Given the magnitude of recent declines in the price of financial assets, commodities, and residential real estate, investors are coping with decisions about how to invest on a go forward basis. Our recent paper (appearing in our Investment Quarterly for Quarter 4, 2008] situates decision making within the context of investor ‘utility,’ where utility measures the investor’s aversion to declines in wealth as well as the investor’s satisfaction with gains in wealth.

For some investors, risk tolerance changes with increases or decreases in their level of wealth. However, many investment policies mandate a constant proportional weighting between stocks and bonds during both bull and bear markets. A fixed investment allocation is usually termed a “Constant Mix” asset management approach. Such an approach is defensible under a variety of commonly held assumptions; and, is often recommended as a reasonable alternative to the risks of market timing. Advisors advocating that investors “stay the course” during perilous market conditions implicitly assume that investors, in general, benefit from a Constant Mix approach.

Warning! Economic disaster is closer than you think.

Why have an investment reserve? The underlying mathematics of compound return indicate that the more volatile the investment, the lower a portfolio’s long-term growth rate, all else equal. An investment that losses 20% in period one needs 25% in period two in order to get back to even. Periods of negative returns not only decrease portfolio value but, if the portfolio is also funding retirement distributions, the distributions take dollars out of the portfolio at the worst possible time. In a nutshell, distributions multiply the bad consequences of negative returns and cap the benefits of positive returns. The Wall Street term for taking money out of portfolios during periods of economic distress is “feeding the bear.”

By now, you have probably worked up the courage to peek at your October statements. For most investment positions (with the exception of some bond funds) returns were “double-digit” negative. The October decline accounts for approximately half of portfolio year-to-date losses across a broad spectrum of asset allocations. In terms of SCLC’s reporting metrics, October results are at the end of the left-tail of the historical distribution of post 1972 returns—declines of this magnitude have happened before; but nevertheless it comes as a shock.

Here are some observations for your consideration:

Some have said the attached newsletter contained many “factoids,” others think we’ve been data mining. I say it’s worth reading. If nothing else, it will provide fodder for water cooler conversations, or for your next cocktail party.

As you know, volatility in many financial markets has increased over the past year. It seems that the ‘volatility’ of TV, radio, and print-media news has also increased. This letter is an update on our investment views.

About six months ago, as U.S. equity prices continued to decline, we sent you a letter indicating that the fallout from the residential housing mortgage crisis was spreading to other financial markets. The mechanism for transmitting this contagion was the banking system. In a nutshell, as the banks’ aggressive home loan portfolios came under pressure, regulators demanded that banks shore up their balance sheets. Many money-center banks had large loans out to hedge funds. Sad to say, some hedge funds chose to maintain double-digit rates of return by levering their investment positions. Financial leverage can turn mediocre investment results into attractive returns—but only at the cost of increasing investment risk. As the banks called the hedge fund loans, the funds had to unwind their investment positions by selling securities. Some hedge funds were leveraged 30 to 1, and had to sell large amounts of securities to raise a sufficient amount of cash to repay bank loans. Some hedge funds went bankrupt [proving, yet again, that there is no riskless investment that can forever generate double-digit returns]. Equity prices continue to decline as leverage is wrung out of the system. Given a long-term view, we suggested that this was a good thing despite the obvious fact that nobody enjoys periods of price decline.

During the last several weeks, world equity markets have coupled and, in general, have moved downwards. Although the magnitude of decline is well within the expected probability distribution of stock prices, nevertheless, some investors may become disconcerted because of a natural human tendency to extrapolate current events into an indefinite future.

One of the basic principles of investing is that the future return on a portfolio of risky assets is a random variable – i.e., not knowable. Over many long planning horizons, under some simplifying assumptions, actual portfolio return converges towards a number that is greater than the risk-free rate available through U.S. Treasuries or bank CDs. Likewise, over a single life’s long-term planning horizon, it is also reasonable to expect that a portfolio of risky assets will outperform a risk-free investment.

Patrick Collins, Ph.D, CLU, CFA has released a working paper on the topic of Multifactor Asset Pricing Models and the Rationale for Investing in Value Stocks.

This article summarizes academic research into multifactor asset pricing models, with specific emphasis on growth and value stocks. The article notes that empirical studies observe that value stocks typically generate superior risk-adjusted returns relative to growth stocks, and addresses implications for the Efficient Market Hypothesis if value stocks, in fact, represent an improperly priced risk factor.

Patrick Collins, Ph.D, CLU, CFA has released a working paper on the topic of The Decision to Replace Trust Owned Life Insurance Policies. Reprinted from the November / December 2005 issue of The Banking Law Journal

There may be many valid reasons to consider life insurance policy replacement. However, the focus in this article is on replacing an existing life insurance contract with a new contract that provides superior financial results. The trustee takes replacement action based on the expectation that the new policy offers a financial instrument better suited to the terms, purposes, distribution requirements, and other circumstances of the trust — a prudent decision-making process. It also addresses the quantitative nature of the analysis (and difficulties therein) and provides an approach which allows the trustee to demonstrate the requisite levels of care, skill, and caution.

Patrick Collins, Ph.D, CLU, CFA, and Josh Stampfli MS (EESOR), have released a working paper on the topic of portfolio rebalancing. The paper begins with an overview of the surprisingly extensive research on the topic, including a survey of various rebalancing strategies and results from several empirical and mathematical studies. The authors go on to explain exactly how portfolio rebalancing can either enhance returns, control risk, or both. In the process they touch on issues both practical, such as taxes, and cerebral, as in Utility Theory. To gain further insight into the economic consequences of rebalance elections, Collins & Stampfli developed a simulation model with which they test nine different rebalance strategies under both portfolio accumulation and decumulation conditions. The results are instructive.