average instead of the high-flying
“glamour” stocks. |
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The chart above shows
the cumulative value of a one-dollar investment in each of three
market segments, starting in January of 1966 and continuing
until December of 2006. The plot line for the S&P 500 represents
a broad measure of stock market performance, the “Large Value
Stocks” line ( Fama-French Large Value Index), attempts to
capture the performance of large cap value stocks, and “Large
Growth Stocks” (Fama-French Large Growth Index), is a measure of
large cap growth stock performance.
While the past performance of any market index is far from a
guaranteed predictor of future returns, we believe that the
relative performance among these three indices is due to the
presence of priced risk factors and will therefore continue in
the long run. Specifically, if you believe that markets do a
pretty good job at pricing securities appropriately in relation
to their relative risk, then value stocks exhibit higher returns
in the long run, not because there’s a free lunch to be had, but
because of the presence of a “value,” or “financial distress”
risk factor. |
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| "Contrarian Investment, Extrapolation
and Risk," by Lakonishok, Shliefer, and Vishny |
| Bars on top indicate years in which
value stocks outperformed growth stocks. |
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| Fees and Expenses |
| Fees and expenses can have an enormous impact
on your investment experience over extended periods of time. The
chart below illustrates the value that a one dollar investment
grows to at three different rates of return, each one-half of
one percent higher than the last. |
| As you can see, a half-percent difference in annual
return can grow to a 15% difference in value over 30
years. Since the future returns to any investment are
not known in advance, the only factor over which we can
exert control now is the level of fees that will be
assessed on an ongoing basis. The chart below compares
the annual operating expenses for three of the mutual
funds we use most frequently in each of their respective
asset classes. These are compared to the average
operating expenses of the entire investment category as
reported in the Morningstar Principia database. |
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| As you can see, the fees assessed by
different mutual funds can vary dramatically. |
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