Weathering the Storm

The stock and bond markets were volatile during the third quarter of 2007. Choppy markets tend to heighten the anxiety level of most investors which can lead to poor investment decisions. Focusing on some basic concepts of sound investing should help you keep on track.

Markets Work
The stock market is an efficient system for gathering widely dispersed information. This does not mean that stocks are perfectly priced, but markets are so competitive that it is unlikely that an individual investor can consistently pick undervalued or overvalued stocks. Therefore a passive approach that captures market returns in an efficient manner is best.

Risk and Return Are Related
The most fundamental concept in modern finance is that investors get rewarded for assuming risk in the capital markets. But you don't get rewarded for just any risk. There's no compensation for company-specific or industry-specific risk that can easily be diversified away. You are rewarded for taking on systematic risk that affects the overall market. The only way to do that is through broad portfolio diversification across multiple asset classes.

Asset Allocation Determines Performance
Academic research has shown that asset allocation determines over 90% of a portfolio's returns over time. By constructing well-balanced, globally diversified portfolios, we strive to maximize expected return for a given level of risk. We also emphasize small cap and value stocks which have historically outperformed the broad market averages.

Market Timing is Risky
A successful market timing strategy requires two correct decisions: when to get out, and when to get back in. There is no evidence that anyone can make even one of these decisions correctly on a consistent basis. As we've seen during the last quarter, the stock market can move in sudden and unexpected ways. In a given year, missing just one or two of the best days of market performance can significantly reduce your annual return. The success rate required to beat a buy-and-hold strategy is unattainable for most market timers.

One of the great challenges to wise investing is maintaining a disciplined approach in the face of noisy capital markets. By keeping the above principles in mind, you should be able to navigate through turbulent times while sticking with a successful long-term investment strategy.

Please do not hesitate to contact me if you have any questions or comments.

Jeffrey J. Brown, MD MBA CFA
Shearwater Capital

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