February 2008 INTRODUCTION The decline of the U.S. stock market at the end of 2007 and during the months of January and early February in 2008, has frightened a lot of investors. The first article takes a look at this period and offers some food for thought. That article also suggests a course of action, depending on whether or not the market deteriorates further. Next is a piece on a victory of the individual investor over the SEC, followed by articles on a delightfully opinionated centrogenarian, and on why to be very cautious in responding to e-mail from someone you do not know. The last major article looks at the nuances of managing a retirement account. We end with a caution to any investor who has received a speeding ticket, a few notable quotes, and Office Matters. --David W. Otto, Editor REFLECTIONS ON THE MARKET Recent volatility in the stock market, combined with significant declines in returns has led to growing fears among investors that a recession may be imminent and those fears may be feeding a further decline in the U.S. stock market. This article, while more technical than most Newsletter articles, will attempt to address the problem of the market, along with Otto & Associates' response. First, some background as to how we got to where we are today. One well-known concept regarding the stock market is that in the short term it is driven by emotions which move between two poles, greed and fear. When things are going well, greed operates ("greed" is a pejorative word to convey something more complicated, but it has become accepted shorthand in the investment world), as investors hope that they will continue to prosper. Fear comes into play (again, we have a word that is shorthand, but less pejorative) when the market begins to lose money. Today the markets have lost more than 11% from the recent high in November of 2007. Fear is the operative emotion. We are taught that greed leads to problems for investors, but those are usually of a long term nature. The results of fear are much more immediate. How do we at O&A take fear into account as we invest our clients' funds? Education is one of the primary things we emphasize. Another important strategy is to invest in a diversified portfolio. All of our clients have a target allocation which includes U.S. stocks, international stocks, and bonds. It is informative to look at what happened to those three categories in the recent three month period of October 31, 2007 to January 31, 2008. While we are long-term investors, market activities during this brief period will serve to illustrate an important point. In the months of November, December and January, returns for the three categories were radically different: U.S. stocks returned -10.9%; international stocks: -14.2%; U.S. bonds: +3.8%. The difference in return between international stocks and U.S. bonds for this period was a whopping 18%! However, the blended return for those three categories (weighted to 50%/20%/30% respectively - which is the approximate weighting for many of our clients) is -7.2%. Losing 7.2% is of concern of course, but it is better than losing 10.9%. While it is not always true, big movements in the stock market often have an opposite effect in the bond market, as happened in this period. Stocks lost money; bonds made money. Diversification worked very well. There is still better news: our clients lost less than the -7.2% of the blended average listed above. Because our investments are tilted to be a bit more conservative, and because during December and the first weeks of January Closed End Bond Funds worked well, our clients, on average, lost 5.0%, less than half what the stock market lost and a positive difference from the blended return of 2.2% (-7.2% vs. -5.0%) is encouraging. In addition to educating clients and emphasizing diversification of portfolios, O&A also tries to analyze trends to find opportunities when they exist. The question is, why have stocks, both international and domestic, lost money? The answer is complicated. To review: to own stocks (O&A clients normally buy stocks through mutual funds, which pick specific stocks to own) is to be an owner of companies. So if a company makes money, then the company is worth more. Whether you buy an interest in a local company for $100,000 or you are part of a much larger group that buys a company for $100,000,000,000, if the company has a very good year or two, we would expect it would be worth more. Likewise, if the company makes money, but for some period of time, makes less than expected, we would anticipate that it would be worth less. The fact that the market has lost 11% in three months suggests that companies must be making a lot less money. However, at this point that is not the case. This fact introduces two additional concepts. First, the market anticipates. Companies do not have to actually lose money in order for investors to decide the company is worth less and bid down the price of the stock. If investors anticipate that a company is going to make less money in the immediate future, the price will normally go down. The current fear is that a recession might cause people to buy fewer products, resulting in companies selling less and thereby making less money. "Herd mentality" is another emotional factor operating in a market decline. Not wanting to be left holding the bag, people head for the exits by selling stocks, and the market loses money. Certainty is impossible in the midst of this kind of turmoil. The predictions of experts for the immediate future of the stock market run the gamut from significant pessimism to guarded optimism. It is likely that companies that have recently had incredibly high earnings will not sustain those profits. If nothing else, competition will drive prices down, making companies less profitable. Yet that still leaves many questions about the future unanswered. Despite uncertainty, we can be assured that over the long haul, most companies will make money. The question is: how much less money will they make now, and for what period of time will they make less money? Because stock prices have fallen significantly, we at O&A are beginning to think about buying stock mutual funds. Indeed, for a few people who were well below their target for U.S. stocks, we have already begun buying. We expect to increase the purchase of stock mutual funds, even though it is likely the market has not yet reached the bottom. If the market continues to deteriorate, we will buy more aggressively. Because our clients are long term investors, they can tolerate short-term losses. Purchasing stocks when the market is in the lower ranges eventually works out. We believe that by maintaining our investment discipline, we will improve the chances of surpassing the blended returns in the three basic categories over the long term, in spite of the uncertainties of the economy and the market in future months. DAVID VS. GOLIATH Three years ago the Financial Planning Association (FPA), the professional organization affiliated with the Certified Financial Planner (CFP) designation, brought a lawsuit against the Securities and Exchange Commission (SEC). This past April they won their case! This item did not receive a lot of press coverage, but the decision of the U.S. Court of Appeals will have wide-ranging and long-lasting implications. Here is what happened. The FPA challenged a ruling by the SEC that said brokers could call themselves "personal financial advisors." The FPA argued that there was a difference between being a salesman and an agent of a brokerage house, and being a member of an authentic profession with professional standards. They further argued that brokers had either to accept fiduciary responsibilities or tell their customers that they were salespeople not responsible for putting client interests ahead of their own interests. A person who worked for a brokerage house could be a salesman, or be a financial advisor that held to the fiduciary code, but he could not be both. Caveat emptor - buyer beware - would not be sufficient. The FPA asserted that the SEC had made some major mistakes. They stressed the inappropriateness of expecting consumers of financial advice and products to tell the difference between someone simply selling a product and someone with earned credentials who has pledged to put the client first, including in the selection of investments. They further said it was unfair for brokers to walk like advisors and talk like advisors while actually serving as sales reps whose primary obligations were to their brokerage houses. The suit against the SEC made a final point. It is not that difficult to become a Registered Investment Advisor (RIA). Such advisors need to register with the SEC, disclose any conflicts of interest up front (not in fine print buried where it would rarely be seen), advise clients, and be accountable for giving advice that is not biased by conflicts of interest. This was not an insignificant victory for consumers. (As most of you know Deborah and David are both RIAs and Certified Financial Planners.) The SEC is charged with protecting individual investors, but many consider their track record in that regard to be abysmal. In this case, however, the court has given a very clear directive to the SEC which is an important step toward greater clarity and integrity in the financial services industry. ANOTHER CENTOGENARIAN Clients at Otto & Associates know that our concerns go beyond managing money. We plan for retirement so clients can continue the life style they have had, and we also do what we can to promote the kind of living that leads to longevity. To that end, O&A has a policy which states that during the quarter any client turns 100, he or she will be charged no management fee. A second client has now achieved that milestone. On December 21, Ruth Hughes, a long-time resident of Mount Kisco, NY, who now lives closer to one of her children in Bath, ME, reached 100. Mrs. Hughes is reasonably healthy and seems to have every marble that she ever possessed. Her family wanted to have a big celebration, with various members coming from around the country. She put her foot down and refused. She doesn't like crowds and said she didn't want a big party. So her family all visited prior to her birthday in groups of 2 or 3. Everyone seemed to enjoy that alternative. Then on her birthday she arranged, according to a report from both Mrs. Hughes and her son, to have a lovely dinner at a restaurant. While she footed the bill, she let it be known that she would not be in attendance - again, because she does not like crowds. So the seven celebrants had a wonderful dinner and used a cell phone to call her while they sang "Happy Birthday." No one from O&A was present on Dec. 21, but David is able to see her on occasional trips to Boothbay Harbor, Maine. We hope the O&A policy motivates other clients to reach toward 100, so they, too, can get a quarter of money management without charge. SPAM You can't be too careful with how you respond to e-mail in your Inbox. A couple of months ago I received a notice from the IRS that I had a tax refund due me of $268.32. The e-mail was sent from the following address: 'Internal Revenue Service' <"refund@irs.gov"> Something didn't seem right, but I could find nothing that I identified as suspicious. And the $268.32 seemed like a benign amount. I took the e-mail to the accountant we use and he confirmed that it was a scam. He said the IRS does not use e-mail to notify taxpayers of refunds. But he could not find anything to give away that it was spam. The address seemed authentic. This reminded me of an incident that happened to a long-time client. Here is what she writes: "I mistakenly replied to an e-mail I received from what I thought was my bank, saying they needed to update my personal information for security purposes. Silly me. I gave them everything, including, worst of all, my Social Security number. About a week later, a vendor, noticing repetitive charges to my bank card, telephoned, advising me to check to be sure nothing unusual was going on. I thought this phone call was probably bogus, but DID call the bank. They unraveled other phony charges, amounting to several thousand dollars." While our client was ultimately not out any money, she had to close bank accounts and open new ones. She had to file reports with various federal credit agencies, including the IRS and Social Security, and with the local police department. She describes the process as "long, time consuming, and nightmarish," and she says that she still occasionally gets something from the IRS expressing confusion about her Social Security number. She concludes, "Just be sure to advise your readers NEVER to give personal information, especially a Social Security number by e-mail." So you have been warned. Just remember: some scams look very legitimate. RETIREMENT CONCERNS To build up a retirement account, save early, save a lot (a good guideline is to save 10% of your income), and spend none of the nest egg before retirement. That's it. Fluctuations in the market need not influence the amount you save, and gains and losses over the years will even out to a gain of between 8% and 10%, assuming the savings plan is invested wisely. The result is a successful retirement. To say this another way, if the returns for a retirement account were miserable in the first years but hit the average in the long run, the return would be exactly the same as if the returns were fantastic in the first years but hit the same average in the long run. The sequence in which higher and lower returns are achieved has no effect. Surprisingly, the same is not true when a retiree begins withdrawing. At this point, return sequence can make a significant difference. Specifically, it is problematic when the portfolio loses money early in retirement. For people who retired in 2000, when the market lost 45% in the following three years, their retirement plan was suddenly in jeopardy, particularly if they had all of their money invested in the stock market. The most common stories were about people who had their money invested in the ".com" stocks, which lost close to 80% during that time. The "total annual return" percentage, the only thing that matters during the accumulation phase, is not the only thing that matters during the distribution phase. So how can retirees protect themselves and to what do they need to pay attention? There are some common sense things that any retiree can do. If a retiree has "just enough" saved for retirement, he needs to pay particular attention to what happens to investments during the early years of retirement. In the cases where return is below normal, retirees should temporarily cut back on spending: defer buying a car or put off taking a big trip. It is also important to limit losses. One suggestion for accomplishing this is to follow a formula: subtract the client's age from 100 and use that number as the maximum percentage of assets to allocate to stocks, a more volatile investment than bonds. At O&A we do not agree with this strategy because it is potentially too simple and may limit returns too severely. So what do we recommend? First, we diversify portfolios, and second, we normally continue our standard allocation in retirement, but take less than average risk within each of the investment categories. Further, we assume a lower investment return than the historical average. These three tactics have worked well for our clients, particularly combined with the common-sense approach mentioned in the above paragraph of limiting spending, should the market returns in the first years of retirement be below expectations. Of course the opposite can happen. If the market does unusually well during the initial years, there will be more money available. That is a "problem" most people can live with. The American Funds family did some research on this matter of safeguarding retirement funds (looking only at the downside of retirement where returns in the early years were below expectations) and published the results. If any of our readers would like a copy of this study, please call the office. SPEEDING TICKET The N.Y. Times had a fascinating article entitled: "Warning: Fast Driving May Lead to More Trading." Two professors were able to find a strong correlation between speeding tickets and trading frequency for residents of Finland. They chose Finland because there is so much data available on its citizens. For the complete article go to http://www.anderson.ucla.edu/documenets/areas/fac/finance/06-06.pdf. The research showed that an investor's turnover rate increased 11% after each additional speeding ticket he received. There was a surprisingly strong correlation, causing the study to be accepted as serious research. In an interview one of the authors acknowledged that as people grow older, they are likely to become more conservative drivers. Not coincidentally, they are also likely to trade less often. Then the authors asked, what is the likely explanation of the correlation between speeding tickets and active stock trading? One possible factor was overconfidence. If a driver deludes himself into thinking he can avoid being caught when speeding, he may also delude himself into believing he has above-average stock-picking ability. While this explanation definitely plays a part in the explanation, the main motivation for increased trading seems to be thrill seeking. Researchers found that "thrill-seekers" trade more often not because they have an inflated belief that they can beat the market, but because they find a static portfolio too boring. But the main question is, did more active trading improve their return? The answer is a clear No. In fact, they did worse after trading costs. The study provides yet more evidence that psychological motivations could play a large role in personal investment decisions. It also provides a clear message that if you are trading on your own, it is wise to engage in some honest self-reflection about your motivations. This is an especially important issue after you have just gotten pulled over for speeding. QUOTATIONS Invest for the long haul. Don't be too greedy and don't get too scared. - Shelby Davis Life is full of loneliness and misery and suffering and unhappiness, and it's all over much too quickly. - Woody Allen Diversification is the conscious choice not to make a killing, in exchange for the blessing of never being killed. - Nick Murray Economic forecasters are like cross-eyed javelin throwers; they don't win any accuracy contests, but they sure keep the crowd's attention. - Shelby Davis OFFICE MATTERS The National NAPFA Conference for Fee Only Planners will be held this year in Long Beach, CA, on May 13 -16. David will be attending along with his daughter, Susan Goodell, who is completing the first of six courses for the CFP. The featured speakers this year cover a wide range of financial planning areas. Eugene Fama, world-renowned academic, applies his research to the real world of investing. Recently he has worked with the privatized social security system in Chile. Robert Arnott is a researcher who has authored over 100 articles. He will be making a case for Fundamental Indexing and comparing that to actively managed mutual funds, which is the primary vehicle used by O&A. David and Mary have a new grandson. Sascha Cole Westermann was born to Elizabeth Otto and Tobias Westermann on April 5, 2007. They live in Buffalo, where Libby teaches in the Art History Department at SUNY Buffalo and Tobias works for the architectural firm of Hamilton Houston Lownie Architects. Some of you have met Kathy Patton, our new staff member. She joins Judy LaPorta on the administrative side and enhances the operations of an office that has been running very smoothly for a number of years - actually since Judy's arrival in 2000.