Can Investors Beat the Market? WhatAstuteInvestorsNeedtoKnow

By Mark J. Smith, CFP®, CPA/PFS, CIMA® – Principal, M.J. Smith and Associates

Becauseoftheextremevolatilityofthestockmarketinrecentyears,manyinvestorsandinvestmentconsultantshavequestionedthevalidityofassetallocation.Inthe1990s,thestrategyofdiversifyingstocks,bondsandcash—knownasassetallocation—cameunderattack.WiththeinventionoftheInternet,aneconomythatneverseemedto slow down, and a fully employed workforce, there seemed to be no need for asset allocation. Growth stocks ap-pearedtobetheonlyanswerforachievingsuperiorreturns.TheStandardandPoor’s500Index,theworld’slargeststock market index, added more technology names to its composition, and with the momentum built into this capitalization weighted index, the S&P 500 seemed unstoppable.

AtM.J.SmithandAssociates,awealthmanagementadvisoryfirm,someofourclientsquestionedowningbonds,realestateinvestmenttrusts(REITs),smallcompanystocksandforeignholdingsinthelate1990s.Notonlydidthese investments display lower past returns than the S&P 500, but apparently they did not present the opportunities desiredinthenewInternet-drivengoldenage.

Howtimeshavechangedsincethelate90s!Thebearmarketof2000-2002andnowthebearmarketof2008havebeen two of the worst in history. From January 1, 2000 through December 31, 2008, the S&P 500 averaged an an-nualized return of -1.38%. This decade is on track to be the second worst in its history. Prior to the 2000-2002 period, stocks had not lost money for three years in a row since 1939-1941, and investors had not experienced a decline like 2008’ssince1931.Thiscentury’sbearmarketsaresecondonlytothoseoftheGreatDepression.Investorshavebeenseriously questioning their beliefs about the market as we enter 2009 and investor sentiments changed from “Why aren’twebeatingthemarket?”to“Whyshouldwebeinthemarket?”Emotionshadturnedfromgreed,whenthemarkets were high, to fear when the markets were much lower.

Fortunately, most of our clients realize the benefits of maintaining a broadly-diversified portfolio and know the dangers of letting emotions drive their investment decisions. While diversification does not guarantee a profit nor protectagainstalossindecliningmarkets,weatM.J.SmithandAssociatesbelievethatthefutureisalways unknown. Successful investing requires the following:

1)Ownqualityinvestments—don’tspeculate 2)Bebroadlydiversifiedacrossandwithinassetclasses 3)Hiresolidinvestmentfirmstobuy/sellthespecificsecurities 4)Bepatientanddonotletemotionstakeyouoffcourse

Itisthislastareawhereaninvestmentmanagementconsultingfirmlikeoursprobablyaddsthemostvalue.Toprovethispoint,Dalbar,Inc.,awell-respectedinvestmentcompanyresearchfirm,comparedthemarket’sreturnforthe20-yearperiodendingDecember31,2007(Buy&Hold,S&P500),totheaveragereturnearnedbyactualshareholdersinequityfunds(AverageEquityInvestor)andarrivedatthefollowingshockingresult.

May 2009

Clients should periodically re-evaluate whether the use of an asset-based fee continues to be appropriate in servicing their needs. A list of additional considerations, as well as the fee schedule, is available in the firm’s Form ADV Part II as well as the client agreement.

CHART 1 Dalbar’s Quantitative Analysis of Investor Behavior Study 2008: 20-year average annual total returns as of 12/31/07

Thischartrevealsthattheaverageinvestor’sreturnswerefarless than the returns the market generated, and the emotions of fear and greedareprimarilyresponsible.Theunfortunatetruthisthatthe averageholdingperiodofafundisonly30months.Typicalinvestorspurchase investments based on attractive past returns (when investmentsarelikelyovervalued)andwantoutwhentheydon’t performordecline(whentheyarepricedless).

SOURCE: Dalbar. Past performance is no guarantee of future results

Keep in mind that the Average Equity Fund Investor (as defined by DALBAR) represents the aggregate action of all investors in equity mutual funds. The return is calculated by treating ag-gregate industry flows as being representative of the average investor and applying these flows to the appropriate performance index. The rate of return investors earn is based on the length of time investors actually remain invested in a fund, amount of dollars bought and sold and the historic performance of the fund’s appropriate index. Indices used in the DALBAR study include the S&P 500 Index for equities and a Long Term Government Bond Fund for fixed income investments.

Toassesshowindividualportfolioscouldperform,comparedtothemarket,weransomereportsandchartsfroma Morningstar database we maintain. We assumed the following hypothetical diversified portfolio:

Footnote: Disclosure below for indexes used for above asset classes

This portfolio is strictly hypothetical. The weighted portfolio, and all associated returns and statistics, are not reflective of any historical advisory recommendation.

The investment profile is hypothetical, and the asset allocations are presented only as examples and are not intended as investment advice. Please consult your financial advisor if you have questions about these examples and how they relate to your own financial situation.

Investing in small cap stocks generally involves greater risks, and therefore, may not be appropriate for every investor.

CHART 2

Annualized Returns as of 12/31/2008 1 Year 3 Year 5 Year 10 Year Barclays Capital Government Credit Bond 5.70% 5.56% 4.64% 5.64% Standard & Poor’s 500 – Large Stocks -37.00 -8.36 -2.19 -1.38 EAFE International Stocks -43.38 -7.35 1.66 0.80 Wilshire REIT -39.20 -11.99 0.65 7.65 Russell 2000 – Small Stocks -33.79 -8.29 -0.93 3.02 S&P GSCI Commodity -46.49 -15.53 -2.36 7.35 1. Barclays Capital Government Credit Bond - Fixed income or bond funds may pay higher rates than CDs, but their net asset values are sensitive to interest rate movements

and a rise in interest rates can result in a decline in the value of the customer’s investment. Individual results will vary.

2. S&P 500 is an unmanaged index of 500 widely held stocks that are generally considered representative of the US stock market.

3. The EAFE index is an unmanaged index that is generally considered representative of the international stock market. These international securities involved additional risks including currency fluctuations differing, financial accounting standards and possible political and economic volatility.

4. Wilshire REIT – REITs have various risks, including possible lack of liquidity: devaluation based on adverse economic and regulatory changes and will fluctuate with the value of the underlying properties.

5. The Russell 2000 index is an unmanaged index of small cap securities, which generally involve greater risk. The prices of small company stocks may be subject to more volatility than those of large company stocks.

This Chart is not representative of an individual client portfolio keeping in mind individuals cannot invest directly into an index. The above indexes are all represented in the pie chart for the Hypothetical Diversified Portfolio.

0%

2%

4%

6%

8%

10%

12%

4.5%

3.0%

11.6%

AverageEquity Investor

Inflation Buy & Hold(S&P 500)

2

1

2

3

4

5

Large Stocks 15%

Bonds 40%

Real Estate Stocks 10%

Small Company Stocks 10%

International Stocks 15%

Commodities 10%

Hypothetical Diversified Portfolio

Diversified Portfolio vs. Market Return Analysis Now let’s compare the results of a hypothetical well-diversified portfolio to the S&P 500 over the last 10 years.

CHART 3

While both portfolios displayed ups and downs during this 10-year period, the path taken was quite different. Let’s compare the actual trailing returns of both portfolios.

Growth of $100,000

Year

3

Chart 2 reveals these facts:

•BondshaveactuallyoutperformedU.S.andinternationalstocksduringthelasttenyears.While,thisisgenerallynotthe case long term, it is a reflection of the fear that has gripped investors during much of this decade. With interest rates the lowest they have been in history, future bond returns are likely to be lower.

•WhilemanyinvestorswereintriguedwiththeS&P500asweenteredthisdecade,itisnowactuallyinlastplaceinterms of performance from 12/31/98-12/31/08 compared to the others on the chart. From a contrarian point of view and based upon numerous valuation metrics, it may actually represent one of the best opportunities today.

•Broadbaseddiversification,asrecommendedbyourfirm,isdesignedtoreducetheriskofthemarkets,butitdoesn’tal-ways do so. For example, 2008 was a very unusual year where even many balanced portfolios saw declines in excess of 20%.

•WhiletheinflationhedgeinvestmentsofbothREITsandcommoditiessawlargelossesin2008,theyhaveaddedsig-nificantlytotheoutperformanceoverthelastdecade.Ifthegovernment’sstimuluspackagehasitsintendedeffect,oneshould count on a reemergence of inflation, which is where these investments perform best.

•WhilebothsmallU.S.stocksandinternationalstockshaveoutperformedtheS&P500overthelastdecade,thishasnotalwaysbeenthecase.Duringmuchofthe90stheoppositewastrue.Bydiversifyingacrossthesethreemarkets,our firm’s intent is to improve overall consistency. While not guaranteed, this has generally been our experience.

With all observations above, please note that past performance is no guarantee of future results and please read the other pertinent disclosures in this research report.

But What About Risk? Inthelate1990s,investorsfrequentlytoldushowrisktoleranttheywere.Itwaseasytoberisktolerantduringthistime,as the 1990s stock market experienced very little risk. Since then, many of these same investors have reassessed their risk tolerance and have decided to make their portfolios more conservative after seeing the downside risk of stocks.

Let’s talk about downside risk. Chart 5 compares the losses, over the last ten years, of the hypothetical diversified portfolio to the S&P 500:

CHART 5Chart 5 reveals that the diversified portfolio experienced significantly lessdownsideriskthanthatofthemarket.Asnotedintheworstthree-year loss analysis, an all-stock portfolio loss of 16% per year would have seen approximately half of the portfolio value eroded, while the diversified portfolio’s loss of 3.9% annually would have experiencedacumulativedeclineoflessthan12%.Thediversifiedportfolio reflects attractive returns in Chart 4, when compared to the returnswithanall-stockportfolio.Obviously,ittakesmuchlongerto recover from a 50% loss than a 12% loss.

Examiningthetotalvolatility(bothgainsandlosses)ofbothportfoliosoverthelasttenyears(asmeasuredbyBeta), thediversifiedportfoliodisplaysonly48%oftheoverallvolatilityofthemarket(Betaof.48).Whenwecomparethe risk/return tradeoffs over the last ten years, we arrive at the following results:

Thehypotheticaldiversifiedportfoliogeneratedgreater returns than an all-stock portfolio but with only 48% of the overall volatility and with signifi-cantlylessdownsiderisk.Therefore,onanabsoluteand risk-adjusted basis, over 10 years, the hypotheti-caldiversifiedportfoliobeatthemarket!Ofcourse,individual results would vary and past performance is not guaranteed.

Please contact our office if you want more updated returns represented in this analysis.

Worst 3 months (a)

-30

-25

-20

-15

-10

-5

0

Downside Risk AnalysisWorst

1 year (b)Worst

3 years (c)

-23.21%

-29.65%

-38.09%

-3.86%

-16.0%

Diversified Portfolio (see pie chart on page 2)

S&P 500

-24.68%

-35

-40

10 Year AnnualReturns 12/31/08

0

2

4

6

-2 10 Year Risk (Beta)12/31/08

5.20%

-1.38%0.48

1.0

Diversified Portfolio (see pie chart on page 2)

S&P 500

SOURCE: Morningstar Footnotes (a) 9-08/11-08 (b) 12-07/11-08 (c) 4-00/3-03 S&P 500, 12-05//11-08 Diversified PortfolioBeta is a measure of a portfolio’s leverage to the benchmark (the benchmark beta=1.0) A portfolio beta of 1.2 indicates that if the benchmark returns 10.0% the portfolio is expected to return 12.0%. If the benchmark returns -10.0% how-ever, the portfolio is expected to return -12.0%.

Worst 3 months (a)

-30

-25

-20

-15

-10

-5

0

Downside Risk AnalysisWorst

1 year (b)Worst

3 years (c)

-8.97%

-19.2%

-9.20%

-26.54%

-3.12%

-16.0%

Diversified Portfolio (see pie chart on page 2)

S&P 500

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CHART 4

Annualized Returns through 12/31/08 1 Year 3 Year 5 Year 10 Year

The Diversified Portfolio (see page 2) -21.72% -2.26% 2.71% 5.20%

Standard & Poor’s 500 – Large Stocks -37.00 -8.36 -2.19 -1.38 Note: this investment is hypothetical and the asset allocation is presented only as an example and is not intended as investment advice. Please consult your financial advisor if you have any questions about this example and how it relates to your financial situation.

You cannot invest directly in an index. Individual results will vary. This investment returns and statistics presented do not reflect the deduction of investment advisory fees, if applicable. Past performance does not guarantee future results. Investing involves risk and you may incur a profit or loss. For the purpose of calculating performance, the portfolio was rebalanced annually to the original model allocation.

The illustration may include reinvestment of dividends and capital gains. It depicts performance without adjusting for the effects of taxations.

Thehypotheticaldiversifiedportfolioexperiencedanunpleasantlossof21.72%lastyear,butbeatthemarket’slossof37%.

CHART 6

What Does This Mean? Wehelpourclientsrealizethattheirfocusshouldnotbeonbeating“themarket”oranyotherrelatedindex.Investorsneedtorecognizethattheprimaryobjectiveinthemanagementoftheirassetsistoachievetheirfinancialgoals.At M.J.SmithandAssociates,beforeanyinvestmentdecisionsaremade,aproperanalysisofretirementgoals,children’seducationfundingneeds,risktolerance,incometaxsituationandtimehorizonisconducted.Onlythenareinvestorsinaposition to make the most important investment decision of all, which is asset allocation. Studies continue to prove, as illustrated in this report, that how you diversify is more important than what stocks, bonds or funds you purchase. Focusing on investments before policy results is putting the “cart before the horse” and having a poor investment process in place.

Why Use an Investment Consulting Firm? Chart 1 reveals that investors could dramatically under-perform the markets because they use a poor investment policy and let the emotions of fear and greed influence their decisions. With the significant rise in the markets since 2002, followed by the recent volatility, investors are under a lot of emotional stress and subject to make the same mistakes reflected in Chart 1. While basic investing fundamentals do not have to be complicated, astute investors recognize the significant value of using an investment management consulting firm.

When seeking a wealth management firm, astute investors look for:

•A firm with integrity that can provide unbiased information and knowledge on not only investment-related topics, but also more comprehensive financial planning areas.Theseareasincluderetirementplanning,taxplanning,estateplanning,college funding and risk management.

•A firm that can align your financial goals with your financial assets and resources to determine the likelihood of successfully achieving those goals.Investmentmanagementfirmsmustsharetheuncertaintiesofthemarketsandothervariableswith investors so that realistic expectations can be established.

•A firm that recognizes the primary focus should be on asset allocation, and that allocation decisions should be made only after a complete review of an investor’s need, willingness and ability to take risk. Designing a carefully laid out investment plan, only to find an investor “bailing out” when market volatility increases, results in potentially serious losses and unmet goals.

•A firm that focuses on how to reduce the tax burden on the returns of the portfolio.Theportfolioshouldbestructuredsothatlesstax-efficientfundsarepositionedinsidequalifiedandnon-qualifiedaccounts(IRAs,40l(k)s,annuities,etc.). Taxablefundsshouldbepositionedinmoretax-efficientinvestments.

•A firm that works on a fee-based—not commission driven— approach, without hidden agendas, and has access to a large universe of top-rated investment choices. While selecting investment companies with great past performance is easy, the firm must have a disciplined monitoring process on future performance and recognize that even the best investments willfrequentlyunder-performduringcertainperiods.Investorsmustbeeducatedabouttheimportanceofknowingwhentoreplaceaninvestmentandtorecognizethatthispartoftheprocessisnotanexactscience.Replacinganinvest-ment made too quickly, due to under-performance, may lead to the same results of the average investor in Chart 1. Clients should periodically re-evaluate whether the use of an asset-based fee continues to be appropriate in servicing theirneeds.Alistofadditionalconsiderations,aswellasthefeeschedule,isavailableinthefirm’sFormADVPartIIas well as the client agreement.

•A firm that has the overall accounting and monitoring systems in place to regularly evaluate the total portfolio’s return and to cross-check and verify that the investor is on track to achieving the goals established.Iftheinvestorisoffcourse,strategiesshould be discussed and reviewed so that the investor can make informed decisions on the best course of action to take.

•A firm that provides the discipline to regularly rebalance the portfolio as needed.Theprocessofrebalancinginvolves selling some of those asset classes that have risen the most and buying, with the proceeds, those investments that have under-performed.Aseasyasitmaysoundto“sellhigh,buylow,”mostinvestorsfinditverydifficulttodo.

•A firm that will constantly educate the investor.Onethingiscertain;changeisconstant.Investorsneedhelpfilteringthrough the noise of the market and dealing with the emotional aspects of world events. Mistakes, such as confus-ing the familiar with the safe, overconfidence, following the herd, having too many eggs in one basket, treating the unlikely as impossible, and purchasing products that you didn’t intend to buy, need to be avoided.

WeatM.J.SmithandAssociatesremainfirmlycommittedtohelpinginvestorsachievetheirfinancialgoals.Wewantto thank the hundreds of valued clients who have been with us over the last 25 years of our firm’s history, and we look forward to forging lasting relationships with our new clients. We welcome any questions you may have.

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About Mark J. Smith and M.J. Smith and Associates

Mark J. Smith is a CERTIFIED FINANCIAL PLANNER™practitioner,aPersonalFinancialSpecialist,aCertifiedInvestmentManagementAnalyst,andaCertifiedPublicAccountant.Hewasthetop-rankednationaladvisorforRaymondJamesFinancialServices,Inc.,forfourconsecutiveyears,andhasbeenrankedinthetopthreeadvisorseveryyearforthepastelevenyears.In2009Barron’smagazinenamedSmithtoitslistoftop1,000wealthadvisors.Thelistisbasedonadvisors’assets under management, revenues, management practices, expertise, insight, trustworthiness and commitment to their clients.

In2008,Registered Rep magazine named Smith one of the top independent broker/dealer rep-resentativesintheU.S.,rankinghim15th,basedonassetsundermanagement,outofmorethan90,000independentbroker/dealerrepresentativesintheindustry.HewasalsoincludedinWorth magazine’s 2008 national list of top 250 wealth advisors, judged on expertise, insight, trustworthiness and commitment to clients.

In2007,Barron’s named Smith the top independent financial advisor in Colorado and number 22 intheU.S.basedonassetsundermanagement,revenuesandqualityofservice.Registered Rep namedhimoneofthetop10outstandingwealthadvisorsinAmerica,selectinghimforselected

based on superior performance in money management, client service, business building, acknowledged peer recognition andrespect,andphilanthropicactivities.In2007and2008,TheWinner’sCircle,anindependentadvocacyorganiza-tion,rankedSmithfirstandthird,respectively,intop-rankedColoradofinancialadvisors.Theselectionteamanalyzedquantitativecriteria,includingassetsmanagedandrevenues.Theirqualitativeresearchincludedinterviewswitheachcandidate’s colleagues and clients and analysis of the firm’s team, credentials, and client service.

M.J.SmithandAssociateswasnamedtoWealth Managermagazine’s2008TopDoglistofbestnationaladvisoryfirmsservinghigh-net-worthclients.Therankingisbasedontheaverageassetsundermanagementperclient.

AnaccountingmajorattheUniversityofIowa,Smithholdsabachelorofbusinessadministrationdegree.HeestablishedM.J.SmithandAssociatesin1983aftergainingexperienceattheinternationalaccountingfirmDeloitte,Haskins&Sells.HealsoservedasthedirectorofincometaxesforAffiliatedBanksharesofColorado,a29-bankholdingcompany,wherehewasinchargeofallincometax-relatedmattersfor37corporations.

M.J.SmithandAssociatesoffersfee-basedassetmanagementserviceswithacomprehensivefinancialplanningapproachwhichincludesincometaxplanning.ThefirmisaregisteredinvestmentadvisorwiththeU.S.SecuritiesandExchangeCommissionandisoneofthefiveleadingofficesoutof1,366independentbranchofficesofRaymondJamesFinancialServices,Inc.,anationalinvestmentcompany.

9635 Maroon Circle, Suite 230 Englewood, CO 80112 T 303-768-0007 | F 303-768-0008 www.mj-smith.com

M.J. Smith and Associates is a Registered Investment Advisor

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of M.J. Smith and Associates and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. Investments mentioned may not be suitable for all investors. Past performance may not be indicative of future results. Be advised that investments in real estate and in REITs have various risks, including possible lack of liquidity and devaluation based on adverse economic and regulatory changes. Additionally, investments in REITs will fluctuate with the value of the underlying properties, and the price at redemption may be more or less than the original price paid. Commodities may be subject to greater volatility than investments in traditional securities. Investments in commodities may be affected by overall market movements, changes in interest rates, and other factors such as weather, disease, embargoes and international economic and political developments. Please note that international investing involves special risks, including currency fluctuations, differing financial accounting standards, and possible political and economic volatility. There is no guarantee that any asset alloca-tion, diversification, strategy, or recommendation will ultimately become successful or profitable nor protect against loss. Tax advice should be sought and provided by an appropriate professional. Rebalancing a non-retirement account could be a taxable event.