Asset Allocation

Asset Allocation Principles
A Resource for Private Investors

20022003
Letter to Investors
To our investing clients:
We are pleased to present the enclosed selection of Asset Allocation Principles, High Net Worth Investment Tools,
Investment Philosophy Concepts, and summaries of Classic Investment Readings. These essays are excerpted from the
twenty-one previously published issues of Financial Management Review and Outlook, a joint publication of Morgan
Stanley Investment Management; the Morgan Stanley Individual Investor Group, including Investor Advisory Services and
Private Wealth Management; and Morgan Stanley Investment Research.
Academic studies have shown that approximately 75% to 91% of the variance in returns from investing activity derives
from the asset allocation decision. Asset allocation has been a core discipline and an area of firmwide focus since the
founding of Morgan Stanley Investment Management (MSIM) over 20 years ago. In recent years, we have extended
this emphasis to the investment needs, goals, and specific circumstances of affluent and High Net Worth family groups,
private foundations, closely-held corporations, and related private investors.
Throughout this publication, our aim is to provide analysis, tools, and concepts of value to sophisticated investors
facing important asset allocation decisions.
We want to emphasize our commitment to providing excellent service, superior quality investment advice, and
financial solutions that meet the needs of substantial private investors.
We greatly appreciate the feedback from, and dialogue with, our private investing clients that these writings have
engendered.

BARTON M. BIGGS
CHAIRMAN
MORGAN STANLEY
INVESTMENT MANAGEMENT
MITCHELL M. MERIN
PRESIDENT AND CHIEF OPERATING OFFICER
MORGAN STANLEY
INVESTMENT MANAGEMENT
JOHN H. SCHAEFER
PRESIDENT AND CHIEF OPERATING OFFICER
MORGAN STANLEY
INDIVIDUAL INVESTOR GROUP
MAYREE C. CLARK
GLOBAL DIRECTOR
MORGAN STANLEY
PRIVATE WEALTH MANAGEMENT
Asset Allocation Principles 2002-2003
PIease refer to important discIosures at the end of this report.
20022003
ASSET ALLOCATION PRINCIPLES 3
David M. Darst The Asset Allocation Process July 1997 5
Meanings, Questions, and Decisions October 1997 7
High Net Worth Investor Behavior January 1998 10
Interest and Dividend Reinvestment April 1998 13
Critical Determinants of Asset Allocation July1998 17
Spending Vs. Reinvesting Income Flows October 1998 20
Asset Allocation Tools and Analysis January 1999 27
Recognizing Turning Points April 1999 34
Structural Considerations July 1999 42
Comparative Financial Measures October 1999 53
Financial Climate Changes January 2000 61
HIGH NET WORTH INVESTMENT TOOLS 71
Ann K. Rusher Annual Reports January 1998 73
Investment Policy Statements April 1998 75
Investment Filters July 1998 77
Evaluative vs. Portfolio Time Horizons October 1998 79
Elizabeth W. Wells Historical Risk & Return Analysis January 1999 81
Jennifer V. King Internet-Based Investment Tools January 1999 85
Stephanie A. Whittier The Family Office in the New Millennium April 1999 87
John W. James, Jr. Evaluating Alternative Investments April 1999 89
Marianne L. Hay Equities: International Investing January 2000 93
Jeffrey S. Alvino Traditional Commodities: Portfolio Diversification Benefits January 2000 99
Frances M. Drake Personal Financial Statements August 2000 101
Jeffrey C. Huebner Investment Alternative: A Tutorial on Exchange Funds April 2002 108
Regina B. Maher/Sharon Gibbons Planning for and Financing a College Education April 2002 110
INVESTMENT PHILOSOPHY CONCEPTS 117
John M. Snyder Construction and Implementation January 1998 119
Thomas C. Frame Qualitative Investment Factors July 1998 123
Jesse L. Carroll, Jr. Investment Manager Selection Criteria January 1999 125
Walter Maynard, Jr. Evolution of the Core Equity Concept April 1999 127
Jesse L. Carroll, Jr. Tax-Efficient Separate Account Management October 1999 132
John M. Snyder The Interplay of Fear, Greed, and Rationality in Equity Investing January 2000 135
Lily Rafii S&P 500 Industry Sector Composition January 2000 137
Stephanie A. Whittier Financial Parenting August 2000 141
Diana Propper de Callejon Venture Capital/Private Equity:
Environmentally Conscious Investing April 2001 147
CLASSIC INVESTMENT READINGS (Excerpts) 151
Philip A. Fisher Common Stocks and Uncommon Profits, 1957 July 1997 153
Benjamin Graham The Intelligent Investor, 1949 October 1997 154
Philip L. Carret The Art of Speculation, 1930 January 1998 156
Gerald M. Loeb The Battle for Investment Survival, 1935 April 1998 158
Warren E. Buffett The Essays of Warren Buffett, 1997 July 1998 160
Charles P. Kindleberger Manias, Panics, and Crashes, 1978 October 1998 162
Peter L. Bernstein Capital Ideas, 1992 January 1999 164
Edwin LeFvre Reminiscences of a Stock Operator, 1923 April 1999 167
Charles Mackay Extraordinary Popular Delusions and the
Madness of Crowds, 1841 July 1999 170
Joseph de la Vega Confusin de Confusiones, 1688 October 1999 173
Walter Bagehot Lombard Street: A Description of the Money Market, 1873 January 2000 177
Fred Schwed, Jr. Where Are the Customers Yachts?, 1940 April 2000 182
Robert J. Shiller Irrational Exuberance, 2000 October 2000 187
John Brooks The Go-Go Years: The Drama and Crashing Finale of
Wall Street's Bullish 60s, 1973 July 2001 195
David F. Swensen Pioneering Portfolio Management, 2000 January 2002 202
3DJH1
The Asset Allocation Process 5
Meanings, Questions, and Decisions 7
High Net Worth Investor Behavior 10
Interest and Dividend Reinvestment 13
Critical Determinants of Asset Allocation 17
Spending Versus. Reinvesting Income Flows 20
Asset Allocation Tools and Analysis 27
Recognizing Turning Points 34
Structural Considerations 42
Comparative Financial Measures 53
Financial Climate Changes 61
3DJH 3
Asset Allocation Principles: The Asset Allocation Process David M. Darst
Asset allocation means different things to different
investor groups. For many institutional investors, asset
allocation means: (i) calculating the rates of return from,
standard deviations on, and correlations between, various
asset classes; (ii) running these variables through a
mean-variance optimization program to produce a
selection of asset mixes having different risk-reward
profiles; and (iii) analyzing and implementing some
version of the desired asset allocation in light of the
institutions goals, history, preferences, constraints, and
other factors.
For High Net Worth private investors, asset allocation
may or may not include these formalized actions. In our
view, most important for private investors is the need to
pursue asset allocation with special attention to: (i) the
tax status and after-tax implications of investments in a
given asset class; and (ii) the investors individual
motivations, personal circumstances, and cyclical and
secular market outlook.
Some, but by no means all, of the strategic issues
affecting wealthy private investors asset allocation
decisions include: the timing and magnitude of
intergenerational income requirements; the ability to
measure, withstand, and be adequately compensated for
bearing risk or loss; absolute and relative performance
goals and benchmarks for measuring returns; the
influence of one or more dominant investment positions
or significant non-tracked asset categories, such as art,
jewelry, or collectibles; and meaningful financial
liabilities such as mortgage debt or margin borrowing.
After a thorough review of the High Net Worth
investors financial profile and objectives, the asset
allocation process can proceed in a multi-step process.
First, assumptions need to be examined and then spelled
out about future expected returns, risk, and the
correlation of future returns between asset classes.
Second, the investor and his or her advisor should select
those asset classes which are appropriate in view of the
investors profile and objectives and which have the
maximum expected return for a given level of risk or,
stated another way, the minimum risk for a given level of
return.
Next, the investor should establish a long-term asset
allocation policy (the Strategic Asset Allocation)
which reflects the optimal long-term benchmark around
which future asset mixes might be expected to vary.
Fourth, the investor should implement Tactical Asset
Allocation decisions against the broad guidelines of the
Strategic Asset Allocation. Fifth, the portfolio of assets
should be periodically rebalanced, with sensitivity to the
tax consequences of such rebalancing, to take account of
the Strategic Asset Allocation framework. Last, the
investor should review the Strategic Asset Allocation
itself, from time to time, to ensure overall
appropriateness given his or her circumstances, frame of
mind, the outlook for each of the respective asset classes,
and the financial markets overall.
Quantitative and Qualitative Decision Framework
Specify
Assumptions
Re: Asset Classes
Conduct
Ongoing
Review
Select
Optimum Asset
Classes
Establish
Strategic
Asset Allocation
Implement
Tactical
Asset Allocation
Rebalance
Strategic
Asset Allocation
3DJH 5
Asset Allocation Principles: The Asset Allocation Process (cont.) David M. Darst
The history of wealthy individual investors focus on
asset allocation can be divided into three broad phases.
Traditionally, most U.S. private investors deployed their
portfolios according to overall perceived-wisdom
guidelines reflecting the investment ethos of the age. In
the 1930s, one version of these guidelines specified 60%
in U.S. domestic bonds and 40% in U.S. stocks. A more
recent version of this standard asset mix, which prevailed
for quite some time, recommended 60% in stocks, 30%
in bonds, and 10% in cash.
Beginning in the mid- to late 1980s, inspired by the
activities of certain institutional investors, a smaller
proportion of wealthy individuals and family groups
began to shift some of their assets into venture capital,
real estate, LBOs, oil and gas investments, and
international and emerging markets equity and debt.
The third phase of private investors evolution in asset
allocation has included exposure, generally through
funds or managed accounts, to a variety of sophisticated
investment strategies known as market-neutral or
absolute-return strategies. In the equity realm, these
strategies include warrant and convertible arbitrage,
hedged closed-end fund and cross ownership arbitrage,
synthetic security arbitrage, and other techniques
involving derivative instruments. In the fixed income
world, these strategies include futures, swap
arrangements, credit risk and yield curve shape
mispricings, and embedded and explicit options
techniques.
It is important for individual investors to recognize the
distinctions among, and the valuation dynamics
underlying, the three major super categories of assets, on
which Robert J. Greer elaborated in a Winter 1997
Journal of Portfolio Management article. The first asset
grouping consists of Capital Assets, such as equities and
fixed income securities. Valuations of these assets are
determined by the capitalization of cash flows from
projected dividend, interest, and terminal value
payments. The values of the second asset grouping,
Consumable or Tradable Assets, such as oil, grains, and
other commodities, are determined by the classical forces
of supply and demand. The valuations for the third asset
grouping, Store of Value Assets, such as art or
currencies, are a function of what someone is willing to
pay for them. Some assets, such as real estate or gold, fit
into more than one of these groupings. Being aware of
the distinctions between the value drivers in each asset
grouping, and the occasional tendency for markets to
misclassify assets (for example, treating stocks as
Consumable Assets, or as Store of Value Assets) can
help private investors in establishing a Strategic Asset
Allocation framework, in implementing tactical asset
allocation decisions, and even in selecting specific
investments.
For further insights on the importance and mechanics of asset allocation,
investors are referred to The Asset Allocation Process, by Barton M. Biggs,
dated October 17, 1996.
3DJH 6
Asset Allocation Principles: Meanings, Questions, and Decisions
David M. Darst
For the tax-sensitive private investor, asset allocation has
several deeper meanings beyond the mathematical
optimization of returns, standard deviations, and
correlations. Very importantly, asset allocation is about
(1) blending the underlying characteristics of a selected
set of asset classes to produce, in effect, a financial alloy
possessing a more favorable risk/reward profile than any
of its component elements. Further, asset allocation is
about (2) recognizing and balancing trade-offs, chief
among them being time horizon, protection goals, and
expected sources of return.
Asset allocation is also about (3) setting minimum
and maximum percentages to ensure sufficient
representation, but not overconcentration, of investment
alternatives. Finally, asset allocation is centrally about
(4) diversification, with the objective of aligning the
expected risk profile of the investors portfolio with his
or her own risk profile. Rather than attempting to time
the market in a limited number of asset classes, asset
allocation seeks, through diversification, to provide
higher returns with lower risk over a sufficiently long
time frame and appropriately compensate the investor for
bearing nondiversifiable volatility.
Private investors face several critical questions and
decisions in the process of asset allocation. These
include: (i) the ultimate length of the time horizon for the
portfolio as a whole; (ii) the degree of volatility or value
impairment the investor can withstand, in the aggregate
and for specific investment categories; (iii) the desired
extent of principal protection versus purchasing power
protection; (iv) the role and amount of core and non-core
asset classes; (v) the degree of patience and conviction
that can be maintained in the face of overall portfolio
underperformance relative to the performance of one or
two asset classes; and, not to be minimized, (vi) the
investors confidence level in the specific return, risk,
and correlation projections on which asset allocation
decisions are based.
Two of the most fundamental, yet least appreciated,
aspects of asset allocation are the role of time, and the
magnitude of purchasing power risk. Investors who can
construct and manage their wealth with a longer time
frame have many more chances to offset the damages
wrought by short-term volatility with the gains earned in
good years. History shows that for most mainstream
asset classes, including bonds and stocks, as the
investors actual holding period lengthens, from 1-year
holding periods, through 5-year and 10-year holding
periods, to 20-year holding periods, the realized rate of
return converges toward the assets long-term quoted
rate of return (this is currently around 12.6% for the S&P
500 and approximately 5.3% for long-term U.S.
Treasury bonds). There is a significant dampening in the
range of returns around the quoted return as the holding
period is extended.
Additional insights are gained from comparing the
compound annual returns of large capitalization U.S.
common stocks, long-term U.S. Treasury bonds, long-
term U.S. Corporate bonds, and U.S. Treasury bills for a
series of 1-, 5-, 10-, and 20-year holding periods
spanning the 71 years from 1926 through 1996.
For 1-year holding periods, large capitalization U.S.
common stocks had negative annual returns in
approximately 30% of the years, but still outperformed
U.S. Treasury bills, U.S. Treasury bonds, U.S. Corporate
bonds, approximately 58% of the time; for 5-year
periods, stocks outperformed bills and bonds
approximately 77% of the time; and for 20-year periods,
approximately 96% of the time.
Effects of Inflation on Purchasing Power
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
12%
15%
Annual
Inflation
Rate
0.99
0.98
0.97
0.96
0.95
0.94
0.93
0.92
0.91
0.90
0.88
0.85
After
1 Year
0.95
0.90
0.86
0.82
0.77
0.73
0.70
0.66
0.62
0.59
0.53
0.44
After
5 Years
0.90
0.82
0.74
0.66
0.60
0.54
0.48
0.43
0.39
0.35
0.28
0.20
After
10 Years
After
20 Years
Ratio of Original/Remaining Purchasing Power
0.82
0.67
0.54
0.44
0.36
0.29
0.23
0.19
0.15
0.12
0.08
0.04
*
* On a pretax basis, an investor would need an asset value of 1.85 times
the original value merely to maintain purchasing power.
3DJH 7
Asset Allocation Principles: Meanings, Questions, and Decisions (cont.)
David M. Darst
Furthermore, the miracle of compound interest depends
on the passage of time. For instance, of the increase in
the value of a 10%-compounding portfolio held for 20
years, 11% of the total gain occurs in the first five years,
17% in the second five years, 28% in the third five years,
and fully 46% occurs in the final five years. Even at
relatively modest annual rates of inflation, over a 20-year
time period, the effective loss in an investments
purchasing power can be debilitating. As shown in the
chart above, at an annual inflation rate of 3%, after 20
years, the investor has lost 46% (1.00 minus 0.54) of his
or her original purchasing power on an investment
whose principal value remains unchanged. Under such a
scenario, the investor would need an asset value of 1.85
times its original value merely to maintain purchasing
power. If taxes had to be paid, the required growth
would be even larger.
While there is no assurance that the annual inflation rate
will always average out to be a certain positive level
over long stretches of time, based on the experience of
the modern era, purchasing power erosion has in the past
been a fact of life and is a significant risk that the
investor should address squarely and prepare for.
For long-term investors, purchasing power risk is at least
as important, if not more so, as multi-period market price
volatility risk. For short-term investors who do not have
the opportunity for good and bad years of investment
performance to offset one another, market price volatility
risk is usually more important than purchasing power
risk.
The implications of time duration and purchasing power
risk for asset allocation thus generally lead to greater
emphasis: (i) in longer-term portfolios, on equities and
equity-like assets which have relatively higher returns
and higher volatility; and (ii) in shorter-term portfolios,
on principal-protected, interest-generating assets that
have relatively lower returns and lower volatility. These
asset allocation guidelines for private investors are
summarized below:
Investor
Characteristic
Factors tending
to emphasize
principal-protected,
interest generating
assets
Factors tending to
emphasize equity-like
assets with projected
principal growth but
higher volatility
Expected Time
Horizon
Short Horizon Long Horizon
Income Needs High and/or
Predictable Needs
Low and/or
Unpredictable Needs
Desired Purchasing
Power Protection
Low Purchasing
Power Protection
High Purchasing
Power Protection
Volatility
Tolerance
Low Volatility
Tolerance
High Volatility
Tolerance
Private investors who have specific income
requirements, but who can adopt a long-term investment
horizon, may prefer to (1) spend small amounts of
principal from a higher total return portfolio to augment
lower levels of actual income return, rather than (2)
constructing a lower total income return portfolio that
has higher levels of actual income return. This policy has
been followed by a number of leading university
endowments, many of whom have developed guidelines
to keep any spending of income plus small amounts of
principal well below their portfolios annual total return.
It is worth noting several caveats concerning historical
and projected return data. Historical single-point asset
class and security returns covering several years or more
are in fact averages of varying sometimes, widely
varying results experienced in the years comprising
the period cited.
Similarly, future returns do not possess the degree of
certainty or accuracy implied by a single-point
projection. A more telling rate of return description
should incorporate a range of plus or minus returns, and
their associated probability, around the single-point
3DJH 8
Asset Allocation Principles: Meanings, Questions, and Decisions (cont.)
David M. Darst
projection. A similar set of product usage warnings
applies to asset class correlation statistics. Correlations
measure the tendency of the returns from a given asset
class or investment to move in the same direction as
another asset class or investment, but not the magnitude
of such movement. Covariance and tracking error data
are needed to specify the magnitude of an investments
movement relative to another.
1
Correlation data also need to be scrutinized to determine:
(i) what length holding period they apply to, such as
monthly returns, quarterly returns, annual returns, or
five-year returns; and (ii) what overall time horizon is
described, such as 1960 through 1980, 1926 through
1996, or 1990 through mid-year 1997. Finally, and most
importantly, inter-asset or inter-investment correlation
numbers are generally not stable to any significant
degree over time, even though many investors assume
they are stable values. For example, as shown in the
accompanying chart, the five-year holding period return
correlation between U.S. large capitalization equities and

1
The concepts of covariance and tracking error relative to correlation are
concisely and we feel lucidly spelled out in Correlation, Tracking Risk,
and Dynamic Asset Allocation, by Neil Chriss, Lisa Polsky, and Roy
Martins, in Morgan Stanleys Global Equity and Derivative Markets,
Volume VII, No. 6, dated June 6, 1997.
U.S. Treasury bonds over the period from 1926 to 1997
has exhibited wide fluctuations, from a high of +0.59 to
a low of -0.38.
Correlation between Large Company Stocks
and Long-Term Government Bonds
-0.40
-0.30
-0.20
-0.10
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
1930 1940 1950 1960 1970 1980 1990
Year End
Correlation
1997
Source: Ibbotson Associates, Stocks, Bonds, Bills, and Inflation
Yearbook, 1998.
Past performance is not a guarantee of future results.
3DJH 9
Asset Allocation Principles: High Net Worth Investor Behavior David M. Darst
Asset allocation principles explore what it is about the
nature, behavior, hopes, and fears of High Net Worth
(HNW) investors that equips them well and/or poorly for
the crucial and challenging task of asset allocation.
Much has been made of the competitive disadvantage of
HNW investors in a global financial marketplace
dominated by institutions. In the asset allocation process,
it is commonly believed that institutional investors will
outperform HNW individuals due to institutions
superior access to investment research, corporate
managements, trading media, quantitative tools, and, not
least, each other.
At the same time, High Net Worth private investors
appear to have several factors working in their favor.
First, many HNW individuals are deeply grounded in
knowledge of the business world they know cycles of
crops, of energy costs, of final-product prices; they
experience companies as groups of people rather than
abstractions, as employees, suppliers, and customers; and
they possess an innate sense of corporate welfare and
values, as a result of having to meet a payroll, expand
market share, and maintain the viability of their own
enterprise.
Second, HNW investors are generally not answerable to
artificial quarterly or annual demarcations of time, nor to
the dictates of committee-based thinking. If the private
investor so desires, he or she can withdraw from an asset
class altogether, or alternatively, ride through the
vicissitudes of markets and leave valuable core long-
term holdings undisturbed.
Third, individual investors are eminently capable
although not all HNW investors display these traits in the
investment realm of distance, objectivity, perspective,
perception, independence, and clear thinking. Perhaps
because it is their own funds that are at stake, HNW
investors tend to experience the pain of losses more
deeply than they experience the pleasure of gains. For
some, this can clarify; for others, this can cloud reason.
Fourth, HNW investors have essentially equal access
with institutions to the great financial leveler: sound
judgment. In the asset allocation and investment
selection process, the characteristic that is most in short
supply is not intelligence, data, or technology resources,
it is judgment. Because individual investors and
professional money managers may be gifted with, or
bereft of, good judgment, it is critical for the HNW
investor to assess candidly whether or not he or she has
good judgment; if not, an individual should not rest until
a person possessed of good judgment can be found to
provide asset allocation advice.
A powerful testament to the force, effect, and success of
private individual investment was demonstrated in the
world of art on November 10, 1997, when the collection
of Victor and Sally Ganz was auctioned at Christies for
$206.5 million. This total established the record for a
single-owner sale of art, surpassing the 1989 sale by
Sothebys of impressionist and modern paintings
belonging to John Dorrance, Jr., for $123.4 million.
The Ganz couples holdings generated extraordinarily
high returns that are rare and difficult to achieve in any
asset class, but in the process, they left a legacy of
valuable lessons for any serious investor. They (i) had
passion and commitment to collecting art; (ii)
concentrated and focused their efforts in a defined
sphere; (iii) came to know their field of endeavor in great
depth; (iv) bought with care, reflection, and analysis; and
(v) exercised patience, letting time and longevity work
for them. Mr. Ganzs first acquisition, Picassos Dream,
was purchased in 1941 for $7,000 and sold at auction for
$48.4 million. Over its 56-year holding period, this
painting generated a compound annual return of 17.1%
before commissions and expenses,
l
an astoundingly high
growth rate over such a long time frame. Another
painting by Picasso, Woman Seated in an Armchair
(Eva), was bought in 1967 for $200,000 and auctioned
30 years later for $24.7 million, producing an equally
uncommon and lofty compound annual return of 17.4%
before commissions and expenses.
1
In their asset allocation activity, HNW investors exhibit
certain behavior, often unwittingly, that can influence the
realization of their investment goals. Since many of these
traits derive from deep-seated human impulses, what is
important in controlling and/or altering them is first and

1
After deduction of the auction houses commission, which is 15% of the
first $50,000 and 10% of the remainder, the compound annual growth
rate for Dream was 16.9%, and for Eva was 17.0%, before any annual
expenses for insurance and other carrying costs, which were not
disclosed.
3DJH 10
Asset Allocation Principles: High Net Worth Investor Behavior (cont.) David M. Darst
foremost, the recognition of their potential existence. A
number of these characteristics, some of which are
contradictory yet still encountered in the same investor,
are set forth in the points below:
Underestimate time horizons. Many private
investors specify a three- or five-year investment
time horizon and invest with a short-term
orientation, when in fact the investment time frame
is 15 to 20 years or more.
Attach too much significance to short-term
results. One key goal of asset allocation is to
dampen volatility and reduce risk through asset class
diversification. The benefits of such a program,
which are usually purchased at the cost of lower
overall returns than the best-performing asset
classes, should be assessed over a sufficiently long
period of time.
Overemphasize volatility risk vs. purchasing
power risk. Particularly when the investors horizon
extends to ten years or more, the erosion of
purchasing power due to inflation can be significant
in asset classes that maintain their nominal value.
HNW investors need to address the risks of inflation
vs. deflation and factor these considerations into
their asset allocation strategy.
Adopt a loss-averse mentality rather than a risk-
averse mentality. Due to an antipathy toward losing
money, many private investors will accept a
smooth return of 10% (with low or no losses) over
a series of market cycles, rather than a bumpy
return of 15% (with occasional periods of testing,
sometimes severe, in down years). After 15 years,
the latter portfolio would be worth approximately
twice the value of the former portfolio, but many
investors are not willing to stomach the volatility.
Overestimate the ability to tolerate risk and/or
illiquidity. In glaring contradiction to their loss-
averse nature, a number of HNW investors
commonly forecast their loss-withstanding threshold
at a much higher level than the profound level of
distress they feel when such losses realized or
unrealized are actually experienced.
Think in nominal terms rather than real terms.
Assuming no change in interest rates and a 3%
inflation rate, a private investor who placed $1
million in tax-exempt bonds, and spent the interest
income each year, would have only $633,251 in real
purchasing power at the end of 15 years, even
though the $1 million value remained whole in
nominal terms.
Allow income needs to tilt the portfolio toward
dividend/interest yield rather than total return.
Wealth creation is a product of the compounding of
capital over an appropriate time span; HNW
investors with high current income needs should
look at the total return from an asset allocation mix,
not merely the current yield level.
Neglect the effects of annual investment expenses.
HNW investors need to be aware of the
compounding effects of annual investment expenses.
As shown in the accompanying chart, over a 15-year
holding period with 8% compound returns, annual
investment expenses (such as custody fees and
transactions costs) of 1.5% effectively reduce the
investors total pretax capital gain by 27.6%.
Reduction in Pretax Capital Gain Due to Annual Expenses
Investment
Annual
Expenses
of 1.0%
Annual
Expenses
of 1.5%
Annual
Expenses
of 2.0%
Holding 8% to 7% 15% to 14% 8% to 6.5% 15% to 13.5% 8% to 6% 15% to 13%
Period Return Return Return Return Return Return
5 years -14.1% -8.5% -21.1% -12.6% -27.9% -16.7%
10 years -16.6% -11.1% -24.3% -16.3% -31.8% -21.4%
15 years -19.1% -14.0% -27.6% -20.4% -35.7% -26.4%
20 years -21.6% -17.1% -31.1% -24.6% -39.7% -31.5%
Source: MSDW Private Wealth Management Asset Allocation Group.
3DJH 11
Asset Allocation Principles: High Net Worth Investor Behavior (cont.) David M. Darst
Desire insurance protection without facing the
premium costs of such protection. Private
investors need to recognize, and be willing to pay for
(in the form of dampened overall return on the
upside and the downside), asset classes which are
included in a strategic asset allocation framework for
defensive, hedging, or insurance purposes.
Project the most recent asset class returns and
measure against the best-performing
benchmarks. Particularly after a series of successful
(or unsuccessful) years of investment returns,
individuals tend to expect such performance to
continue indefinitely. At the same time, HNW
investors want returns that match or exceed the top-
performing indices or asset classes. In part, these
desires, and the relative outperformance of the S&P
500 index vs. a substantial majority of mutual funds
during many years of the early- and mid-1990s, have
fueled the dramatic expansion of assets in stock and
bond index funds, from $2.1 billion in 1987 to
$140.6 billion at the end of the third quarter in 1997.
Experience wide swings in sentiment, confidence,
and patience. Throughout recorded history, this is
human nature. Over time, successful asset allocation
comes from the ability to distinguish cyclical and
secular movements, and act accordingly.
Ignore asset allocation trade-offs. HNW private
investors should recognize the virtual impossibility
of finding an asset class that simultaneously meets
all the desired criteria: deep liquidity; stable,
guaranteed principal values; high current yields; and
capital growth that consistently and substantially
outperforms inflation, taxes, and the popular indices.
Taking into account the special strengths of HNW
investors, as well as their behavioral tendencies
enumerated above, it is possible to draw some
conclusions about the requisite skills for successful asset
allocation over time.
To achieve success in asset allocation, private investors
might anticipate an approximately equal weighting of
skills between: (1) selecting asset classes; (2) monitoring
asset classes; (3) acting with conviction on high- and
low-performing asset classes; and (4) rebalancing asset
classes. This is shown in the chart below.
Anticipated Asset Allocation Skills Weighting
Monitoring
Asset Classes
Rebalancing
Asset Classes
Selecting
Asset Classes
Acting with
Conviction on
Asset Classes
By far the most important skills in successful asset
allocation are: (1) selecting asset classes; and then (2)
acting with conviction on those asset classes that are
destined to be long-term winners and losers. This is
shown in the chart below.
Actual Asset Allocation Skills Weighting
Monitoring
Asset Classes
Rebalancing
Asset Classes
Selecting
Asset Classes
Acting with
Conviction on
Asset Classes
It is not so much a question of how many times the HNW
investor is right or wrong, but how emphatically he or
she responds in consequence of being right. If the asset
classes are well chosen, and acted upon with conviction,
the relative importance of asset class monitoring and
rebalancing should diminish significantly in comparison.
3DJH 12
Asset Allocation Principles: Interest and Dividend Reinvestment David M. Darst
One of the most important, yet least appreciated, aspects
of investing in specific asset classes is the concept of
interest and dividend reinvestment. For compounding to
work its highly beneficial effects on portfolio values
over time, attention must be paid to the necessity, the
consequences, and the challenges of investing coupon
payments or dividends at sufficiently high rates of return.
Spending such income flows, using them to pay taxes, or
reinvesting them at low returns can significantly reduce
the Realized Compound Yield and thus the total long-
term asset value of a portfolio.
For High Net Worth investors, the reinvestment of
coupon and dividend payments, in as tax-advantaged a
manner as possible, is of vital importance in actually
achieving the long-term quoted returns from debt or
equity securities. This is particularly true, the longer the
investment holding period and the higher the expected
compound rates of return.
Coupon Reinvestment in Fixed Income Securities
The proportion of a fixed income securitys return that is
represented by the reinvestment of interest coupons
increases: (i) the higher the coupon; (ii) the higher the
initial yield to maturity; and (iii) the longer the maturity
of the instrument. For sufficiently high-coupon, long
maturity bonds, purchased at sufficiently high initial
yields to maturity, the assumed reinvestment of interest
coupons, assumed to be at that same, high initial yield to
maturity, can account for a dramatically large share of
the total funds received from an investment.
The Importance of Interest on Interest
10% Annual Coupon Bond, 30-Year Maturity, 10% Yield to Maturity
5 Years 10 Years 20 Years 30 Years
$2,000
$6,000
10,000
14,000
18,000
$3,000 = 30 coupons x $100/coupon
$1,000 = Principal Repayment
30-year total = $17,449.40
Total Funds
Received
$13,444.40 = Reinvestment of
Interest Coupons
Maturity
For example, as shown in the accompanying chart, for a
$1,000 par value, 30-year, 10% annual coupon bond,
purchased at a 10% yield to maturity, the total funds
received over the life of the bond amount to $17,449.40.
Of this total, $1,000, or 5.7%, represents the repayment
of principal; $3,000, or 17.2%, represents 30 years
payment of $100 annual coupons; and $13,449.40, or
fully 77.1%, represents the aggregate total generated by
the reinvestment of each $100 annual
1
coupon at an
interest rate of exactly 10%.
Source of Funds Amount Percent of Total
Principal $1,000.00 5.7%
Coupons $3,000.00 17.2%
Coupon Reinvestment $13,449.40 77.1%
Total $17,449.40 100.0%
As a percent of the total funds received from a 10%
annual coupon bond purchased at a beginning yield level
of 10%, the importance of coupon reinvestment, also
known as interest on interest, ranges from 77.1% on a
30-year bond, to 55.4% on a 20-year bond, to 22.8% on a
10-year bond, to 6.9% on a 5-year bond. This is shown
in the table below:
Annual Coupon Bonds Purchased at 10%
and 5% Yields to Maturity
$1,000 Par Value Bonds
Percentage of Total Funds Received
Coupon
Initial
Yield to
Maturity
Years to
Maturity
Repayment
of
Principal
Interest
Coupons
Reinvestment
of Interest
Coupons
Total
Funds
Received
10% 10% 5 62.1% 31.0% 6.9% $1,610.51
10% 10% 10 38.6% 38.6% 22.8% 2,593.74
10% 10% 20 14.9% 29.7% 55.4% 6,727.50
10% 10% 30 5.7% 17.2% 77.1% 17,449.40
5% 5% 5 78.3% 19.6% 2.1% $1,276.28
5% 5% 10 61.4% 30.7% 7.9% 1,628.89
5% 5% 20 37.7% 37.7% 24.6% 2,653.30
5% 5% 30 23.1% 34.7% 42.2% 4,321.94
The table also demonstrates the diminished importance
of coupon reinvestment at lower coupon rates and initial
yield levels. For instance, for a 30-year, 5% annual
coupon bond, purchased at a 5% initial yield to maturity,
the reinvestment of interest coupons represents 42.2%, or
$1,821.94, of the $4,321.94 in total funds received by the
investor.

1
For the sake of simplicity, annual, rather than semiannual, coupons are
used in this analysis. For a $1,000 par value, 10% bond, with 60
semiannual coupons of 5%, the total funds received amount to
$18,679.19, of which $14,679.19, or 78.6%, represents the reinvestment
of interest coupons at an assumed rate of 10%.
3DJH 13
Asset Allocation Principles: Interest and Dividend Reinvestment (cont.) David M. Darst
For short-maturity bonds, the importance of coupon
reinvestment is modest, regardless of coupon and
beginning yield level. For 5-year, 10% coupon bonds,
purchased at a 10% yield to maturity, the reinvestment of
interest coupons represents 6.9% of total funds received,
and for 5-year, 5% coupon bonds, purchased at a 5%
yield to maturity, the reinvestment of interest coupons
represents only 2.1% of total funds received.
In practice, interest rates do not remain stable for the
entire life of a 30-year bond, much less a bond of 20, 10,
or even 5 years maturity. Investors are thus subject to
one key form of reinvestment risk, or the chance that
coupons (or principal) will not be able to be invested at a
rate equal to the bonds original yield to maturity. A
further complication for High Net Worth Investors stems
from the annual taxability of interest and dividend
income.
In response to these tax considerations, High Net Worth
investors have sought, whenever possible, to own any
securities that have a meaningful degree of reinvestment
risk in tax-advantaged structures, such as a Foundation
or a 401(k) plan. A tax-advantaged structure is especially
important in the case of zero coupon bonds, which
otherwise incur taxes on the phantom interest income
that is not paid in cash but which is considered by the tax
authorities to accrete each year.
Zero Coupon Bonds
Zero coupon bonds eliminate coupon reinvestment risk
by means of the annual internal compounding of capital
values, to a final value for the bond (usually its $1,000
par value). Zeros have been popular with low-tax or tax-
advantaged investors seeking to lock in a specific
compounding rate of interest at the time of the bonds
purchase. In addition, some investors seek out zero
coupon bonds due to their high degree of capital value
responsiveness in reaction to interest rate changes.
Without a coupon that requires annual reinvestment
exactly at the yield to maturity prevailing at the time of
purchase, zero coupon bonds derive a meaningful
proportion of their total funds received from the internal
compounding, or accretion, from their initial investment
value to final par value. The accompanying table
illustrates how this proportion varies (i) by the bonds
initial yield to maturity and (ii) its total number of years
to maturity.
Zero Coupon Bond Accretion Percentage
$1,000 Par Value
Percentage of
Total Funds Received
Initial Yield
to
Maturity
Years to
Investment
Initial
Investment
Total
Accretion to
Par Value
Final
Par Value
10% 5 62.1% 37.9% $1,000.00
10% 10 38.6% 61.4% 1,000.00
10% 20 14.9% 85.1% 1,000.00
10% 30 5.7% 94.3% 1,000.00
5% 5 78.4% 21.6% 1,000.00
5% 10 61.4% 38.6% 1,000.00
5% 20 37.7% 62.3% 1,000.00
5% 30 23.1% 76.9% 1,000.00
For zero coupon bonds, purchased at a 10% yield to
maturity, the percentage of total funds received
represented by internal compounding, or accretion,
ranges from 37.9% for a 5-year bond to 94.3% for a 30-
year bond. At 5% yields to maturity, the percentage of
total funds received represented by internal
compounding, or accretion, ranges from 21.6% for a 5-
year bond, to 76.9% for a 30-year bond.
The Effects of Not Reinvesting Coupons
Additional insights about the importance of coupon
reinvestment can be gained by calculating the actual
Realized Compound Yield that results from spending,
rather than reinvesting, a bonds annual coupon
payments. The table below outlines the effects of not
reinvesting coupons.
Realized Compound Yields
When Coupons Are Not Reinvested
Annual Coupon, $1,000 Par Value Bonds
Total Funds Received
Realized
Compound
Yield
Coupon
Initial
Yield to
Maturity
Years to
Maturity
With
Coupons
Reinvested
Without
Coupons
Reinvested
Without
Coupons
Reinvested
10% 10% 5 $1,610.51 $1,500.00 8.45%
10% 10% 10 2,593.74 2,000.00 7.18%
10% 10% 20 6,727.50 3,000.00 5.65%
10% 10% 30 17,449.40 4,000.00 4.73%
5% 5% 5 $1,276.28 $1,250.00 4.56%
5% 5% 10 1,628.89 1,500.00 4.14%
5% 5% 20 2,653.30 2,000.00 3.53%
5% 5% 30 4,321.94 2,500.00 3.10%
3DJH 14
For 10% coupon bonds, purchased at a 10% yield to
maturity, not reinvesting the coupons lowers the
effective Realized Compound Yield from 10% to 8.45%
for a 5-year bond, and from 10% to 4.73% for a 30-year
bond. For 5% coupon bonds purchased at a 5% yield to
maturity, not reinvesting the coupons lowers the
effective Realized Compound Yield from 5% to 4.56%
for a 5-year bond, and from 5% to 3.10% for a 30-year
bond.
The proportion of Realized Compound Yield represented
by the reinvestment of interest coupons increases with
higher coupon rates, higher yield levels, and longer
maturities. A comparison of: (i) the proportion of total
funds received represented by the reinvestment of
interest coupons; to (ii) the proportion of total Realized
Compound Yield represented by the reinvestment of
interest coupons is set forth below:
1
Coupon Reinvestment As a Proportion o f Total
Funds Received and Realized Compound Yield
Annual Coupon, $1,000 Par Value Bonds
Reinvestment of Interest Coupons
Coupon
Initial
Yield to
Maturity
Years to
Maturity
Proportion
of Total
Funds Received
Proportion of
Total Realized
Compound Yield
10% 10% 5 6.9% 15.5%
10% 10% 10 22.8% 28.2%
10% 10% 20 55.4% 43.5%
10% 10% 30 77.1% 52.7%
5% 5% 5 2.1% 8.8%
5% 5% 10 7.9% 17.2%
5% 5% 20 24.6% 29.4%
5% 5% 30 42.2% 38.0%
For 10% bonds, purchased at a 10% yield to maturity,
the proportion of total Realized Compound Yield
accounted for by the reinvestment of interest coupons
ranges from 15.5% for a 5-year bond, to 52.7% for a 30-
year bond. For 5% bonds, purchased at a 5% yield to
maturity, the proportion of total Realized Compound
Yield accounted for by the reinvestment of interest
coupons ranges from 8.8% for a 5-year bond, to 38.0%
for a 30-year bond.

1
The Standard & Poors 500 Index was originally the Standard and
Poors 90 Index: it became the Standard & Poors 500 Index on March
4, 1957.
Dividend Reinvestment in Equities
Dividend reinvestment plays the same equally crucial
role in the long-term results achieved from investment in
equities that coupon reinvestment plays in fixed income
investing. At the same time, investors, regulators, and
corporations often pay insufficient attention to this
important component of equity investing and asset
allocation.
The effects of dividend reinvestment become even more
pronounced over a long time frame. The accompanying
The Growth of $1.00 Invested in the
Standard and Poors 500 Index
January 1, 1925 through December 31, 1997
1925 1935 1945 1955 1965 1975 1985 1997
$0.3
$1.0
$10.0
$100.0
1000.0
5000.0
Index
Year-End
$1,828.33
$76.07 Total Return Index
Capital Appreciation Index
$5,000.0
$1,000.0
Source: Ibbotson Associates, Stocks, Bonds, Bills, and Inflation
Yearbook, 1998.
chart shows the growth of $1.00 invested in the Standard
& Poors 500 Index
2
on January 1, 1925. At the end of
1997, this $1.00 investment, with dividends reinvested
and without taking account of taxes, had grown to
$1,828.33, for a 10.84% compound rate of growth over
this 73-year time span.
The Effects of Not Reinvesting Dividends
If the dividends were not reinvested each year
3
, the $1.00
original investment would have grown to $76.07 before
taxes, a 73-year compound rate of growth of 6.11%. The
key determinants of the amount of shortfall are: (i) the
compound rate of return for equities; (ii) the rate of
dividend yield that is to be reinvested; and (iii) the length
of the reinvestment period.
2

2
For the purposes of simplicity, the dividends (which are generally paid
on a quarterly basis in the U.S.) are assumed to be reinvested annually;
quarterly reinvestment would produce a 10.42% compound annual rate
of growth for 73 years.
3DJH 15
Percentage Shortfall in Portfolio Values From Neglecting Dividend Reinvestment
Based on 12% and 9% Compound Annual Equity Returns
For A $1.00 Initial Investment, Final Portfolio Value After
Compound
Annual
Equity
Return
Of Which Annual
Dividend
Reinvestment
Component 5 Years 10 Years 20 Years 40 Years 70 Years
12% All Dividends Reinvested $1.76 $3.11 $9.65 $93.05 $2,787.80
Uninvested Annual Dividends
Percentage Shortfall Due to Not Reinvesting Dividends
12% 2% 9% 17% 30% 51% 72%
12% 3% 12% 24% 42% 66% 85%
12% 4% 16% 31% 52% 77% 92%
12% 5% 20% 37% 60% 84% 96%
5 Years 10 Years 20 Years 40 Years 70 Years
9% All Dividends Reinvested $1.54 $2.37 $5.60 $31.41 $416.73
Uninvested Annual Dividends
Percentage Shortfall Due to Not Reinvesting Dividends
9% 2% 9% 17% 31% 52% 73%
9% 3% 13% 24% 43% 67% 86%
9% 4% 17% 31% 53% 83% 93%
9% 5% 21% 38% 61% 85% 96%
As can be seen in the chart below, equity dividend
yields vary over time, depending on corporations
dividend policies and the overall level of stock prices.
The actual percentage dividend rate subject to
reinvestment thus depends on market conditions
throughout the length of the investors holding period.
The percentage shortfalls from various ending portfolio
values, as a result of not reinvesting the dividends, are
shown above.
Dividend Yields on the Standard & Poors 500 Index
January 1, 1925 through December 31, 1997
0
1
2
3
4
5
6
7
8
1950 1958 1966 1974 1982 1991 1999
Dividend Yield
in Percent
Source: Bloomberg Financial Markets.
A $1.00 initial investment held for 5 years, at a
compound annual growth rate of 12%, will grow to a
final portfolio value of $1.76. If 2% of the 12%
compound growth rate represents dividends that should
have been reinvested, but were not, the portfolios final
value ends up 9% below $1.76, at $1.61. If 5% of the
12% compound growth rate represents dividends that
should have been reinvested but were not, the
portfolios 5-year final value ends up 20% below
$1.76, at $1.40.
For long periods of time, the percentage and absolute
dollar contribution from the reinvestment of dividends
are even more dramatic. A $1.00 initial investment,
held for 70 years at a compound annual growth rate of
12%, will grow to a final portfolio value of $2,787.80.
If 2% of the 12% compound growth rate represents
dividends that should have been reinvested but were
not, the portfolios final value ends up 72% below
$2,787.80, at $789.75, for a dollar shortfall of
$1,998.05. If 5% of the 12% compound annual growth
rate represents dividends that should have been
reinvested but were not, the portfolios 70-year final
value ends up 96% below $2,787.80, at $113.99, for a
dollar shortfall of $2,673.81.
3DJH 16
Asset Allocation Principles: Critical Determinants of Asset Allocation
David M. Darst
Distilled to its purest form, asset allocation for High Net
Worth investors is intended, among other objectives, to
help answer four fundamental questions: (i) What is the
proper mix between equities, fixed income securities,
alternative investments, and cash equivalent
instruments? (ii) What is the proper mix between
domestic and non-domestic securities? (iii) What is the
proper reference currency, and the proper degree of non-
reference currency exposure? and (iv) What is the proper
division of assets between publicly-traded and private
investments?
Critical Determinants of Asset Allocation
In developing an appropriate response to each of these
questions, High Net Worth investors need to carefully
assess the critical determinants of asset allocation. These
critical determinants can be grouped under a few broad
rubrics, analogous in some sense to the investors own
highly individualized set of income statement factors,
balance sheet factors, and off-balance sheet factors.
Each investors history, current situation, and
expectations for the future will shape the degree of
emphasis to be placed on these asset allocation
determinants, as set forth below:
Income Statement Factors
Tolerance for bearing risk or loss. An investors
ability to withstand losses in a given investment
position or asset class is influenced by the severity
of the loss in percentage and absolute terms, the
duration of the loss, whether it is realized or
unrealized, expected future price action, the price
behavior of other investment instruments, general
economic conditions, and not least, the investors
own emotional, financial, and psychological profile.
Cyclical and secular market outlook. A highly
important influence on strategic and tactical asset
allocation is the investors qualitatively- and
quantitatively-driven sense of where markets are
going, how long they will take to reach their price
targets, and the pattern of price movements
stairstep, continuous, highly volatile, or an extended
waiting period, followed by a sharp upward or
downward move.
Confidence level in projections. One of the great
separators of highly successful investors or asset
allocators from less fortunate ones is the age-old
decision between conviction and flexibility.
Investors who know they are right have the courage
of their convictions; at the same time, investors who
discover flaws in their own thinking must have the
flexibility to face facts and reverse course if
necessary.
Investors and assets tax status. The High Net
Worth investor's tax status federal, state, local,
and cross-border; income, capital gains, and estate;
current and future brings a crucial set of variables
to bear in structuring an optimal allocation of assets,
as does the tax treatment of all the capital and
income flows from an investment.
Balance Sheet Factors
Individual motivations and circumstances. It is
worthwhile for the HNW investor to reflect on the
ultimate goals and objectives of the assets being
allocated for whose benefit are the assets being
invested? What do these assets mean in the context
of the beneficiaries other circumstances? In what
blocks of time does the investor reckon? What
planned commitments and unforeseen developments
should be allowed for?
Influence of dominant investment positions. Asset
allocation for High Net Worth investors should take
account of large existing or contractually-expected
investment positions, capital flows, options, and
restricted securities. At the same time, objectivity
and rigorous analysis are required to weigh the
merits and costs of retaining dominant investment
positions vs. diversification of all or a portion of
these positions into other asset classes.
Financial requirements, liabilities, and
contingencies. Planned annual expenditure levels,
margin debt, mortgages, and other liabilities affect
the asset allocation decision because the certainty of
such outlays often leads to the selection of asset
classes and investments having predictable payment
streams to meet these obligations.
Significant non-tracked assets. Many High Net
Worth investors have a considerable portion of their
overall wealth tied up in asset categories that are not
included in conventional asset allocation
frameworks. Such assets include: (i) royalty streams
from media-related, oil, gas, forestry, and mining
3DJH 17
Asset Allocation Principles: Critical Determinants of Asset Allocation (cont.)
David M. Darst
interests; (ii) art, collectibles, antiques, and jewelry;
and (iii) ownership positions in family businesses,
undeveloped land, and other real property.
Off-Balance Sheet Factors
Ability to recognize and evaluate trade-offs. We
believe the entire asset allocation process hinges on
the investors skill at recognizing and judging a
series of financial factors. How important is one set
of factors compared with another set of factors? For
any given tradeoff, how much of the costs and
benefits of one variable has to be foregone in order
to obtain a more favorable cost-benefit profile in
another variable? Several of the most frequently-
encountered asset allocation tradeoffs are listed in
the table below:
Asset Allocation Tradeoffs
Characteristic
Tending toward
lower risk,
lower return vs.
Tending toward
higher risk,
higher return
Time Frame Short-term vs. Long-Term
Asset Allocation Strategy Diversification vs. Concentration
Harvesting/Consumption
of Returns Current vs. Deferred
Form of Returns Income vs. Change in Capital Value
Pattern of Returns Predictable vs. Variable
Access/Convertibility Liquid Investments vs. Illiquid Investments
Goals and benchmarks for returns. We believe
another crucial determinant of a High Net Worth
investors asset allocation is the universe of goals
that his or her investment activity is intended to
achieve, and the relative importance assigned to
each. These goals include safety of principal,
protection of purchasing power, and specified levels
of annual pretax or after-tax returns. Prudence and
realism are essential in the selection of an
appropriate absolute benchmark, or the construction
of a blended benchmark, against which the
investors results are to be measured.
Timing, nature, and size of portfolio outflows.
When and in what form capital is to be returned to
the ultimate beneficiaries of the portfolio can cause
meaningful shifts in asset allocation.
Matching Asset Classes With Wealth Levels and
Investor Needs
As High Net Worth investors progress through the stages
of wealth creation and wealth realization, their needs and
concerns evolve, as does the array of asset classes
appropriate for their investment portfolios. This
progression is depicted in the accompanying diagram:
Matching Asset Classes with Wealth Levels and HNW Investor Needs
Wealth Seeding Phase Wealth Building Phase Wealth Realization Phase
Lower
Wealth
Levels
Higher
Wealth
Levels
Basis Needs
Intermediate Needs
Advanced Needs
Philanthropy,
Multiple Estates
Education, Retirement,
Lifestyle Enhancement,
Intergenerational Transfers
Housing, Healthcare,
Sustenance
Wealth
Level
Time
Venture Capital
Alternative Investments
Market Neutral Investments
Private Equity
Private Real Estate
International Equities
International Fixed Income
Securities
Real Estate and REITs
Commodities
Domestic Fixed Income Securities
Domestic Equities
Mutual Funds
Cash Equivalents
Level One
Level Two
Level Three
Asset Classes with
Lesser Liquidity,
Greater Complexity
Asset Classes
with Greater
Liquidity,
Lesser
Complexity
3DJH 18
Asset Allocation Principles: Critical Determinants of Asset Allocation (cont.)
David M. Darst
Wealth Seeding Phase
For those individuals who are in the beginning or
wealth seeding part of their wealth creation activity,
basic needs are paramount and include: housing,
healthcare, food, clothing, and insurance. If surplus
capital is available for investments, HNW investors
should consider asset classes that are characterized by a
reasonable degree of liquidity and understandability.
These asset classes generally include domestic equities,
domestic fixed income securities, and cash equivalents,
either directly or in mutual fund or partnership form.
Wealth Building Phase
As individuals progress through the growth or wealth
building phase of their wealth creation activity, their
needs expand, to include education, lifestyle
enhancement, retirement, and intergenerational transfers.
At the same time, although not in all cases, their range of
investible asset classes expands to include not only the
abovementioned asset classes, but also international
equities, international fixed income securities, real estate
and REITs, and commodities.
Wealth Realization Phase
When individuals acquire significant wealth in the
wealth realization phase through a liquidity event
such as a merger or acquisition, a securities offering, or
inheritance, the circle of their needs may expand yet
again, to include philanthropy and the maintenance of
multiple estates. In this phase, High Net Worth investors
can and should encompass an even broader range of
asset classes in addition to those considered by
individuals in the wealth seeding and wealth building
phases. These more advanced asset classes may also be
characterized by a lower level of liquidity and a
somewhat greater degree of complexity, and include
venture capital, alternative investments, market neutral
investments, private equity, and private real estate.
Effects of Financial Market Environments on Asset
Allocation and Investor Behavior
Financial market conditions can exert a powerful
influence not only on asset allocation, but also on
prevailing approaches to investor behavior and
investment strategy. For example, in a mature bull
market for equities, cash as an asset class and market
timing are denigrated in favor of a virtually fully
invested investment approach and a long-horizon, buy-
the-dips mentality toward stocks. The accompanying
chart presents a back-of-the-envelope estimate of
investors motives in a bull market compared with their
motives in a bear market.
Behavioral Effects of Financial Market Environments
70%
15%
15%
10%
60%
30%
Favorable Financial
Market Environment
Unfavorable Financial
Market Environment
Making Money
Diversification
Avoiding Losses
Avoiding Losses
Diversification
Making Money
Bull Market Motives Bear Market Motives
Effects on Investors
Significant amounts of newly-created
individual wealth
Wide range of geographical, asset
class, and implementation strategies
Heightened and frequently
unrealistic investor expectations
Investor satisfaction with existing
financial intermediaries
Explicit and implicit assumption of
risk
Equities, equity-like products, and
margin borrowing more important in
investment mix
Interest in performance investing,
alternative investments, and absolute
return strategies
Proliferation of investment
management boutiques, consultants,
and third-party capital raisers
Focus on capital appreciation
Effects on Investors
Wealth reduction and less newly-
created wealth
Narrow range of geographical, asset
class, and implementation strategies
Investor dissatisfaction with
investment performance
Investor flight to high-quality
financial intermediaries
Emphasis on risk reduction, risk
control, and risk management
Short- and intermediate-term fixed
income securities more important in
investment mix
Reduced interest in non-mainstream
investments
Consolidation/closure of investment
management boutiques, consultants,
and third-party capital raisers
Focus on capital preservation
The chart also contrasts some of the commonly-
encountered effects of a favorable financial market
environment on asset allocation with those of an
unfavorable financial market environment. In periods of
prolonged rising prices for financial assets, High Net
Worth investors are willing to entertain a wider range of
geographical, asset class, and implementation strategies.
Amidst heightened expectations and risk assumption,
investors tend to focus heavily on capital appreciation,
equities and equity-like products, alternative
investments, and absolute return strategies.
In periods of prolonged falling financial asset prices,
High Net Worth investors tend to concentrate on a
narrowed range of geographical, asset class, and
implementation strategies. Investors primary focus is
typically on capital preservation and mainstream
investments of a defensive character, such as short- and
intermediate-term fixed income securities. Expectations
are restrained and risk awareness is crucial.
3DJH 19
Asset Allocation Principles: Spending Versus Reinvesting Income Flows
David M. Darst
A frequently encountered and highly important issue in
the asset allocation process revolves around the
investors decision to spend, or alternatively to reinvest,
some portion or all of the annual returns from an
investment. The answer to this question is shaped in part
by the investors own preferences and the timing of his
or her required capital flows, and in part by the level,
pattern, and longevity of returns from a given asset class.
Consciously or unconsciously, investors often evaluate
spending now versus in the future, not only in financially
quantifiable terms, but also according to hard-to-define
measures such as utility or enjoyment. In doing so,
investors need to take account of the effects of
compounding, inflation and deflation in the general price
level, and not least, psychological and highly
individualized attitudes toward current and postponed
gratification.
It is worthwhile to analyze the overall effect on
intermediate cash flows including those funds which
are spent, and the terminal value of a portfolio of: (i)
spending annual investment returns immediately after
they have been earned; or (ii) reinvesting these returns at
the overall rate of return of the portfolio. The annual
investment returns can be in the form of dividend or
interest income accrued or received, realized or
unrealized capital gains, or some combination thereof.
The Effects of Spending vs. Reinvestment as a
Function of the Rate of Return
20-Year Investment Horizon, 20% Annual Returns
The first accompanying table shows the effects of
spending vs. reinvestment, of varying proportions of
annual returns for a $1,000 initial investment held for a
period of 20 years with annual returns of 20%. It should
be pointed out that generating 20% returns for 20 years,
while it has been achieved by some investors in certain
asset categories, is an extraordinary accomplishment.
Such rates of return, for so long, are relatively rare, even
for performance-oriented investors in equities or fixed-
income securities, much less for asset managers in less
efficient markets such as private equity or venture
capital. In the two immediately following sections, a
similar analysis has been carried out for 20-year
investment horizons using annual returns of 10% and
5%, respectively.
Several simplifying assumptions have been made in
order to highlight some of the important principles which
derive from this analysis. For example, it is assumed, but
highly unlikely, that the investor can reinvest the annual
returns from his or her investments at exactly the same
rate as the investments original rate of return 20% in
the first table displayed here, 10% in the second table,
and 5% in the third table. In addition, income taxes,
capital gains taxes, inflation and deflation, and
transaction costs are not considered here. Any one of
these factors can introduce meaningful subtleties into the
conclusions.
3DJH 20
Asset Allocation Principles: Spending Versus Reinvesting Income Flows (cont.)
David M. Darst
The Effects of Spending vs. Reinvestment
$1,000 Investment, 20-Year Horizon, 20% Annual Return
Total
Compound Total
Interest Invested Grand Total
Earned on Funds Total of Invested
Total Annual Annual Received Annual Funds
Payments Payments Plus Payments Received
Repayment Received and Received and Principal That Were Plus Spent
of Principal Reinvested Reinvested Repayment Spent Funds
0% ($0) of Annual Return Reinvested, 100% of Annual Return ($200) Spent
$1,000 $0 $0 $1,000 $4,000 $5,000
% of Grand Total 20% 0% 0% 80% 100%
1,000 1,000 8,334 10,334 3,000 13,334
% of Grand Total 7% 7% 64% 22% 100%
1,000 2,000 16,669 19,669 2,000 21,669
% of Grand Total 5% 9% 77% 9% 100%
1,000 3,000 25,003 29,003 1,000 30,003
% of Grand Total 3% 10% 84% 3% 100%
1,000 4,000 33,338 38,338 0 38,338
% of Grand Total 3% 10% 87% 0% 100%
The table shows the flows of funds generated by: (i)
repayment of the original $1,000 investment; (ii) the
receipt and reinvestment of 0%, 25%, 50%, 75%, and
100%, respectively, of the annual returns from the
investment; and (iii) annual payments received and
reinvested. The sum of these respective amounts is
identified as the total invested funds received and
reinvested. In addition, the fifth column of the table
accounts for that portion of the total annual returns that
was not reinvested, i.e., the portion of the annual returns
that was spent. The final column shows the grand total
of invested funds that have been received and the spent
funds that were received each year and spent during the
lifetime of the investment.
As is shown in the first row of the table, when all of the
annual return is spent, and none is reinvested, at the end
of twenty years the investor possesses: (i) the original
$1,000; plus (ii) the fond memories of all the good that
was generated throughout the passage of twenty years
time by the spending of the 20% annual return ($200), or
$4,000 in all. The sum of these two amounts equals
$5,000.
At the other end of the spectrum, on the bottom row of
the table, when none of the annual return is spent, and it
is all reinvested, twenty years of 20% compound annual
returns leaves the investor with a reasonably austere two
decades of no spending in the interim, but an ending
grand total of $38,338. This is over 7.5 times the grand
total of money accumulated by the investor who spent
each year's returns. Put another way, foregoing the utility
resulting from the spending of $200 each year for 20
years ($4,000) would have produced an additional
$33,338 in ending accumulated monetary value at the
end of this time frame.
From the middle three rows of the table, it can be seen
that if the investor had been able to reinvest 25%, 50%,
or 75% of the 20% annual returns at 20% for 20 years,
he or she would have ended up with terminal
accumulated monetary values of $13,334, $21,669, or
$30,003, respectively.
3DJH 21
David M. Darst
$1,000 Investment, 20-Year Horizon, 10% Annual Return
Total
Compound Total
$1,000 $0 $0 $1,000 $2,000 $3,000
% of Grand Total 33% 0% 0% 67% 100%
1,000 500 932 2,432 1,500 3,932
% of Grand Total 25% 13% 24% 38% 100%
1,000 1,000 1,864 3,864 1,000 4,864
% of Grand Total 21% 21% 37% 21% 100%
1,000 1,500 2,796 5,296 500 5,796
% of Grand Total 17% 26% 48% 9% 100%
1,000 2,000 3,727 6,727 0 6,727
% of Grand Total 15% 30% 55% 0% 100%
The second accompanying table sets forth the effects of
annual returns for a $1,000 investment, held for a period
of 20 years, with annual returns of 10%. Generating 10%
nominal returns for 20 years has been within the realm of
possibility for many investors over the past several
decades, and is a frequently-encountered target rate of
return by a number of investors in modern times.
Extended periods of sub-10% returns have persisted in
various deflationary eras, however, and it bears repeating
that past performance is not a guarantee of future results.
Looking in the first row of the table shows that at the end
of twenty years with 10% annual returns, the investor
who reinvested nothing and spent all of his or her $100
annual return (generated by the $1,000 initial
investment) would have been able to avail himself or
herself of a grand total of $3,000. At the other extreme,
the last row of the table shows that the investor who
reinvested everything and spent nothing would end up
with $6,727 in ending accumulated monetary value. This
is over 2.2 times the grand total of money accumulated
by the investor who spent each years returns.
If the investor had been able to reinvest 25%, 50%, and
75% of the 10% annual returns at 10% for 20 years, he
or she would have ended up with terminal accumulated
monetary values of $3,932, $4,864, and $5,796,
respectively.
3DJH 22
David M. Darst
$1,000 Investment, 20-year Horizon, 5% Annual Return
Total
Compound Total
$1,000 $0 $0 $1,000 $2,000 $2,000
% of Grand Total 50% 0% 0% 50% 100%
25% ($12.50) of Annual Return Reinvested, 75% of Annual Return ($37.50) Spent
1,000 250 163 1,413 750 2,163
% of Grand Total 45% 12% 8% 35% 100%
1,000 500 327 1,827 500 2,327
% of Grand Total 43% 21% 15% 21% 100%
75% ($37.50) of Annual Return Reinvested, 25% of Annual Return ($12.50) Spent
1,000 750 490 2,240 250 2,490
% of Grand Total 40% 30% 20% 10% 100%
1,000 2,000 653 2,653 0 2,653
% of Grand Total 38% 38% 24% 0% 100%
The third accompanying table depicts the effects of
annual returns for a $1,000 investment held for 20 years,
with annual returns of 5%. While 5% returns over any
given two-decade time frame are by no means a
certainty, they have been achievable for such time
horizons in each of several broad classes of investments,
including equities, long-term government bonds, and
long-term corporate bonds.
The first row of the table shows that the end of a twenty-
year investment horizon with 5% annual returns would
produce a grand total of $2,000 (on a $1,000 initial
investment) for an investor who reinvested nothing and
spent all of his or her $50 annual return. On the contrary,
the last row of the table points out the fact that the
investor who reinvested everything and spent nothing
would have garnered $2,653 in final accumulated
monetary value. This is approximately 1.3 times the
grand total of the money at the disposal of an investor
who spent each years returns.
Rows two, three, and four of the table show that if the
investor had actually reinvested 25%, 50%, and 75% of
the 5% annual returns at 5% for 20 years, he or she
would have ended up with total accumulated monetary
values of $2,163, $2,327, and $2,490, respectively, or
some combination thereof.
3DJH 23
David M. Darst
$1,000 Investment, 10-year Horizon, 20% Annual Return
Total
Compound Total
$1,000 $0 $0 $1,000 $2,000 $3,000
% of Grand Total 33% 0% 0% 67% 100%
25% ($50.00) of Annual Return Reinvested, 75% of Annual Return ($150) Spent
1,000 500 798 2,298 1,500 3,798
% of Grand Total 26% 13% 22% 39% 100%
1,000 1,000 1,596 3,596 1,000 4,596
% of Grand Total 22% 22% 34% 22% 100%
1,000 1,500 2,394 4,894 500 5,394
% of Grand Total 19% 28% 44% 9% 100%
1,000 2,000 3,192 6,192 0 6,192
% of Grand Total 16% 32% 52% 0% 100%
The Effects of Spending vs. Reinvestment as a
Function of the Investment Time Horizon
The fourth accompanying table shows the effects of
spending vs. reinvestment of varying proportions of
annual returns for a $1,000 investment, held for a period
of 10 years rather than 20 years, with annual returns of
20%. It is worth repeating that 20% annual returns are
extraordinarily high, and achieving such investment
performance is rare, even if only for one decade, not two.
At the end of 10 years with 20% annual returns, the
investor who reinvested nothing and spent all of his or
her $200 annual return would have been able to avail
himself or herself of a grand total of $3,000. The
investor who reinvested everything and spent nothing
would own $6,192 in ending accumulated monetary
value. This is just over 2 times the grand total of money
at the disposal of an investor who spent each years
returns.
If the investor had reinvested 25%, 50% and 75% of the
20% annual returns at 20% for 10 years, he or she would
own ending accumulated monetary sums equal to
$3,798, $4,596, and $5,394, respectively.
Implications of Spending vs. Reinvestment
To illuminate some of the implications of the spending
vs. reinvestment decision, the fifth accompanying table
sets forth data drawn from the 20-year investments with
20%, 10%, and 5% annual returns, and for comparison,
the 10-year investment with 20% annual returns.
One key implication of the spending vs. reinvestment
decision is that the final accumulated effects of
postponing spending are dramatically higher, the higher
the reinvestment rate. For example, given a 20-year
investment horizon, with 100% of annual returns
reinvested, the final accumulated monetary value
amounts to $38,338 at 20% annual returns, $6,727 at
3DJH 24
David M. Darst
10% annual returns, and $2,653 at 5% annual returns
(box A in the table).
Similarly, the effects of postponing spending on the final
accumulated monetary value are significantly higher, the
longer the investment horizon. For instance, assuming
20% annual returns, with 50% of the annual returns
reinvested, the investor will have amassed $21,669 in
ending accumulated monetary value at the end of a 20-
year investment horizon, over 4.7 times the $4,596
accumulated at the end of a 10-year investment horizon
(box B in the table).
A third implication of the spending vs. reinvestment
decision is that at sufficiently low rates of return (and for
short- to intermediate-term investment horizons of 10
years or less), the monetary effects of postponing
spending are not all that significant. To demonstrate this
contrast, for a 20-year horizon and 20% annual returns,
the ratio of the final accumulated monetary value for
100% reinvestment of the annual returns to that for 0%
reinvestment of the annual returns is 7.7x (box C), with
the absolute dollar difference between these two paths
amounting to $38,338 minus $5,000, or $33,338. In
contrast, for a 20-year horizon and 5% annual returns,
the ratio of the final accumulated monetary value for
100% reinvestment of the annual returns to that for 0%
reinvestment of the annual returns is 1.3x (box D), with
the absolute dollar difference between these two
alternatives amounting to $2,653 minus $2,000, or $653.
Ending Accumulated Monetary Values
$1,000 Investment
Annual Rate of Return and Reinvestment
% of Annual
Returns
Reinvested
10-Year
Horizon 20-Year Horizon
20% 20% 10% 5%
0% $3,000 $5,000 $3,000 $2,000
25% 3,798 13,334 3,932 2,163
50% 4,596 21,669 B 4,864 2,327
75% 5,394 30,003 5,796 2,490
100% 6,192 38,338 6,727 2,653 A
Ratio of 100% 2.1x 7.7x C 2.2x 1.3x D
Reinvestment
Rate to 0%
Reinvestment
Rate
3DJH 25
David M. Darst
An additional important implication of the spending vs.
reinvestment decision relates to the Realized Compound
Yield of the total investment funds received (as distinct
from any monies that were spent rather than reinvested).
As shown in the accompanying table, merely reinvesting
some of the annual returns into the original asset class
can raise the Realized Compound Yield to a meaningful
percentage of the Realized Compound Yield that would
have been achieved if 100% of the annual payments had
been reinvested.
For example, if over a 20-year investment horizon, 25%
of the annual returns were reinvested, the proportion of
the full-reinvestment Realized Compound Yield that
would be achieved at 20% annual returns would be 62%;
(box A in the table); at 10% annual returns, 45% (box
B); and at 5% annual returns, 34% (box C).
Realized Compound Yield Tradeoffs of Spending vs. Reinvestment
Percentage Share of Annual Return
Realized Compound
Yield (RCY) of Total
Investment Funds
Received
Realized Compound
Yield as a Percentage
of RCY if 100% of
Annual Payments had
been Reinvested
Reinvested Spent
20-Year Horizon, 20% Annual Returns
0% 100% 0.0% 0%
25% 75% 12.4% A 62%
50% 50% 16.1% 80%
75% 25% 18.3% 92%
100% 0% 20.0% 100%
0% 100% 0.0% 0%
25% 75% 4.5% B 45%
50% 50% 7.0% 70%
75% 25% 8.7% 87%
100% 0% 10.0% 100%
0% 100% 0.0% 0%
25% 75% 1.7% C 34%
50% 50% 3.1% 62%
75% 25% 4.1% 82%
100% 0% 5.0% 100%
0% 100% 0.0% 0%
25% 75% 8.7% 43%
50% 50% 13.7% 68%
75% 25% 17.2% 86%
100% 0% 20.0% 100%
3DJH 26
Asset Allocation Principles: Asset Allocation Tools and Analysis
David M. Darst
In the asset allocation process, we believe investors can
reap important benefits, and reduce the impact of
suboptimal decisions, when they can simultaneously
apply perspective a long-term, macro tool, and depth
of analysis a short-term, micro tool. This is easier said
than done, and takes patience, skill, and experience.
To this end, investors require an array of tools that can
furnish structure and sharpen reflection. In a way,
investors need a figurative telescope, to identify
important trends, and the duration and magnitude of the
likely effects of these trends, on the principal asset
classes. At the same time, investors need a figurative
microscope, to deconstruct and evaluate the essential
features of specific investments and investment
managers within a given asset class.
The following sections review several of these tools:
societal analysis; a bull-and bear-market cycle analysis;
an economic and financial scenario analysis; an investor
satisfaction analysis; and an analysis of the key decision
points in investment strategy implementation.
Societal Analysis
A fundamental asset allocation issue which we believe
investors need to assess is the degree of stability, growth,
national cohesiveness, and forward thinking in an
economy. This would apply to domestic and
international investing, in equities, fixed income
securities, currencies, and alternative investments,
including venture capital, private equity, real estate, and
other structures such as hedge funds. In our view, the
soundness and attractiveness of an investment is vitally
linked to the overall health of a countrys society,
comprised, among other features, of interdependent
financial, economic, political, and social factors.
The accompanying chart displays many of these building
blocks of the human condition.
Building Blocks of the Human Condition
Free-market solutions
Prudent risk assumption
Healthy growth, price level
changes, valuation, and
psychology
Falling risk premiums
Capital formation
Portfolio and direct
investment flows
GDP expansion
Rising living standards
Adjustment and reform
energy
Integration into regional
and world markets
Transparency
Structural reform
Enlightened leadership
Respect for and support of
empowerment
Pluralism, checks and balances
Credible legal and regulatory
frameworks
Asset privatization
Respect for contracts and rights
Access to opportunity
Atmosphere of liberation
Rising expectations and life
expectancy
Environmental enhancement
Physical and mental well-being
Capital destruction
Capital flight
Higher risk premiums
Forced and voluntary
deleveraging and risk
aversion
Puncturing of asset bubbles
Government intervention
Exchange controls
GDP contraction
Reduced consumption,
savings, and investment
Monetary hoarding
Commodity-driven
deflation
Currency-induced inflation
Isolationism and trade
barriers
Declining living standards
Reduced legitimacy of
authority
Leadership turnover
Repressive policies
Nationalist fervor
Oligarchic control
Asset nationalization
Rule by decree
Rending of traditional order
Backlash against status quo
Sense of impoverishment
Xenophobia and international
confrontation
Denunciation of free markets
Ethnic, social, religious tensions
Acts of desperation
Negation of contracts and rights
Environmental abuse
Chronic illness, malnutrition, and
reduced life expectancy
Financial Economic Political Social
C
o
n
s
t
r
u
c
t
i
v
e
D
e
s
t
r
u
c
t
i
v
e
3DJH 27
Asset Allocation Principles: Asset Allocation Tools and Analysis (cont.)
David M. Darst
Nations and regions seek to realize their aspirations in a
continuous, upward-moving pattern, but along the way,
these dreams often encounter the vagaries of economic
and financial cycles, external events, periods of conflict
and peace, shifting confidence levels, and altered
priorities. Before committing significant amounts of
assets to a specific area of the world, it is useful for
investors to ask themselves where a nation is heading, on
a spectrum of constructive or destructive actions.
For example, in the financial realm, is the nation likely
to continue pursuing capital-friendly policies, or is it
likely to adopt capital-unfriendly policies? Several of the
causes and effects associated with each of these
governmental and market tendencies are shown in the
chart. In the economic sphere, investors need to take note
of favorable vs. unfavorable developments and policies,
and whether these policies are acting from outside the
system (exogenous events) or inside the system
(endogenous events). In the political sector, investors are
well advised to ascertain whether a countrys policies and
politics are keeping pace with, leading, or out of phase
with, the support and will of the people. Finally, in the
social arena, to what degree is the country upholding or
ignoring the basic rights, responsibilities, and
entitlements of the populace?
Often, the answers to these questions do not admit of
precise measurement nor calculation. Of prime
importance to the investor is to gain an overall sense of
the current and future climate affecting investment
activity.
Market Cycle Analysis
Another important cornerstone of the asset allocation and
investment process is the determination of what stage of
the market cycle a specific asset class (or subcategory of
an asset class) is in, as well as an awareness of the
principal forces driving price levels within that stage.
The prices of financial assets (such as stocks and bonds)
and real assets (such as commodities, precious metals,
art, and collectibles) are typically determined by some
varying combination of a trinity of forces: fundamentals;
valuation; and psychology or technical factors. They
generally follow a pattern akin to that shown in the
accompanying chart.
The Varying Importance of Factors Driving Asset Prices Across Market Phases
General vertical
direction (but not
horizontal direction)
of asset price
movements
Market Phase
Fundamentals
Valuation
(etc.)
Psychology/
Technical
Bottom
Early Stage
Recovery
Mid-Stage
Bull Market
Peak of Bull
Market Bear Market
20%
Improving but ignored
20%
Attractive, but no
takers
60%
Exhaustion, disbelief,
and demoralization
30%
Solid underlying
performance
50%
Abundant bargains
20%
Doubt, reflection, and
conversion
40%
Sweet summer of
growth
30%
Willingness to pay up
30%
Faith, hope, and
charity
20%
Optimistic, long-
duration projections
20%
Revised models justify
stretching
60%
Euphoria, greed, and
extrapolation
30%
Overawareness of
deteriorating conditions
20%
Shocked recognition of
outlandish prices paid
50%
Fear, panic, and
loathing
Note: The percentages indicated above are hypothetical only and reflect the personal views of the author.
3DJH 28
David M. Darst
In simplified form, these assets prices, subject to
reversals, to different degrees of magnitude, and
especially, duration in time, can be said to progress
through five major phases. These phases include: (i) a
bottoming phase, in which depressed prices generate
little or no investor enthusiasm; (ii) an early-stage
recovery phase, in which bargain prices begin to
convince investors of their underlying merits; (iii) a mid-
stage bull market phase, in which fundamental measures
of worth succeed in attracting greater numbers of
investors; (iv) a peak bull market phase, in which
investors increasing enthusiasm for the asset class
pushes prices to extreme levels; and, (v) a bear market
phase, in which swelling ranks of investors abandon their
enthusiasm for the asset and willingly offer it for sale.
The chart also displays the varying degree of importance
of the three key driving forces across the five phases
experienced in a classical market cycle. Fundamentals
(including those characteristics which define the inherent
attractiveness, utility, or purpose of the asset) tend to
play only a small role in influencing price movements at
the bottom, and at the top, of a market cycle.
Fundamentals generally come to the fore in the
determination of prices during the middle stage of a bull
market, when investors usually exhibit their most
rational behavior.
Valuation (which takes into account the pattern, timing,
and present worth of an assets cash flows and terminal
value, both relative to itself and to other kinds of assets)
tends to exert its greatest influence in the early stages of
a bull market. During such phases, very attractive values
often convert investors from disbeliveers to believers. In
other phases of a market cycle, values are more a
lagging, rather than a leading, instigator of investor
action.
Psychological and technical factors play a very
important role in pushing asset prices to extremely
elevated or depressed levels at the peaks or troughs of
market cycles. Psychological forces span the gamut of
human emotion and include mania, greed, euphoria,
gullibility, doubt, fear, panic, regret, and even loathing of
others and self. Technical forces encompass the liquidity
of an asset, the origins and destinations of investors
funds flows, and the attractiveness or unattractiveness of
a given asset relative to other assets. Taken together,
psychological and technical factors may very well and
often do dominate fundamental and valuation influences
at market extremes.
Scenario Analysis
After the investor has given thought to societal
influences, and to the prevailing phase and associated
forces of the market cycle for an asset class (or subclass),
he or she could profitably devote thought and resources
to a hypothetical economic and financial scenario
analysis. The chief value of such an analysis derives
from: (i) the relative completeness of the range of
scenarios considered, from optimistic to pessimistic; (ii)
the rough translation of forecasted economic results into
their resultant effects on various asset classes; (iii) the
need to assign probabilities to each of the scenarios; and
(iv) the construction of a tactical (usually having a one-
year time horizon) asset allocation appropriate for the
investor in question.
Several caveats should be kept in mind when
constructing and evaluating a series of scenarios and
their anticipated effects on financial markets and
portfolio construction. Forecasts, and especially their
associated probabilities, are purely predictions, not
actual circumstances. They rarely come to pass in as
internally consistent a manner and to the degree that they
are expected to happen. Moreover, economic and
financial history is filled with many outcomes that were
not originally part of the forecasting vernacular, and thus
were totally unpredicted.
The accompanying chart contains a matrix constructed to
analyze the likely effects of various economic and
financial scenarios in the U.S.
3DJH 29
David M. Darst
Hypothetical Economic and Financial Scenario Analysis
Scenario
1
Scenario
2
Scenario
3
Scenario
4
Scenario
5
Scenario
6
Projected Outlook
High Growth,
Low Inflation
High Growth,
Increasing Inflation
Lower Growth,
Increasing Inflation
Zero Growth,
Some Inflation Disinflation Deflation
Economic
U.S. GDP
CPI Inflation Rate
U.S. Corporate Profits
Other Variables
World GDP
Japanese Yen/US Dollar
Capital Markets
ST Interest Rates
LT Interest Rates
U.S. Equity Total Return
U.S. Bond Total Return
Probabilities
Moderate HNW Tactical Asset Mix
Equities
Bonds (Duration Yield-Dependent)
Cash

+ 3.5%
+ 2.5%
+ 12.0%
+ 2.8%
150
5.5%
6.0%
+ 15.0%
11.2%
10%
60%
25%
10%
5%

+ 3.5%
+ 4.5%
+ 10.0%
+ 2.0%
150
6.5%
6.5%
+ 8.0%
17.2%
10%
60%
20%
10%
10%

+ 2.0%
+ 5.0%
+ 5.0%
+ 1.5%
170
6.5%
7.0%
+ 2.0%
22.6%
20%
50%
25%
10%
15%

0.0%
+ 2.0%
5.0%
+ 1.0%
180
4.0%
4.5%
10.0%
+ 9.3%
35%
45%
35%
10%
10%

0.0%
+ 0.5%
8.0%
0.0%
200
3.5%
4.0%
15.0%
+ 17.2%
15%
40%
40%
8%
12%

1.0%
2.0%
12.0%
1.0%
225
3.0%
3.0%
25.0%
+ 35.0%
10%
30%
50%
5%
15%
Note: The percentages indicated above are hypothetical only and reflect the personal views of the author.
In the chart, which covers the time frame for the twelve
months looking forward from the date of the analysis,
Scenario 1 calls for a period of high real economic
growth (+3.5%), accompanied by reasonably subdued
consumer price inflation (+2.5%), and increasing U.S.
corporate profits (+12.0%). Other variables associated
with such an outcome would include rising real world
GDP (+2.8%), and an end-of-period currency exchange
rate of 150 Japanese yen per U.S. dollar. In such
circumstances, 3-month U.S. Treasury bill rates are
projected to end the period at 5.5% and the 30-year U.S.
Treasury bond is projected to yield 6.0%. As a result,
broad-based U.S. equity indices are projected to provide
a total return (including dividends) of +15.0%, and the
30-year U.S. Treasury bond is projected to provide a
total return (including coupons) of -11.2%, assuming that
long Treasury rates began the twelve-month period at
5.0%.
In this hypothetical example, a probability of only 10%
is assigned to Scenario 1. Should the High Net Worth
investor feel strongly that Scenario 1 will come to pass,
he or she may adopt a tactical (one-year) asset allocation
consisting of 60% equities, 25% bonds (with the
maturity and coupon dependent on the degree of the
investors conviction about the interest rate outlook),
10% alternative investments, and 5% in cash equivalent
instruments.
At the other end of the spectrum, Scenario 6 predicts a
period of deflation, in which real economic activity
contracts by 1.0%, consumer prices fall 2.0%, and U.S.
corporate profits decline 12.0%. Other variables
associated with such an outcome would include an
outright decline in world GDP of 1.0%, and an end-of-
period currency exchange rate of 225 Japanese yen per
U.S. dollar. In such an environment, 3-month U.S.
Treasury bill rates are projected to end the period at
3.0% and the 30-year U.S. Treasury bond is projected to
yield 3.0%. As a result, broad-based U.S. equity indices
are projected to provide a total return (including
dividends) of -25.0%, and the 30-year U.S. Treasury
3DJH 30
David M. Darst
bond is projected to provide a total return (including
coupons) of +35.0%.
In this hypothetical example, a probability of only 10%
is also assigned to Scenario 6. Should the High Net
Worth investor feel strongly that Scenario 6 will come to
pass, he or she may adopt a tactical (one-year) asset
allocation consisting of 30% equities, 50% bonds (with
the maturity and coupon dependent on the degree of the
investors convictions about interest rates), 5%
alternative investments, and 15% in cash equivalent
instruments.
Investor Satisfaction Analysis
At the same time as the investor surveys the external
forces described above, he or she would need to
consider, and if possible, to quantify in some
approximate fashion, the range of his or her internal,
emotional responses that will be engendered by the
markets affirmation or rejection of the investors asset
allocation decisions.
For example, if the investor expects the price of a
specific asset class to rise, he or she is faced with the
decision to buy the asset (or hold onto the asset, if
already purchased), or sell the asset. These decisions can
be arrayed into a decision tree similar to the one
constructed in the accompanying chart.
In the aftermath of the investors decision either to hold
(buy), or to sell a specific asset, its price may rise,
remain about the same, or decline. Each of these
outcomes will produce some degree of utility
happiness or disappointment on the part of the
investor, which, together with some degree of investor
reflection the entirely human second-guessing of
previous actions follows in its wake. Taken together,
this investor utility, combined with investor reflection,
yields some degree of investor satisfaction or
dissatisfaction, ranging from mild to the extreme.
The investor can assign some arbitrary, yet consistent,
scale of numerical rating to these potential outcomes, in
order to assess their relative effect on the investors own
psyche, and to rank various results versus other results.
For instance, the chart shows how one particular
investor (even though the scale is numerically based, the
units of satisfaction are highly subjective and specific to
each investor) might react to twelve possible outcomes,
themselves a function of: (i) the investors opinion as to
the likely future course of asset prices; (ii) the action
actually taken by the investor, either influenced by the
investors own opinion, or in total disregard of those
feelings; and (iii) the actual course of market outcomes.
Investor Satisfaction as a Function of Investor Actions and Market Outcomes
INVESTOR
OPINION
SELECTED
INVESTOR
ACTIONS
MARKET
OUTCOMES
UNITS OF INVESTOR
UTILITY
(RANGE: -10 to +10)
UNITS OF INVESTOR
REFLECTION
(RANGE: -3 to +3)
A
s
s
e
t
C
la
s
s
P
r
ic
e
s
U
p
A
s
s
e
t
C
la
s
s
P
r
ic
e
s
D
o
w
n
H
E
D
G
E
D
A
G
A
IN
S
T
P
R
IC
E
D
E
C
L
IN
E
Knew it was
going down,
should have sold,
did nothing
Thought it was
going up, held
on, turned out
wrong
Miraculously
sold, watched it
drop, and
dodged a bullet
Bought
insurance
which repaid
the damage
U
p
Flat
Down
Flat
U
p
Flat
U
p
Flat
U
p
UNITS OF INVESTOR
SATISFACTION
(RANGE: -13 to +13)
Elation and
exaltation:
held on and
confirmed sense
of rightness
H
E
L
D
A
S
S
E
T

S
O
L
D
A
S
S
E
T
-13 -11 -9 +8 +9 +13
Investor Satisfaction Spectrum
+10
+7 +3 +10
0 -1 -1
-7 -2 -9
-6 -1 -7
+3 +1 +4
+5 +3 +8
+6 +2 +8
0 +1 +1
-8 -3 -11
-2 -1 -3
-1 -1 -2
+6 +3 +9
Down
Down
Down
Note: The percentages indicated above are hypothetical only and reflect the personal views of the author
3DJH 31
David M. Darst
For example, following the topmost branch, at each of
the three nodes on the decision tree on the previous page,
signifies that the investor thought the prices of the asset
class were going to rise; the investor held (or purchased)
the asset; and in fact, prices did go up. In turn, for this
particular investor, such a sequence of events produced
+7 units of investor utility (on a subjectively set scale of
+10 units to -10 units), which, taken together with +3
units of investor reflection (also on a subjectively set
scale of +3 units to -3 units), produced +10 units of
overall investor satisfaction (on a combined potential
scale of +13 units to -13 units).
As shown in the Investor Satisfaction Spectrum at the
bottom of the chart on the previous page, (i) the
investors conviction that prices were going to rise; (ii)
his or her holding onto the asset; and (iii) the actual fact
of the price rise led, in this instance, to a highly positive
set of emotions, including a sense of rightness about
investment outcomes, and elation over the investors
own feelings of mastery and financial acumen.
At the opposite end of the spectrum, is the range of
feelings brought about by: (i) the investors belief that
the prices of the asset class were going to decline; (ii) the
investors holding onto the asset rather than selling it;
and (iii) prices experiencing a downturn. For a given
investor, this sequence of events produced -8 units of
investor utility, which, taken together with -3 units of
investor reflection, produced -11 units of overall investor
satisfaction. In such an instance, the investor had a
strong feeling that prices were going down, and should
have sold, but did not. On the Investor Satisfaction
Spectrum, the actual experience of the price decline
tends to lead to a complex and unsatisfactory set of
emotions, possibly including self-recrimination, and the
constant playing out in the investors mind of a series of
what-if scenarios.
The investor satisfaction analysis described here has
many shortcomings, not the least of which is its attempt
at placing numerical values on what are often variable
and highly personalized feelings. On the other hand, one
of the chief contributions of such an exercise is to
stimulate and organize the investors thinking about
potential outcomes and their emotional effects, prior to
taking investment action.
Strategy Implementation Analysis
As the asset allocation process proceeds, investors are
faced with a series of choices about how to implement an
investment strategy that is consistent with and reflective
of their asset allocation goals. Surrounding each of these
choices is a series of factors that helps determine which
alternative is most appropriate for the investor. Several
of these decision points, and a limited number of the
possibilities available to the investor at each decision
point, are set forth in the chart on the next page.
The choices along the continuum, from left to right on
the chart, start with large-scale issues, such as the macro
asset class selection decision. This analysis assumes that
the investor has chosen the equity branch of the decision
tree; many of the same principles and choices discussed
here are applicable, with some modification, in other
asset classes such as debt securities or alternative
investments. Given the choice of equities, a number of
more detailed alternatives present themselves.
For example, an investor who decides to invest in
equities needs to determine whether large capitalization
or small capitalization issues are more appropriate.
Among the factors and there are more than those
enumerated here that will help determine the most
appropriate course are: (i) the position of large-cap
versus small-cap issues in their respective market cycles;
and (ii) the relative valuation of these two equity
groupings, compared with their respective historic
valuation ranges and with each other.
Similarly, the growth equity versus value equity decision
hinges in part on whether the marketplace as a whole is,
and/or is likely to become, focused primarily on income
statement items, such as margins and growth rates in
revenues, cash flow, and earnings. Such an environment
may indicate a decided popularity tilt toward growth
equities. Alternatively, the market as a whole may be,
and/or may be likely to become, focused primarily on
balance sheet items, such as cash levels, debt-to-equity
ratios, contingent liabilities, and book values. Such an
environment may indicate that value equities are in favor
with investors.
3DJH 32
David M. Darst
Having made a selection between large- and small-cap
equities, and between value and growth, investors
usually select an industry or industries, and then one or
more than one company in these industries. The industry
choice is influenced by the cyclical and secular financial
and operating characteristics of the industry, as well as
the investors affinity for and understanding of industry
dynamics. The company choice is determined by a broad
range of factors, three of the most important of which
are: (i) the quality of management; (ii) the attractiveness
of the companys business, and (iii) how well the
company is taking advantage of the business opportunity
facing it.
Once the investor has decided on industries and
companies, he or she often encounters a number of
different ways to invest. These investment vehicles
include common stock, options, futures, warrants,
convertible bonds and preferred stock, futures, equity-
linked bonds, index-tracking securities, and funds and
other pooled vehicles, either in partnership form or fund
form. The decision as to which investment instrument to
use is often a function of: (i) how much time and
understanding the investor brings to the process; and (ii)
comparative transaction costs.
After the form of investment has been determined, some,
but not all, investors give consideration to the overlay
selection decision. A portfolio overlay shifts the
risk/return profile in some way, either toward a more
conservative investment stance, or toward a more
aggressive investment stance. The range, form, cost
spectrum, and availability of these portfolio overlay tools
have expanded considerably in recent years, and include
devices for: hedging the capital value of the portfolio or
individual positions; currency hedging; and borrowing or
lending money or securities. Whether to employ these
techniques, and which ones to use, are a function of the
investors views about market outcomes, and his or her
predilection for simplicity versus complexity in asset
allocation and investment strategy.
Viewed in a broad context, we feel it is useful for
investors to marshal as many relevant tools as they
can, to contribute insight, rigor, and fresh thinking to
the asset allocation process. The relative degree of
time and emphasis to be devoted to these tools
societal analysis, market cycle analysis, financial
scenario analysis, investor satisfaction analysis, and
strategy implementation analysis will depend to a
large degree on market conditions, the asset class(es)
and investment(s) being considered, and the
investors own frame of mind.
Decision Points in Investment Strategy Implementation

MACRO
ASSET
CLASS
SELECTION
EQUITIES
VS.
FIXED INCOME
SECURITIES
LARGE
VS.
SMALL
EQUITIES
GROWTH
VS
VALUE
EQUITIES
INDUSTRY
SELECTION
COMPANY
SELECTION
INVESTMENT
FORM
SELECTION
OVERLAY
SELECTION
DETERMINING
FACTORS
Traditional
Traditional
Plus
Alternative
Equities
Plus
Fixed
Income
Equities
Large Cap
Small
Cap
Stocks
Common
Spyders
Convertibles
Leaps
Growth
Value
Pharmaceuticals
Technology
Merck
American
Home
Products
Capital
Hedging
Currency
Hedging,
Borrowing
Lending
!Expected Outcomes
!Simplicity vs. Complexity
!Vocation vs. Avocation
!Cost Considerations
!Management Quality
!Opportunity Maximization
!Financial Characteristics
!Affinity and Understanding
!Income Statement Items
!Balance Sheet Items
!Stage in Market Cycle
!Relative Valuation
!Income Needs
!Principal Protection
!Purchasing Power Protection
!Risk Profile
!Liquidity Needs
!Magnitude of Wealth
3DJH 33
Asset Allocation Principles: Recognizing Turning Points
David M. Darst 4/23/99
Set forth below are excerpts from a 40-page treatment of
financial market excesses potentially indicative of
turning points. Copies of the full essay are available
upon request.
It is widely held that long-term investment success is
dependent on asset allocation, the timely balancing and
blending of different asset classes to reduce risk and
achieve targeted return objectives. Equally important, in
our view, is knowing when to be significantly
overweight or underweight certain investments and asset
groups at the beginning or end of turning points that
demarcate sustained movements in prices, economic
growth rates, and financial market values that may last
for a decade or more.
These turning points do not always follow the same
pattern. For example, in some cases, a pronounced shift
from high inflation to much lower levels of inflation, or
from moderate inflation to disinflation or deflation, has
been sparked by an unexpected event or policy measure
that was immediately recognized as a sea change by a
majority of investors. In other cases, the shift was a
subtle one, obvious only in retrospect. Similarly, the
turning point may be set in motion by one single factor,
or by a combination of forces acting together.
Perhaps one of the twentieth centurys greatest investors
and asset allocators was Paul Cabot, manager of the
Harvard University endowment for 17 years. He is
credited with shifting Harvards portfolio from a
preponderance of bonds to a heavy emphasis on equities
beginning in the late 1940s, in the face of a heavily pro-
bond, anti-equities stance in financial markets and, for
that matter, among many of the Trustees of Harvard
College at the time. When asked about the requirements
for success in investing, Mr. Cabot replied with
quintessential Yankee brevity and directness: You need
only two things. First, you have to get all the facts.
Second, and much more difficult, you have to face the
facts.
In order better to face the facts, investors would be well
served to regularly step back from the daily, weekly, and
quarterly information flow and ask themselves several
key questions. These questions include: (i) How is a
given asset class going to perform over the next two to
five years or more? (ii) Who is going to buy these assets
at prices that will produce the projected investment
returns? and (iii) Are the seeds of radically different
price behavior for these assets being sown by extreme
conditions that are apparent but perhaps overlooked by
the marketplace?
To answer these questions, the investor needs not only to
be able to identify obvious things, such as patterns,
linkages, the buildup of pressures, and cause-effect
relationships, but also to spot much more subtle and
hard-to-predict factors, such as the degree of persistence
of forces, the applicability of lessons learned in prior
episodes, and the distinction between what changes or
evolves in human nature and what remains truly constant
and unchanging. Sometimes, it can take decades, or even
a century, to revert to a mean. At other times, the mean
changes, and prices never revert to the old mean.
Particularly in the advanced stages of major bull or bear
markets, investors can lose track of the successive order-
of-magnitude differences between the difficulty of
predicting first, the direction of a price move; second,
the magnitude of a price move; third, the associated
degree of variance around a price move; and fourth, and
considerably more difficult, the timing of a price move.
Rightly or wrongly, investment reputations, not to
mention investment fortunes, have been created or
destroyed based on the investors skill (or luck) in
predicting, or in totally missing, the time when an old era
is closing and a new one is about to dawn.
As of early 1999, the degree and duration of the U.S.
equity markets advance since 1982 has led to two
powerfully conflicting points of view about the future
direction of equity prices. On the one hand, many
investors and market strategists see America as having
entered a new era of high equity returns, propelled by a
so-called new paradigm of technological progress,
quiescent inflation, low interest rates, and not least, the
apparent triumph and spread of the American capitalistic
model. This model includes incentivization, shareholder
activism, multinational penetration into the global arena,
3DJH 34
Asset Allocation Principles: Recognizing Turning Points (cont.)
David M. Darst
deregulation, flexible product and labor markets,
corporate restructuring, free trade, rising living
standards, innovation, and risk-taking. U.S. equities are
viewed by this group as a good short-term speculation
and an excellent long-term investment, with bonds seen
at best as a passable short-term investment and more of a
long-term speculation. A subgroup of the new-era, new-
paradigm investors believes that even if they are
incorrect, and equity prices move downward, they will
nevertheless be able to: (i) sell out at or near the markets
peak; or (ii) protect themselves through the nimble use of
hedging maneuvers such as the sale of stock index
futures or the purchase of put options.
On the other hand, a considerably smaller proportion of
the investment population possesses a no less firmly
defended sense that the U.S. equity markets are nearing
extreme points of valuation, euphoria, investor
participation, and narrowness of equity price advance. In
the view of this group, the very high equity returns of the
latter five and ten years of the 19821999 bull run herald
meaningfully lower, not higher, equity returns over the
early years of the new century, particularly when viewed
against the backdrop of longer-term societal trends such
as low savings rates, wide income inequalities, and an
erosion in the quality of the public elementary and high
school educational infrastructure.
Regardless of the investors own view, he or she should
rigorously and discerningly scan the horizon for signs of
excess, signs that, appropriately interpreted in time, may
give indication of an important and impending turning
point in the returns generated by a given asset class.
There is no lack of signs of topsy-turviness to the
1999 investment climate. First, a growing body of
evidence suggests that value is undervalued, while
excessively high valuations are prized. Second, in
many instances, financial markets, not central banks,
are considered by some observers to set monetary
policy for nations, through the medium of currency
values and interest rates. Third, the outcome of the
real economy is felt to be dependent on the financial
sector, rather than financial sector outcomes
reflecting developments in the real economy. Fourth,
things that were once considered to be linked are seen
to be delinking such as the U.S. economy from
that of large portions of the rest of the world, and
annual price changes in the service sector from those
in commodities or the manufacturing sector. Fifth,
things that were once considered to be loosely linked
are seen to be linking such as equity market
correlations around the globe, not to mention the
circular connection between the stock market, the
economy, and wealth-, income-, and leverage-driven
consumer spending. Finally, the traditional market-
influencing forces of corporate profitability, earnings
progress, and growth in book values have been
augmented and/or entirely supplanted by powerful
new forces, including financial television, the
Internet, equity mutual fund flows, and indexing.
Table 1: The Effects of Investment Opinions and Actions
Short-Term, Cyclical Opinions
and Actions
Long-Term, Secular
Opinions and Actions Effects
Correct Incorrect The investors transient, short-term success may be seriously
vitiated or wiped out as long-term trends overtake short-term
trends.
Incorrect Incorrect The investor may experience highly unfavorable and perhaps
destructive investment results.
Incorrect Correct The investor may be able to survive, and eventually prosper,
depending upon the form and amount of realized and unrealized
losses vs. gains.
Correct Correct The investor may compound investment capital at advantageous
rates of return.
3DJH 35
David M. Darst
Cyclical vs. Secular Analysis
A critical element in recognizing financial turning points
is the ability to differentiate between developments that
are short-term, or cyclical (from the Greek word kyklos,
meaning circle), and those that are long-term, or
secular (from the Latin word saecula, meaning age, or
epoch). As markets get closer to extreme points,
investors perversely tend to focus on shorter- and
shorter-term indicators that are in fact cyclical in nature,
while at the same time assigning secular significance to
such trends and projecting them further and further out
into the future.
In such circumstances, investors should more than ever
be bringing long-term indicators within their analytical
and reflective compass. This process is rendered all the
more complicated since: (i) cyclical and secular
indicators will only very rarely all point in the same
direction at any given moment in time, some
indicators will be flashing a positive signal, others
negative; and (ii) cyclical and secular time periods often
overlap with, and are in fact comprised of, one another.
The benefits to the investor of being right in his or her
opinions and actions, and the costs of being wrong, will
produce differing results, depending upon the time
frame, magnitude, form, and sequencing of realized and
unrealized investment outcomes. A simplified version of
our analysis of four commonly encountered scenarios is
set forth in Table 1.
Keeping in mind the substantial overlaps between
cyclical and secular developments, investors should
monitor those areas which are evidencing significant
change at the margin. A selected list of important
cyclical and secular indicators is contained in Table 2.
It is worth repeating that the assignment of factors to the
Fundamental, Valuation, and Psychological/Technical/
Liquidity headings, or to the Cyclical or Secular
categories, in Table 2 is highly arbitrary and by no
means fixed. For example, in the early stages of a bull
market in equities, investors may very well rely on
classical valuation measures (such as Dividend Yields,
Price-to-Book ratios, and even Price/Earnings multiples)
as short-term guideposts, whereas in the later stages of a
bull phase, these yardsticks may be totally downplayed
as cyclical indicators and instead treated as secular
indicators, or even ignored altogether. In such
environments, investors may instead be focusing on
model-based valuation measures, such as Dividend
Discount Models, the Real Earnings Yield, and the
Anticipated Equity Risk Premium. The important thing
is not to get too caught up in or fixated upon one or two
cyclical indicators to the exclusion of others, nor to
ignore the subtle signals being given off by secular
measures.
Excesses Potentially Indicative of Turning Points
As a recapitulation of the main points in this essay, this
section sets forth a summary of the key conclusions
about areas of excess that may be indicative of turning
points. Because of the wide degree of publicity and
analytical commentary devoted to: (i) Americas position
as the worlds largest debtor nation, its continuing
balance of payments deficit, and its financial dependence
on foreign purchases of dollar assets; and (ii) the Year
2000 computing problem, these topics are not treated in
detail here, even though each factor has the potential to
spark a turning point. Similarly, no direct treatment is
given to bolt-from-the-blue events such as health
epidemics, natural disasters, acts of terrorism, social
instability, or geopolitical developments involving areas
including China, Russia, North Korea, the Balkans, or
the Persian Gulf and Middle East.
3DJH 36
David M. Darst
Table 2: Cyclical and Secular Investment Indicators
Short-Term, Cyclical Indicators
(Looking for the Presence or Absence of Pressures)
Long-Term, Secular Indicators
(Looking for the Presence or Absence of Excesses)
Fundamental Fundamental
Gross Domestic Product Change and Composition
- Consumer Employment, Confidence, Income, Consumption, and
Savings
- Business Output, Investment, and Purchasing Plans
- Government Receipts and Expenditures
- Imports and Exports
Corporate Profits
- Earnings Patterns, Estimates, and Revisions
- Quality of Earnings
Short-Term and Long-Term Interest Rates
- Money Supply Growth
- Shape of the Yield Curve
- Credit Spreads vs. U.S. Treasury Yields
- Taxable/Tax-Exempt Yield Relationships
Price Level Changes
- Raw Materials
- Employment Costs
- Producer and Consumer Prices
Currency Exchange Rates
- Current Account Balance
- Balance of Payments
- Inflation and Interest Rate Differentials
Technological Progress, R&D Spending
Productivity Trends
Investment and Infrastructure Spending
Education, Health, and Security Spending
Tax Rates and Fiscal Policy
Demographic Trends and Living Standards
Environmental and Climatological Trends
Long-Term Commodity Price Trends
Long-Term Manufactured Goods Price Trends
Global Supply/Demand Relationships
Corporate Profitability and Defensibility Trends
Accounting Rule Changes
Openness of World Markets
Cross-Border Capital Flows
Geopolitical Relationships
Reserve Currency Relationships
Monetary Policy
Valuation Valuation
Dividend Discount Models
Inflation-Based P/E Models
Tactical Inflation-Based P/E Models
Real Earnings Yields
Fisher Inflation-Based Bond Models
Bond-Stock Yield Spreads
Anticipated Equity Risk Premiums
Price/Earnings Ratios
Price/Book Value Ratios
Price/Cash Flow Ratios
Price/Sales Ratios
Dividend Yields
Market Capitalization/Replacement Cost
Market Capitalization/GDP
Psychology/Technical/Liquidity Psychology/Technical/Liquidity
Volatility and Standard Deviation
Supply/Demand Relationships
- Gross and Net Mutual Fund Flows
- Investor Cash Ratios
- Corporate Share Repurchases
- Gross and Net Equity Issuance
- Cash M&A Activity
Investor Sentiment
- Market Vane Traders Sentiment
- Investors Intelligence Insider Buy/Sell Ratio
- Investors Intelligence Advisory Service Sentiment
Ratio
Political/Electoral Effects
Technical Measures
- Confirmation/Non-Confirmation of Price Indices
- Percentage of Stocks Above their 200-Day Moving Average
- Daily Volume
- New Highs vs. New Lows
- Net Advances vs. Declines
- Breadth Ratios of Advancing to Declining Volume
- Sector Rotation and Relative Sector Performance
Merger and Acquisition Waves
Industry Sector Performance/Nifty Mania
Financial and Investment Leverage
Societal Views Toward Capital
Popular Sentiment and Will
Intergenerational Wealth Transfers
3DJH 37
David M. Darst
Fundamental Excesses Potentially Indicative of
Turning Points
Deflationary Forces have been unleashed with
some degree of severity in Japan and many countries
in non-Japan Asia; less severe, but no less serious,
deflationary trends have been encountered in several
European countries and in certain U.S. industrial
sectors. It is an open question whether the right mix
of monetary, fiscal, and regulatory policies can be
implemented to stimulate demand, and reduce
supply, in a timely enough fashion to prevent
deflationary price movements from leading to more
widespread declines in economic output.
Money Supply Growth in the U.S. seems to have
reached unsustainably high levels, that in past
history have preceded monetary policy tightenings to
cool off the economy and reduce inflationary
pressures. The effects of the high money growth
rates have been dampened by the powerful
deflationary forces operating in many sectors of the
U.S. economy and overseas. In the past, episodes of
high money supply growth have generally not ended
well for investors.
The Position of the Federal Reserve has undergone
significant change in recent years. On the one hand,
the financial markets have generally come to expect
that the Fed will rescue a widening circle of
financial sectors when they fail, but will allow
bubble-like conditions to continue. On the other
hand, the financial markets are beginning to sense
that they are now much larger, and possibly more
powerful, than the Fed.
Leverage and Consumption reflect the several-
decades trend of increased borrowing relative to
GDP by the Federal Government, Nonfinancial
entities including Households, and the Financial
Sector. Due in part to the late 1990s surge in stock
market values, households have continued to
consume at rates which outstrip their income growth,
in the process increasing households debt relative to
their disposable income, and reducing the personal
saving rate to zero. Other sectors, including the
securities industry, have also moved toward higher
levels of leverage. This increased leverage increases
financial risk and narrows the margin of safety in the
event of an economic downturn.
Derivatives have burgeoned in total notional
amounts outstanding, to surpass the aggregate global
value of debt and equity securities, and even total
global GDP. Over 70% of these derivatives have
been individually structured and are traded over-the-
counter. While these instruments are a tool for
controlling risk as well as assuming risk, they have
played a central role in several significant financial
losses and systemic crises in recent years.
Derivatives introduce elements of, and raise
questions about, leverage, actual-vs.-expected
trading liquidity, complexity, counterparty
creditworthiness, and international regulatory
oversight.
Demographics have acted as a powerful additive
source of funds to U.S. equities markets during the
1980s and 1990s, as the Baby Boomer generation
has begun investing for retirement. At some point
early in the new century, investors are likely to shift
their focus to several key issues, including: (i) who
will buy the Baby Boomers financial assets at
favorable prices; (ii) projected net funds outflows
from the Social Security Trust Fund and private
pension plans; (iii) the sharply declining share of the
worlds population in developed countries vs.
developing countries; and (iv) significant declines in
the working age population in many developed
nations.
Valuation Excesses Potentially Indicative of
Turning Points
U.S. Equity Valuations in the late 1990s have been
defended in many quarters as being justified by low
inflation rates, interest rates, and Equity Risk
Premiums, and a variety of other model-based
constructs, but in other circles, have been viewed as
seriously and extraordinarily overvalued. This latter
skepticism has been based upon: (i) very high
valuations for the Internet-related stocks, and to a
somewhat lesser degree, for selected other drug,
consumer products, and technology companies; and
3DJH 38
David M. Darst
(ii) Price/Earnings, Price to Book Value, Price to
Cash Flow, Dividend Yields, Market Capitalization-
to-GDP, and Market Capitalization-to-Replacement
Value ratios that for the S&P 500 index were
registering readings that were at twice or more the
level of their 50- to 70-year median values.
The Duration and Divergence of U.S. Equity
Returns have traced out extraordinary patterns
through the 1980s and 1990s. Depending upon how
a market correction is defined compared to an actual
bear market, the Standard & Poors 500 index from
October 1990 through early 1999 had risen the
longest (over 100 months) and the farthest (up more
than 420%) of any bull market in the 20th century,
substantially exceeding the second-place holder, the
great bull market of the Roaring 20s. At the same
time, the late 1990s have witnessed a possibly
unprecedented divergence in performance between:
(i) the S&P 500 index and many broader-based
indices, such as the Value Line 1700, the NYSE
Composite, and the Russell 2000; (ii) growth stocks
and value stocks; and (iii) large capitalization stocks
and small capitalization stocks. While neither the
long duration nor the wide divergence of U.S. equity
returns is sufficient in and of itself to cause a
reversal of the trend in stock prices, both
developments are indicative of the buildup of market
forces and the shift of investor thinking into
potentially dangerous patterns of complacency and
narrowness.
U.S. Pharmaceutical Stocks in the late 1990s
carried very high historical valuations on a
Price/Earnings and Price-to-Sales basis, and account
for a meaningful percentage of the total U.S. equity
market capitalization. In part, these lofty valuations
have stemmed from the reliability, profitability, and
high barriers to entry of the drug industrys income-
generating capability. By the end of the 1990s, this
high-margin, high P/E industry was facing: (i) the
expiration of patent protection in the 19992005
period for several high-revenue drugs; (ii) increasing
costs for drug marketing and promotion activity; and
perhaps most seriously, (iii) early signs of
impending downward pressure on drug prices from
several quarters.
Japan in the 1990s has experienced severe damage
to its equity and real estate markets, its banking
industry, and its economy. On the eve of the new
century, questions remain about whether the
essential conditions had been put in place to return
Japan to economic and financial health. Thoughtful
analysis of past and unfolding conditions in Japan
can yield valuable lessons about their boom-to-bust
experience, their disinflationary/deflationary price
spiral, their decline into a liquidity trap, and
successful and unsuccessful ways of attempting to
restart a major developed economy such as Japan.
Gold price movements have been virtually ignored
by mainstream investors in the 1990s who have
traditionally considered a rise in the gold price as an
indicator of a return of higher inflation and rising
interest rates. In a world facing deflationary
pressures, mainstream investors and gold specialists
need also to consider downward movements in the
price of gold as a potential referent to disinflationary
or deflationary price and interest rate trends.
Psychological/Technical/Liquidity Excesses Potentially
Indicative of Turning Points
The Equification of Society refers to the pervasive
position that equity investing has come to occupy in
American life in the late 1990s. During such
equification periods, the media and popular
conversation become filled with stories of rapid wealth
accumulation, a broadening of access to successful
speculation and investment techniques, and a belief that
high and positive equity returns could be earned
indefinitely. Caution, risk awareness, moderation, and
financial conservatism are significantly downplayed.
Mania-like characteristics infect certain market sectors
and the prices of a narrowing list of highly popular
stocks become increasingly detached from
fundamental- or valuation-based considerations,
instead being driven primarily by perception,
psychology, liquidity flows, and technical factors such
as short-covering and the underwriting calendar.
3DJH 39
David M. Darst
Perhaps an additional sign of excess is the simultaneous
coexistence of each of the twelve areas of excess
summarized here. Considered together, they increase the
potential for instability in any one area to spread to and
be reinforced by instability in another area.
Questions to Consider
As investors ponder the course of economic, financial,
and social trends, and their likely effects on the
fundamental, valuation, and psychology/liquidity/
technical factors affecting asset and security prices, they
should formulate a list of relevant questions and strive to
develop a range of outcomes, extending from the likely
to the barely possible. Several of these questions are set
forth below.
Fundamental Questions
What factors could meaningfully arrest real
economic growth, leading to stagnation or an actual
decline in economic output? What would be the
likely extent and duration of such a slowdown or
contraction? What would be the pattern of overall
corporate profits, and specific industries profits,
under such circumstances?
What domestic or international events or policies
would cause interest rates to rise or fall in a major
way from prevailing levels?
Are certain regions, economies, and industries facing
an epoch of benign price deflation, propelled by
productivity growth, technological advances, and
increasing supply? How narrow is the margin
between benign price deflation and harmful price
deflation, and what developments could shift
deflation from the benign kind to the harmful kind?
What is the position of equities vs. debt, domestic
vs. international securities, currency relationships,
and privately vs. publicly traded investments in the
event of a deflationary episode, or the reflationary
policy actions to avoid such an outcome?
Valuation Questions
What lessons can be learned about the shifting role
of valuation-based disciplines in bear market
episodes in Modern Times in Japan in the 1990s, in
non-Japan Asia between 1997 and 1999, and in the
U.S. in 1973-1974?
After Price/Earnings ratios have experienced a
meaningful multi-year expansion to historically high
levels, what factors would be necessary to sustain
P/Es at these high levels, and/or move them even
higher, for an extended period of time?
Will the pattern of future equity bear market
episodes fall: (i) more on equities than on bonds, or
equally on both? (ii) more on U.S. than on overseas
markets, or equally on both? (iii) more on the S&P
500 than on the Russell 2000, or equally on both?
(iv) more on growth stocks than on value stocks, or
equally on both?
For portfolio holding periods of five to ten years or
more, is it preferable to invest in companies that
appear to be relatively good value, based on low
multiples of current earnings, or in companies that
have exceptional growth potential, even if they
appear expensive in valuation terms?
Psychology/Liquidity/Technical Questions
What forces and/or events would cause U.S.
Households to meaningfully reduce their exposure to
equity investments?
How can the investor determine the minimum
ongoing level of investment exposure to any given
asset class? What is the investors comfort zone of
investment exposure in periods of rising, flat, or
falling prices and overall returns for various asset
classes?
What are the risks, rewards, appropriate parameters,
and best implementation strategies of investment
contrarianism? What market forces and
environments determine whether the investor should
hold firm to principle and resist the crowd, and what
market forces and environments dictate that the
investor should not fight the crowd?
3DJH 40
David M. Darst
Closely related to the consideration of these and other
questions is the concept of Scenario Analysis, which is
the consideration of the consequences and investment
implications should various events, trends, and/or
policies come to pass. A number of potential scenarios
are treated in the following section.
Scenario Analysis
In looking for potential excesses that foretell major
turning points in financial markets, investors should keep
in mind that the temporal length and percentage change
of an index price movement, in and of themselves, are
not sufficient to spark a reversal in trend. As a general
principle, a long upward or downward price movement
can be interrupted and perhaps sent in an new direction
in one of three major ways: (i) through one or more
major external shocks to the economic system or
prevailing confidence levels; (ii) through the buildup and
eventual denouement of significant internal imbalances
within an economy; and/or (iii) through monetary, fiscal,
trade, or other policy errors that have deleterious
consequences for key sectors of a countrys, a regions,
or the worldwide economy.
Table 3 sets forth a number of potential scenarios,
grouped into the categories of External Shocks, Internal
Imbalances, and Policy Errors.
It should be pointed out that the potential scenarios
shown in Table 3 are by no means a complete listing of
possible developments. We believe the usefulness of
such a list of possible scenarios stems from the advance
reflection that an investor can devote to: (i) the
anticipated effects of one or more of these (or other)
outcomes on the short-term and long-term price behavior
of equities, fixed income securities, alternative
investments, cash, and currencies; and especially
important, (ii) the likely response of central banks,
regulators, governments, investors, and other financial
market participants to a given scenario.
Table 3: Scenarios with Potentially Serious Consequences
External Shocks
Debt rescheduling talks are
initiated and/or default is declared
by a major international borrower.
Foreign investors execute large-
scale sales of U.S. dollar-
denominated financial assets.
Tensions escalate toward wider
armed conflict in troubled regions.
Confrontation spreads between
governments and financial
markets.
An export battle breaks out
between China and other Asian
countries.
Y2K problems and/or cyber-based
computer viruses disrupt
Information Technology resources.
Internal Imbalances
Large-scale losses are revealed in
the lending and/or derivatives
markets.
One or more large financial
institutions declares insolvency.
Highly valued equity market
sectors (such as Internet stocks)
experience significant price
declines.
Economic recovery fails to take
hold in Japan, Russia, Brazil, or
other important economies.
Bad bank loans, amounting to 30
40% of GDP, lead to a banking
crisis in China.
Policy Errors
Excessive monetary liquidity is
injected (or suddenly withdrawn)
worldwide, leading to significant
asset price inflation (or deflation),
and/or general price level inflation
(or deflation).
Major currency instability develops
in the Yen, Euro, U.S. dollar,
and/or other currencies.
Governments adopt protectionist
policies that restrict the flow of
goods and/or capital.
3DJH 41
Asset Allocation Principles: Structural Considerations David M. Darst
An often overlooked aspect of the asset allocation
process concerns the form and structure in which the
High Net Worth investor owns, controls, and ultimately
disposes of his or her assets. For individual investors,
how the assets are owned, conserved, should be as
important as what assets are owned, what risk
management actions are taken, and what overall
investment strategy is pursued. These structural concerns
seem of greater consequence than ever before in a
technologically-advanced world that places a premium
on finding sound counsel, wise judgment, and prudent
financial conduct. These qualities become more highly
prized as investors seek greater choice through open
financial services architecture, greater convenience
through multiple access channels, and greater control
over expenses through unbundling and ease of
comparison pricing. In general, it is to the investors
benefit to have assets compound: (i) over as long a time
as possible; (ii) in as tax-advantaged a format as
possible; and (iii) keeping investment-related expenses
as constrained as possible.
The comments and guidelines contained in the following
paragraphs relative to tax and legal matters are intended
as background information. Morgan Stanley Dean Witter
does not provide tax or other legal advice. Investors
should consult with their own tax and legal advisors for
any such advice.
Structural Considerations
To achieve their financial goals, and to build wealth, in
the last two decades, individual investors have
increasingly embraced a number of tax-advantaged and
other structures, including Individual Retirement
Accounts, 401(k) plans, deferred compensation
arrangements, fixed and variable annuities, custodial
accounts under the Uniform Gifts to Minors Act
(UGMA) or the Uniform Transfer to Minors Act
(UTMA), Educational IRAs, Series EE Savings Bonds,
and state-sponsored college tuition savings programs
also known as Section 529 Plans). In addition, to achieve
diversification and professional management, individual
investors have utilized so-called consulting or wrap
accounts, which combine investor risk and return
objective profiling, and asset allocation, with manager
selection and monitoring. This process usually involves
an asset-based fee. More recently, taxable investors have
begun to pay attention to the tax advantages of: (i)
purchasing securities directly, or having their assets
managed on a separate-account basis, rather than through
mutual funds; (ii) investing in mutual funds with so-
called high tax-efficiency ratings (the percentage of a
mutual funds total returns that it retains after taxes); and
(iii) owning special tax-managed mutual funds, which
seek to minimize fund holders tax bills. According to
Morningstar Research, as of mid-1999, there were 56
tax-managed mutual funds, with $18 billion in assets, up
from only one such fund in 1988.
Tax-managed funds investment tactics, as well as those
of tax-conscious separate-account managers and
individual equity investors, include: (i) a low-turnover,
long-term buy-and-hold approach to investment
holdings; (ii) an orientation toward companies whose
annual returns are mainly in the form of capital gains
rather than dividends; and (iii) where appropriate, the
offsetting of realized capital gains through the judicious
realization of capital losses within the same tax year.
Evolution of Individual Focus
It may be asserted that in recent times, many individual
investors are in the process of, or are contemplating, an
important expansion in their financial thinking. This
transformation follows in similar fashion the significant
broadening of individual investors earlier scope, from a
focus purely on equity diversification, to a wider focus,
encompassing asset allocation. This process is depicted
in Exhibit 1.
3DJH 42
Asset Allocation Principles: Structural Considerations (cont.) David M. Darst
Exhibit 1: The Evolution of Individual Investor Focus
Scope of
Investor Focus
Time
International
Equities
Fixed
Income
Securities
Alternative
Assets
Domestic
Equities
Cash
Trusts &
Estates
Insurance
Financial
Planning
Asset
Allocation &
Investment
Strategy
Tax&
Liability
Management
Equity
Diversification
Equity
Diversification
Financial
Management
Financial
Management
Asset
Allocation
Asset
Allocation
Technology
Consumer
Cyclical
Healthcare
Utilities
Financial
With the passage of time, the breadth of many individual
investors focus tends to undergo a shift in emphasis. As
investors make their first investments in equities and
mutual funds, their primary focus tends to center on the
proper degree of concentration and diversification in
their portfolios. Industry and company groupings are a
commonly utilized means of establishing and monitoring
equity diversification parameters. Later, reflecting
greater levels of accumulated and invested assets,
investors generally become more aware of asset
allocation issues, including the proper proportion of
domestic vs. international securities, stocks vs. bonds,
and conventional vs. alternative assets, with the last
category including private equity, venture capital, hedge
funds, and real estate. Even later, as assets build and the
breadth of investors considerations widens, individuals
find themselves devoting attention to a wider set of
decisions. In addition to asset allocation and investment
strategy concerns, financial management matters of
interest include the use of personal trusts, insurance,
financial planning (which may include retirement
planning and education planning, in addition to estate
planning), and the many forms of tax and liability
management.
Evolution of Individual Investor Objectives
Put another way, as assets grow, the principal objectives
and concerns of individual investors progress through a
series of stages, as shown in Exhibit 2.
3DJH 43
Exhibit 2: The Evolution of Individual Investor Objectives and Concerns
Principal Objectives
and Concerns
Wealth
Stage
The
Enhancement,
Preservation, and
Protection of
Wealth
The
Enhancement,
Preservation, and
Protection of
Wealth
Wealth
Accumulation
Stage
The Deployment and
Distribution of
Wealth:
The Deployment and
Distribution of
Wealth:
During the Investors
Lifetime
After the Investors
Lifetime
Wealth
Realization
Stage
Wealth
Seeding
Stage
The Creation
and
Cultivation of
Wealth
The Creation
and
Cultivation of
Wealth
When individual investors are in the process of building
up their portfolio (and non-portfolio) investments the
Wealth Seeding Stage their principal objectives and
concerns center on the creation and cultivation of
wealth. In the next stage the Wealth Accumulation
Stage investors are concerned with the enhancement,
preservation, and protection of wealth. In a still more-
advanced stage the Wealth Realization Stage
investors turn their attention to the deployment and
distribution of wealth: (i) during the investors lifetime;
and/or (ii) after the investors lifetime. To an increasing
degree, the earlier in these three Wealth Stages the
investor begins to think about financial management
issues, as well as the asset allocation and equity
diversification issues portrayed in Exhibit 1, the greater
the likelihood of achieving such financial goals as
efficiency, expense control, and enhanced wealth
retention.
Importance of Financial Planning
For investors along virtually the entirety of the wealth
spectrum, Financial Planning can bring discipline, order,
and rationality to the process of thinking about and
preparing for the future. Financial Planning refers to the
process of: (i) collecting information about the investors
assets, liabilities, income, and spending; (ii) integrating
these data into a set of financial projections; (iii) making
assumptions, and quantifying them, about growth rates in
income, expenditures, capital and liability values, and
the tax environment; (iv) reviewing the originally
projected outcomes and various what-if scenarios that
are driven by meaningful alterations in any of the key
assumptions and forecasts; and (v) periodically updating
the inputs and outputs of the financial plan to reflect
changes in the investors family and economic
circumstances, the financial market outlook, and tax
realities.
3DJH 44
The process of Financial Planning can help investors in
several ways. First, Financial Planning can provide a
structured framework for organizing and dealing with
wealth in any of its three major embodiments (i)
wealth as a significant change in circumstances,
including such means as inheritance, the sale or public
offering of an ownership position in a business,
retirement with large sums in various forms as self-
directed pension plans, awards from legal judgments, or
lottery winnings; (ii) wealth as a projected accumulation
of revenue flows vs. expenditure flows over a span of
years; and (iii) wealth as an already existing, established
fortune, in any of several forms, including real estate,
livestock, boats, aircraft, other real property, art,
antiques, jewelry, collectibles, and financial assets.
Second, Financial Planning can provide the investor with
a more comprehensive understanding of the role and
effects of time in achieving established goals and
objectives, such as funding educational expenses,
effecting intergenerational wealth transfers, meeting
retirement spending targets, and donating assets and/or
income flows to philanthropic institutions.
A third benefit of Financial Planning derives from the
array of information, choices, and decisions that are
surfaced and placed before the investor. Among the key
subjects that Financial Planning leads the investor to
consider are: (i) the forms, amounts, and vehicles of
insurance coverage; (ii) the types, duration, conditions,
and beneficiaries of various forms of personal trusts;
(iii) the size and timing of tax payments, including
income, capital gains, estate, gift, property, and other
taxes, at the local, state, federal, and in some cases, at the
international level; (iv) the timing and structure of
pension and retirement account inflows and outflows;
and (v) the costs, conditions, magnitudes, and risks of
borrowing and other forms of explicit and contingent
liabilities. These assessments provide the investor and
his or her adviser with an integrated, consistent platform
for making investment recommendations and decisions.
Two additional benefits of Financial Planning include:
the increased awareness of the potential need to make
decisions that balance trade-offs between various
financial objectives; and the timely attention that gets
devoted to important monetary and personal issues well
in advance of their reaching a critical state.
Importance of Personal Trusts
When properly designed, managed, and kept updated,
Personal Trusts can be a powerful tool that can help: (i)
reduce estate taxes, avoid capital gains taxes, reduce
family income taxes, and facilitate tax-advantaged gifts;
(ii) transfer property to beneficiaries in a timely manner;
(iii) control the management and distribution of assets
placed in a given trust; (iv) avoid the probate process,
with its associated expenses, public disclosure, and time
delays; (v) carry out personal and financial affairs in the
event of incapacitation; and (vi) protect assets against
family disagreements and creditors claims. As such,
trusts often serve to prevent the unintended and hasty
dissolution of assets that the individual investor has, in
many cases, expended an intensive effort to build up
over a significant time period.
The basic concepts underlying Personal Trusts trace their
origins to the practice of medieval knights leaving a
portion or all of their property in the hands of a trustee to
provide for family survivors and care for assets during
the absence which resulted from their going off to fight
in the Crusades. The legal principles and procedures
affecting Personal Trusts have thus evolved over
decades, even centuries, and are still evolving in
legislatures and the courts. Among other factors, the
structure of Personal Trusts often reflects: (i) the skill
and knowledge of the individuals attorney selected to
draft the trust document; (ii) the imposition of
appropriate standards of fiduciary responsibility and
investment prudence on the part of the designated
trustee(s); (iii) the basic tenets of property law governing
the form, duration, and conditionality of property
disposition and use; (iv) federal estate taxes, which must
be paid within nine months of death and which quickly
rise to as high as 60% (the 55% top rate plus a 5% surtax
between $10 and $17.2 million); (v) federal gift taxes,
which have certain maximum lifetime donor or death
exclusions; (vi) special factors, such as contemplation of
death and generation-skipping rules; and (vii) the skill
3DJH 45
and capabilities of the trustee(s) chosen to administer
and invest the trust.
Personal Trusts can be divided into two groups: (i) living
trusts, created during the individuals lifetime; and (ii)
testamentary trusts, created under the individuals will
and which take effect only upon his or her death. In
addition, Personal Trusts can be: (i) revocable trusts,
which allow individuals to transfer property to a trust,
modify the terms of the trust, change the beneficiaries or
the trust+ee of the trust, and even revoke the terms of the
trust at any time while they are alive; or (ii) irrevocable
trusts, which do not allow the terms of the trust to be
changed nor its assets returned to the donor once the
trust has been established. Individuals who use
irrevocable trusts are generally willing to accept some
loss of control of assets in order to take advantage of gift
tax exclusions and to avoid, reduce, or defer federal
estate taxes.
A selection of types and uses of Personal Trusts is set
forth in Exhibit 3.
It is worth noting that the brief descriptions of certain
features, types, and uses of the trusts in Exhibit 3
Charitable Trusts; Grantor Retained Trusts; Dynasty,
Crummy, and Life Insurance Trusts; Marital and Credit
Shelter Trusts; and Childrens and Special Needs Trusts
are intended to suggest merely some, but by no means
all, of the ways in which they can be and have been used
by individuals in tax planning, estate planning, and
charitable giving. Investors should consult their own
attorney for specific advice in the proper uses of
Personal Trusts within their estate or financial plan.
Exhibit 3: Selected Types and Uses of Personal Trusts
Similar to a Charitable Remainder
Trust, except the charity receives the
annual income, and other individual
beneficiaries receive the assets.
Trust receives charitable deduction
each year for its distributions to
charity.
Charitable Trusts
Charitable Trusts
Charitable Remainder Trust
(CRT)
Tax-exempt irrevocable trust.
Highly appreciated assets may be
sold by the trustee free of capital gains
taxes.
Beneficiary receives annual payment,
charity receives the assets at the end
of the trust's term.
Assets transferred to a CRT are
entitled to a current year tax deduction
and reduce the donor's net estate.
Charitable Lead Trust
(CLT)
Charitable Remainder
Annuity Trust (CRAT)
Charitable Remainder Unitrust
(CRUT)
Net Income Makeup Charitable
Remainder Unitrust (NIMCRUT)
Grantor Retained
Trusts
Grantor Retained
Trusts
Grantor Retained Annuity Trust
(GRAT)
Payments from the trust asset goes
to designated recipients for a
specified time period.
Unlike a CRT, all assets eventually
transfer to beneficiaries.
Trust freezes the value of the assets
for tax purposes at their worth
when the trust is established.
Securities or other assets that are
likely to appreciate are often used
to fund a GRAT.
Can reduce estate taxes if donor
survives the term of the trust and if
trust assets appreciate at a rate
greater than IRS projections.
Grantor Retained Unitrust
(GRUT)
Similar to a GRAT, except the
annual payments are set as a
fixed percentage of the year-end
market value revalued annually
rather than as a fixed percentage
of the initial market value at the
time the trust was funded.
Dynasty, Crummy, and
Life Insurance Trusts
Dynasty, Crummy, and
Life Insurance Trusts
Life Insurance Trust
A Crummy Trust that
purchases life insurance on
the grantors life. In a
properly structured trust, the
life insurance death benefit
passes income and estate tax
free to the beneficiaries.
Existing life insurance
policies can be gifted to a life
insurance trust in order to
remove the death proceeds
from the owners estate.
Credit Shelter Trust
Assets placed in this trust are
usually equal to the applicable
federal credit amount.
Enables the trust grantor and his
or her spouse to maximize the
federal applicable exclusion
available to each party.
Upon the death of the surviving
spouse, designated beneficiaries
can continue to receive income
payments or the trust's assets
outright.
Marital and Credit Shelter
Trusts
Marital and Credit Shelter
Trusts
Qualified Terminal Interest
Property Trust (QTIP)
Allows the grantor to provide
lifetime income for his or her
surviving spouse and control the
ultimate distribution of the trust's
assets for selected beneficiaries.
Often used to ensure that if the
surviving spouse remarries, he/she
cannot disinherit the children from
the first marriage.
Qualified Personal Residence
Trust (QPRT)
Childrens and
Special Needs Trusts
Childrens and
Special Needs Trusts
2503(b) Trust
Trust income must be paid
to the child and cannot be
accumulated.
Principal passes to the child
at a future date specified in
the trust.
Often funded with $10,000
gifts exempted from gift tax
by the annual exclusion.
Special Needs Trust
Allows a disabled child or
family member to receive
financial support
specifically earmarked to
supplement, rather than
supplant, government
assistance programs.
Properly utilized, the
beneficiary can still qualify
for SSI disability benefits.
The annual payments from this CRT
are equal to a fixed percentage of the
trust assets when established.
are equal to a percentage of trust
assets revalued annually.
are equal to the lesser of the trust net
income or a percentage of assets
revalued annually.
Qualified Domestic Trust
Gifts to the trust for a non-resident
alien spouse qualify for the estate
tax marital deduction and upon
death of NRA spouse, the assets
go to other beneficiaries.
2503(c) Trust
Similar to the 2503(b) trust
except that income may be
accumulated.
In return for this right, the
child must have access to the
principal when he/she turns
age 21.
Dynasty Trust
An irrevocable trust designed to
pass wealth to multiple
generations while removing the
assets from future estate and
generation-skipping taxes.
Dynasty trust provisions can be
added to many kinds of trusts
including Credit Shelter,
Crummy, and Life Insurance
Trusts.
Crummy Trust
An irrevocable trust designed
to allow grantors to take
advantage of the annual
$10,000 per recipient gift tax
exclusion.
Most attractive to married
couples with many
beneficiaries.
Trust holds title to the grantors
home or vacation home for a
selected number of rent-free years,
after which the trust terminates and
the home is transferred to the
beneficiaries.
Grantor can continue to live in the
home if rent is paid.
Enables the grantor to make a gift
of a valuable asset at a substantial
discount in gift taxes.
3DJH 46
Importance of Life Insurance and Annuities
Life insurance and annuities can be powerful financial
tools that, appropriately understood and utilized, can
provide significant tax and estate planning benefits. At
the same time, both of these classes of instruments have
some degree of complexity associated with them, and
can yield less favorable economic results when used
improperly.
Life Insurance
Life insurance is one of the many forms of insurance
products, which, in the non-life category, also include
automobile, household, health, disability, and long-term
care insurance. Each of these non-life insurance products
may fulfill important needs within an individual
investors overall financial planning. The forms and
amounts of any insurance coverage should be evaluated
in light of: (i) the individuals specific risk profile and
financial circumstances; and (ii) product-specific
characteristics such as coverage and benefit periods,
deductibles and elimination periods, inflation provisions,
and benefit triggers, among other features.
In its most basic form, life insurance involves a
contractual relationship between the policyholder and an
insurance company, in which the policyholder pays
insurance premiums to the insurance company. In return,
the insurance company agrees to pay the face value (also
known as the maturity value, or death benefit) of the
insurance policy to the designated beneficiary upon the
death of the insured person.
Life insurance has many purposes, including: (i) a source
of liquidity for the payment of estate taxes upon the
death of the insured, thus helping to keep intact all or a
part of the insureds business, property, or investments;
(ii) the payment to the insureds business of funds
sufficient to hire a replacement for him or her, and/or to
meet any general business needs, following the death of
the insured; (iii) the ability to replace the income,
royalties, or earnings stream that would be eliminated or
reduced upon the death of the insured; and (iv) to restore
and/or build wealth for surviving heirs of the insured. In
view of these and other uses, life insurance is often
purchased to provide a sense of security to the policy
beneficiaries, and peace of mind to the insured, that the
beneficiaries financial concerns will be assuaged after
the death of the insured.
Life insurance also offers significant tax and liability
management benefits. First, any increase in the cash
value (investment) component of life insurance is not
subject to income tax until the accumulated profit is
withdrawn from the policy. Second, reflecting legislative
awareness of the fact that life insurance is generally paid
for in after-tax dollars, the cash value and death benefit
of life insurance are not subject to income tax at death.
Third, the insured is allowed to borrow against nearly the
full cash value of the policy without incurring taxes.
While the many life insurance companies offer a wide
and at times bewildering array of life insurance products,
in essence, these products can be divided into two main
categories: term insurance and permanent (cash value)
insurance. Selected types and uses of life insurance are
shown in Exhibit 4.
Term insurance lasts for a specified period and generally
has no cash build-up or investment component. The
insured pays premiums that provide insurance coverage
up until the end of the term, at which point the coverage
ceases. Term insurance can be annual renewable, with
premiums that keep rising each year, and level-payment
term, in which the insured pays a fixed amount each year
for the duration of his or her coverage. Renewal options,
with various associated conditions, including medical
examinations and higher premium levels, are a feature of
many term insurance policies. During the conversion
period specified in the contract, the policy owner may
convert the policy to permanent insurance without
evidence of insurability.
Permanent (cash value) insurance combines the death
benefit feature of conventional term insurance with a tax-
deferred investment build-up feature. As with term
insurance, the pricing of cash value insurance depends
upon: (i) the insureds age, gender, and health; and (ii)
3DJH 47
Exhibit 4: Selected Types and Uses of Annuities and Life Insurance
Funds are invested in the
General Account* of the
insurance company.
Interest rates are guaranteed
for a stated period of time.
Funds accumulate without tax
until withdrawal or conversion to
an immediate annuity.
Withdrawals from any deferred
annuity are subject to ordinary
income taxes up to the basis of
the original investment.
Withdrawals prior to age 59 are
subject to a 10% IRS penalty
under most circumstances.
The value of an annuity is also
subject to surrender charges
which decrease annually
normally during the first 6 to 8
years of the contract.
Any gains in contract value are
subject to ordinary income taxes
at death.
After an initial upfront purchase,
payments over time consist of a
combination of principal and
interest (or earnings, if a variable
contract) based on expected
mortality or for a fixed period.
Term Insurance
Term Insurance
Annual Renewable
Level Premium
Re-Entry Term
Permanent (Cash Value) Life Insurance
Universal Life
Immediate Annuities
Immediate Annuities
Deferred Annuities
Deferred Annuities
LIFE INSURANCE
LIFE INSURANCE
ANNUITIES
ANNUITIES
Types of Deferred
Annuities
Types of Deferred
Annuities
General Comments
Term Insurance
Term Insurance
Annual Renewable
Premium increases on each policy
anniversary date until the policy terminates.
Some contracts are renewable to age 100, but
become prohibitively expensive in later years.
Level Premium
Re-Entry Term
Whole Life (Participating)
Level premiums for life, or some
predetermined time period.
Cash value is invested in the General
Account* of the insurance company.
Excess interest and mortality gains are
paid as dividends.
Dividends can be re-invested and often
in later years become high enough to
pay the remainder of insurance
premiums.
Insured pays a fixed amount each year
for the duration of coverage.
Universal Life
Premiums are calculated on a level
(target) annual basis, but may be
skipped (resulting in lower cash
values and earnings).
Interest on policies is normally
declared monthly based on the
companys General Account
investment performance.
Premiums and interest increase the
policys cash account value.
Premiums can be increased or
decreased periodically.
Mortality and expense charges
decrease the cash account value.
Immediate Annuities
Immediate Annuities
Variable Life
Similar to Whole Life and Universal
Life except cash value is invested in
separate accounts as in variable
annuities.
Available as Single Premium
(SPVL), but then is subject to
annuity rules for withdrawals or
loans.
Second-To-Die
(Survivorship)
Deferred Annuities
Variable Annuity
LIFE INSURANCE
LIFE INSURANCE
Premiums are fixed on a level basis,
usually for five, ten, fifteen, or twenty year
periods.
Contracts are often renewable for one or
two additional periods, but at a stepped up
rate.
ANNUITIES
ANNUITIES
Funds are invested in
segregated accounts not
generally subjected to the
claims of the companys
creditors. Various
investment combinations
and options are available,
including equity funds, bond
funds, and cash management
funds. Variable annuities are
registered instruments
subject to SEC rules and
regulations. Investment
changes can be made
without taxation.
Fixed Annuity
Coverage is limited to the time period stated
in the contract, e.g., 10 years, or to age 70.
Usually has a provision for conversion to
permanent (cash value) life insurance.
Right to convert may end prior to the end of
the contract period.
Conversion rights are often overlooked but
are a major factor in pricing of coverage.
Major types of term insurance:
Re-Entry term is similar to Annual
Renewable term, but is issued at more
favorable rates that are conditional upon
passing a medical exam each year or each
stated period.
Contract is for the life of insured(s).
Premiums over mortality and
expense charges accumulate in a
reserve fund as cash value which
accumulates free of income taxes.
Cash value can be borrowed or
surrendered, but gains upon
surrender are subject to ordinary
income tax.
No income tax at death.
Basic types of permanent insurance:
Variable Products
Other
Types of Deferred
Annuities
Types of Deferred
Annuities
Fixed Products
* Investments in the insurance companys General Account usually have the principal guaranteed by the company, and are subject to the claims of the
insurance companys creditors.
any special features, fees, and terms contained in the
policy. Investors should carefully scrutinize the
composition and level of fees in cash value insurance
contracts, including: (i) sales charges and surrender
charges; (ii) one-time and ongoing administrative fees;
(iii) mortality charges, or the cost of insurance; (iv) state
premium taxes; and (v) management fees on the assets in
the investment portion of the contract. It is generally a
good idea to draw upon the resources and expertise of an
insurance professional to compare the terms, costs, and
benefits of the wide variety of policies written by
different life insurance companies.
The two principal types of permanent (cash value)
insurance are: (i) universal life insurance, in which the
cash build-up portion of the insurance policy is invested
in and guaranteed by the insurance companys general
investment account, and is subject to the claims of the
insurance companys creditors, if the insurance company
should experience financial difficulty; and (ii) variable
life insurance, in which the insured can select how the
cash value portion of the insurance policy is to be
invested, separate from the insurance companys general
investment account and thus separate from its creditors.
Individuals need to be aware of two additional features
regarding life insurance. First, a life insurance contract
can be considered a Modified Endowment Contract
(MEC) under federal tax law if it is paid up via a single
premium or a small number of premium payments.
Withdrawals from the accumulated cash value, and/or
loans against the cash value, of a Modified Endowment
Contract are fully taxable up to the amount of
accumulated earnings in the contract. Usually, the
3DJH 48
insured needs to reach paid-up status in no shorter a time
period than a certain number of years (determined by
various complex calculation methodologies), in order to
avoid having his or her life insurance policy classified as
an MEC.
Second, the life insurance proceeds (the net death
benefit) will be included in the insureds estate: (i) if the
estate is named as the life insurance beneficiary; (ii) if
the death benefit is earmarked through documents, such
as a trust, to pay off a liability otherwise payable by the
estate, including estate taxes; or (iii) if the insured holds
at death or within three years of death the right to receive
or control the economic benefits of the life insurance
policy, its proceeds, or its cash value (known as incidents
of ownership).
Annuities
An annuity is defined as either a fixed and/or a variable
stream of payments at specified time intervals, in
consideration of a stipulated premium paid either in prior
installment payments or in a single payment. Annuities
can be classified as either immediate or deferred.
Immediate annuities are those that begin annuity
payments currently or immediately. Deferred annuities,
offered primarily by life insurance companies: (i) allow
the tax-deferred compounding of the underlying
investment, with a 10 percent IRS penalty for
withdrawals of earnings before age 59 (with exceptions
for death, disability, and lifetime level payments); and
(ii) generally carry a death benefit, which reimburse an
annuity owners beneficiaries for the account value of
the annuity contract should the annuity owner die during
the term of the annuity.
Fixed annuities pay a set percentage of the investment,
determined by yield levels prevailing at the time the
annuity contract is purchased. Variable annuities returns
vary according to the annuity buyers investment
selections, ranging from equity funds, to bond funds, to
money market funds, and known as subaccounts. Tax-
free switching is allowed for variable annuity owners
who wish to shift their investments from one subaccount
to another. Some of the features of fixed and variable
annuities are shown in Exhibit 4.
Variable annuities tax-deferred status has made them a
popular investment vehicle for individual investors in the
second half of the 1990s. In deciding whether to take
advantage of annuities tax-deferred compounding
benefits, investors should analyze the potential tax
savings offered by annuities compared with the various
fees and restrictions placed on annuities. Annuities may
carry surrender charges, which require investors to pay
to the insurer a percentage of their annuity investment if
they decide to surrender the annuity, generally within the
first six to ten years of buying it. For a seven-year
surrender charge structure, the surrender charge is
usually 7% in the first year, declining by a percentage
point each year to zero percent by the eighth year.
Sales expenses, or loads, can be either back-end or front-
end, as with mutual funds, but these charges generally
tend to be higher than sales charges on mutual funds.
The relatively high expense levels associated with
annuities imply that their tax deferral benefits are
worthwhile if the investor holds on to the annuity for a
long enough time to defray the surrender charges and
other expenses. In short, the investor should investigate
and quantify the trade-off between (i) the deferral of
capital gains and ordinary income taxes; and (ii) the
annuitys surrender charges, other contract expenses, and
any taxes and penalties imposed on early withdrawals.
Variable annuities often offer enhanced death benefits
and, in some cases, living benefits. Most variable
annuities guarantee a minimum death benefit equal to the
account value or the original principal, whichever is
higher. This basic death benefit is often supplemented by
a guarantee that locks in the highest anniversary value
and/or 5% minimum annual increase. The guaranteed
death benefit ensures heirs of a minimum return
regardless of market performances.
Annuity owners can also enjoy living benefits. These
benefits take the form of a guaranteed income base or an
outright return of principal guarantee. The minimum
income base is usually calculated using the highest
3DJH 49
anniversary value of fixed annual increase, similar to an
enhanced death benefit. Living benefits protect the
individuals future income from a severe market decline
while preserving upside potential.
Importance of Tax and Liability Management
Tax Management
Tax management refers to the importance of taking into
account the federal, state, local, and international
income, capital gains, withholding, estate, gift, and
property tax implications of investment actions and
investment structures. For example, investors should
keep in mind the Alternative Minimum Tax (AMT),
which has been designed to make sure that taxpayers pay
a minimum level of federal income tax, without regard to
how many credits and deductions they may be allowed to
take. Each year, taxpayers who may be subject to the
AMT carry out the following two steps: (i) they add back
to ordinary income certain deductions (such as real estate
taxes and state and local income taxes) and preference
items (such as accelerated depreciation, passive losses
from partnerships, and interest income from private
activity municipal bonds issued after August 7, 1986);
and (ii) they undertake a tax computation that is parallel
to their normal tax calculation. If the AMT amount is
less than or equal to the regular tax, the taxpayer pays
only the regular tax. Because the AMT exemption
amounts are not indexed for inflation, with the passage
of time, an increasing number of taxpayers are becoming
subject to AMT taxation.
In addition to Alternative Minimum Tax considerations,
investors asset allocations, investment policies, and tax
management strategies should reflect some or all of the
following tax-related decisions, among others:
Type of Security Owned (e.g., the interest income
from U.S. Government and certain Federal Agency
securities is exempt from state and local government
income taxes, and the interest from most state and
local government securities is exempt from federal
income taxes);
Timing of Investment Actions (e.g., in periods of
broad securities price appreciation, it may be
advantageous for the investor to make IRA
contributions or charitable gifts of assets at the
beginning, rather than at the end, of the investors
tax year);
Capital Gains Tactics (e.g., assets held longer than
a year and a day qualify for more favorable long-
term capital gains tax rates rather than short-term
capital gains, which are taxed at ordinary income tax
rates; other tactics include the offsetting of short-
term capital gains with short-term capital losses, and
the identification of specific lots of securities when
they are to be sold, rather than adoption of the first-
in, first-out (FIFO) cost basis);
Type of Account for Asset Ownership (e.g.,
certain amounts and/or types of assets might be more
appropriately held in a childs account rather than a
parents, or in a conventional account rather than in
an IRA/Roth IRA account); and
Employer Securities (e.g., an investor
contemplating a lump sum distribution including
employer securities might elect to apply the Net
Unrealized Appreciation rules, thus allowing capital
gains rather than ordinary income tax treatment on
the price appreciation of the employer securities;
other measures may be taken to avoid triggering
capital gains when an employee decides to exercise
his or her incentive stock options).
It is worth reiterating that: (i) the tax management
stratagems discussed here are by no means a complete
listing of potential tax management actions, nor are they
fully described; (ii) just as investors should not ignore
tax considerations in their financial management
activities, so should they not allow taxes to become the
primary driver of their investment actions, to the
detriment of other factors; and (iii) investors should
consult with their own tax and legal advisors for tax or
other legal advice.
3DJH 50
Liability Management
In the investors quest to achieve his or her financial
goals, liability management can be as important as asset
management. The investors liability management
decisions include the type, amount, cost, maturity, and
terms of borrowings, as well as the tax-deductibility of
interest payments. It is important for investors to consult
their tax advisors regarding the deductibility of interest
before taking any tax-related borrowing actions, and to
utilize their own and/or others resources to perform
payment and amortization comparisons across various
debt products and alternatives.
Three of the most common forms of borrowing by
individuals include: (i) margin borrowing, with some or
all of the investors securities holdings used as collateral
for the margin loans; (ii) mortgage and home equity
loans and lines of credit; and (iii) credit card debt.
Borrowing may be undertaken for a variety of purposes,
including: the desire to raise funds without liquidating
assets; the purchase of a new home, the improvement of
an existing home, or the refinancing of an already-
outstanding first mortgage; to expand the investors own
business or to pay educational expenses; or to effect
improved cash flow management through debt
consolidation.
For mortgage and home equity loans and lines of credit,
the investors choices encompass: whether payments
should be interest-plus-principal or interest only; the
percentage of the assets value to be financed; whether to
have a fixed- or adjustable-rate loan, and if the latter, the
index on which the rate is based, the interest rate
adjustment period, any interest rate floor or ceiling
options, and conversion features allowing a switch from
adjustable to fixed rate; and the use of eligible securities
as collateral in lieu of a cash down payment.
Credit card borrowings are another widely-utilized
source of debt financing by individuals. The interest paid
on consumer borrowing debt is not tax deductible, but
interest payments on home mortgages and/or home
equity loans and home equity lines of credit generally
are. Differentiating characteristics of credit card debt
include interest rates, penalty charges, annual fees, cash
rebates, discounts on goods and services purchased,
expense management and tracking systems, and airline
mileage rewards based on charge volume.
Phases and Cycles in Asset Allocation and
Investment Management
It is important to realize that investors face a series of
phases and cycles in the structuring, allocation, and
investment management of their assets. A schematic
depiction of these phases and cycles is set forth in
Exhibit 5. The time periods shown along the bottom of
the Exhibit are not fixed for all investors, nor even for
the average investor, but are included to give a
representative idea of the time that may be devoted to
each major phase of an investors experience, shown
here to last between 20 years (20002020) and 40 years
(20002040).
The first phase for the asset allocation and investment
management process may be called the engagement
phase, generally lasting two to five years, in which the
investor acquires and learns asset allocation and
investment management skills. In this phase, the investor
should find out what investment areas he or she has an
affinity for, while studying and learning from the great
body of investment wisdom and knowledge.
The next phase of the asset allocation and investment
management process may be termed the growth phase,
generally lasting four to ten years, in which the investor
broadens and deepens his or her asset allocation and
investment management skills. In this phase, the investor
applies an increasing degree of acumen and
understanding to asset allocation and investment
management styles, techniques, and resources.
The third phase of the asset allocation and investment
management process may be called the realization
phase, generally lasting six to fifteen years, in which the
investor leverages and demonstrates mastery in the
investment realm. In this phase, the investor takes
advantage of the tools, experience, relationships, and
know-how that he or she has built up through a variety of
financial market environments and the changing personal
financial circumstances that are an adjunct of lifes
normal progress.
3DJH 51
Exhibit 5: Phases and Cycles in Asset Allocation and Investment Management
25 Years 410 Years 615 Years 810 Years
The lengths and slopes of phases will
vary widely. The mix of required
investment skills will vary within phases.
Cycles and secular market forces will be
powerful and will sometimes augment,
sometimes neutralize, each other.
Phases often overlap and blend into one
another. Pace in one phase may or may
not carry over into the next phase.
Cycles come in several forms: financial
cycles, learning cycles, attitude cycles,
and life cycles.
Skills
Acquiring
Phase
Skills
Learning
Phase
Skills
Deepening
Phase
Skills
Broadening
Phase
Skills
Mastery
Phase
Skills
Leveraging
Phase
Skills
Renewal
Phase
Skills
Treasury
Phase
Engagement Growth Realization Affirmation
Goals Goals Goals Goals
Advice Advice Advice Advice
2000
2000
2002
2005
2002
2005
2006
2015
2006
2015
2012
2030
2012
2030
2020
2040
! Find investment areas youre good at.
! Find investment areas you like.
! Be honest with yourself.
! Develop good investment habits.
! Know your strengths and weaknesses.
! Focus on: price vs. value.
! Work on valuation skills and study
them.
! Set investment goals and write them
down.
! Learn from mistakes.
! Be expert in certain investment areas.
! Develop an investment philosophy.
! Find great investors, and learn from
them.
! Hone judgment skills.
! Pick your investment areas of emphasis.
! Take appropriate risks.
! Understand the risks and rewards of
concentration vs. diversification.
! Find one, two, or three significant
investment ideas each year.
! Engage each resource in personal,
professional, intellectual, and
emotional excellence.
! Expand investment competence along
several fronts.
! Stay focused, stay organized.
! Build and maintain reserves of mental
and psychological strength.
! Exchange tools and knowledge with others.
! Produce, reap, harvest, and reinvest.
! Concentrate on reaching your fullest
human and investment potential.
! Foster positive energy in yourself and
others.
! Leverage knowledge, relationships,
and wisdom.
! Support, enhance, and encourage your
major fonts of investment wisdom.
! Nurture others and yourself.
! Dont let yourself get upset by your
own or others mistakes.
! Learn from all quarters.
! Synthesize, create, advise, and
cross-pollinate.
! Teach others to think not merely in
one-year increments.
! Keep learning, growing, and pushing
the envelope.
! Stay excited and transmit enthusiasm.
! Reflect on what has gone before and
apply it.
! Grow by helping others grow.
! Make your gifts count.
Source: MSDW Private Wealth Management Asset Allocation Group
The fourth phase of the asset allocation and investment
management process may be termed the affirmation
phase, generally lasting eight to ten years or more, in
which the investor renews, draws upon, and extends
his or her financial understanding and skills storehouse.
In this phase, the investor is engaged in an active and
fruitful two-way exchange of learning and lore with
other investors.
Cycles of market volatility, price advance and decline,
and fundamental, valuation, and psychological/
technical/liquidity excesses will be woven through
these four broad phases. In this process of blending
cycles and phases, several general principles are worth
keeping in mind. First, the lengths and rates of progress
within phases can vary widely. The mix of required
asset allocation and investment management skills will
vary within phases. Second, cycles and secular market
forces can be powerful and can sometimes augment,
sometimes offset, each other. Third, asset allocation
and investment management phases often overlap and
blend into one another. The pace of progress in one
phase may or may not carry over into the succeeding
phase. Finally, cycles come and go in several forms;
these include financial cycles, learning cycles, attitude
cycles, and life cycles.
3DJH 52
Asset Allocation Principles: Comparative Financial Measures David M. Darst
Over time, success in asset allocation and investment
strategy is highly dependent on the investors skill in
evaluating price-versus-value relationships, between and
within asset classes, specific investments, and currencies.
Based upon this knowledge and acumen, successful
investors are able to identify and purchase superior-
performing investments and asset classes, and equally
important, they are able to avoid inferior-performing
investments and asset classes.
At its heart, the entire investment banking and
investment management realm revolves around assessing
the true value of something compared to its price. The
investment research and asset management disciplines,
the public and private equities and debt trading, capital
markets, and underwriting functions, as well as merger,
acquisition, restructuring and divestiture activity, all
hinge upon the cardinal question: Is the value of a given
asset greater than, equal to, or less than its price?
Significant effort, and a great many quantitative and
qualitative tools and techniques, have been brought to bear
on the question of how to determine the value of a
financial asset, not to mention the value of real assets such
as art, property, collectibles, livestock, and jewelry. Many
investors are of the opinion that the value of an asset is
determined by what someone will pay for it at a particular
moment in time. Other investors use various discounted
cash flow (DCF) models and similar constructs that take
into account the timing, magnitude, and riskiness of the
income streams and terminal price of an asset. Still others
rely on the market-clearing prices of comparable assets
that have recently been bought and sold.
Common sense, perceptiveness, honest and rigorous
analysis, and good judgment are tools that are potentially
at the disposal of most investors. With a modest degree
of effort, it is possible to assemble relevant data about
comparable investments in an identified asset class.
Within reason, and when applied with a dose of healthy
skepticism, this information can often be a resource in
helping to identify investments that are substantially
overvalued or undervalued.
To demonstrate the application of this approach, the
following paragraphs focus on one asset class, publicly-
traded equities. A similar approach that of assembling,
comparing, and reflecting upon the resultant investment
implications can be followed in a number of other asset
classes, ranging from high grade, high yield, convertible, or
emerging markets debt, to mutual funds, hedge funds, or
unit trusts, to various forms of private equity, oil and gas,
venture capital, or real estate investments. It can be safely
stated that each of these asset classes or sub-asset classes
has certain characteristics that are unique, and thus worthy
of special analytical methodologies. At the same time,
many of the underlying goals and principles apply broadly
across asset classes. These guidelines include: (i)
consistency of calculation; (ii) selection of an appropriate
analytical time frame; (iii) creativity and soundness in
comparing data; (iv) restraint in drawing unrealistic
conclusions; and (v) and conviction and patience in waiting
for prices to come back into line with value.
Profitability, Protection, and Plowback
Within the publicly-traded equities asset class, one
approach to generating outstanding long-term investment
performance has been to identify great businesses, invest
in them at reasonable prices, and hold onto them for long
periods of time. In this way, the favorable fundamental
economics of the company, the power of compounded
returns, and the relative tax advantages and reduced
expenses of a low-turnover approach can generally be
reflected in superior investment results, eventually
overcoming short-term fluctuations in securities prices.
A critical ingredient in this approach to common stock
investing is the ability to identify companies that have: (i)
true long-term economic attractiveness; (ii) the ability to
defend their money-making characteristics from
competitive and/or governmental inroads; and (iii)
sufficient opportunities to reinvest their retained profits at
high rates of return. These three qualities may be described
as Profitability, Protection, and Plowback, respectively. It is
equally important to the effectiveness of this approach to
select appropriate measures of these traits that can be
measured across a number of years and that are reasonably
comparable across companies and industries.
3DJH 53
Asset Allocation Principles: Comparative Financial Measures (cont.) David M. Darst
Exhibit 1 contains Profitability, Protection, and
Plowback data for a number of well-known corporations,
selected to illustrate a range of performance results
according to each of these three criteria.
Profitability
For each of the companies shown in Exhibit 1,
Profitability for the three years from 1997 through
1999E has been measured according to two benchmarks
Gross Margin and Operating Margin. Gross Margin is
defined as a companys Sales less its Cost of Goods
Sold, expressed as a percentage of Sales. For example, it
can be seen that the 19971999E Gross Margin for Intel
has averaged 58.0%; for IBM, 37.8%; and for Estee
Lauder, 77.3%. Microsofts three-year average Gross
Margin was 83.8%, and Boeings was 10.8%.
The Operating Margin measure generally reflects how
much of a companys sales revenue is able to be brought
down to the bottom line, after deducting: (i) the Cost of
Goods Sold; (ii) Selling, General and Administrative
expenses; and (iii) Research and Development outlays. For
example, the 19971999E average Operating Margin of
Dell was 10.4%, even though its Gross Margin was a
relatively slender 22.0%. By comparison, the three-year
average Operating Margin of IBM was 11.5%, 1.1
percentage points more than Dells, with IBMs Gross
Margin 37.8%, a full 15.8 percentage points more than
Dells. Armed with this information, the investor can
weigh the relative strategic and tactical advantages and
disadvantages of Dells much lower rate of spending on
Research and Development (1.6% of Sales, compared to
6.1% of Sales for IBM), as well as its lower Selling,
Exhibit 1: Measures of Profitability, Protection, and Plowback for Selected U.S. Corporations
Profitability Protection Plowback
Price 52 - Week Market Cap. 1997-1999E Average (%) 1997-1999E Average (%) ROE %
Company 10/15/99 Low - High ($Bn) Gross Margin Operating Margin R&D Margin SG&A Margin 1994 1996 1998
Boeing $42.50 $31.0 - $48.5 $38 10.8 3.4 3.5 3.9 8.8 8.9 9.1
Dell 42.81 26.3 - 55.0 109 22.0 10.4 1.6 9.8 22.9 48.9 62.9
IBM 107.88 64.9 - 139.2 195 37.8 11.5 6.1 20.1 12.7 27.1 32.6
Heinz 43.56 41.9 - 61.8 16 38.2 16.1 n/a 21.1 23.9 27.0 46.0
Sun Microsystems 92.56 23.4 - 99.4 72 51.3 12.7 7.0 27.6 12.0 23.2 25.8
Intel 70.88 40.8 - 89.5 234 58.0 35.9 9.7 12.2 27.7 30.6 26.4
Gillette 36.19 33.1 - 64.4 39 61.8 27.3 n/a 38.7 34.6 27.4 31.4
Gucci
1
80.50 33.6 - 89.6 8 64.6 23.6 n/a 39.5 n/a 48.3 45.4
Coca-Cola 49.94 47.3 - 75.4 123 69.0 26.3 n/a 43.1 48.8 56.7 42.0
Estee Lauder 42.19 27.5 - 56.5 10 77.3 12.1 n/a 65.3 16.1 21.3 22.4
American Home Products 44.94 38.5 - 70.3 59 72.3 23.6 12.0 18.3 35.9 27.1 28.2
Pfizer 36.88 31.5 - 50.0 143 84.2 28.1 16.8 40.4 30.0 27.7 29.9
Microsoft 88.06 49.8 - 100.8 450 83.8 46.5 16.2 26.3 27.2 31.5 28.8
1
Gross margin, operating margin, and SG&A margin for Gucci are based on the average of 1997 and 1998.
Sources: The Value Line Investment Survey for Profitability, Protection, and Plowback data; Bloomberg L.P. for price, 52-week high and low, and market capitalization data.
Definitions: Gross Margin = Sales - Cost of Goods Sold as a percent of Sales.
Operating Margin = Gross Margin - SG&A and R&D as a percent of Sales.
SG&A Margin = Selling, General, & Administrative expenses as a percent of Sales.
R&D Margin = Research & Development costs as a percent of Sales.
ROE = Return on Equity = Earnings as a percent of Book Value.
E = Estimate.
3DJH 54
General, and Administrative expenses (9.8% of 1997
1999E Sales for Dell, compared to 20.1% of 1997-1999E
Sales for IBM).
Protection
Two rough measures of a companys ability and skill at
protecting its profitability are: (i) its percentage of Sales
spent on Research and Development; and (ii) its
percentage of Sales spent on Selling, General, and
Administrative expenditures, which include marketing,
promotion, and advertising outlays meant to preserve the
companys competitive standing and market share. It
should be pointed out that a high level of Research and
Development, and/or a high level of Selling, General,
and Administrative expenses, are in and of themselves
no guarantee of a companys success in defending its
position. What is most important is the degree of efficacy
of these two expense streams, which is in turn a
reflection of managements ability to wisely deploy
corporate resources, to conceive and execute a winning
strategic vision, and not least, to hire, empower,
motivate, and retain talented human resources.
Of the companies shown in Exhibit 1, Boeing and Dell
spent 3.5% and 1.6%, respectively, of their 19971999E
Sales on Research and Development, while Pfizer and
Microsoft spent 16.8% and 16.2%, respectively. Sun
Microsystems spent 7.0%, Intel spent 9.7%, and
American Home Products spent 12.0% of their 1997
1999E Sales on Research and Development.
For many companies, the percentage of Sales spent on
Selling, General, and Administrative expenses is a
barometer of these firms ongoing efforts to fortify their
competitive position. Such companies may well be
investing in marketing, advertising, selling, and
promotion expenses to widen and deepen the strategic
and tactical defenses around their brand, their salesforce,
and/or their distribution system. At the same time,
however, a high absolute percentage of Sales spent on
Selling, General, and Administrative expenses may be an
indicator of managerial inefficiency, excessive corporate
largesse, and/or an inefficient and bureaucratic
infrastructure that impedes rather than fosters
competitive progress and market responsiveness. For this
reason, the investor and his or her sources of investing
counsel should spare no effort in attempting to
deconstruct the Sales, General, and Administrative
expense category and look at the data in their various
component parts.
For example, Exhibit 1 shows that Pfizer, Coca-Cola,
and Estee Lauder spent 40.4%, 43.1%, and 65.3%,
respectively, of their 19971999E Sales on Selling,
General, and Administrative expenses. Each of these
companies devotes considerable corporate funds and
energy to its salesforce, its distribution infrastructure,
and its advertising and promotion activities, all of which
are integral to the protection and renewal of their brands
and competitive positioning.
At the other end of the spectrum, Boeing and Dell spent
3.9% and 9.8% of their 1997-1999 Sales on Selling,
General, and Administrative expenses. Each of these
companies has a considerably lower Gross Margin than
Pfizer, Coca-Cola, and Estee Lauder, and thus there is
less absolute room in percentage of Sales terms to devote
to SG&A expenses. In addition, part of Boeings
protection of its competitive position derives from such
things as its technological knowhow, its supplier
relations, its servicing network, and its aftermarket
support. Dells defense of its competitive edge stems in
part from such things as its sophisticated manufacturing
and assembly prowess, its Internet-based sales and
marketing strategy, and its inventory and financial
management skills.
The key point to keep in mind is that a companys
defensive strength may, or may not, be associated with a
high percentage of its sales spent on Research and
Development and/or Selling, General, and
Administrative expenses. It is important for the investor
to consider these expenditures: (i) as a percentage of the
overall Gross Margin available for protection activity;
(ii) in the context of industry dynamics relating to
changing forms of corporate differentiation and
competition; (iii) as but two among several measures of
franchise protection and enhancement; and (iv) in their
deconstructed or component form, if these data are
available.
3DJH 55
Plowback
One characteristic of a business as an attractive
investment candidate is the range of opportunities for
that company to continue to reinvest its earnings at high
rates of return over a long period of time. Among the
measures of this ability are multi-year trends in the
companys Return on Equity (ROE), defined as the
companys Net Earnings After Taxes as a percentage of
its Shareholders Equity, or Book Value.
Exhibit 1 shows that Dell had a 1998 ROE of 62.9%
(compared with 48.9% in 1996 and 22.9% in 1994),
Heinz had a 1998 ROE of 46.0% (compared with 27.0%
in 1996 and 23.9% in 1994), Gucci had a 1998 ROE of
45.4% (compared with 48.3% in 1996), and Coca-Cola
had a 1998 ROE of 42.0% (compared with 56.7% in
1996 and 48.8% in 1994).
Certain caveats should be associated with the use of a
companys Return on Equity as a measure of its profit
plowback potential. First, a companys Return on Equity
may change over the short- or intermediate-term due to
shifting industry fundamentals over which the company
has little or no control. Such factors include interest
rates, energy and other commodity prices, the overall
level of economic activity, and specific demand trends
for the industry(ies) and country(ies) in which the
company operates. Investors have thus tended to value
highly a companys ability to generate high Returns on
Equity through changing circumstances.
Second, the quality of a companys ROE is only as good
as the quality of its accounting policies and financial
management practices. The quality of earnings data may
be influenced by: revenue recognition procedures;
customer payment behavior assumptions; inventory,
research and development, and depreciation conventions;
pension plan investment returns; the level of employee
stock option compensation; and a host of subjective
accounting judgments associated with merger,
acquisition, restructuring, and divestiture activity. The
degree of subjectivity in earnings calculations
underscores the need to read the footnotes to corporate
financial statements and to look behind the stated
numbers in order to ensure that multi-year, multi-
company comparisons are carried out on a consistent
basis.
Third, Return on Equity computations are influenced by
the amount of financial leverage (the debt-equity mix) a
company has on (and off) its balance sheet. For instance,
a company which earns $100 million after taxes, with a
balance sheet consisting of $500 million in Equity and
no Long-Term Debt, may be said to generate a 20%
ROE, while a similar company which earns $100 million
after taxes with a balance sheet of $200 million in Equity
and $300 million in Long-Term Debt may be said to
generate a 50% ROE. In practice, both companies have
earned the same amount of money after taxes in an
absolute sense $100 million. Whether a 20% ROE or
a 50% ROE should be considered a valid measure of
plowback, and whether one result should be considered
superior to the other, is a function of: (i) industry
operating and financial characteristics; (ii) corporate
policies affecting the deployment of significant cash
flow generation; (iii) the nature of the industry and
economic environment in which the company operates;
and especially importantly, (iv) investors views of the
risks associated with corporate leverage.
Comparative Financial Data
The process of evaluating asset classes and specific
investments across time can be enhanced by adding
selected data that yield valuable insights and perspective.
These corporate characteristics include, but are not
limited to, absolute measures such as revenues, net
income, total equity market capitalization, long term
debt, and shareholders equity, as well as derived ratios
such as market capitalization/revenues, book value/share,
price to book value, and long term debt as a percentage
of total debt and equity market capitalization.
Exhibit 2 brings these data together in one place for 28
companies in 10 industry groups of the Standard &
Poors 500. These data, based primarily on 1998 final
operating results and late 1999 (mid-October) market
prices, are obtainable relatively easily from sources such
as The Value Line Investment Survey and Bloomberg.
3DJH 56
Assembling the data in this fashion can yield valuable
insights about value-to-price relationships by facilitating
comparisons within and across industries. In Exhibit 2,
four years worth of data are shown for 1992, 1994,
1996, and 1998. Where further analysis is called for, or
in those cases where the investor wants more data upon
which to base his or her decisions, it is possible to add a
few columns to the comparison matrix to show a string
of consecutive years. Several comparisons within
industries are set forth in the following sections.
Technology
In the technology sector, Cisco Systems and IBM are
shown to have roughly equal equity market
capitalizations as of late 1999 $224.3 billion for
Cisco vs. $226.1 billion for IBM. Even though the stock
market appeared to be appraising these two companies at
approximately the same value, IBM had almost ten times
the 1998 revenues of Cisco $81.667 billion vs.
$8.459 billion. Similarly, IBMs 1998 net income was
over three times that of Cisco $6.328 billion vs.
$1.873 billion.
Putting the numbers together in this fashion should incite
the investor to reflect upon the reasons why IBM and
Cisco had virtually equal market capitalizations, even
though IBM was much larger than Cisco as measured by
revenue and net income. Among the factors that could be
contributing to this disparity are two financial measures
shown in Exhibit 2. First, Cisco had significantly higher
Operating Margins than IBM. For 1992, 1994, 1996, and
1998, Cisco generated Operating Margins of 40.1%,
41.7%, 37.4%, and 35.8%, respectively, whereas for the
same years, IBMs Operating Margins were 15.0%,
17.5%, 18.5%, and 17.3%, respectively. Second, Cisco
had no long term debt outstanding as of the end of 1998,
whereas IBMs $15.508 billion in long term debt
outstanding represented 44.4% of IBMs combined long
term debt and shareholders equity.
To be sure, these two measures do not entirely explain
why, as of the second half of 1999, the stock market was
placing an equivalent value on companies of such
differing magnitude. One plausible explanation is that
investors, research analysts, and investment bankers may
not generally consider Cisco and IBM together, and thus
they may be relatively unaware of these differences.
Other possible reasons include investors perceptions of:
(i) each companys forms of competitive edge and its
degree of market dominance of its respective markets;
(ii) the degree, volatility, and duration of growth
prospects for the economic sectors in which each
company operates; (iii) the relative strengths of each
companys business model; and (iv) the fact that the
market may be temporarily over- or under-valuing either
company.
Energy
In the Energy sector, Exxon and Royal Dutch Shell
provide several interesting financial comparisons. For
1998, Exxon generated revenues of $100.697 billion, 8%
more than Royal Dutch Shells $93.692 billion.
Similarly, Exxons 1998 net income of $6.44 billion was
25% greater than the 1998 net income of Royal Dutch
Shell, $5.146 billion. Yet as of the second half of 1999,
the equity market capitalization of Exxon, $181.6 billion,
was 50% greater than that of Royal Dutch, $124.0
billion. One possible explanation might have related to
relative price-earnings multiples in the primary equity
market in which each of these two companies shares are
traded in America for Exxon, and in the Netherlands
for Royal Dutch Shell.
In searching for some of the additional factors
underlying this discrepancy between Exxons and Royal
Dutch Shells equity market capitalizations relative to
the narrow differences between these two oil titans
revenues and net income, Exhibit 2 offers some clues
and insights for further exploration. Even though Royal
Dutch Shell earned higher operating margins than Exxon
in 1992, 1994, 1996, and 1998 15.1% vs. 11.3%,
15.7% vs. 12.7%, 17.5% vs. 13.2%, and 13.9% vs.
12.2%, respectively Exxon generated a substantially
higher return on equity than Royal Dutch in each of
these years 14.2% vs. 10.0%, 12.3% vs. 9.7%, 16.0%
vs. 12.8%, and 14.7% vs. 9.4%, respectively.
3DJH 57
Stated another way, as of the second half of 1999, equity
investors may have taken account of the fact that Exxon
was able to generate $6.44 billion in 1998 net income using
$43.750 billion in shareholders equity, whereas Royal
Dutch Shell produced $5.146 billion in net income
$1.254 billion less than Exxon while using $54.962
billion in shareholders equity $11.212 billion more
than Exxon. The disparity in the efficiency of the
employment of shareholders equity may reflect: (i)
differing relative emphases of geographic regions in
Exhibit 2: Asset Allocation Principles: Comparative Financial Measures
Ticker Company Name
1998
Revs
($bil)
1998
Net Inc.
($bil)
Mkt.
Cap
($bil)
Mkt.
Cap/
Revs
Shrs
O/S
(mil)
Book
Value/
Share
10/15/99
Mkt.
Price
Price/
Book
Value
Capital Goods
BA Boeing 56.154 1.120 38.3 0.68 900 12.62 42.50 3.37
GE General Electric 51.546 9.296 378.7 7.35 3271 11.89 115.75 9.74
MMM Minnesota Mining and Manufacturing 15.021 1.526 36.0 2.40 403 14.77 89.38 6.05
Technology
CSCO Cisco Systems 8.459 1.873 219.8 25.98 3271 4.55 67.19 14.77
DELL Dell Computer 18.243 1.460 108.7 5.96 2540 0.92 42.81 46.54
INTC Intel 26.273 6.178 234.5 8.92 3308 7.05 70.88 10.05
IBM International Business Machines 81.667 6.328 226.1 2.77 1809 10.36 125.00 12.07
MSFT Microsoft 14.484 4.786 449.9 31.06 5109 3.17 88.06 27.78
Basic Materials
DD DuPont 24.767 2.861 70.5 2.85 1129 12.39 62.44 5.04
IP International Paper 19.541 0.308 19.6 1.00 413 28.93 47.38 1.64
Precious Metals
HM Homestake Mining 0.803 0.257 2.5 3.14 260 3.23 9.69 3.00
NEM Newmont Mining 1.454 0.069 4.4 3.01 168 8.61 26.13 3.03
Energy
XON Exxon 100.697 6.440 174.8 1.74 2428 17.98 72.00 4.00
RD Royal Dutch Shell 93.692 5.146 123.8 1.32 2144 15.38 57.75 3.75
SLB Schlumberger 11.816 1.394 29.8 2.52 548 14.86 54.38 3.66
Consumer Cyclical Durables
F Ford Motor 144.416 6.570 61.8 0.43 1222 20.36 50.56 2.48
GM General Motors 161.315 2.956 40.1 0.25 645 22.87 62.13 2.72
Consumer Cyclical Nondurables
DIS Walt Disney 22.976 1.871 49.8 2.17 2071 9.46 24.06 2.54
EK Eastman Kodak 13.406 1.419 22.4 1.67 317 12.35 70.88 5.74
PG Procter & Gamble 37.154 3.780 123.1 3.31 1320 7.79 93.31 11.98
Consumer Staples
KO Coca-Cola 18.813 3.533 123.3 6.55 2469 3.41 49.94 14.64
MO Philip Morris 74.391 5.372 73.3 0.99 2398 6.66 30.56 4.59
HealthCare
AHP American Home Products 13.463 2.715 58.8 4.37 1308 7.33 44.94 6.13
JNJ Johnson & Johnson 23.657 3.678 125.4 5.30 1344 10.11 93.31 9.23
MRK Merck 26.898 5.248 165.1 6.14 2350 5.42 70.25 12.96
Finance
CMB Chase Manhattan 32.379 4.016 55.4 1.71 832 26.90 66.50 2.47
JPM J.P. Morgan 18.238 1.067 18.6 1.02 176 60.38 105.69 1.75
MER Merrill Lynch 35.853 1.513 23.4 0.65 364 27.25 64.25 2.36
Utilities
T AT&T 53.223 5.235 192.7 3.62 4461 9.70 43.19 4.45
FON Sprint 17.134 0.889 50.0 2.92 781 14.19 64.00 4.51
Source: The Value Line Investment Survey and FactSet Research Systems, Inc.
3DJH 58
which each company operates; (ii) a differing mix of
exploration, production, refining, marketing, and
transportation businesses and assets; and (iii) differing
degrees of diversification pursued by both enterprises, in
such fields as petrochemicals and chemicals. In fact, at the
end of 1997, Royal Dutch Shell had shareholders equity
amounting to $60.386 billion, and during 1998, the company
initiated corporate restructuring activities amounting to an
announced $5.5 billion in writeoffs, charges, and deductions
against this $60.386 billion in shareholders equity.
Exhibit 2: Asset Allocation Principles: Comparative Financial Measures (cont.)
Ticker
1992 Op.
Mgn.
(%)
1994 Op.
Mgn.
(%)
1996 Op.
Mgn.
(%)
1998 Op.
Mgn.
(%)
1992
ROE
(%)
1994
ROE
(%)
1996
ROE
(%)
1998
ROE
(%)
Long-
Term
Debt
($bil)
Share-
holders
Equity
($bil)
LTD as
% of
Tot. Cap.
BA 9.9 10.5 9.8 6.0 18.9 8.8 8.9 9.1 6.103 12.316 33.1
GE 15.0 17.4 18.3 21.2 18.4 22.4 23.4 23.9 0.681 38.880 1.7
MMM 21.5 22.2 23.7 22.6 18.6 20.0 24.1 25.7 1.614 5.936 21.4
CSCO 40.1 41.7 37.4 35.8 34.4 37.1 32.4 26.4 0.000 7.107 0.0
DELL 7.9 8.1 9.8 11.0 27.5 22.9 48.9 62.9 0.512 2.321 18.1
INTC 34.4 42.2 45.3 43.2 19.8 27.7 30.6 26.4 0.702 23.377 2.9
IBM 15.0 17.5 18.5 17.3 5.2 12.7 27.1 32.6 15.508 19.433 44.4
MSFT 40.2 42.2 41.0 55.0 32.3 27.2 31.5 28.8 0.000 16.627 0.0
DD 15.0 17.9 36.1 22.9 14.4 21.6 34.0 20.9 4.495 13.954 24.4
IP 12.5 12.7 13.9 12.2 6.5 6.6 4.6 3.5 8.212 8.902 48.0
HM 17.1 22.8 24.9 20.5 nmf 9.2 2.6 nmf 0.357 0.736 32.7
NEM 33.0 26.8 24.1 35.1 17.1 11.3 8.3 4.8 1.201 1.440 45.5
XON 11.3 12.7 13.2 12.2 14.2 12.3 16.0 14.7 4.530 43.750 9.4
RD 15.1 15.7 17.5 13.9 10.0 9.7 12.8 9.4 6.032 54.962 9.9
SLB 22.3 20.5 21.2 24.3 15.6 11.7 15.1 17.2 3.285 8.119 28.8
F 15.7 21.0 21.2 24.9 nmf 24.5 16.3 28.1 65.851 23.409 73.8
GM 11.9 16.5 15.6 16.1 nmf 44.1 19.9 24.4 52.574 14.984 77.8
DIS 21.4 22.0 21.4 22.0 17.4 20.2 9.5 9.6 9.562 19.388 33.0
EK 19.2 18.8 19.5 20.5 16.1 24.3 32.1 35.6 0.504 3.988 11.2
PG 13.3 15.6 17.5 20.6 20.6 25.0 26.0 30.9 5.765 12.236 32.0
KO 23.7 25.5 23.7 29.8 48.4 48.8 56.7 42.0 0.687 8.403 7.6
MO 20.5 17.2 20.3 21.0 39.3 37.0 44.3 33.2 11.906 16.197 42.4
AHP 26.9 27.7 26.6 27.0 38.5 35.9 27.1 28.2 3.859 9.615 28.6
JNJ 20.9 22.4 24.6 26.6 31.4 28.2 26.6 27.1 1.269 13.590 8.5
MRK 39.5 35.3 29.8 28.5 48.9 26.9 32.4 41.0 3.221 12.802 20.1
CMB n/a n/a n/a n/a n/a 13.2 11.4 16.8 18.925 23.838 44.3
JPM n/a n/a n/a n/a 19.6 12.7 13.8 9.5 27.607 11.261 71.0
MER n/a n/a n/a n/a 20.8 17.5 23.5 12.3 57.563 12.334 82.4
T 15.1 16.1 22.1 27.5 20.1 27.2 27.6 20.5 5.556 25.522 17.9
FON 24.4 25.8 27.5 17.9 15.0 18.9 14.4 7.1 11.942 12.448 49.0
3DJH 59
Consumer Cyclical Durables
An additional comparison involves two of the worlds
leading automobile companies, Ford and General Motors.
From Exhibit 2, it can be seen that Ford had 1998
revenues that were 10% lower than General Motors
strike-penalized 1998 results, $144.416 billion vs.
$161.315 billion. At the same time, perhaps owing to
differences in product mix and cost structure, Ford had
wider operating margins than General Motors in 1992,
1994, 1996, and 1998 15.7% vs. 11.9%, 21% vs.
16.5%, 21.2% vs. 15.6%, and 24.9% vs. 16.1%. Again,
partly because of the UAW strike at GM, Ford earned
115% more than General Motors in 1998 $6.37 billion
vs. $2.956 billion. Partly as a result, Fords equity market
capitalization as of the second half of 1999 was 42% more
than General Motors $56.7 billion vs. $40.0 billion.
(The marketplace appeared to be taking little or no account
of GMs stake in Hughes Electronics.)
It is also worth pointing out that comparing two or more
companies profitability, protection, and plowback
results and their financial data: (i) may or may not
provide insight as to which company was overvalued and
which was undervalued, i.e., whether an appropriate
relationship between the two companies values would
be restored by an increase in the value of the
undervalued company, or a decrease in the value of the
overvalued company; (ii) may not yield a definitive
answer as to whether perhaps both enterprises were
overvalued or undervalued; and (iii) may very well give
no indication as to the time frame over which more
normal value-to-price relationships might once again
prevail. In applying these tools to asset allocation and
investment strategy, the investor would be wise to
develop and bring to bear such time-tested qualities as
patience, rigor, creativity, common sense, and good
judgement.
3DJH 60
Asset Allocation Principles: Financial Climate Changes David M. Darst
One of the chief challenges in achieving successful
investment results over any meaningful time horizon is
knowing how to recognize, anticipate, and respond to
changes in the financial climate, as distinguished from
changes within the financial climate.
Assessing Changes in the Financial Climate
Major climatological shifts in the outlook for financial
assets often call for profound reflection and a reordering
of asset allocation percentages. For example, the 1950s
and 1960s were generally characterized by significant
economic expansion in the United States and favored an
asset allocation with an overweighting in equities and
equity-like assets. By contrast, the 1970s witnessed
rising inflation in the general price level (accompanied
by two OPEC-led increases in crude oil prices), rising
interest rates, a 14.7% decline in the S&P 500 index in
1973 followed by a 36.5% decline in 1974 and
generally unappealing returns for equities as an asset
class for the better part of 10 years.
Helped by heightened Federal Reserve resolve to bring
down inflation beginning in October 1979, long-lived
economic and profit growth, and households direction
of their retirement and investment plans into stocks and
equity mutual funds, the 1980s and 1990s again
rewarded an emphasis on equities and equity-like assets
in investors asset allocations. On the other hand, in
Japan during the 1990s, a period of economic
retrenchment and general price disinflation, the returns
from owning Japanese Government Bonds were two and
one-half times greater than the returns from owning
Japanese equities.
Entry into a new millennium presents investors with
fresh opportunities for reflecting upon and assessing the
climate for financial markets and specific asset classes.
Factors we see that argue in favor of a sustained high
commitment to equities and equity-like assets include: (i)
robust economic growth and profitability in the U.S. and
most areas of the world; (ii) continued technological
progress and generally capitalism-friendly governments;
and not least, (iii) reasonably benign prognoses for price
level changes, liquidity and capital flows, and monetary
and fiscal policies.
Factors we see that argue for a reduction in the asset
allocation percentage devoted to equities and equity-like
assets include: (i) high historical equity valuation
measures (such as price/earnings, price/book value, and
price/sales ratios); (ii) low U.S. personal savings rates
and current account deficits at the highest levels in 110
years, depicted in Exhibit 1; (iii) the magnitude,
complexity, and pervasiveness of various forms of
financial leverage, among them consumer and corporate
borrowing, the dramatically expanded use of derivatives,
and the proliferation of highly leveraged institutions; (iv)
signs of technical deterioration and anomalous equity
market price behavior, including wide divergences in
equity prices, the increasing narrowness of equity sectors
experiencing price advances, and divergent bond-stock
price movements; (v) one-year S&P 500 volatility
expectations priced by options at levels reached only
twice in the past 50 years in 1974 and 1987, as shown
in Exhibit 2; and (vi) evidence of late-cycle financial
market conditions, including intensive equity
underwriting activity, record-high merger and acquisition
volume, frenetic share turnover levels, and investment
euphoria in many technology- and Internet-related
stocks.
Exhibit 1: U.S. Current Account: 1889 1999
99E 89 79 69 59 49 39 29 19 09 1900 1889
8
6
4
2
0
-2
-4
8
6
4
2
0
-2
-4
Percent of GDP
Source: Historical Statistics of the United States, Morgan Stanley Dean
Witter Economics Research.
3DJH 61
Asset Allocation Principles: Financial Climate Changes (cont.)
David M. Darst
Exhibit 2: Actual and Option-Implied Volatility
R
o
l
l
i
n
g

1
2

M
o
n
t
h

A
c
t
u
a
l

V
o
l
a
t
i
l
i
t
y
5
10
15
20
25
30
Jan 50 Dec 59 Nov 69 Oct 79 Sep 89 Aug 99
Current 1-Year S&P 500
Option-Implied Volatility
Notes: Data are as of November 29, 1999.
Source: Morgan Stanley Dean Witter Research
Shifting Patterns of Investor Behavior
Analysis of the last two decades of the twentieth century
can yield insights into the evolution of investor behavior
and how these changes have tended to affect the
deployment of investors funds. During the 1980s, many
investors were beginning to gain exposure to the
concepts and concrete details of asset allocation, and as
part of this process, embraced a variety of investment
strategies, including large-, mid-, and small-
capitalization equities, value and growth styles, and
international equities in developed and emerging
markets. For many investors, bonds were included
primarily as a means of achieving asset diversification.
Investment turnover tended to be low, as investors
pursued buy-and-hold strategies and gauged their
performance in relative terms compared to a limited
number of benchmarks. Individual investors often
accessed equities and other financial assets through
mutual funds.
In the 1990s, many investors responded to changes
within the financial market environment by focusing to a
lesser degree on fixed income securities, international
equities, mid- and small-capitalization equities, and
value-based investment approaches, favoring instead
large-capitalization, growth-based U.S. equity
investment styles. To an increasing degree, investors
sought out alternative asset classes such as private
equity, venture capital, real estate, and hedge funds.
Investment turnover tended to increase, compared with
portfolio turnover levels of a decade earlier, as investors
began to trade more actively in search of momentum-
based investment strategies intended to produce high
absolute, rather than relative, returns. Increased emphasis
was placed on the construction, selection, and
comparison of benchmarks. Partly for tax reasons, partly
to reduce investment costs, and partly due to the alluring
investment performance of selected equity industry
groups, individual companies, and the Initial Public
Offering market, individual investors focused to an
increasing degree on the direct ownership of equities
rather than through mutual funds.
If anything, the net effect of these shifting patterns of
investor behavior has reduced investors opinions of the
value and efficacy of asset allocation. The merits of asset
diversification, risk control, and long-horizon investing
have been downgraded in the thinking of many investors,
in favor of high-performance, annual capital growth as
the overriding objective.
Asset Bubble Phenomena
After financial markets have produced high returns for a
number of consecutive years, signs may emerge of
increasingly stretched valuations and irrational investor
psychology. Although it is extremely difficult to predict
market tops and bottoms, it is no less difficult to identify
when an asset bubble has formed. Nevertheless, several
tell-tale indications, some of which have been identified
around the turn of the twentieth century into the twenty-
first century, are set forth in the following points:
Widespread Wealth Creation: Since 1994, U.S.
households equity holdings have appreciated by $5
trillion, reaching over $9 trillion at the start of 2000.
As part of this process, the number of U.S.
households with a net worth of $1 million or more
rose from 4 million households in 1990 to 8 million
at the end of 1999.
Unrealistic Expectations: Reflecting their positive
experiences of the most recent few years, investors
responses to several widely quoted financial surveys
3DJH 62
David M. Darst
indicated that: (i) they expected the returns from
equity ownership to persist at annual percentage
rates of 1520 percent or more for the indefinite
future; (ii) the capital risks from equity ownership
are minimal; and (iii) asset diversification
encompassing meaningful levels of cash, fixed
income securities, commodities, and other non-
equity-like assets makes little financial sense.
Investor Complacency: Many investors arrive at
the conclusion that the risks of being out of the
equity markets far outweigh the risks of remaining
virtually fully invested in equities; as a result, these
investors are devoted to a buy the dips mentality,
and feel similarly strongly that it does not matter
trying to identity major cyclical and even secular
turning points in equities prices.
Financial Inadequacy: As they observe large new
fortunes being created through the Initial Public
Offering and Merger and Acquisitions processes, a
not inconsiderable number of well-off investors have
feelings that their fortunes are not large enough;
these feelings are often exaggerated as a result of
significant perceived or actual disparities between
the comparors and comparees ages, depth of
business experience, absolute wealth levels, and the
future growth prospects of the assets comprising
their respective patrimonies.
Disrespect for Money: In times of substantial
inflation in the prices of financial assets, a growing
portion of the investor population exhibits some of
the same signs of disrespect for the value of money
that individuals also display during periods of high
inflation in the prices of goods and services; in other
words, the psychological benefits of current
consumption appear to outweigh the benefits of
deferred consumption, and in the process,
individuals effectively devalue the worth of money
as a store of value compared with the utility of
money as a medium of exchange.
Taxation Overawareness: In virtually all economic
conditions, many investors allow tax considerations
to exert too strong an influence in their financial
decision-making, but this overawareness of the
importance of tax factors in investing tends to
assume even larger scope in late-stage bull markets
as investors seek to keep as large a share as possible
of their capital gains from falling into the coffers of
the fiscal authorities.
Paper Riches, Purchasing Power Poverty: Due to
lockup agreements, restrictions on sales by insiders
and affiliates, and concerns over the signals that
sales by corporate officers and directors might send
to the financial marketplace, many individuals
equity wealth on paper is not able readily to be
turned into spendable funds.
Financial Lessons
In the debate over the relevance and applicability of the
Old vs. New paradigm in the economy, the proper level
of the Equity Risk Premium, and the effects of the
Internet on commerce, financing, and investing, it is
worth keeping in mind that over many centuries, if not
millennia, of recorded history, many aspects of human
reasoning, character, and behavior remain unchanged as
they relate to financial affairs. Individuals are driven by
fear, confidence, greed, hindsight, uncertainty, hopes,
dreams, regret, and attraction to grandiose schemes.
Individuals are influenced by memory, self-doubt,
despair, self-recrimination, envy, and pangs of
conscience. Individuals act out of noble motives and
ignoble motives.
As markets approach extreme levels of over- or
undervaluation, a few of the timeless financial lessons to
remember are enumerated in the precepts below.
Lesson 1: Markets Dont Go On Forever. No
matter how euphoric or demoralized financial price
trends may seem, at some point, conditions change,
and the markets establish a decidedly new direction,
3DJH 63
David M. Darst
governed by the basic laws and principles of
economics, science, statistics, psychology, and
compound interest. In the words of William
Shakespeare:
Thus sometimes hath the brightest day a cloud,
And after summer evermore succeeds
Barren winter with his wrathful, nipping cold;
So cares and joys abound, as seasons fleet.
Henry VI Part 2, Act II, Scene iv
Lesson 2: It Is Extremely Difficult to Time a
Market Top or Bottom. The financial arena is
littered with the reputations, and in some cases, the
fortunes, of investors and market strategists who at a
particular juncture in time came to the conclusion
that a major turning point had been reached. Even
though the countervailing forces build up on an
oscillating pendulum the higher that pendulum
reaches, it is just as important to understand the
strength and duration of the forces that set the
pendulum in motion, so as to entertain the notion
that the pendulums path may endure yet longer
before eventually reversing. So too with financial
market conditions.
Lesson 3: Markets Often Correct Through the
Mean. During a sustained market upswing or
downswing, one of the most discredited principles of
asset allocation is that of reversion to the mean. By
this phrase, it is asserted that, over time, the returns
from owning a given asset class tend to gravitate
toward the long-term average for that asset category.
When investors have been experiencing some years
of abnormally high or low returns, not only do they
begin to believe that those returns will not likely
return to the long-term mean returns for that asset
class, they also generally lose sight of the fact that
those long-term average returns imply that the asset
will produce returns as far (and as often) below the
mean as above the mean.
Lesson 4: Relative Valuations Are Relative.
Investors who purchase an asset because of its
attractive valuation relative to some other asset (e.g.,
the purchase of U.S. pharmaceutical shares because
their price-earnings ratios appear attractive relative
to the price-earnings ratio of the S&P 500 index)
should not forget the fact that if absolute valuations
decline, relative valuations may (or may not)
improve even as the investor experiences a loss in
capital values.
Lesson 5: Humans Are Fallible. In economists
parlance, one of the assertions of prospect theory is
that individuals ascribe too low a probability to
likely results and too high a probability to highly
unlikely results. As markets move for a long time in
one direction, investors may very well find
themselves overestimating the likelihood that the
markets will continue indefinitely to move in the
original direction, while underestimating (or
ignoring altogether) the likelihood that the markets
may at some stage reverse course and move against
the prevailing market trend.
Asset Allocation Implications
If the investment lessons set forth in the previous section
have any relevance and validity, powerful arguments can
be made for painstaking attention to the selection of a
sound asset allocation policy reflecting: the investors
goals, risk tolerance, and other circumstances; projected
financial market conditions; and the usefulness of
diversification among and within asset classes.
One of the main objectives of diversification is to
improve the risk-reward ratio of the investors overall
asset mix. Stated another way, through diversification,
the investor intends to: (i) lower the portfolios overall
volatility (one measure of risk) while accepting the
tradeoff that this may lead to a lowering of the
portfolios returns; or, to (ii) increase the portfolios
overall returns without increasing portfolio risk by an
equal proportion.
3DJH 64
Asset Allocation Principles: Financial Climate Changes (cont.) David M. Darst
Perspective can be gained on this point by comparing the
multiyear course of annual total returns (including
income as well as capital gains or losses) for several
asset classes for which reliable data are available. The
asset classes and their relevant benchmarks selected for
comparison purposes include the following:
U.S. Equities
Large-Capitalization Growth: S&P 500/BARRA
Growth Index of the 250 stocks in the S&P 500
Index with the highest price-to-book value ratios.
Large-Capitalization Value: S&P 500/BARRA
Value Index of the 250 stocks in the S&P 500 Index
with the lowest price-to-book value ratios.
Mid-Capitalization: Russell Midcap Index of the
800 smallest companies in the Russell 1000 index,
as measured by total market capitalization.
Small-Capitalization Growth: Russell 2000
Growth Index of that portion of the 2000 companies
with higher price-to-book value and price/earnings
ratios than the other companies in the Russell 2000
value Index.
Small-Capitalization Value: Russell 2000 Value
Index of that portion of the 2000 companies with
lower price-to-book value and price/earnings ratios
than the other companies in the Russell 2000 growth
Index.
International Equities
International Equities: Morgan Stanley Capital
International EAFE index of more than 900
companies in the developed stock markets of
Europe, Australasia, and the Far East.
Fixed Income Securities
Intermediate-Term Bonds: Lehman Brothers
Intermediate Government/Corporate Bond Index of
selected intermediate-term governmental and
corporate bonds with maturities of up to 10 years.
For the years 19791999, Exhibit 3 ranks each of the
above-mentioned asset classes in order of annual
investment performance, thereby displaying the shifting
pattern of asset class returns covering more than two
decades.
Several important asset allocation implications emerge
from careful observation of these data. First, the five
sub-asset classes of the U.S. equity market have often
generated widely differing returns. For example, in the
years in which Small Capitalization Value equities
ranked first in investment performance (1981, 1982,
1983, 1988, and 1992), Large-Capitalization Growth
equities ranked much lower seventh, fourth, sixth,
sixth and sixth, respectively. Second, all the different
asset groups have ranked as the best or second-best
performing asset class. Large-Capitalization Growth
ranked first or second nine times, Small-Capitalization
Value nine times, International Equities seven times,
Large-Capitalization Value five times, Intermediate-
Term Bonds four times, Mid-Capitalization three times,
and Small-Capitalization Growth three times. Third,
International Equities were the best performing asset
class for three years in a row (19851987), followed by
four years in a row (19891992) in which they were the
poorest performing among these seven asset groups,
followed yet again by two years in a row (19931994) in
which they were the best performing asset class.
While deeper analysis of Exhibit 3 can yield many
additional class-to-class comparisons, two additional
powerful overall insights relating to asset allocation
stand out from these results. First is the difficulty the
investor might very well experience in attempting to
shift successfully each year (or even every two years)
into the best-performing asset groups. It might thus
follow that a sensible investment strategy (which also
has the benefit of reducing transaction costs) might
involve some healthy use of diversification, leavened
with as much perspective as possible on how certain
asset groups might be reasonably expected to perform on
a multiyear basis. Second, and equally importantly, is the
way asset groups rotate from the bottom to the top, or
from the top to the bottom, of the performance rankings.
3DJH 65
David M. Darst
The cycling of International Equities from the best-
ranked to the worst-ranked, and back again to the best-
ranked, has already been cited; of equal note is the fall of
Large-Capitalization Growth equities from the top
performance ranking in 1989, to second in 1990, fourth
in 1991, sixth in 1992, and seventh in 1993, before
rebounding to second place in 1994, followed by four
first place performance rankings in a row, from 1995
through 1998 and second place in 1999. This pattern of
high-to-low-to-high investment results also argues in
favor of intensive thought being directed to the
investors strategic asset allocation, coupled with an
appropriate blending of different asset classes and sub-
classes.
Exhibit 3: Annual Return for Various Asset Classes (1979 1999)
Ranked in order of performance (best to worst)
1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989
Russell 2000
Growth
50.83%
Russell 2000
Growth
52.26%
Russell 2000
Value
14.85%
Russell 2000
Value
28.52%
Russell 2000
Value
38.64%
LB IT
Gvt/Corp
14.38%
MSCI EAFE
56.72%
MSCI EAFE
69.94%
MSCI EAFE
24.93%
Russell 2000
Value
29.47%
S&P/BARRA
500 Growth
36.40%
Russell 2000
Value
35.38%
S&P/BARRA
500 Value
39.40%
LB IT
Gvt/Corp
10.50%
LB IT
Gvt/Corp
26.10%
S&P/BARRA
500 Value
28.89%
S&P/BARRA
500 Value
10.52%
S&P/BARRA
500 Growth
33.31%
S&P/BARRA
500 Value
21.67%
Russell
Midcap
23.00%
MSCI EAFE
28.59%
Russell
Midcap
26.27%
Russell
Midcap
32.52%
Russell
Midcap
32.50%
Russell
Midcap
2.40%
Russell
Midcap
23.26%
MSCI EAFE
24.61%
MSCI EAFE
7.86%
Russell
Midcap
32.01%
Russell
Midcap
18.20%
S&P/BARRA
500 Growth
6.50%
S&P/BARRA
500 Value
21.67%
S&P/BARRA
500 Value
26.13%
S&P/BARRA
500 Value
21.16%
Russell 2000
Value
25.39%
S&P/BARRA
500 Value
0.02%
S&P/BARRA
500 Growth
22.03%
Russell
Midcap
23.82%
S&P/BARRA
500 Growth
2.33%
Russell 2000
Value
31.01%
S&P/BARRA
500 Growth
14.50%
S&P/BARRA
500 Value
3.68%
Russell 2000
Growth
20.37%
Russell 2000
Growth
20.17%
S&P/BARRA
500 Value
15.72%
MSCI EAFE
24.43%
MSCI EAFE
-1.03%
S&P/BARRA
500 Value
21.04%
Russell 2000
Growth
20.13%
Russell 2000
Value
2.27%
Russell 2000
Growth
30.97%
LB IT
Gvt/Corp
13.12%
LB IT
Gvt/Corp
3.67%
Russell
Midcap
19.80%
LB IT
Gvt/Corp
12.76%
MSCI EAFE
6.18%
S&P/BARRA
500 Value
23.59%
Russell 2000
Growth
-9.24%
Russell 2000
Growth
20.98%
S&P/BARRA
500 Growth
16.24%
Russell
Midcap
1.43%
S&P/BARR A
500 Value
29.68%
Russell 2000
Value
7.41%
Russell 2000
Value
-7.11%
S&P/BARRA
500 Growth
11.95%
Russell 2000
Value
12.43%
LB IT
Gvt/Corp
6.00%
LB IT
Gvt/Corp
6.41%
S&P/BARRA
500 Growth
-9.81%
MSCI EAFE
-0.86%
LB IT
Gvt/Corp
8.61%
Russell 2000
Growth
-15.83%
LB IT
Gvt/Corp
18.05%
Russell 2000
Growth
3.58%
Russell 2000
Growth
-10.48%
LB IT
Gvt/Corp
6.78%
MSCI EAFE
10.80%
Source: Brandywine Asset Management, Ibbotson Associates, and Morgan Stanley Dean Witter Investment Research.
3DJH 66
Harvard Management Company Asset Allocation
A practitioner of strategic asset allocation combined with
asset diversification that we believe has been highly
successful is the Harvard Management Company
(HMC), the investment arm of Harvard University.
Exhibit 4 shows the fiscal year (June 30) 19901999
investment returns of the Harvard Management
Company General Investment Account, net of all fees
and expenses, compared with the similar-period returns
of Harvards Composite Benchmark Index, the S&P 500
Index, the Salomon Brothers Intermediate Government
Bond Index, and the MSCI Europe, Australasia, and the
Far East Index (EAFE).
Exhibit 3: Annual Return for Various Asset Classes (1979 1999)
Ranked in order of performance (best to worst)
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
LB IT
Gvt/Corp
9.17%
Russell 2000
Growth
51.19%
Russell 2000
Value
29.14%
MSCI EAFE
32.94%
MSCI EAFE
8.06%
S&P/BARRA
500 Growth
38.13%
S&P/BARRA
500 Growth
23.96%
S&P/BARRA
500 Growth
36.52%
S&P/BARRA
500 Growth
42.16%
Russell 2000
Growth
43.09%
S&P/BARRA
500 Growth
0.20%
Russell 2000
Value
41.70%
Russell
Midcap
16.34%
Russell 2000
Value
23.84%
S&P/BARRA
500 Growth
3.13%
S&P/BARRA
500 Value
36.99%
S&P/BARRA
500 Value
21.99%
Russell 2000
Value
31.78%
MSCI EAFE
19.98%
S&P/BARRA
500 Growth
28.25%
S&P/BARRA
500 Value
-6.85%
Russell
Midcap
41.51%
S&P/BARRA
500 Value
10.53%
S&P/BARRA
500 Value
18.60%
S&P/BARRA
500 Value
-0.64%
Russell
Midcap
34.45%
Russell 2000
Value
21.37%
S&P/BARRA
500 Value
29.98%
S&P/BARRA
500 Value
14.68%
MSCI EAFE
27.05%
Russell
Midcap
-11.50%
S&P/BARRA
500 Growth
38.37%
Russell 2000
Growth
7.77%
Russell
Midcap
14.30%
Russell 2000
Value
-1.55%
Russell 2000
Growth
31.04%
Russell
Midcap
19.00%
Russell
Midcap
29.01%
Russell
Midcap
10.08%
Russell
Midcap
18.23%
Russell 2000
Growth
-17.41%
S&P/BARRA
500 Value
22.56%
LB IT
Gvt/Corp
7.17%
Russell 2000
Growth
13.36%
LB IT
Gvt/Corp
-1.95%
Russell 2000
Value
25.75%
Russell 2000
Growth
11.26%
Russell 2000
Growth
12.95%
LB IT
Gvt/Corp
9.48%
S&P/BARRA
500 Value
12.72%
Russell 2000
Value
-21.77%
LB IT
Gvt/Corp
14.63%
S&P/BARRA
500 Growth
5.07%
LB IT
Gvt/Corp
8.73%
Russell
Midcap
-2.09%
LB IT
Gvt/Corp
15.31%
MSCI EAFE
6.36%
LB IT
Gvt/Corp
7.87%
Russell 2000
Growth
1.24%
LB IT
Gvt/Corp
0.39%
MSCI EAFE
-23.19%
MSCI EAFE
12.49%
MSCI EAFE
-11.85%
S&P/BARRA
500 Growth
1.68%
Russell 2000
Growth
-2.43%
MSCI EAFE
11.55%
LB IT
Gvt/Corp
4.06%
MSCI EAFE
2.06%
Russell 2000
Value
-6.43%
Russell 2000
Value
-1.49%
Notes: S&P/BARRA 500 Growth and S&P/BARRA 500 Value indices are constructed by dividing the stocks in the S&P 500 Index according to price-to-book ratios. The
Growth indices contain stocks with higher price-to-book ratios. The Value index contains stocks with lower price-to-book ratios. The indices are market-capitalization-
weighted, and their constituents are mutually exclusive.
MSCI EAFE: A Morgan Stanley Capital International Index that is designed to measure the performance of the developed stock markets of Europe, Australia and the
Far East.
LB IT Gvt/Corp: Lehman Brothers Intermediate Government/Corporate Bond Index is composed of the LB IT Government Bond Index and the LB IT Corporate Bond
Index. Maturities up to 10 years.
3DJH 67
Exhibit 4: Harvard Management Company (HMC)
Total Returns
Fiscal year
(Ending June 30)
Harvard
GIA
1
Composite
Index
S&P
500 SBIG
2
MSCI
EAFE
3
1990 7.5% 13.3% 16.4% 7.7% 3.2%
1991 1.1 8.6 7.4 10.8 (11.2)
1992 11.8 10.3 13.5 14.2 (0.3)
1993 16.7 12.7 13.6 12.0 20.7
1994 9.8 6.8 1.4 (1.2) 17.3
5-year annual rate 9.3 10.3 10.3 8.6 5.3
1995 16.8 17.2 26.1 12.6 1.9
1996 26.0 22.3 26.1 5.0 13.6
1997 25.8 20.0 34.7 8.2 13.2
1998 20.5 17.1 30.2 10.6 6.4
1999 12.2 18.9 22.7 3.1 7.9
5-year annual rate 20.1 19.1 27.9 7.8 8.5
10-year annual rate 14.6% 14.6% 18.8% 8.2% 6.9%
1
General Investment Account (GIA); net of all fees and expenses.
2
Salomon Brothers Intermediate Government Bond Index
3
MSCI, Europe Australasia Far East Index (EAFE)
Source: Harvard Management Company.
In Exhibit 4, it can be seen that the overall return of the
HMC portfolio was 9.3% per annum for the five fiscal
years 1990 through 1994, 20.1% per annum for the five
fiscal years 1995 through 1999, and 14.6% for the 10
fiscal years 1990 through 1999. Over the full 10-year
time frame, Harvard turned in what we view as highly
respectable investment results, matching the performance
of its Composite Benchmark Index, underperforming the
S&P 500 Index by 4.2% per annum, and outperforming
the Salomon Brothers Intermediate Government Bond
Index and the MSCI EAFE Index by 6.4% per annum
and 7.7% per annum, respectively.
As of June 30, 1999, Harvards strategic asset allocation
also known as the HMC Policy Portfolio was invested in
11 separate asset classes as set forth in Exhibit 5.
The HMC Policy Portfolio shown in Exhibit 5 represents
the most recent version of Harvards desired long-term
asset mix, against which the Harvard Management
Company has the flexibility to vary the short- and
intermediate-term percentages, within certain prescribed
boundaries, invested in the respective asset classes. For
example, while domestic equities represent 32% of the
Harvard policy portfolio, the Harvard Management
Company may be permitted to invest as much as 40% or
as little as 25% in domestic equities (the actual asset
allocation ranges are not disclosed in the HMC Annual
Report). Harvard manages most of its domestic equities
through two internal groups, one focused on fundamental
equity analysis and stock selection, and the other
dedicated to merger arbitrage, convertible arbitrage, and
paired securities arbitrage.
Harvard has earmarked 4% of its Policy Portfolio to various
absolute return investment strategies involving arbitrage,
absolute value trades, and hedging techniques designed to
produce positive returns regardless of the overall market
direction. A significant portion of the HMC policy
portfolio, 5%, is dedicated to foreign equities, partly
oriented to arbitrage strategies and partly indexed to the
EAFE index, with incremental returns generated by lending
securities from the Harvard investment portfolio.
Harvard has targeted 9% of its assets for investment in
emerging markets. These assets are invested via four
methods: through an external asset manager; through the
purchase of closed-end funds selling at deep discounts
from net asset value; through private equity funds; and
1.8% (equal to 20% of the total emerging markets
category) in emerging markets debt. An aggregate of two
percent of the HMC Policy Portfolio is directed toward
high-yield securities, of which one-half is invested by an
external manager in the bankruptcy sector of the high-
yield market.
Exhibit 5: Harvard Management Company
Policy Portfolio
Domestic equities 32%
Absolute return 4
Foreign equities 15
Emerging markets 9
High-yield securities 2
Commodities 5
Real estate 7
Private equities 15
Domestic bonds 11
Foreign bonds 5
Cash (5)
Total 100%
Note: As of June 30, 1999.
Source: Harvard Management Company.
3DJH 68
In the commodity portion of Harvards asset allocation,
consisting of 5% of the total Policy Portfolio, the
primary focus is on finding and exploiting mispricings
among similar securities. A total of seven percent of
Harvards strategic asset allocation is invested in real
estate, consisting of office buildings, residential
properties, hotels, and retail projects, supplemented by
10 externally managed real estate funds.
A significant portion, 15%, of the Harvard Management
Company Policy Portfolio is invested in private equities,
made up of approximately 60 private equity partnerships
run by external managers. Harvard has 11% of its
strategic asset allocation devoted to domestic bonds, and
5% devoted to foreign bonds, and in both sectors, its
investment approach is primarily oriented toward the
arbitrage of virtually similar over- and undervalued fixed
income securities.
Harvard does not target cash as an asset class in its
Policy Portfolio. In fact, in the course of its investing,
hedging, and arbitrage activities, Harvard targets a
strategic borrowing position (negative cash) representing
5% of its total assets. With a relatively heavy emphasis
on international investments, arbitrage strategies, various
forms of private equity (including real estate) and
borrowing and lending overlays, the Harvard
Management Company has been able to generate
respectable 5- and 10-year annual rates of return in its
General Investment Account.
Summary
To be sure, not all investors have efficient access to
internal and external resources similar to those at the
disposal of Harvard University. At the same time, we
believe private investors can position themselves to
improve their risk-adjusted investment returns by: (i)
adapting some of the Harvard Management Companys
approaches including the structuring of a targeted,
diversified strategic asset allocation; (ii) assessing
important changes in the financial climate; (iii)
recognizing shifting patterns of investor behavior and
secular signs of excessive financial asset inflation; (iv)
examining the investment performance of various asset
classes and sub-asset classes over time; and (v) being
mindful of and heeding time-honored investment
lessons.
3DJH 69
Annual Reports 73
Investment Policy Statements 75
Investment Filters 77
Evaluative vs. Portfolio Time Horizons 79
Historical Risk & Return Analysis 81
Internet-Based Investment Tools 85
The Family Office in the New Millennium 87
Evaluating Alternative Investments 89
Equities: International Investing 93
Traditional Commodities: Portfolio Diversification Benefits 99
Personal Financial Statements 101
Investment Alternative: A Tutorial on Exchange Funds 108
Planning for and Financing a College Education 110
3DJH 71
High Net Worth Investment Tools: Annual Reports
Ann K. Rusher
High Net Worth investors are constantly bombarded with
company, industry, and financial market information.
One of the most important sources of company
information is the annual report. The purpose of this
article is to synthesize those insights that we believe are
most relevant for the High Net Worth investor and to
arm the reader with a strategy to get the most out of
reading an annual report.
Lesson 1: The annual report is only one of many
resources available to the individual investor.
However, the annual report also happens to be one of the
most easily obtainable information sources.
Some highly successful investors believe that annual
reports are not only one of the most accessible
investment resources, but also the best. During the 1996
Berkshire Hathaway Annual Meeting, Warren Buffett
said, In my view, you cant read Wall Street research
reports and get anything out of them. Youve got to get
your arms around it yourself. I dont think weve ever
gotten an idea from a Wall Street research report.
However, weve gotten a lot of ideas from annual
reports.
As shown in the accompanying table, there are a variety
of sources of company information, some more easily
available than others to HNW investors.
Lesson 2: Retain a healthy level of skepticism about
the information provided.
For instance, when reading the Letter to Shareholders,
the HNW investor should ask certain questions: What
are they really saying? And more importantly: What are
they not saying? Is the Chairman forward-or backward-
looking? Are the language and the substance of the
message candid or turgid? Key sections to read carefully
include:
Footnotes: These include descriptive information on
accounting methods, commitments, lease
obligations, contingencies, legal proceedings, and
significant events that should lend insight into the
numbers in the financial statements. All material
information must be disclosed in these footnotes, so
the HNW investor will often find important
information that is not evident on the balance sheet
or the income statement.
Investment Resources
Availability to the
HNW Investor
Company Websites Accessible over the Internet.
Value Line Reports Available by subscription or
in most public libraries.
Annual Reports and other
SEC Filings (10-K, 10-Q,
8-K)
Obtainable from the com-
pany, over the internet, or
from the HNW investors
Investment Representative.
Industry Financial Ratios Published by Dun & Brad-
street, S&P, Robert Morris
Associates, and the FTC.
May be found in most public
or college libraries.
Media (Barrons, Business
Week, Forbes, Fortune)
Available by subscription,
over the Internet, and at most
public libraries.
Wall Street Research
Reports
Available from the HNW
investors Investment Rep-
resentative.
Investment Newsletters Available by subscription.
Some are better than others.
PC Based Stock Screening
Software
Available for purchase;
prices vary.
Company Annual Meetings Generally, though not
always, limited to share-
holders of record.
Investor Conference Calls Dial-in numbers available
from the HNW investors
Investment Representative.
Company Visits (also those
to Competitors, Suppliers,
and Vendors)
Traditionally the province of
institutional investors and
Equity Research Analysts.
Limited access for individual
investors.
3DJH 73
High Net Worth Investment Tools: Annual Reports (cont.)
Ann K. Rusher
Selected Ways a Company Can Influence the
Numbers in an Annual Report
1. Changing accounting principles, such as from LIFO to
FIFO, or vice versa.
2. Financial restructuring that results in a restatement of
prior years results or an earnings increase or decrease
in subsequent years.
3. Manipulating income recognition by overshipping
products and then having to take a loss when the goods
are returned.
4. Taking substantial losses in one year in order to have
an improvement in the following year, sometimes
referred to as big bath accounting.
5. Not clearly showing the effect of executive stock
options as compensation expense. (New accounting
rules on disclosure of stock options went into effect as
of December 15, 1997 requiring companies to show
basic and diluted EPS figures.)
6. Using discretionary expenses such as depreciation
rates, advertising, and research and development as
income-smoothing devices.
Managements Discussion and Analysis:
Required by the SEC since 1968, and in a revised
format since 1980, in this section the company
discusses such important topics as: (i) results of
operations; (ii) capital resources; and (iii) liquidity.
Lesson 3: It is important for the HNW investor to
make his or her own decision about investing in a
company, partnership for the long term.
However, a savvy HNW investor should also be aware of
other individual and institutional investors motivations
for buying and selling.
Positive trends include: (i) upward growth in sales; (ii)
profit margin expansion; and (iii) improving balance
sheet liquidity.
Red flags are evidenced by: (i) time-intensive or costly
legal proceedings; (ii) a large addition to reserves; (iii)
receivables and/or inventories growing at too fast a rate;
and (iv) a change of accounting firms.
What the Pros Watch as Price Influences
Selection Strategy
% of Institutions
Employing
Strategy
Earnings Surprise 54.1%
Return on Equity 50.8
Analysts Earnings Revisions 48.4
Price-to-Cash-Flow Ratio 48.4
Projected Five-Year Profit Growth 45.9
Debt-to-Equity Ratio 43.4
Earnings Momentum 41.0
Relative Strength 38.5
Price-to-Earnings Ratio 34.4
Price-to-Book Ratio 33.6
Analysts Opinion Changes 33.6
Earnings Variability 31.1
Dividend Discount Model 29.5
Price-to-Sales Ratio 27.9
Neglected Stocks 24.6
Beta 13.9
Earnings Estimate Dispersion 13.9
Dividend Yield 12.3
Earnings Uncertainty 12.3
Foreign Exposure 12.3
Size 12.3
Low Stock Price 7.4
Interest-Rate Sensitivity 5.7
Source: Barrons, December 8, 1997.
Lesson 4: The HNW investor should not waste his or
her time studying every guide to reading annual
reports, but instead should focus on one or two and
then go directly to the company annuals.
By reading the report of the company in which the HNW
investor is interested, as well as its one or two chief
competitors, information can be gleaned on products,
trends, ownership by management, insider transactions,
and managements vision and techniques that may affect
the decision to invest either in the company or the
industry.
There is a plethora of books and articles on how to read
an annual report. Two highly effective guides, in our
view, are: Keys to Reading an Annual Report, Second
Edition, by George Thomas Friedlob, Ph.D., C.P.A., and
Ralph E. Welton, Ph.D., (Barrons, 1995); and How to
Read a Financial Report, by John A. Tracy (John Wiley
& Sons, Inc., 1994). Both of these are available over the
Internet through Amazon.com for under $20.
3DJH 74
High Net Worth Investment Tools: Investment Policy Statements
Ann K. Rusher
A determining factor in structuring a High Net Worth
investors asset allocation is the development of a formal
investment policy. One key measure of the success of an
asset allocation is whether it reflects the expectations of
the investor, and the investment manager, as set forth in
the Investment Policy Statement.
An Investment Policy Statement is a set of guidelines.
The purpose of a formal investment policy is to establish
a sound investment framework that protects the portfolio
from both the portfolio manager and the investor making
subjective, tactical changes during distressing market
conditions that may deviate from the investor's long-term
investment goals and focus. The more clearly the
Investment Policy Statement defines the investors goals,
the more useful a tool it will be in managing not only the
portfolio, but the overall investment management
relationship.
The misdemeanors of investment management are
almost all due to an inadequate advance understanding
by an investor or portfolio manager (or both) of either
the internal realm of client objectives or the external
realm of capital markets and investments, or both. If a
major decision is truly fiduciary in nature, it never
needs to be done quickly. Time-urgent decisions are
never fiduciary. All too often, investment policy is both
vague and implicit, left to be resolved in haste, when it
is easy to make the wrong decision at the wrong time
for the wrong reasons.
Charles D. Ellis, Investment Policy, Second Edition, 1993.
The construction of an Investment Policy Statement for a
HNW investor is often a self-discovery process for the
investor, the investors family group or organization, and
the investment manager. Some questions that a HNW
investor may want to start thinking about prior to
embarking on the creation of a formal Investment Policy
Statement are outlined below. The process requires
intensive collaboration and interaction between the
Investment Representative, the HNW investor, and the
appropriate asset allocation resources and generally
requires several or more business days to complete. The
HNW investor has the central responsibility for defining,
amending, and assuring implementation of his or her
long-term investment policy.
TEN QUESTIONS THAT A HIGH NET WORTH
INVESTOR MIGHT THINK ABOUT
1. What do you want to accomplish with your life?
2. How do you think about money and investments?
3. What are some of your formative life and business
experiences?
4. What causes your great moments of elation and
satisfaction?
5. What person in your life has influenced you the most
and/or commanded your greatest respect and why?
6. What are the ultimate whys for your investing
activity? Aside from increasing your after-tax risk-
adjusted rate of return, are you planning to give
money to your grandchildren, to a charity, or to an
alma mater?
7. Are there any areas of investing that you would like
to understand better? How much do you want to
learn about investments?
8. How do you cope with loss? Is there anything in
your life experience that has affected your ability to
tolerate risk?
9. What games of chance and skill do you play and
why?
10. How would you describe your expectations of an
ideal investment management relationship?
Although Investment Policy Statements are specifically
tailored to the needs of each HNW investor, they
generally cover the following topics:
The overall investment objective(s) of the assets
under the supervision of the Investment Manager;
The primary investment goal(s) and return
objectives;
The scope of asset purview of the Investment
Manager;
The HNW investors estimated annual income
needs in nominal terms and how they should
primarily be met;
The HNW investors portfolio investment time
horizon;
The targeted long-term annual performance
objective of the HNW investor on a pretax basis;
3DJH 75
High Net Worth Investment Tools: Investment Policy Statements (cont.)
Ann K. Rusher
Tax, trust, and estate planning considerations and
purview;
Investment turnover constraints in light of the tax
status of the HNW investors portfolio;
The Investment Managers proposed asset allocation
framework to meet the HNW investors stated total
return requirements;
General asset class weighting guidelines within
certain ranges stated as a percentage of total assets;
Guidelines for liquidity events and changes in
projected rates of return;
Targeted risk and volatility as indicated by the
HNW investor's return objectives and investment
horizon;
Investor preferences for investing in certain asset
classes and investment positions;
The liquidity needs of the HNW investor;
The HNW investors projected combined effective
Federal, state, and local tax rates;
Portfolio investment quality standards and
underlying principles;
Trading and settlement procedures as they relate to
the HNW investors portfolio;
Custody arrangements for the assets in the HNW
investors portfolio;
Portfolio reporting objectives, needs, and
considerations; and
The extent of external manager selection,
monitoring, trading, and settlement procedures.
Other important considerations relate directly to the
HNW investors asset allocation decision. These
questions have been adapted from the Strategic
Investment Policy process described in the 1994 Harvard
Business School case, The Harvard Management
Company, and are important for ensuring that the HNW
investor and his or her Investment Representative have
fully addressed the investors needs relating to liquidity,
risk tolerance, benchmarks, and balance sheet
considerations.
HIGH NET WORTH INVESTOR ASSET
ALLOCATION CONSIDERATIONS
Current vs. Future Needs: How should the High Net
Worth investor think about providing for this
generation of beneficiaries versus future beneficiaries?
Income Requirements: Are the current income needs
of this generation greater than average, and can greater
than average spending levels be justified?
Asset Mix: What mix of assets, return assumptions,
time horizon, and tax parameters is necessary to
achieve targeted levels of real after-tax spending?
Should the High Net Worth investors asset allocation
and spending policies be coordinated, and if so, how?
Absolute vs. Relative Benchmarks: Should High Net
Worth investors care about how their own asset
allocation policies compare to those of similarly-
situated investors, or should they invest only according
to their own sense of appropriate direction?
Risk Tolerance: To what extent can High Net Worth
investors make meaningful judgments about their own
ability to tolerate portfolio risk?
Balance Sheet Considerations: To what extent should
other major categories of the assets and liabilities of
High Net Worth investors, such as art, real estate, or
mortgage debt, influence their overall asset allocation
policies?
Finally, a systematic review of the investors investment
policy guidelines should be conducted with an
appropriate degree of regularity in case the investor's
current income needs, long-term goals, and/or
investment experience change in any meaningful way.
Writing things down before you do them can keep you
out of trouble. It can bring you peace of mind after you
have made your decision. It also gives you tangible
material for reference to evaluate the whys and
wherefores of your profits or losses.
Gerald M. Loeb, The Battle for Investment Survival, 1935.
3DJH 76
High Net Worth Investment Tools: Investment Filters
Ann K. Rusher
Past issues of the Asset Allocation Review and Outlook
have highlighted the texts of Philip A. Fisher, Benjamin
Graham, Philip L. Carret, Gerald M. Loeb, and Warren
E. Buffett. Each of these five great investors have a set
of filters specific to their own investment styles,
disciplines, and expertise, to which they apply each
proposed investment.
In the August 1997 issue of the Outstanding Investor
Digest, a Berkshire Hathaway shareholder asked how
Warren Buffett and Charlie Munger could substantiate
the claim that within five minutes they can tell whether
or not Berkshire might be interested in investing in a
company. Buffett answered that, in addition to being
already familiar with virtually every company of any size
that would be of interest to Berkshire, he and Charlie
have a list of filters, developed over time, that help them
isolate companies which they can understand and value
as investors. Buffett, later in a conversation with another
shareholder, reiterated that they can end 98% of the
conversations with potential sellers in the middle of the
first sentence by using their primary filters: (i) that they
understand the business; and (ii) that it has a sustainable
competitive edge.
Investors, particularly High Net Worth individuals,
should consider developing a list of investment filters. In
fact, most investors innately use a number of
qualifications that they automatically look for before
purchasing a security. Some require that the company
meet a minimum capitalization or that it has a product
with which they are familiar, while others have more
specific financial, operating, religious, environmental, or
even moral filters to which they apply potential new
investments.
The process of creating a set of investment filters is
similar to the process of forming an investment
philosophy, which entails a certain amount of experience
in investing and the study of the philosophies of several
great investors. One might start a list of filters by
recalling the companies in which he or she did or did not
invest and the reasoning behind each decision. Those
circumstances or qualities that seem to be recurring in
each investment decision may, in fact, be an investment
filter. As the investor begins to develop a set of filters, he
or she may develop a greater level of confidence in each
investment decision.
The accompanying table sets forth many of the
investment filters drawn from the writings of Fisher,
Graham, Carret, Loeb, and Buffett. The HNW investor
may adopt certain of these filters as his or her own or use
the chart as a worksheet when considering specific stock
purchases. In approaching each company, the HNW
investor may want to qualify how many of the
investment filters the company meets and which of these
five great investors might have considered investing in
the security. If the worksheet is full of check marks, then
the company might represent a sound investment. On the
other hand, if there are relatively few check marks, the
investor may decide not to purchase the security. The
HNW investor may find that those filters which apply to
their own investing may become the basis for the
investors own customized list of filters.
In the same Outstanding Investor Digest article, Warren
Buffett makes the important point that if the company
does not pass a sufficient number of the filters, the HNW
investor has to be able to walk away from the potential
investment. He states, You cant buy a stock just
because somebody else thinks its going to go up or
because your friends made a lot of easy money lately, or
anything of the sort. A list of filters serves as a
sounding board and a consistency check for each
potential equity investment.
To invest successfully over a lifetime does not require
a stratospheric IQ, unusual business insights, or inside
information. Whats needed is a sound intellectual
framework for making decisions and the ability to keep
emotions from corroding that framework.
Benjamin Graham, The Intelligent Investor
Readers should note that the table on the following page is based on the
sources listed below:
Philip A. Fisher, Common Stocks and Uncommon Profits, 1958.
Benjamin Graham, The Intelligent Investor, 1949.
Philip L. Carret, The Art of Speculation, 1930.
Gerald M. Loeb, The Battle for Investment Survival, 1935.
Lawrence A. Cunningham, The Essays of Warren Buffett: Lessons for
Corporate America, 1997.
3DJH 77
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3DJH 78
High Net Worth Investment Tools:
Evaluative vs. Portfolio Time Horizons
Ann K. Rusher
When setting overall investment objectives and forming
investment policy, High Net Worth investors need to
consider two separate, yet related, time frames over which
to assess investment performance: (i) the evaluative time
horizon; and (ii) the portfolio time horizon.
Evaluative Time Horizon: A High Net Worth investors
evaluative time horizon is that defined period of time
during which the investor will assess the intermediate-
term operation of the portfolio. Over such a time frame,
the High Net Worth investor monitors turnover and tax-
efficiency, liquidity needs, and whether the investment
manager is adhering to the stated investment objectives. It
is also the period over which the High Net Worth investor
assesses investment strategies and decides whether the
original strategic plan should continue to be used or
replaced with one that more closely fits market realities
and the stated portfolio objectives. The evaluative time
horizon may be as short as one year and as long as five
years, but is most commonly around three years, and may
or may not cover a full financial market cycle.
Portfolio Time Horizon: A High Net Worth investors
portfolio time horizon is that long-term period over which
the assets are being invested to fulfill the overall purposes
of the portfolio and to meet the ultimate objectives of its
beneficiaries. The portfolio time horizon may extend for
five, ten, or twenty years, or indefinitely (for instance, in
the case of a foundation or a private corporation).
Both the evaluative and portfolio time horizons play an
integral role in determining the risk profile, appropriate
investment parameters, and asset allocation for a High Net
Worth investment portfolio. For example, if an investors
evaluative time horizon is three years and his or her
portfolio time horizon is twenty years, then during that first
three-year time period, he or she might appoint investment
managers to carry out intermediate-term objectives that aim
toward the ultimate goal of the assets over the twenty-year
portfolio time horizon. If a particular manager or strategy
did not adhere to or fit the stated investment objectives by
the end of the three-year evaluative time horizon, then it
would be replaced. On the other hand, if each component of
the portfolio was in fact meeting all of the investors
original goals, the investor might keep the managers and/or
strategies in place and continue to monitor them over
succeeding three-year evaluative periods during the twenty-
year portfolio time horizon.
An Investors Intended vs. Actual Time Horizon
In selecting an evaluative and a portfolio time horizon,
the investor recognizes that the intended time horizon
will most probably not match the actual time horizon
over which the portfolio is assessed. This is exemplified
in the practice of twenty-five year olds trading and
marking-to-market their 401(k) programs on a daily or
even hourly basis. It is also associated with the
heightened media coverage of the financial markets that
has made even long-term investors acutely conscious of
their investments on a minute-to-minute basis.
With the immense amount of real-time information
available about the global economies, and the profound
intertwining of the international financial markets, it is
difficult for a High Net Worth investor to make
investments and not monitor them with some degree of
frequency during a five-, ten-, or even twenty-year
portfolio time horizon. Although the initial strategies
chosen may, in fact, achieve the intended investment
objectives at the end of the portfolio time horizon, the
psychological profile of High Net Worth investors does
not necessarily warrant such a long lock-up period.
Liquidity needs deriving from personal financial
hardship, global economic events, or other changes in
the circumstances for the beneficiaries of the assets may
also necessitate having an evaluative time horizon.
Short-Term Trading vs. Long-Term Investing
Another way to compare the portfolio time horizon and
the evaluative time horizon is by the types of assets and
securities bought and used by the High Net Worth
investor to meet the stated portfolio objectives over these
two time frames. Those assets and securities purchased
to meet portfolio objectives over the longer portfolio
time horizon should be considered as art such as high-
quality stocks that the High Net Worth investor can hang
on the wall and keep in the portfolio for decades. For
example, with impeccable-quality holdings, High Net
Worth investors are more likely to reap the positive
benefits of compounding dividend reinvestment which is
important in actually achieving the stated long-run rates
of return from equity ownership.
That portion of an investors portfolio which is
associated with the evaluative time horizon may be
subject to some greater degree of tactical, short-term
adjustment. This part of the assets may be considered as
complementary to the long-term portfolio allocation and
objectives. In this context, the evaluative time horizon
may encompass the investors proclivity to take
advantage of short-term price/value discrepancies within
various asset classes. For the fully-taxable High Net
Worth investor, the ratio of time invested to total
compound return for this trading portion of the portfolio
may be higher, and the resultant investment performance
less tax-efficient, due to higher turnover.
3DJH 79
Evaluative vs. Portfolio Time Horizons (cont.)
Ann K. Rusher
Set forth in the diagram below is a summary of the
relationship between a High Net Worth investors
evaluative and portfolio time horizons. It can be used to
help determine the relative degree of focus on each, given
the investors portfolio constraints, goals, and objectives.
The Evaluative Time Horizon is a Function of:
The short-term outlook for the financial markets.
The investors Comfort/Concern Ratio about:
(i) His or her own financial conditions;
(ii) His or her asset selection capability: and
(iii) His or her investment managers.
The Portfolio Time Horizon is a Function of:
The chronological age of the High Net Worth
investor.
The long-term outlook for the capital markets.
The stage of the High Net Worth investors
wealth accumulation.
The ultimate purpose and disposition of the
assets.
3DJH 80
Historical Risk & Return Analysis
Elizabeth W. Wells
The asset allocation decision is driven by a host of
qualitative and personal factors, but it also needs a
meaningful degree of quantitative grounding. For the
most part, this quantitative grounding focuses on the
returns and risks of various potential combinations of
asset classes.
Appropriate usage of these quantitative tools depends on
a number of factors, including the recognition that: (i)
the future is never an exact duplicate of the past; and (ii)
the further out into the future one looks, the greater the
degree of probability that returns will tend toward their
long-term average.
A quantitatively-based approach can take many different
forms, including a pure Historical Analysis of different
asset classes and combinations of those asset classes. In
addition, with an Optimization Model, the investor can
use historical or projected returns to create an asset
allocation which is on the so-called efficient frontier.
The efficient frontier is a concept from Modern Portfolio
Theory, which, among other postulates, describes
combinations of asset classes that will provide the most
return for a given level of risk.
Both the pure Historical Analysis and the Optimization
Model can be tailored to the preferences and profile of
the investor, depending on a number of factors. There are
many decisions to be made when selecting the data to
perform the analysis, including: which benchmarks to
use for each asset class; the period of time under
analysis; and the length of each portfolio holding period
within the overall time frame being reviewed.
An example of this approach is shown in the
accompanying series of charts. The investment results
displayed in these charts are commonly cited throughout
the asset allocation literature to show the historical
outperformance of stocks over bonds. In this case,
portfolios have been constructed consisting of varying
weightings of stocks and bonds. Using historical
monthly data series available for U.S. stocks, U.S.
government bonds, and cash, the portfolios were
analyzed from January 1950 to September 1998, over
various one-, three-, five-, and ten-year portfolio holding
periods.
Chart 1: U.S. Domestic Risk & Reward One-Year Returns
(1)(2)(3)
January 1950 September 1998
- - - - -

Notes: (1) Rolling one year returns using monthly data.
(2) Source: Ibbotson Associates, Inc.
(3) Stocks: S&P 500 Total Return: Bonds: U.S. Long Term Government Total Return; Cash: U.S. 30 Day T-Bill Total Return.
Past performance is not indicative of future returns.
-35.2%
-32.1%
-29.1%
-25.8%
-22.6%
-19.1%
-15.6%
-11.9%
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-14.5%
12.4%
55.0%
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52.2%
11.1%
49.4%
10.4%
46.4%
9.7%
43.7%
8.9%
42.6%
8.2%
44.2%
7.4%
45.8%
6.6%
47.5%
5.8%
49.0%
20.9%
19.7%
18.6%
17.3%
16.0%
14.7%
13.3%
11.9%
10.4%
8.9%
Single
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Ending
9/98
-35.2%
-32.1%
-29.1%
-25.8%
-22.6%
-19.1%
-15.6%
-11.9%
-12.3%
-14.5%
Worst
Return
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-6.4%
-5.5%
-4.6%
-4.1%
-3.7%
-3.4%
-3.3%
-3.3%
-3.5%
Avg
Loss
12.4%
11.7%
11.1%
10.4%
9.7%
8.9%
8.2%
7.4%
6.6%
5.8%
Avg
Return
18.2%
16.6%
15.3%
14.0%
12.8%
11.6%
10.6%
9.9%
9.6%
9.8%
Avg
Gain
55.0%
52.2%
49.4%
46.4%
43.7%
42.6%
44.2%
45.8%
47.5%
49.0%
Largest
Return
19.3%
17.9%
17.2%
16.9%
16.0%
15.0%
15.2%
16.0%
20.2%
27.0%
%
Neg
80.7%
82.1%
82.8%
83.1%
84.0%
85.0%
84.8%
84.0%
79.8%
73.0%
%
Pos
10%
80%
10%
10%
70%
20%
10%
60%
30%
10%
50%
40%
10%
40%
50%
10%
30%
60%
10%
20%
70%
10%
10%
80%
10%
0%
90%
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Portfolio
Mix:
One-Year Returns, 1950-1998
Largest Return Worst Return Average Return
Cash
Stocks
Bonds
10%
90%
0%
3DJH 81
Historical Risk & Return Analysis (cont.)
Elizabeth W. Wells
For example, in Chart 1, a portfolio that was comprised
of 90% stocks, 0% bonds, and 10% cash, and that was
held for a series of one-year holding periods, returned an
average of 12.4% for the 574 separate one-year periods
from January 1, 1950 through September 30, 1998. Over
this time period, the worst one-year return was
35.2%, and highest one-year return was 55.0%. This
portfolio mix experienced one-year holding period
returns that were negative 19.3% of the time, and the
average loss in the losing years over this time period was
7.0%. This portfolio mix had positive returns 80.7% of
the time, and the average gain in the positive years over
this time period was 18.2%.
On the other hand, Chart 1 also shows that a portfolio
that was comprised of 0% stocks, 90% bonds, and 10%
cash, and was held for a series of one-year holding
periods, returned an average of 5.8% for the 574 separate
one-year periods from January 1, 1950, through
September 30, 1998. Over this time period, the worst
one-year return was 14.5%, and highest one-year return
was 49.0%. This portfolio mix experienced one-year
holding period returns that were negative 27.0% of the
time, and the average loss in the losing years over this
time period was 3.5%. This portfolio mix had positive
returns 73.0% of the time and the average gain in the
positive years over this time period was 9.8%.
An analysis of these two asset mixes in Chart 1
demonstrates how a heavily equity-concentrated
portfolio has outperformed a heavily bond-concentrated
portfolio over the nearly 48 years from 1950 to 1998.
The 90% equity portfolio returned an average of 12.4%
from January 1950 to September 1998, and the 90%
bond portfolio returned an average of 5.8% from January
1950 to September 1998. At the same time, the analysis
also demonstrates how the range of returns experienced
by the investor for the bond portfolio was significantly
smaller than the range of returns for the equity portfolio.
The accompanying table shows the number of sample
portfolios used to construct the charts. For example,
using data series from January 1950 to September 1998
and a holding period of one year, 574 sample portfolios
Chart 2: U.S. Domestic Risk & Reward Three-Year Returns
(1)(2)(3)
- -
-9.0%
-7.9%
-6.7%
-5.6%
-4.5%
-3.4%
-3.2%
-3.5%
-4.0%
-4.5%
11.9%
30.6%
11.3%
29.5%
10.7%
28.3%
10.0%
27.1%
9.4%
26.1%
8.7%
25.3%
8.0%
24.8%
7.3%
24.0%
6.6%
23.4%
5.8%
23.7%
20.9%
20.0%
19.1%
18.1%
17.1%
16.1%
15.1%
14.1%
13.0%
11.9%
Single
Year
Ending
9/98
0% -9.0%
-7.9%
-6.7%
-5.6%
-4.5%
-3.4%
-3.2%
-3.5%
-4.0%
-4.5%
Worst
Return
-2.8%
-2.3%
-1.9%
-1.6%
-1.4%
-1.5%
-1.4%
-1.3%
-1.0%
-1.4%
Avg
Loss
11.9%
11.3%
10.7%
10.0%
9.4%
8.7%
8.0%
7.3%
6.6%
5.8%
Avg
Return
12.9%
12.1%
11.4%
10.6%
9.8%
9.0%
8.3%
7.7%
7.3%
7.4%
Avg
Gain
30.6%
29.5%
28.3%
27.1%
26.1%
25.3%
24.8%
24.0%
23.4%
23.7%
Largest
Return
4.9%
4.7%
4.4%
3.8%
2.9%
2.2%
2.2%
2.9%
7.1%
16.4%
%
Neg
95.1%
95.3%
95.6%
96.2%
97.1%
97.8%
97.8%
91.1%
92.9%
83.6%
%
Pos
10%
80%
10%
10%
70%
20%
10%
60%
30%
10%
50%
40%
10%
40%
50%
10%
30%
60%
10%
20%
70%
10%
10%
80%
10%
0%
90%
10%
90%
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Portfolio
Mix:
Three-Year Returns, 1950-1998
3DJH 82
Elizabeth W. Wells
were analyzed for each asset mix. This is to say, that for
any given asset mix and a one-year holding period, one
sample portfolio is constructed in January 1950, held for
one year, and the average annual return is calculated for
that holding period. A new sample portfolio is
constructed in February 1950, held for one year, and so
forth. For any given asset mix and a three-year holding
period, one sample portfolio is constructed in January
1950, held for three years, and the average annual return
is calculated for that holding period. A new portfolio is
constructed in February 1950 and held for three years,
and so forth.
Chart
Data Series
Time Period
Length of
Holding Period
Number of
Sample
Portfolios
1 Jan 1950-Sept 1998 1 Year 574
2 Jan 1950-Sept 1998 3 Year 550
3 Jan 1950-Sept 1998 5 Year 526
4 Jan 1950-Sept 1998 10 Year 466
This same type of analysis can be done, with
international asset classes, where a similar trend of
stocks outperforming bonds is evidenced using the
historical data (these charts are not included in this
publication, but are available from the investors Morgan
Stanley Dean Witter resource person). The international
analysis is limited, however, by the availability of
historical data that do not stretch back much beyond 15
years for international asset classes. For example, the
data for international bonds are available only for the
time period beginning in January 1985.
The limited historical returns available for the
international bond asset class restrict the number of
sample portfolios available to calculate the average
return for the time period under consideration. This
effect is a major caveat to historical return analyses
involving international asset classes, and is exaggerated
as the rolling investment period increases from one, to
two, to five years, as is shown in the domestic series of
charts.
Chart 3: U.S. Domestic Risk & Reward Five-Year Returns
(1)(2)(3)
-

-3.1%
-2.1%
-1.2%
-0.2%
-0.4%
-0.7%
-1.2%
-1.2%
-2.0%
-2.4%
11.6%
27.4%
11.0%
26.4%
10.4%
25.2%
9.8%
24.0%
9.2%
22.9%
8.6%
22.3%
7.9%
22.3%
7.9%
22.3%
6.5%
22.9%
5.8%
23.1%
18.4%
17.4%
16.4%
15.4%
14.4%
13.4%
12.3%
11.3%
10.2%
9.1%
Single
Year
Ending
9/98
10%
90%
0% -3.1%
-2.1%
-1.2%
-0.2%
-0.4%
-0.7%
-1.2%
-1.5%
-2.0%
-2.4%
Worst
Return
-1.4%
-0.8%
-0.7%
-0.1%
-0.2%
-0.5%
-0.7%
-0.6%
-0.7%
-0.8%
Avg
Loss
11.6%
11.0%
10.4%
9.8%
9.2%
8.6%
7.9%
7.2%
6.5%
5.8%
Avg
Return
11.8%
11.2%
10.6%
10.0%
9.3%
8.7%
8.0%
7.4%
6.8%
6.5%
Avg
Gain
27.4%
26.4%
25.2%
24.0%
22.9%
22.3%
22.3%
22.6%
22.9%
23.1%
Largest
Return
1.1%
1.0%
0.4%
0.4%
0.4%
0.4%
0.6%
1.3%
2.5%
7.2%
%
Neg
98.9%
99.0%
99.6%
99.6%
99.6%
99.6%
99.4%
98.7%
97.5%
92.8%
%
Pos
10%
80%
10%
10%
70%
20%
10%
60%
30%
10%
50%
40%
10%
40%
50%
10%
30%
60%
10%
20%
70%
10%
10%
80%
10%
0%
90%
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Portfolio
Mix:
Five-Year Returns, 1950-1998
3DJH 83
Elizabeth W. Wells
For example, the average return for a U.S. Domestic
portfolio described in Chart 1, with a holding period of
one year, is calculated using 574 sample portfolios. On
the other hand, the average return for a Global portfolio
with a holding period of one year is calculated using
only 145 sample portfolios, because the time period
extends from 1985 to 1998.
Investors can gain a good indication of the volatility of a
given asset mix by noting the range of returns
experienced for various holding periods. For example,
for the portfolio mix shown in the top line of Chart 1, for
one-year holding periods, the highest annual return was
55.0%, and the lowest annual return was -35.2%. This
can be contrasted with the portfolio mix shown in the top
line of Chart 3. For holding periods of 5 years, the
highest five-year annualized return was 27.4%, and the
lowest five-year annualized return was 3.1%. From a
comparison of these charts, the investor can infer that the
longer he or she holds a given asset mix, the narrower
the range of returns that will be experienced.
Chart 4: U.S. Domestic Risk & Reward Ten-Year Returns
(1)(2)(3)
1.1%
1.2%
1.3%
1.4%
1.6%
1.7%
1.7%
1.7%
1.4%
0.1%
10.9%
18.2%
10.5%
17.7%
10.0%
17.5%
9.4%
17.0%
8.9%
16.6%
8.3%
16.4%
7.8%
16.2%
7.1%
15.9%
6.5%
15.8%
5.9%
15.5%
16.1%
15.7%
15.2%
14.7%
14.2%
13.7%
13.1%
12.6%
12.0%
11.4%
Single
Year
Ending
9/98
10%
90%
0% 1.1%
1.2%
1.3%
1.4%
1.6%
1.7%
1.7%
1.7%
1.4%
0.1%
Worst
Return
10.9%
10.5%
10.0%
9.4%
8.9%
8.3%
7.8%
7.1%
6.5%
5.9%
Avg
Return
18.2%
17.7%
17.5%
17.0%
16.6%
16.4%
16.2%
15.9%
15.8%
15.5%
Largest
Return
10%
80%
10%
10%
70%
20%
10%
60%
30%
10%
50%
40%
10%
40%
50%
10%
30%
60%
10%
20%
70%
10%
10%
80%
10%
0%
90%
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Cash
Stocks
Bonds
Portfolio
Mix:
Ten-Year Returns, 1950-1998
Notes: (1) Rolling ten year returns using monthly data.
(3) U.S. Stocks: S&P 500 Total Return: Bonds: U.S. Long Term Government Total Return; Cash: U.S. 30 Day T-Bill Total Return.
3DJH 84
Internet-Based Investment Tools
Jennifer V. King
The growth of the internet has realized and surpassed
many early forecasters predictions, in the breadth of its
adoption, in average daily online usage, and in range of
functionality. According to Morgan Stanley Dean Witter
research analyst Mary Meeker, as of late 1998, it was
estimated that there were 82 million internet users, with
this total projected to grow to 400 million or more by the
year 2002.
To date, the internet has been viewed, first, as a research
tool, then, as a medium for advertising, and more recently,
as a channel for the purchase of goods and services. Many
of the investment-related services available on the internet
have been developed with a mass market in mind, but
High Net Worth investors should consider which of this
suite of functions has applicability to their needs.
The investment-related internet sites discussed here range
from research sources to online trading services, and are
depicted in the diagram on the accompanying page.
Research Sources
Investors can access a wide range of internet-based
resources to quickly obtain company-specific information.
Among such sources are: (i) the SEC, for 10-K, 10-Q, and
8-K reports; (ii) company-specific sites, for annual reports,
product information, and other corporate data; (iii) Wall
Street firms, for general information, and, for qualified
clients of a given firm, access to their client-link portal
which allows rapid access to current data, company global
research publications, and reports; (iv) investor chat
rooms, for investors shared comments, insights, and
internet access providers give-and-take about specific
companies outlooks and results; and (v) price quote
services, giving price data in a variety of formats and
delivery patterns.
On-line Trading
Since its inception a few years ago, on-line trading has
grown in popularity at a rapid pace. Most of the on-line
trading websites available today are reliable and fast.
However, as is the case with all websites on the internet,
some problems still exist, such as busy signals and lost or
slow connections. On-line trading allows an individual to
perform his or her own research and conduct trading
activities without the assistance of an investment
representative. Most on-line trading sites provide a full
range of products stocks, options, mutual funds, and
bonds, but some, such as www.treasurydirect.gov,
specialize in only one area. As with every activity in the
investment arena, trading on-line requires due diligence,
research, and caution before moving ahead.
Economic Forecasts, Financial Advice, and Market
Commentary
The internet is host to a whole range of sites that provide
economic forecasts and current data on various economic
indicators, such as the unemployment rate, the consumer
price index, and stock and bond prices. Financial advice is
also readily available on-line. Almost all of the financial
advice sites provide a disclaimer stating that they cannot
be held liable for any advice that results in a loss for the
investor. For a day-by-day, and in many cases, an intraday
account of market activity, there are several sites that
provide market commentary. These sites are set up by
companies or independent operators with varying degrees
of depth of coverage.
Investment Education
Investors can avail themselves of the fundamentals of an
on-line investment education from leading investment
management firms with websites, such as Fidelity
Investments and The Vanguard Group. Most of the
information provided on these firm-sponsored sites is
available exclusively to the companies paying customers,
and in some cases, a demonstration is provided for
potential customers.
Currently, a handful of websites provide portfolio
reporting and tax software free of charge. The software
can be downloaded from the website, provided that the
program is compatible with the investors PC operating
system. Among the portfolio tracking software packages
are: (i) MedVeds Quote Tracker (www.medved.net),
which can monitor an unlimited number of portfolios
displayed in a spreadsheet-like format; (ii) Alpha
Microsystems (www.alphaconnect.com), which sets up
portfolios with mutual funds, U.S. and Canadian stocks, as
well as fixed-income securities; and (iii) StockTick
(www.naconsulting.com), which contains several portfolio
analysis features.
Effective Use of Internet Investment Resources
Access to rapid and reliable connectivity is an important
element in maximizing the effectiveness of the internet as
an investment resource. A fast computer and a speedy
hookup either at work, at school, or in libraries, with a
high-speed, T-1 connection make a great deal of
difference not only in the amount of time expended, but in
the quality of the search.
When choosing between pay-per-use vs. fee-based
payment methods, paying for an investment research
vehicle or for an on-line trading service may be worth it,
depending on how much time is spent conducting research
3DJH 85
Internet-Based Investment Tools (cont.)
Jennifer V. King
or how often the investor plans to trade. It is often a good
idea to evaluate the trial plan if one is provided. One thing
to keep in mind is that if these types of expenses are
incurred to generate investment income, they may thus
be tax deductible. Investors should check with their own
tax counsel for specific tax advice in this and other
matters.
The criteria used to determine effective use of the
internet as an investment tool apply in varying fashion to
the four Selected Internet Investment Resource
categories displayed in the diagram below, but in general
terms, the criteria are:
Accessibility
Ease of use
Design and layout
Judicious mix of data, tools, and research
Overall cost
Regardless of the apparent extremes of overvaluation
(and the eventual more realistic valuations) that internet-
related stocks have engendered for investors, the worth
of internet-based tools should continue to grow in the
period ahead.
Sources of Regular Reviews of Websites
In order to keep up with the ever-increasing number of
available on-line investment resources, investors can find
website reviews in the following publications, among
others:
Barrons
Review of On-line Brokers
(around mid-March each year)
Best Web Sites for Investors
(around late November each year)
Business Week
Your Money
Money
Worth
Fortune
SmartMoney
Wall Street Journal
Technology Supplement
(around early December each year)
On-line Trading Supplement
(around early September each year)
Selected Internet Investment Resources
Research Sources On-line Trading
Economics Forecasts
Financial Advice
Market Commentary
Investment Education
Regulatory Bodies
U.S. Securities and Exchange
Commission (www.sec.gov)
NASD Regulation Public Disclosure
Program
(www.nasdr.com/2000.htm)
New York Stock Exchange
(www.nyse.com)
Representative Company Sites
Berkshire Hathaway Inc.
(www.berkshirehathaway.com)
Coca-Cola
(www.thecoca-colacompany.com)
Disney (www.disney.go.com)
Representative Wall Street Firms
Morgan Stanley Dean Witter
(www.msdw.com)
Merrill Lynch (www.ml.com)
Goldman Sachs (www.gs.com)
JP Morgan (www.jpmorgan.com)
Citicorp (www.citicorp.com)
Salomon Smith Barney
(www.smithbarney.com)
Investor Chat Rooms
Talk City (www.talkcity.com)
Silicon Investor (www.techstock.com)
Gomez Advisors (www.gomez.com)
Price Quote Services
PC Quote (www.pcquote.com)
Data Broadcasting Corporation
(www.dbc.com)
Finance Online
(www.finance-online.com)
Invest-o-rama
(www.investorama.com)
Equities
Discover Brokerage Direct
(www.discoverbrokerage.com)
E*Trade (www.etrade.com)
Charles Schwab (www.schwab.com)
Waterhouse Securities
(www.waterhouse.com)
Datek Online (www.datek.com)
Fixed Income Securities
Treasury Direct
(www.treasurydirect.gov)
TradeWeb (www.tradeweb.com)
The Bond Market Association
(www.investinginbonds.com)
(www.bondmarkets.com)
Mutual Funds
New England Funds
(www.mutualfunds.com)
American Century
(www.americancentury.com)
Futures
Jack Carl Futures
(www.jackcarl.com)
Lind-Waldock (www.lindonline.com)
Timber Hill
(www.interactivebrokers.com)
Zap Futures (www.zapfutures.com)
Economic Forecast
Federal Reserve Board
(www.federalreserve.gov)
U.S. Department of Commerce
(www.doc.gov)
U.S. Department of Labor
(www.bls.gov)
Financial Advice
Kiplingers (www.kiplinger.com)
Quicken (www.quicken.com)
Interloan (www.interloan.com)
Armchair Millionaire
(www.armchairmillionaire.com)
Market Commentaries
The Street.com (www.thestreet.com)
CBS Market Watch
(www.marketwatch.com)
Microsoft Money Central
(www.moneycentral.com)
CNN Financial Network
(www.cnnfn.com)
Briefing.com (www.briefing.com)
CNBC (www.cnbc.com)
Investment Management Firms
Fidelity Investments
(www.fidelity.com)
The Vanguard Group
(www.vanguard.com)
T. Rowe Price (www.troweprice.com)
Franklin Resources, Inc.
(www.frk.com)
Independent Services
Hoovers Online (www.hoovers.com)
Bloomberg (www.bloomberg.com)
Investors Business Daily
(www.investors.com)
Morningstar (www.morningstar.net)
Moodys Investors Service
(www.moodys.com)
Dow Jones University
(http://dju.wsj.com)
Grants Interest Rate Observer
(www.grantspub.com)
Notes:
The sites shown here do not represent a complete list, but a partial
selection of sites considered to be useful; and
Some sites qualify under more than one rubric: e.g., Hoovers Online
could equally be listed under Research Sources, or under Investment
Education.
3DJH 86
The Family Office in the New Millennium
Stephanie A. Whittier
Over the past decade or so, the family office has become
a financial market participant whose role, while still
valuable, has not experienced the same growth and
consolidation as the other areas in the investing and
financial services arena and therefore lacks many of the
resources that it needs to be effective.
In Bill Gates recent book, Business @ The Speed of
Thought: Using a Digital Nervous System, Gates asserts
that the 1980s were about quality, the 1990s about
re-engineering, and the 2000s are about velocity. The
HNW investor should ask whether his or her family
office is equipped to handle the wealth generation to
keep pace with the velocity of the next 10 decades.
Overestimating the impact of the next two years and
underestimating the impact of the next 20 years can
have a significant impact on financial and estate
planning goals.
As CEO of the familys financial resources, the HNW
investors strategy should be to develop the right vision and
get the right people to execute it. Set forth below are some
ideas and insights gained from extensive exposure to and
involvement with the family office decision process.
Critical Success Factors Affecting the Family Office
in the New Millennium
1. Integrity, intelligence, and effectiveness in execution
with a bias toward preservation of capital and risk
management.
2. Superior quality investment insight, access to
service, and highly tailored solutions to complex
financial, tax, and legal issues.
3. Reporting capabilities and technology that can
deliver information that is immediate, constant (real
time), accurate, and understandable.
4. The ability to share knowledge about a wide variety
of top-quality investment managers.
5. Procedures for controlling excessive paperwork and
preserving the orderliness of custodied assets.
6. Demonstrated initiative in making specific
recommendations in anticipation of and/or in
response to market conditions.
7. The simplification of the HNW investors financial
life.
Traditionally, the family office was thought of as a
formal organization for creating, managing, and
preserving the substantial wealth of old-line families.
Faced with the prospect of once-vast fortunes
dissipating, descendants of the DuPonts, Vanderbilts,
Rockefellers, and others used the family office as a
means to preserve and manage their collective wealth.
Today, the expense of a full-service single-family office
can be considerable. The family office may not wish to
dedicate or have the resources to properly counsel,
diversify, custody, and report on all assets efficiently
enough to justify the costs of doing so.
Morgan Stanley Dean Witters Wealth Management
Service, and similar services at a small number of other
firms evolved out of the need for a cost-effective way to
provide the High Net Worth investor with services that
were traditionally offered through the family office, and
were cost-effective only for the super-rich.
Family Office Decision Considerations
Lifestyle
Decisions
Investment
Universe
Tailored
Family
Office
Structure
Family Office
Investment Process
Full-Time Investing
Family Office
Services
Part-Time Investing
Other Business Interests
U.S. Only
Global
Non-U.S. Only
External Generalist
External Asset Class Specialists
Internal Generalist
External Asset Class Specialists
Internal Generalist
Internal Asset Class Specialists
Full Service
Hybrid
Specific Services
l Investment
Experience
l Financial Markets
Interest
l Additional Business
Interests
Decision Making Considerations
l Existing Asset
Base
l Investment
Objectives
l Diversification
l Asset
Correlations
l Risk Management
l Asset Class Preferences
l Implementation Preferences
l Assets Under Management
l Proximity
l Staffing
l Family Size and
Complexity
l Financial Service
Needs
l Cost Constraints
l Generational
Issues
3DJH 87
The Family Office in the New Millennium (cont.)
By providing objective strategic asset allocation, tax and
estate planning, outside investment manager evaluation
and selection, performance reporting, tax tracking and
custody, a wealth management service-type product can
function as, and/or augment, the financial arm of the
family office, allowing the family office to do what it does
best: concentrate on developing a multigenerational wealth
blueprint. A wealth management service is designed to
interact with and complement other service providers. The
accompanying Universe Comparison Chart shows the
range and intensity of functions provided by various levels
of a family office, and demonstrates how these services
can provide a high level of consistency and focus in asset
management, custody, and reporting, and complement
other important service providers, such as the familys
own estate attorney and CPA.
Fortunes can be made or lost overnight. There is no uni-
form philosophy or style for family wealth management.
The process can be micro-managed, or the decision-
making process can be delegated across the lines of
strategic planning, accounting, tax, investments, and
philanthropic giving. It is important to set goals, run the
family office as a business, establish succession planning
early on, and remain objective. Significant analysis and a
thorough, professional approach to wealth transference
will reduce the probability of asset erosion due to
erroneous or haphazard planning.
It is important to take strategic risks, yet operate with a
certain amount of conservatism. The family office must
keep its eye on this process if it hopes to preserve, grow
and apply wealth for the benefit of the family.
Family Office Universe Comparison
Intensity of Service Provided

Not
Provided
Low Medium High
Full-Service
Family Office
Limited Family
Office w/ Outside
Consultant
Limited Family
Office w/ MSDW As
Wealth Manager
No Family Office
w/ MSDW As
Wealth Manager
Family Office Functions
Asset Management
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Asset Allocation
External Manager Selection and Monitoring
Restricted Stock Transactions
Risk/Liability Management
Investment Policy Formulation
Custody & Reporting
Custody of Assets
Financial Asset Servicing
Performance Analysis
Return Attribution
Quarterly Summary Reports
Cash Management
Liquidity Management
Foreign Exchange
Wire Transfers
Personal Financial Services
Trust and Estate Planning
Tax Preparation
Collateralized Loans
Education
Philanthropic Advice
3DJH 88
Evaluating Alternative Investments
John W. James, Jr.
We think a High Net Worth investor can gain the
opportunity to improve the performance of his or her
investment portfolio through the judicious use of
alternative investments, an asset class that includes
private equity and venture capital, hedge funds, real
estate, and commodities. This asset class is generally
characterized by (i) a relatively high degree of
heterogeneity among its subcomponents; (ii) a relatively
low correlation with standard stock and bond market
benchmarks; (iii) the potential for comparatively high
returns, relative to conventional stock and bond
investments; and (iv) patterns of significant volatility of
returns on or outright loss of capital in an
investment. With these considerations in mind, and a
careful assessment of the investors own risk tolerance, a
portfolio can be constructed with a strategic allocation to
appropriate alternative investments that can potentially
augment returns and diversify risk across a variety of
market environments.
We believe the low correlation between many alternative
investments and more traditional investments makes
such an exposure attractive as a balancing device within
the investors overall asset allocation. In challenging
market conditions, in which conventional asset classes
may suffer, alternative investments may provide
significant diversification, thereby improving the
portfolios overall performance. The accompanying table
demonstrates the degree of low or inverse correlation
from 1980 through 1998, for one-year holding periods,
between: (i) the S&P 500 stock and 30- year U.S.
Treasury bond benchmarks, and (ii) representative
Correlations Among Asset Classes: Jan 1980Dec 1998
S&P
500
U.S.
30-Yr.
Bond Commodities
Hedge
Fund
Fund of
Funds
Real
Estate
Private
Equity
Funds
S&P 500 1.00
U.S. 30-Yr. Bond 0.31 1.00
Commodities
1
-0.19 -0.14 1.00
Hedge Fund
Fund of Funds
2
-0.03 0.18 0.09 1.00
Real Estate
3
0.62 0.36 -0.06 -0.03 1.00
Private Equity
Funds
4
0.30 -0.16 -0.07 -0.17 0.31 1.00
Source: Ibbotson Associates.
1
Goldman Sachs Commodities Index.
2
Managed Account Reports (MAR) Fund/Pool Total Return Index.
3
NAREIT Total Return Index.
4
Venture Economics Private Equity Index.
Note: Quarterly data and one-year holding periods used for all series.
alternative investments. Studies have shown that even a
modest allocation to an alternative asset class of low
correlation to the rest of a portfolio can effectively
enhance and protect performance
.1
A variety of quantitative and qualitative considerations
should be taken into account when determining the
allocation of funds to alternative investments. The
accompanying list of criteria can be used to evaluate a
wide range of alternative investments. Primary among
these considerations is the investors degree of comfort
with increased levels of volatility and restricted access to
his or her funds for extended periods of time. In addition,
each major type of alternative investment presents its
own specific areas for analysis.
Criteria for Alternative Investment Evaluation
1. Proficiency, experience, and adaptability of
investment managers.
2. Terms of investment: lock-up, liquidity, and
withdrawal considerations.
3. Degree of volatility and uncertainty of returns.
4. Use of leverage: amounts, terms, and risk control
mechanisms.
5. Form and timing of payment of gains and return
of capital.
6. Treatment of losses, including potential
obligations related to failed investments or
insolvent partners.
7. Availability of audited statements of performance.
8. Fee structure and compensation of managers.
9. Participation of managers in the underlying
investment vehicle.
10. Monitoring of investments by managers through
board representation and other means.
The following paragraphs highlight a few of what we
feel are the important considerations to assess when
making an investment in four of the principal classes of
alternative investments.

1
Are Hedge Funds Worth the Risk? by Leah Modigliani, Morgan
Stanley Dean Witter U.S. Investment Perspectives, December 3, 1997.
3DJH 89
Evaluating Alternative Investments (cont.)
John W. James, Jr.
Private Equity/Venture Capital
Through the vehicles of private equity and venture
capital funds, High Net Worth investors can access
specialized investment opportunities not readily
available to most investors. Over time, these types of
investments can result in significant gains, as ones
partial ownership in a growing business increases in
value, but such investments can also involve substantial
risks that an investor must evaluate carefully.
To begin, a High Net Worth investor must be prepared
for his or her allocation to such an investment to remain
illiquid for the intermediate to long term. Private equity
and venture capital funds typically require that the
invested capital remain in the partnership for a minimum
of three years, sometimes significantly longer. In
addition, during this extended time period, such an
investment may experience a much greater degree of
volatility and uncertainty of performance than exhibited
by more traditional investment classes. Often, the
performance of a venture capital investment is not
measurable with any high degree of certainty for a period
of years.
While such illiquidity might dissuade some investors, for
those able to accommodate the risks, there can be
additional long-term rewards. Investing in non-efficient
markets, where information is scarce and where specific
business expertise is essential, can work to a High Net
Worth investors benefit and augment investment
returns. David J. Swenson, the Chief Investment Officer
for the endowment of Yale University since 1985, has
regularly sought investment opportunities in less
efficient markets. Mr. Swenson has noted that, in recent
years, there has been a much greater differential between
the 25th and 75th percentile performance in illiquid
investments than in traditional ones, suggesting that one
can produce incrementally better returns in alternative
investments through the careful selection of better
managers.
2
Therefore, the evaluation of the experience
and abilities of a private equity or venture capital fund
manager becomes one of the most important criteria in
selecting an investment fund.
Consider the role of the managers of a private equity or
venture capital fund. As the investment-selection body

2
Harvard Business School case study: Yale University Investments
Office, Harvard Business School Publishing, Boston, 1995, p.4.
of the fund, these managers utilize the full measure of
their experience to rigorously evaluate private equity and
venture opportunities by identifying the potential and
risks of specialized business investments.
The business risks facing a fledgling company in which
the fund might invest often range from the expected
such as the company struggling to retain its competitive
advantage in an evolving business environment, and/or
effective management of the companys growth to the
unexpected such as the resignation of key company
personnel or unanticipated litigation. It follows from this
high degree of uncertainty that one of the most important
considerations a venture capital fund manager seeks in
making an investment in a company, independent of the
details of the particular venture, would be the reliability,
leadership, and proven adaptability of the investee
companys management team.
A venture capital fund managers own experience in
successfully managing a business can prove invaluable
by enhancing his or her ability both to select promising
businesses for the funds portfolio and to provide
effective management guidance on portfolio companies
boards. Accordingly, a High Net Worth investors
selection of a private equity or venture capital fund
should consider the fund managements ability to
identify and resolve management and operational
challenges facing its portfolios businesses and to
contribute to the strategic development of the funds
portfolio companies.
In all cases, the investor should be fairly certain that his
or her investment interests can be defended in virtually
all scenarios. He or she should understand in detail the
mechanics governing the distribution of profits from
successful investments and the precautions taken to
protect his or her investment in the event of worst-case
scenarios. The investor should ascertain whether he or
she could face drawdown or follow-on obligations in the
case of a failed investment or the default of another
partner in the fund. Ultimately, the investor should be
satisfied with the degree of the funds contingency
planning and the establishment of prudent exit strategies,
where feasible.
One indication that an investment would receive
premium attention from the funds managers is the
management teams own substantial investment in the
fund. A High Net Worth investor should look for this
3DJH 90
John W. James, Jr.
level of commitment and involvement from private
equity and venture capital fund managers.
Real Estate
We believe investing in real estate, either through a fund
of private investments or through the purchase of REITs,
can augment portfolio performance through generally
less-correlated investments, effectively reducing the risk
of an investors portfolio to fluctuations in the broader
markets. This diversification benefit, however, may
come at the cost of liquidity and the assumption of
different types of risk indigenous to the real estate
business. Among the important considerations when
investing in a real estate fund is the selection of effective
managers, both for their investment management
experience and their proximity to deal flow, which
should facilitate the identification of and successful
engagement in advantageous transactions.
While being in touch with sources of new real estate
opportunities is essential, we believe it is the experience
and proficiency of the managers that determine the
funds ability to make productive use of its resources and
relationships to secure auspicious investments. An
investor should understand the investment selection
process in detail, the level of the managers participation
in structuring or investing in recent deals, and be
confident that the management of the fund is in a
position to command a leadership role in pursuing future
investments.
Investors in real estate must be prepared to accept the
reduced liquidity and increased length of time that an
investment in this asset class requires. In most cases,
REITs offer greater liquidity than a direct investment
fund, but both investment approaches require planning
for the intermediate to longer term.
A real estate funds list of previously completed deals,
and their performance, can give an indication of the
funds success in the transactions with which it has been
involved, and what capacity its involvement has
assumed. For example, a fund which has regularly and
successfully been the majority holder or managing
partner in its investments may generally be considered to
have evidenced a leadership role.
An investor should have a thorough understanding of
exit strategies and any obligations in the event of a failed
investment or a catastrophic loss. In addition, he or she
should be comfortable with the use of leverage, if any, in
the fund. Understanding the compensation structure
would also be important for a real estate fund, especially
where compensation based on appraised portfolio values
could present a conflict of interest. As with private
equity and venture capital investments, managers
participation in the real estate investment vehicle is an
important indication of alignment with the interests of
outside investors, in our view.
Hedge Fund Fund of Funds
High Net Worth investors have sought out hedge funds
to provide low correlation to the rest of a portfolio, with
the goal of providing positive returns regardless of
overall market direction. Hedge funds have for many
years been associated with large returns, and
occasionally, magnified losses. As a result of well-
publicized negative performance during all or part of
1998 by some hedge funds, investors have become
significantly more discerning in their approach to hedge
fund investments. We found that one way to control risk
in making hedge fund investments is through a hedge
fund fund of funds, a structure which itself invests in
several hedge funds, thus diversifying exposure to any
one hedge funds fortunes.
As with the private equity and real estate asset classes,
the success of a strategy in the hedge fund fund of funds
asset class would depend heavily on the experience of
the manager. An investor should determine the relevance
of the managers investment experience within the stated
investment discipline(s), the strength of his or her track
record, and the clarity of his or her philosophy as a
hedge fund strategist and investment manager. Also
valuable in making a full assessment is a list of recent
investments by the fund, their performance results, and
an indication of the other types of investors in the fund.
While hedge funds have traditionally been known to be
very protective of their performance data, in recent years,
hedge funds have placed an increased emphasis on
transparency of strategies and performance
measurement. Investors should take advantage of this
higher degree of disclosure to understand more clearly
how individual funds strategies work. The recent
compilation of 1998 hedge funds, and hedge fund fund
of funds, performance in Barrons shows a significant
difference in range of performance between hedge funds
3DJH 91
John W. James, Jr.
and hedge fund fund of funds.
3
Among hedge funds, the
average performance of the 10 best-performing funds in
1998 was +120.1%, while the 10 worst-performing funds
lost an average of 56.9%. Such a wide range of
performance among hedge funds argues for
diversification among hedge funds, thereby limiting
exposure to any single funds strategy. Among hedge
fund fund of funds, the average performance of the top
and bottom 10 funds in 1998 was +21.4% and 25.1%, a
much narrower range.
The wide variance of hedge funds performance
underscores the need for an investor to understand the
means by which a fund of funds manager constructs a
portfolio of hedge fund investments to perform
effectively as a diversified unit. In addition, an investor
should understand clearly the performance of the hedge
fund as expressed by its investment returns, the volatility
of the returns, and the correlation of the returns to
standard industry benchmarks. In evaluating the
diversification strategies and interpreting the
performance metrics of a hedge fund fund of funds, the
expert advice of a qualified fund evaluator may be
useful.
An investor should clearly understand the procedures of
the hedge fund fund of funds for capital withdrawal. He
or she should determine what level of liquidity to expect,
both in normal market conditions and in more distressed
market situations. It should be clear to what extent the
hedge fund fund of funds is constrained by the liquidity
of individual funds in fulfilling withdrawal requests for
investors. An investor should understand the use of
leverage in the funds strategies and be knowledgeable
about what market circumstances might result in a
capital call or other financial obligation. Finally, an
investor should determine the fee structure for the hedge
fund fund of funds, making sure that the hedge fund fund
of funds fee is comprehensive and includes all
subordinate funds management fees.
Commodities
While commodity investments are often regarded as
volatile, this volatility is frequently amplified by the
associated use of leverage by many commodity
investors. An exposure to commodities can offer stability
to a portfolio in times when other financial markets
experience volatility. At the same time, commodities

3
Barrons, February 15, 1999.
sensitivities to a separate set of influences can work
against the investor in an otherwise positive financial
market environment, and commodity prices can shift
rapidly in the face of global political and economic
events.
As with the asset classes discussed earlier, the
experience of the managers managing a commodities
portfolio may provide the best indication of an
investments ability to execute a consistent and logical
investment discipline. An investor should ensure that the
manager has a qualifying amount of relevant background
experience in the commodities markets and in
investment management.
The investor should understand the degree of
diversification in the commodity fund and understand the
interplay and correlations between the various parts of
the portfolio. The investor should also investigate how
leverage and short-selling strategies may be applied to
enhance portfolio returns, and should understand the
extent of any potential magnification of losses due to the
use of these strategies in the event of unfavorable market
moves. The investor should also be aware of any
potential financial obligations which could arise in a
negative market environment. Finally, the investor
should confirm the dates and terms of the availability of
invested funds for withdrawal and the process by which
distributions on gains are paid.
Personal Investment Considerations
Once an investor has reviewed the merits of a potential
investment in an alternative investment class using the
guidelines discussed above, it is important for the
investor to consider the investment in the context of his
or her broader investment portfolio. After determining an
appropriate allocation, taking into account the investors
tolerance for volatility and illiquidity, the investor should
request and review a proposal for investment from a fund
under consideration. This information should include
audited performance data, statements of strategies and
investment disciplines, and the terms of investment.
Applying the evaluation criteria listed at the beginning of
this essay to the offering memorandum, and pursuing the
other relevant analyses in each of the alternative asset
class subcategories described above, should help a
potential investor in alternative assets in making better-
informed investment decisions.
3DJH 92
Equities: International Investing
Marianne L. Hay
In our view, there are two principal reasons to consider
international investing:
Enhancing Returns
Reduction of Portfolio Volatility
Both can be achieved by adding international equities to
a domestic equity portfolio. Of course, international
investing does require the additional consideration of
what to do about currency risk. Holding assets in foreign
currencies is an important risk factor that can
considerably enhance, reduce, or even negate any
benefits of international equity exposure.
Enhancing Returns
Asset Allocation (in short, owning the right country at
the right time) can have a significant impact on
performance. Exhibit 1 shows the best and worst country
performers in the MSCI World Index (MSCI World)
since 1980.
No country persistently comes out on top, although Hong
Kong, with four entries, and Finland, with three, both
appear regularly among the best performers (Nokia is
principally responsible for Finlands performance in the
last two years). Similarly, no one country dominates as
the worst performing market. It is interesting to note that
the U.S., which has dominated major market returns in
the 1990s with an annual average performance of 18.2%,
does not appear once as the top performing market.
Similarly, Japan, which dominated returns in the 1980s
with an annual average return of 28.7% between 1980
and 1989, only appears once (1987) as the top
performing market. Both the U.S. and Japan examples
illustrate the same core conclusion on global asset
allocation: that meaningful long term changes in an
economy or sector are the real decision factors in
investment performance. An insight into such factors is
what leads to steady, consistent performance and
more importantly, can help avoid protracted losses such
as in the case of Japan.
Exhibit 2 consists of the annual percentage change in the
major world markets over the last 20 years NASDAQ
is shown as a proxy for technology. Note how Japan was
a consistent outperformer prior to 1990, but just as
consistent an underperformer after 1990. This illustrates
how at the end of the 1980s, investors in Japan had a
difficult but crucial choice to make. Japan had
appreciated 28.7% per annum. There were strong signals
that the stock market was overvalued and had been for
some years. Japan was 46% of total world market
capitalization (Exhibit 3), and the opportunity cost of
underweighting the market could be high given its stellar
performance in preceding years.
Exhibit 1: MSCI World Country Best and Worst Performers Since 1980
-100%
-75%
-50%
-25%
0%
25%
50%
75%
100%
125%
150%
175%
200%
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
Italy
Belgium
Sweden
France
HK
Sweden
Norway
Spain
Denmark
HK
Austria
Singapore
Spain
Japan
Germany
Belgium
Portugal
Finland
Austria
UK
HK
HK
NZ
Finland
Denmark
USA
HK
Finland
Switzerland
Spain
Portugal
Finland
Finland
HK
Austria
Japan
Malaysia
Norway
Belgium
BEST
WORST
Source: Datastream, MSCI data.
3DJH 93
Equities: International Investing (cont.)
Marianne L. Hay
Exhibit 2: Stock Market & NASDAQ Returns 1980 to 1999
MSCI Return 19801989
1
12/31/80 1981 1982 1983 1984 1985 1986 1987 1988 1989
Japan 30.3% 15.9% -0.5% 24.9% 17.1% 43.4% 99.7% 43.2% 35.5% 1.8%
Europe 14.5% -10.4% 5.7% 22.4% 1.3% 79.8% 44.5% 4.1% 16.4% 29.1%
USA 30.0% -4.1% 22.1% 22.0% 6.0% 32.8% 17.5% 3.9% 15.9% 31.4%
NASDAQ Composite
2
33.9% -3.2% 18.7% 19.9% -11.2% 31.4% 7.4% -5.3% 15.4% 19.3%
MSCI Return 19901999
1
1990 1991 1992 1993 1994 1995 1996 1997 1998 12/31/99
Japan -36.0% 9.1% -21.3% 25.7% 21.6% 0.9% -15.4% -23.5% 5.2% 61.8%
Europe -3.4% 13.7% -4.2% 29.8% 2.7% 22.1% 21.6% 24.2% 28.9% 16.2%
USA -2.1% 31.3% 7.4% 10.1% 2.0% 38.2% 24.1% 34.1% 30.7% 22.4%
NASDAQ Composite
2
-17.8% 56.8% 15.5% 14.7% -3.2% 39.9% 22.7% 21.6% 39.6% 85.6%
Note: Boxed returns indicate best performance.
1
All returns are annual Total Returns in USD.
2
NASDAQ is proxy for technology. Returns are Price Index returns.
Source: Datastream, MSCI Data.
Exhibit 3: World Stock Market Capitalization
Japan
46%
Other
9%
U.S.
26%
Europe
19%
Japan
21%
Other
10%
U.S.
49%
Europe
20%
1989 1999
1979
Total Value: US$1.1 Trillion
Total Value: US$8.1 Trillion Total Value: US$31 Trillion
Europe
27%
U.S.
44%
Other
14%
Japan
15%
Source: Datastream.
No individual sector or country dominates performance
indefinitely, however, and Japan performed poorly in the
1990s beginning with a fall of 36% in 1990. It took
considerable insight and courage to leave the market, and
most investors were fully invested in Japan when the
market corrected.
Generally speaking, in the 1970s, a European investor
would have benefited from investing in Japan but not in
the U.S., while a U.S.- based investor would have done
well to invest outside the U.S. In the 1990s, global
investors would have enhanced returns by investing in
the U.S. The changing structure of U.S. industry through
rationalization and M&A activity, the investment by
U.S. companies into faster-growing overseas
marketplaces, as well as the rise of technology, have led
to persistently high returns from the U.S. in the 1990s.
In allocating assets internationally, there is no one factor
which can be identified as marking a turning point in
either a positive or a negative direction. In our asset
allocation process, we look at a range of factors,
including:
Within the Global Environment
Inflation
Economic growth
Currency trends
The chances of contagion as investors move toward
or away from a region/country or asset class, for
example, as they did in the emerging market crisis of
the late 1990s.
3DJH 94
Marianne L. Hay
Global liquidity
Global competitiveness as it applies to specific
industries
Within an Individual Country
The outlook for interest rates and inflation
The outlook for corporate profits
Political and social factors
The long-term supply of, and the demand for
equities. For example, we expect the equification of
Europe to continue in the next decade and act as a
positive on the performance of equities
Valuation also plays an important role. Factors
considered here are current and projected price to
earnings, price to cash flow and price to book value,
together with their historic ranges. Cheap companies or
markets do not necessarily go up, or overvalued
countries or markets do not necessarily go down when
expected. There must be other changes in fundamentals
to improve or reduce investor confidence.
Reduction of Portfolio Volatility
While it is desirable to maximize return by investing
globally, the risk involved must also be considered. Perhaps
the best risk definition is the chance of the portfolio return
falling short of an investors requirement due to an adverse
move in the asset class in which it is invested. Risk is
commonly measured by the standard deviation of returns.
The higher the percentage standard deviation, the wider the
range of possible returns one can expect. A low-risk asset,
such as a Treasury bill, will have a small standard
deviation. A more volatile higher risk asset, such as an
emerging market equity, will have a large standard
deviation.
Between 1990 and 1999, Europe produced an average
return of 14.5% per annum with a standard deviation of
14.8% (Exhibit 4). During the period, the majority of
returns from European equities, therefore, fell in the
range of 0.3% to 29.3%. Europe produced lower returns
than the S&P 500 over the period and had a higher risk
profile.
Thus, it is obvious that a European investor would have
done well to invest globally. However, thanks to the
effect of diversification (different risks in different
markets partly canceling each other out), even the case
for a U.S. investor investing internationally is a viable
one.
To come to a more quantitative conclusion, by plotting a
chart of risk and return numbers over the last 30 years,
from a U.S. investors standpoint (Exhibit 5), a 40%
combination of EAFE with 60% S&P exposure would
have produced a return of 13.3% and reduced the risk by
154 basis points. This seems a worthwhile reduction in
risk for only an 8 basis points reduction in performance
per annum.
Exhibit 4: Global Equity Performance Total Return Index in US Dollars: 1970 1999
1
S&P 500 Europe Japan EAFE Pacific ex Japan
Return (%)
2
19701979 5.0% 8.6% 17.4% 10.1% 9.4%
19801989 17.6% 18.5% 28.7% 22.8% 12.9%
19901999 18.2% 14.5% -0.7% 7.3% 10.0%
19701999 13.4% 13.8% 14.5% 13.2% 10.7%
Risk (%)
3
19701979 16.0% 17.0% 19.7% 15.7% 27.3%
19801989 16.4% 18.0% 22.1% 17.4% 25.7%
19901999 13.4% 14.8% 25.9% 17.1% 21.6%
19701999 15.4% 16.6% 22.9% 16.8% 24.9%
Note: Boxed returns are referred to in text.
1
Period ending December 31, 1999. MSCI USA is used as a proxy for S&P 500 data before 1979.
2
Returns are annualized USD Total Returns over the period.
3
Risk is defined as annualized standard deviation.
Source: MSCI data.
3DJH 95
Marianne L. Hay
Exhibit 5: International Diversification for U.S.
Investors Portfolio of S&P 500 and EAFE
1
from 19701999, Risk-Reward Trade-Off
13.1%
13.2%
13.3%
13.4%
13% 14% 15% 16% 17%
% Risk
%

R
e
t
u
r
n
S&P 500
EAFE
40%
EAFE
Return Risk
S&P 500 13.40% 15.4%
EAFE 13.20% 16.8%
Correlation 50%
1
EAFE: Europe, Australasia and the Far East.
Note: Priced as of December 31, 1999. MSCI USA is used as a proxy
for S&P 500 data before 1979. Returns are annualized USD Total
Returns over the period. Risk is defined as annualized standard
deviation.
Source: MSCI.
For European-based investors, international diversi-
fication also makes sense from a risk standpoint
(Exhibit 6). The optimal allocation was 40%
international (World ex-Europe) and 60% domestic.
This allocation returned 10.6% per annum compared to
11.1% from a pure European portfolio, but reduced risk
by 71 basis points.
Our Current Risk/Return Outlook
Carrying out the same exercise using our projected
returns for different stock markets, we can evaluate the
risk/return trade-off for different country allocations.
This analysis leads us to a current geographic
allocation for equities in an international portfolio as
shown in Exhibit 7. We are currently positive on the
outlook for Europe because of the economic recovery,
the likely continuance of M&A activity, and the best
earnings growth outlook in a long time. In addition, we
favor Japan where we see restructuring continuing and
domestic Japanese investors investing some of their
high level of savings in the stock market as returns in
their traditional investments Post Office Savings
Accounts and bonds seem poor. Emerging markets
are recovering and are in the best shape (in inflation
terms) in decades, in our view.
Exhibit 6: International Diversification for European
Investors Portfolio of Europe and World ex-
Europe from 19701999, Risk-Reward Trade-Off
9.8%
10.0%
10.2%
10.4%
10.6%
10.8%
11.0%
11.2%
15.0% 15.5% 16.0% 16.5% 17.0% 17.5%
% Risk
Return Risk
Europe 11.1% 16.1%
World ex-Europe 9.9% 17.3%
Correlation 71.6%
%

R
e
t
u
r
n
Europe
60% Europe
World Ex Europe
Note: Priced as of December 31, 1999. Returns are annualized EUR
Total Returns over the period. Risk is defined as annualized
standard deviation.
Source: MSCI.
Exhibit 7: International Investor Equity Allocation
January 11, 1999
Current
Allocation Benchmark
1
USA 40% 49%
Europe 33% 30%
Japan 17% 13%
Asia 2% 3%
Emerging Markets 8% 5%
Global Equities 100% 100%
1
95% MSCI World Index and 5% MSCI Emerging Market Free Index
(EMF).
Source: MSCI.
The country decision is an important part of asset
allocation, but the question of sector should also be
considered. Until two years ago, the average
correlation of countries and sectors (Exhibit 8) tracked
each other. Over the last 12 months, global sectors
have become less correlated, implying an increasing
role for sector selection in diversification (Exhibit 9).
3DJH 96
Marianne L. Hay
Exhibit 8: Global Country versus Sector Correlation
C
o
u
n
t
r
y

C
o
r
r
e
l
a
t
i
o
n
0.2
0.3
0.4
0.5
0.6
Aug 90 Jun 92 Apr 94 Feb 96 Dec 97 Oct 99
Country
Sector
0.45
0.50
0.55
0.60
0.65
0.70
S
e
c
t
o
r

C
o
r
r
e
l
a
t
i
o
n
Data as of November 30, 1999.
Source: Morgan Stanley Dean Witter Quantitative Research.
Exhibit 9: Global Sector Performance (U.S. Dollar)
50
100
150
200
250
Jan-96 Apr-96 Aug-96 Nov-96 Mar-97 Jul-97 Oct-97 Feb-98 May-98 Sep-98 Jan-99 Apr-99 Aug-99 Dec-99
Capital Equipment
Services
Consumer Goods
Energy
Finance
Materials
Source: Morgan Stanley Dean Witter Emerging Markets Equity
Research.
Currency
The worlds financial markets are huge. Global equities
and fixed income securities issued total approximately
$50 trillion today. However, as large as the securities
markets are, they are dwarfed by the size of the foreign
exchange market. Global foreign exchange trades are
estimated at more than $1.4 trillion per day.
Unfortunately for the investor, no one can forecast
currency movements with any degree of reliability, so
this prompts the question, does it make sense to hedge
currency exposure? The answer is not clear despite
the masses of academic research that has been done on
the subject.
We have compared the investment returns with and
without hedging currency risks for investors investing
outside their home markets in the U.S., Europe, and
Japan over a 30-year time span (Exhibit 10). A U.S.
investor would have done best not hedging his
international exposure, but both European and Japanese
investors would have been wise to hedge. (No account
was taken of the hedging costs which have to be
considered in a real investment portfolio.)
Exhibit 10: Impact of Hedging Since 1969
1
0
200
400
600
800
1000
1200
1400
1600
1800
1969 1973 1977 1981 1985 1989 1993 1997
World Ex U.S. Hedged
World Ex U.S. Unhedged in USD
U.S. Investor Point of View
0
200
400
600
800
1000
1200
1969 1973 1977 1981 1985 1989 1993 1997
World Ex Europe Hedged
World Ex Europe Unhedged in EUR
European Investor Point of View
0
200
400
600
800
1000
1200
1400
1600
1969 1973 1977 1981 1985 1989 1993 1997
World Ex Japan Hedged
World Ex Japan Unhedged in JPY
Japanese Investor Point of View
1
Last data is December 31, 1999. All returns are annualized Price Index returns over the period. The hedged index is the index in Local Currency; and
therefore the equivalent of theoretical hedging (if hedging were cost-free). The unhedged index is the index in the currency of the investor, therefore, and
benefiting from a strengthening of the currency.
Source: Datastream.
3DJH 97
Marianne L. Hay
Exhibit 11: Portfolio Risk Levels, Varying Combinations of Global vs. Domestic Equity
12%
13%
14%
15%
16%
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
European Investors Perspective
15%
16%
17%
18%
19%
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
Allocation to Foreign (Non-European) Markets
Risk (st.dev)
for European Investor
U.S. Investors Perspective
Allocation to Foreign (Non-U.S.) Markets
Risk (st.dev)
for U.S. Investor
ZONE OF INDIFFERENCE: NO
SIGNIFICANT EXTRA RISK IN
HAVING UP TO 50% OF
EQUITIES OUTSIDE DOMESTIC MARKET
ZONE OF INDIFFERENCE: NO
SIGNIFICANT EXTRA RISK IN
HAVING BETWEEN 20% AND 70% OF
EQUITIES OUTSIDE DOMESTIC MARKET
Charts show the volatility of varying combinations of the MSCI Europe and the MSCI World as Europe, as measured in DM over the past 15 years, and of
the MSCI USA and MSCI World ex USA as measured in dollars over the past 18 years.
Source: Datastream, Morgan Stanley Dean Witter Research, MSCI.
Given the inconclusive evidence from practice and
academia, our stance on hedging is that the decision to
hedge or not is part of the asset allocation process, but at
the outset of an investment program, the investor and his
or her asset manager should consider whether they would
be more comfortable from a volatility aspect with their
non-domestic exposure hedged. In general terms, hedged
assets have a lower volatility, but this comes at a cost.
Conclusion
International investing can help to enhance returns and
reduce risk. European and U.S. investors can diversify
outside their domestic markets over a wide range of
international exposures without altering the risk profile
(Exhibit 11).
In other words, the international investor should be able
to freely choose which portfolio mix within a range will
deliver the highest expected return, with diminished
concern about markedly increasing portfolio risk. This
clearly shows the opportunity for asset allocation
strategies.
Oscar Vermeulen and Stephane Macresy contributed
exhibits and comments to this article.
3DJH 98
Traditional Commodities: Portfolio Diversification Benefits
Jeffrey S. Alvino
Background
The portfolio management process seeks to identify the
optimal portfolio for an investor. Nobel Prize winners
Markowitz and Sharpe popularized the idea that
investors seek to obtain the highest achievable return
while attempting to minimize the risk of loss. The locus
of portfolios representing the maximum expected return
for each level of risk defines the Markowitz Efficient
Frontier in the mean-variance plane. Investors would
therefore select the asset allocations that lie on the
efficient frontier at the point of tangency with the
return/risk trade-off ratio that maximizes their utility
(satisfaction). Asset class alternatives are generally
evaluated on the basis of their expected return, risk, and
correlation to other assets within the portfolio mix.
While there is rarely a shortage of investment
opportunities available to investors that seek to provide
an attractive risk/return profile, combining assets whose
returns are highly correlated would not improve the
risk/return ratio.
Commodities as an Asset Class
Traditional commodities offer investors an opportunity
to participate in an asset class with a long-term historical
risk-and-return profile that is comparable to stocks and
bonds, but whose returns have been negatively correlated
with those of stocks and bonds. (Table 1)
Table 1: Comparative Risk and Return Profile
(1/1970 9/1999) Commodities
1
Stocks
2
Bonds
3
Annualized Return 9.08% 13.36% 9.28%
Annualized Risk 11.63% 15.39% 9.52%
Correlation w/Bonds (0.40) 0.51 1.00
Correlation w/Stocks (0.22) 1.00 0.51
1
Commodities: Bridge Commodity Research Bureau Index (CRB) Total
Return Index.
2
Stocks: Standard & Poors 500 Total Return Index.
3
Bonds: Salomon Brothers LT High Grade Corporate Bond Total Return
Index.
Sources: MSDW Commodities Research, Bloomberg Financial Markets.
As Chart 1 below shows, the effect of adding traditional
commodities to a portfolio of financial assets is to shift
the efficient frontier up and to the left.
Chart 1: Markowitz Efficient Frontier (Mean Variance)
1970 1999
Risk
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
Return
Stocks/Bonds/Commodities
Stocks/Bonds
Chart 1, above, illustrates the diversification benefits that
traditional commodities may offer a financial asset
portfolio. At virtually every level of acceptable risk
tolerance facing the stock and bond investor over the
past 30 years, a strategic allocation to traditional
commodities would have improved the return per unit of
risk. We see this improvement in risk diversification as
the result of the attractive correlation attributes that are
exhibited by the asset class. Proponents of traditional
commodities are not alone in their support of investment
opportunities that may improve diversification as a result
of a low degree of co-movement with other assets during
normal market environments. However, the relative
attractiveness of the various assets can diverge during
different market scenarios.
Diversification When You Need It
The classical analysis of behavioral decision-making is
based on the assumption that investors are risk averse;
that they expect to be compensated with added return for
taking on increasing amounts of risk. However, risk
defined by the standard deviation, as is typical in
Modern Portfolio Theory, assumes that investors are
unbiased regarding both positive and negative outcomes.
In fact, both recent behavioral decision research and
common sense suggest that investors may be more
accurately described as having an aversion to losses
(loss aversion). Therefore, it may be more appropriate
3DJH 99
Traditional Commodities: Portfolio Diversification Benefits (cont.)
Jeffrey S. Alvino
to judge an investment opportunity on its ability to
provide diversification benefits during various market
phases and during difficult market events when
investment security is needed most. The following
excerpts from journal articles illuminate this concept.
Correlations between markets, during market
events, increase dramatically during those times
when major market dislocations occur. For
example, the correlations between emerging and
developed markets increased substantially during
the Asian market collapse in 1998; the correlation
between the U.S. junk bond market and the treasury
bond market actually changed its sign during the
1987 U.S. stock market crash.
1
When it really matters, diversification does not
work. It is bad enough that correlations are
unpredictable during major market events.
Compounding this is that large market moves are
contagious. A dislocation in one market does not
leave the other markets untouched; the correlation
between markets is compounded by an increase in
volatility across markets. The direct implication of
the tendency for correlations between markets to
increase during times of crisis is that diversification
across markets has its limits. And those limits are
most constraining when diversification is needed the
most during periods of market crisis.
1
For each of the other six G-7 countries,
correlations with the U.S. returns are higher in
down markets than in up or mixed [market]
states. The average negative semicorrelation is
nearly double the positive semicorrelation.
2
Some of
the differences are dramatic. For example, the
United StatesGerman [equity market] correlation is
9% in up states and 52% in down states. The
difference in state-based correlations is not just
related to cross-equity correlations. Consistent with
the equity analysis, the correlation of equities and
bonds is more than double in negative-returns
states.
3
In contrast, an investment in traditional commodities
may offer diversification benefits when they are needed
most. Figure 1 and Figure 2, illustrate the performance of
commodities in all quarters from 1Q1970 through
3Q1999 in which the stock and bond markets
experienced a loss. It is notable that commodities
generated a positive return in 24 of the 34 quarters (71%)
in which stocks suffered a loss and in 30 of the 36
quarters (83%) in which bonds experienced a loss.
Perhaps more importantly, commodities generated a
positive return in 17 of the 21 quarters (81%) in which
both the stock and bond markets had negative results.
The average quarterly return for commodities during
these quarters was 7.8%.
Figure 1: Performance During
Stocks Negative Quarters, 1Q703Q99
-30% -20% -10% 0% 10% 20% 30%
Sep 99
Commodities had a gain in 24 of 34 (71%) quarters in which stocks had a loss
Mar 94
Sep 90
Sep 86
Mar 84
Mar 82
Mar 80
Dec 77
Sep 75
Mar 74
Mar 73
Mar 70
Stocks
Commodities
Figure 2: Performance During
Bonds Negative Quarters, 1Q703Q99
-20% -10% 0% 10% 20% 30%
Sep 99
Commodities had a gain in 30 of 36 (83%) quarters in which bonds had a loss
Mar 94
Sep 90
Sep 86
Mar 84
Mar 82
Mar 80
Dec 77
Sep 75
Mar 74
Mar 73
Mar 70
Bonds
Commodities
_____________________
1
Richard Bookstaber, Global Risk Management: Are We Missing the Point?
The Journal of Portfolio Management, vol. 23, no. 3 (Spring 1997).
2
The term positive semicorrelation refers to the correlation exhibited during
instances of positive market performances, whereas negative semicorrelation
refers to the correlation exhibited during negative market environments.
3
Claude Erb, Cambell Harvey, and Tadas Viskanta, Forecasting International
Equity Correlations, Financial Analysts Journal, (NovemberDecember
1994).
3DJH 100
High Net Worth Investment Tools: Personal Financial Statements
Frances M. Drake
Investors can readily pinpoint the economic basis of their
current financial position through a well-constructed
Personal Financial Statement (PFS). Similar to corporate
financial statements, a PFS reveals an investors
financial condition by means of a balance sheet and an
income statement. The PFS also allows investors to fully
assess their progress toward achieving financial goals.
Financial statement preparation is an essential step in the
implementation of asset allocation, wealth preservation,
tax/estate planning, risk management, total net worth
assessment, and household budgeting strategies.
A PFS allows investors to view their entire financial
picture, as well as evaluate the interdependence of each
part. Banks and other lending institutions will sometimes
require a PFS before issuing a letter of credit, real estate
or business loan, or other collateral obligation. Personal
Financial Statements are also useful in preparing legal
documents such as wills, pre-nuptial agreements, or
trusts. At times, the PFS may be a mandatory
requirement for disclosure purposes, as in the case of
Board members of public companies, or individuals in or
seeking public office.
Exhibit 1: Type of Financial Statement and Uses
Balance Sheet Obtaining credit, regulatory reporting,
gauging the long-term effects of financial
planning, comparing year-to-year investment
results, and legal documents.
Income Statement Tax planning, budgeting for large
expenditures, and analyzing the effects of
short-term income and spending activity
on available capital resources.
The beauty of the Personal Financial Statement lies in
the fact that it can be looked at in various stages of
disaggregation. For example, a large component of an
individuals net worth may be in the form of: (i) his or
her personal residence; (ii) a concentrated equity
position; or (iii) ownership of a closely-held business. A
key feature of the PFS is the ability to view it in various
versions for example, with or without large assets. This
exercise can be instrumental in deciding how to protect
and diversify an investors wealth position. When used
in this manner, a PFS lays the groundwork for financial
projections, planning, and future investments.
Step 1: Keep Current Financial Records
To guarantee their integrity, the data to be included in a
Personal Financial Statement are best obtained from
current, accurate records and documents. Exhibit 2 lists
important documents that should be kept up to date and
filed in a secure location. Pertinent information from
these documents will then be readily available as input
into the appropriate section(s) of the Personal Financial
Statement template. Investors may choose to have copies
of their financial documents sent directly to their
professional advisors for verification, safekeeping, and
monitoring purposes.
Exhibit 2: Essential Documents for Preparation of
Personal Financial Statements
Checking, money market, savings, and brokerage account
statements and transaction confirmations;
IRAs, 401(k)s, Keogh plans, employee stock ownership
plans, employee stock purchase plans, pension plans, and
other retirement and employer related compensation and
benefit packages;
Paycheck stubs;
Prior tax returns, taxes owed and tax-deductible expenses;
Receipts and appraisals from art, collectibles, furnishings,
antiques, jewelry, and real estate;
Lease, property, and life insurance policies;
Financial statements or tax returns of separate entities such as
closely-held businesses, entities of ownership interest, or
trusts;
Financial plan (if one has been prepared);
Mortgage documents;
Loan documents;
Wills;
Property tax statements;
Inventories of safe-deposit contents; and
Other documents related to personal assets.
3DJH 101
High Net Worth Investment Tools: Personal Financial Statements (cont.)
Frances M. Drake
Step 2: Prepare The Balance Sheet
The balance sheet, also known as the statement of
financial condition, provides a snapshot of the investors
position at a specific point in time. The balance sheet
delineates all material assets and liabilities, and from it
an investors total net worth can be calculated. The final
computation of subtracting all liabilities, including taxes
that have accrued and tax liabilities that would be owed
on the sale of assets, from all assets will equal total
liabilities and net worth.
The balance sheet provides a framework by which
potential interdependent relationships among asset
classes may be analyzed. By reviewing financial assets
and liabilities at least once each fiscal year, an individual
can gauge financial progress and set future goals based
upon his or her asset/liability mix and income/spending
levels. Information obtained from the documents listed
in Exhibit 2 provide most, if not all, the input needed to
create the balance sheet.
A detailed sample personal balance sheet template is set
forth in Exhibit 3. Ideally, this document should be
prepared in the form of a working spreadsheet allowing
the investor to view different scenarios by modifying
numbers, introducing and comparing asset classes, and
recalculating net worth percentages. Supporting
spreadsheets or documents can be attached to the balance
sheet, along with notes on those assets that warrant a
more detailed description.
Assets are classified as either current or non-current, and
are arranged in descending order according to the degree
of cash-convertibility of each instrument. Current assets
include cash and cash equivalents, marketable securities,
short-term government securities, accounts receivable,
prepaid expenses, and the cash value of life insurance
policies. Current assets, sometimes referred to as liquid
assets, are defined as being easily convertible into cash
within a time frame of less than one year. Non-current
assets are generally acquired and held for the long-term.
Such assets include most durable goods, such as
property, buildings at their appraised value, machinery,
furniture, jewelry, art, precious metals, automobiles, and
antiques.
Non-current financial assets include securities that are
not immediately saleable and may include restricted
stock, shares in exchange funds, and investments in
venture capital, private equity, and hedge funds. Closely-
held and thinly-traded stocks are also considered not
readily marketable. The sale of certain types of real
estate holdings may be impeded by the terms of a
contract or liens attached to it. For balance sheet
purposes, illiquid or partially-liquid assets such as
restricted stock may need to be valued at some degree of
discount from quoted market prices and possible taxes
due when these assets are sold.
Likewise, liabilities are divided into current and non-
current liabilities, and are customarily arranged in order
of their payment due date. Liabilities represent
obligations to transfer monies to creditors either in
current or future fiscal periods. Current liabilities include
short-term bank debt, the current portion of long-term
debt, accounts payable, interest payable, and taxes
payable. Payments of current liabilities are expected
within the same fiscal period in which the charge
occurred. Non-current liabilities, meanwhile, encompass
auto loans, lease payments, mortgages, other
intermediate- to long-term debt, and deferred taxes.
Step 3: Prepare the Income Statement
While the balance sheet provides a fixed-point view of
the amount and the structure of the investors assets, the
income statement is a record or projection of inflows and
outflows over a specific period of time. The income
statement can be used in conjunction with the balance
sheet to monitor or manage changes in total net worth.
The income statement is divided into three sections:
revenues (income); expenses (expenditures); and net
income (gain or loss).
The income statement can provide a framework for
performing a budget analysis by disclosing the amounts
of income earned and by helping to document spending
3DJH 102
Frances M. Drake
Exhibit 3: Sample Personal Balance Sheet Template
Assets Monetary Value % of Total Assets
Cash, Savings Accounts, and Certificates of Deposit
Money Market Account(s)
Marketable Securities
Savings Bonds and Treasury Bills
Stock and Bond Mutual Funds
Corporate and Municipal Bonds
Notes Receivable
Interest Receivable
Cash Value of Life Insurance Policies
Royalties
Stock Options
Investments in Closely-Held Businesses and Private Companies
Investments in Public Companies
IRA Accounts
Retirement Plans
Income Interests in Testamentary Trusts
Remainderperson Interests in Testamentary Trusts
Investments in Real Estate
Personal Residences
Automobiles
Jewelry
Antiques
Crystal, China, and Sterling Silver
Other Personal Effects
Total Assets
Liabilities Monetary Value % of Total Liabilities
Personal Debts
Automobile Loans
Home Equity Loans
Home Mortgages
Margin Loans
Credit Card Loans
Other Consumer Borrowings
Alimony/Child Support Payable
Total Debts
Estimated Taxes
Income Taxes
Capital Gains Taxes
Real Estate Taxes
Other Taxes
Total Taxes
Net Worth
Total Liabilities and Net Worth
3DJH 103
Frances M. Drake
habits. If revenues exceed expenses, a net surplus is
available for additional investments; if expenditures
exceed revenues, an investor may need to take action to
increase his or her income stream or curtail spending
levels. An income statement is frequently prepared when
the investor is contemplating a major purchase, such as a
business, a residence, oil and gas interests, or a
substantial parcel of real estate.
The income statement is also useful for tax preparation
purposes or when a major change occurs in ones
financial situation, such as the receipt of a large
dividend, interest payment, or a sizable short-term
capital gain from the sale of securities or property.
Individuals who will find the income statement
particularly useful include: (i) retirees; (ii) self-employed
persons; (iii) day traders who may incur short-term
capital gains taxes; (iv) investors in stock options; and
(v) investors who employ techniques which may incur
large capital gains taxes. Investors are encouraged to
view their finances in much the same way as a securities
analyst views a companys financial statement. The more
of each years income that can be transferred to the
balance sheet annually in the form of liquid assets and
capital assets with the potential to appreciate in value,
the greater the potential to increase wealth over time.
Once again, a working spreadsheet is ideal, preferably
one that is computer-based and that can be easily
updated on a regular basis. Income statements can be
prepared on a monthly, quarterly, and/or annual basis
depending on an individuals income level, tax bracket,
and tax-sensitivity. A detailed sample personal income
statement template is provided in Exhibit 4.
Step 4: Tax Planning Using the Personal Financial
Statement
Tax planning is a considerable area that ties into and can
benefit from PFS analysis. By aggregating ones assets,
liabilities, and income in one place, a Personal Financial
Statement allows an investor to more accurately gauge to
what extent his or her assets have appreciated or
depreciated and can thus help to understand any future
tax liabilities. Future tax liability is an estimate of taxes
that may be payable in the future owing to circumstances
such as the sale of appreciated assets which may then
trigger capital gains taxes. Calculation of future tax
liability assumes a complete, voluntary sale of all assets
as of the date of the financial statement, and is the total
amount of taxes that would be assessed on such a
liquidation. All estimated taxes at the federal, state,
county, and city level must be included in this
calculation. The potential liability for all these taxes in
their entirety is called the effective tax rate the average
rate at which income is taxed.
It is important to note that, on the federal level, the rate
at which income from the sale of an asset is taxed
depends on the type of asset and the length of time the
asset has been held by the investor. Therefore, taxable
items must be segregated between those taxable as
capital gains and those taxable as ordinary income.
Effective tax rates must then be developed for each
category.
If state, county, or city tax codes impose capital gains at
rates different from ordinary income, this difference
should be noted when computing the effective tax rate
for capital gains. Otherwise, if any differences in state,
county, or city taxes are immaterial in amount, using the
same combined state, county, and city effective rate for
ordinary income and taxable gains is usually acceptable.
When determining potential tax liability, the investor
needs to know not only the current values of the assets
and the current amounts of the liabilities, but also their
cost basis and the dates they were acquired. If the
estimated current value of an asset is greater than the
assets cost basis, the asset has unrealized appreciation in
value. If the estimated current value of an asset is less
than the assets cost basis, the asset has unrealized
depreciation in value. If the tax basis of a liability is
greater than the liabilitys estimated current amount, the
liability has unrealized appreciation in value. If the
reverse is true, the liability has unrealized depreciation
in value.
3DJH 104
Frances M. Drake
Exhibit 4: Sample Personal Income Statement Template
Revenues Monetary Amount % of Total Income
Gross Salary
Bonuses & Commissions
Partnership Income
Interest and Dividends
Realized Capital Gains
Alimony/Child Support received
Trust Distributions
Pension Income
Social Security Distribution
Gifts
Other Income
Total Income
Expenses Monetary Amount % of Total Income
Fixed and Semi-Fixed Expenses
Home Mortgages/Rents
Loan Payments
Insurance Payments
Alimony/Child Support Payments
Taxes
Income Taxes
Social Security Taxes
Capital Gains Taxes
Real Estate Taxes
Other Taxes
Variable Expenses
Food
Clothing
Utilities
Rent
Home Maintenance/Improvements
Transportation
Medical and Health Expenses
Child Care Expenses
Tuition/educational expenses
Investments/Savings Payments
Contributions/Gifts
Entertainment/Vacation
Personal Care
Other
Total Expenses
Net Income
3DJH 105
Frances M. Drake
Keeping in mind the need to segregate those assets taxed
as capital gains from those taxed as ordinary income, the
investor can take the sum of the unrealized appreciation
and depreciation of the assets and liabilities in each
group separately. Then, each sum should be multiplied
by the effective tax rate for its effective category. Adding
the two products together produces the total estimated
future income tax liability.
If the difference between unrealized appreciation and
unrealized depreciation is negative, there is net
unrealized depreciation, and no future income tax
liability is recorded. This is because no tax is assessed
when net depreciation occurs, and is also based on the
assumption that there will be zero appreciation in the
future.
Step 5: Using Goals as a Framework to Analyze the
Personal Financial Statement
The Personal Financial Statement is an invaluable tool to
help individuals and families achieve their goals,
whether they are education-, retirement-, or
philanthropy-related. Upon analyzing a Personal
Financial Statement, an investor may decide that his or
her current financial position does not adequately allow
for his or her goals to be met. The investor may decide
to: (i) defer additional pre-tax income to a tax-deferred
investment plan; (ii) adjust total current income and the
amounts allotted to different expenditures; (iii) increase
or decrease interest income and dividends from current
investments; (iv) offset capital gains against losses; and
(v) study how the sale of some assets may affect tax
liabilities.
In addition, analysis of a Personal Financial Statement can
enable the investor to identify his or her risk tolerance. For
instance, if an investor has a low risk tolerance, he or she
will likely invest in low-risk asset classes. Thus, an
abundance of low-risk assets on the investors Personal
Financial Statement may indicate a low risk tolerance.
Based on insights about his or her risk tolerance, the
investor can then gain a useful and realistic perspective on
the investors financial standing and take steps to increase
his or her chances of achieving goals.
Armed with this information regarding risk tolerance and
the distribution of the investors assets, a Personal
Financial Statement can be a powerful tool in helping the
investor to construct and optimize his or her asset
allocation framework. By strategically altering the
percentage of assets allocated to cash, equity, fixed
income, and alternative investments, the investor can seek
to maximize returns while minimizing tax liability and
risk.
The Personal Financial Statement can also be used as an
aid in financial planning. Different balance sheet scenarios
may be constructed for specific circumstances. For
example, excluding assets that are not immediately salable
from the balance sheet may provide a clearer picture of the
investors ability to meet current expenses, whereas the
inclusion of personal items is useful when assessing
wealth that can be passed from generation to generation.
Most investors should periodically reallocate their
investment resources as their own criteria and goals
change throughout life. For a young investor in the wealth-
seeding phase of wealth creation, higher-risk investments
can be tolerated. During the wealth-building phase,
investments may become more balanced and moderated in
terms of riskiness as the investor begins to address
childrens educational expenses and retirement. Lastly, as
the investor enters retirement and the wealth realization
phase of the investment lifecycle, tax and estate
considerations as well as capital preservation will probably
be of greatest consequence.
The Personal Financial Statement is one way to clearly
view an investors total resources and test the implications
of various reallocation strategies on paper before actually
implementing them. Achieving important life-goals is not
as simple as choosing to make a purchase or balancing a
checkbook. To accomplish these objectives, it helps to
create, examine, and update one or multiple balance sheets
and income statements that take into account the investors
complete financial situation.
A list of selected resources to help the investor prepare a
Personal Financial Statement is set forth in Exhibit 5.
3DJH 106
Frances M. Drake
Exhibit 5: Resources to Assist in the Preparation of a Personal Financial Statement
Software Books Websites Professionals
Microsoft
Money
Keys to Business and Personal Financial
Statements
(1)
www.mycfo.com Financial Advisor/Investment
Representative
Quicken Checklist and Illustrative Financial Statements
for Personal Financial Statement Engagements
(2)
www.financialengines.com Certified Public Accountant
My Database Audit and Accounting Guides
(2)
www.aicpa.org Certified Financial Planner
Microsoft Works Personal Financial Statement
(2)
www.money.com Bookkeeper
CashPlan Pro Registered Investment Advisor
Notes:
(1)
Nicholas G. Apostolou, Barrons Educational Series Inc., 1991.
(2)
American Institute of Certified Public Accountants, 1983, 1990, 1999.
The following sources were used as references for this article: (1) Keys to Business and Personal Financial Statements, by Nicholas G. Apostolou;
and (2) MicroMash, Preparing Personal Financial Statements, by Mary Ellen Phillips.
3DJH 107
Investment Alternative A Tutorial on Exchange Funds
Jeffrey C. Huebner
The risk of holding highly concentrated, single-equity
positions may compel some investors to actively seek
diversification strategies, particularly in light of the
market conditions experienced over the past two years.
The more risk-tolerant investor may deploy a type of
derivatives strategy to limit the exposure to price
fluctuations in the stocks that are owned, typically a
short-term solution. Some investors may choose to
reduce their exposure by selling a portion of their stock
position, paying any applicable capital gains taxes, and
then reinvesting the proceeds elsewhere in the market. In
addition to these potentially effective strategies for
diversifying concentrated equity positions, investing in
an exchange fund may provide a tax-efficient,
disciplined, and long-term solution for investors.
Effectively, investors in an exchange fund have agreed to
swap exposure in a single security for shares in a
diversified portfolio, without triggering a taxable event.
The simple mechanics of the exchange entail a group
of individual subscribers, each holding a concentrated
equity position in one or more securities, who contribute
some or all of their equity position to the fund in
exchange for a pro rata ownership of the fund as a whole.
Ownership is in the form of fund shares, typically in a
Limited Partnership or a Limited Liability Company (an
LLC). Through an exchange fund, investors can
exchange their concentrated equity positions for a long-
term ownership stake in a diversified and professionally
managed investment. An exchange fund may provide an
inherent discipline to an investors overall asset
allocation, in that the funds investment objective will
likely remain unchanged, and the investment typically
will be made with a longer-term perspective in mind.
The composition and investment objective of exchange
funds are varied; an exchange fund may be set up as an
emerging growth fund, a multi-cap growth fund, or a
large-cap growth portfolio, among other objectives.
Based on the portfolio managers investment criteria,
certain securities will be deemed acceptable for inclusion
in the fund. During the offering period, potential
investors who hold an acceptable security will complete
a subscription booklet if they choose to participate. The
potential pool of contributed equities is aggregated by
the funds general partner at the conclusion of the
offering period and prior to the closing. An Inspection
Report (a pro forma composition of the fund) is
distributed to those who have completed the subscription
documents, allowing investors to review the entire
portfolio before making a final investment decision. The
market price of the contributed securities is determined
at or near the closing date of the fund. Potential investors
will find a detailed description of the fund in the offering
memorandum informing them of the risks, tax
implications, fees, and redemption/dissolution specifics
associated with the investment. Since each fund has its
own terms and conditions, each offering memorandum
should be evaluated on its own merits and may warrant
consultation with professional advisors.
Typically, there is minimal, if any, current cash flow
from an exchange fund, although some exchange funds
may provide a small, annual distribution to their
investors. Since subscribers to an exchange fund
typically surrender the dividend and voting rights
associated with their stock, this investment vehicle may
not be appropriate for investors who rely upon the
dividend income from the securities they hold. However,
some exchange funds will allow for a small redemption
from the fund on a periodic basis to meet any additional
income needs an investor might have.
Exchange funds can be offered to investors through
broker-dealers, investment management firms, or
specified third parties. An exchange fund contribution
typically is not considered a market transaction and thus
does not exert selling pressure on individual stock prices.
Additionally, the resale rules of SEC Rule 144 (such as
filing and volume conditions) may not be applicable in
an exchange fund transaction. Current regulations dictate
that exchange funds hold a portion of the fund assets in
illiquid or qualifying assets at their closing to allow
for the tax-free exchange of the equity contributed to the
fund.
The availability of exchange funds varies, and depends
upon the number of portfolio managers currently
sponsoring funds. Consequently, there may be numerous,
few, or no exchange funds available to investors at any
3DJH 108
Investment Alternative A Tutorial on Exchange Funds (cont.)
Jeffrey C. Huebner
given point in time. Historically, exchange funds have
been structured as stand-alone funds. More recently,
however, a second style, known as a hub-and-spoke
exchange fund, has been introduced.
Stand-alone exchange funds generally have a
specified one-time offering period when the
funds are being offered to potential investors;
subsequently, they will be closed to new
investors. Prior to the closing, investors are
apprised of the primary equities that will
comprise the portfolio; however, subscribers
may not be able to easily view the past
performance of that particular group of
securities and how they perform as a unit. The
one-time closing of the fund may place limits
on the portfolio manager going forward, since
no new or additional equity positions can be
added to the fund. However, some investors
appreciate the assurance that the equity
portfolio is unlikely to change substantially
over time due to the portfolio managers
actions. Stand-alone exchange funds are more
likely to be structured as smaller, niche-
oriented funds, i.e., a small-cap exchange
fund or a technology-oriented exchange fund,
which investors may find attractive.
Hub-and-spoke exchange funds, by contrast,
tap into an existing portfolio of securities.
This structure allows potential investors to see
the current portfolio and view its past
performance, prior to subscribing to the fund.
The hub-and-spoke structure enables the
portfolio manager to add more securities to
the overall portfolio through future exchange
fund closings. With this structure, the
portfolio manager may be able to better
manage the composition of the fund in
response to market conditions and in keeping
with the original investment criteria. Hub-
and-spoke funds tend to be larger funds with a
more diversified equity portfolio.
Typically, the minimum subscription amount for an
exchange fund contribution is $1 million of equity,
which may consist of more than one security.
Subscribers generally are required to have more than $5
million in overall investments in order to participate in
an exchange fund. There may be a placement fee, based
on the size of the subscription, and an annual
management fee generally associated with an exchange
fund. It is possible that the diversification and the tax-
efficient features of an exchange fund may substantially
offset applicable fees.
An exchange fund can be structured with a limited life or
it can be structured as a perpetual fund. Although some
funds may offer subscribers the ability to redeem any
time after the closing, albeit with a penalty, investors
typically are committed to an exchange fund for a period
of at least two to three years. Investors seeking to redeem
their investment prior to the seven-year anniversary of
their contribution, a prescribed regulatory time frame,
should expect to receive some amount of their original
securities back, based upon the performance of the fund.
Investors who remain in the fund for seven years or more
generally will be offered the choice of requesting: (i)
their own stock back; (ii) a diversified basket of
securities; or (iii) a pro rata piece of the entire portfolio.
Since their inception in the early 1960s, informal
estimates suggest that more than $15 billion in equity has
been contributed to exchange funds. The tax-efficient,
disciplined, long-term nature of these vehicles has
attracted many participants to this investment vehicle.
Investors who believe that an exchange fund may fit with
their investment strategy should contact their Financial
Advisor or Investments Representative for further
details.
Since exchange funds are usually offered through
private placements exempt from registration with the
US Securities and Exchange Commission, they cannot
be marketed as a prospecting tool by the placement
agent. Placement agents are expected to have an
established business relationship with the prospective
investor in order to comply with federal securities
rules.
3DJH 109
Planning for and Financing a College Education
Regina B. Maher
Sharon Gibbons
Learning is a treasure which accompanies its owner
everywhere Chinese Proverb
Introduction
Next to retirement, investors might list college education
as their most important savings goal. For many investors,
education is a significant expense, especially when there
is more than one child to provide for. In addition,
advanced degrees are becoming more broadly sought and
are often requisite to moving ahead in certain fields.
Planning for a college education or an advanced degree
can be an exhilarating experience, yet a tedious chore
financially and strategically. The amount of information
available on the topic can be daunting and under recent
changes to the tax code, much of which takes effect in
2002, some new advantages as well as complexities need
to be considered.
The College Board reports that in 2001-2002, average
college costs rose between 5.5 and 7.7 percent at four-
year institutions, with charges for room and board also
rising.
1
Six percent of all students attend schools where
the annual tuition alone costs $24,000 or more. Several
leading educational figures have stated that a college
education is still well within the grasp of all Americans -
in fact, for the 2001-2002 school year, a record $74
billion was available in student financial aid from
federal, state, and institutional sources.
2
Many higher
education specialists hold that the cost of a college
education should be viewed as an investment that
provides personal and financial dividends for a lifetime.
US Census Bureau statistics support this notion: a
college graduate earns approximately 80 percent more on
average than an individual whose highest degree is a
high school diploma.
Financing Vehicles for Education
Education savings incentives have been expanded under
recent tax legislation. The Economic Growth and Tax
Relief Reconciliation Act of 2001 has made Section 529
plans and Education IRAs (now called Education
Savings Accounts) even more appealing as a means of
saving for college. Perhaps as a result, Cerulli Associates

1
The College Board, Trends in College Pricing 2001, Washington, DC: 2001
2
The College Board, Trends in Student Aid 2001, Washington, DC: 2001
estimates that the total college savings market will grow
by close to $80 billion over the next five years (from an
estimated $22 billion in 2001 to $101 billion in 2006),
with more than one-half of that total due to Section 529
savings plans and one-third due to Education Savings
Accounts. According to Cerulli Associates, it is likely
that a good portion of the new assets will represent
savings that would not have occurred otherwise, from
investors looking to realize tax savings.
3
It will now be possible to contribute to both of these
types of plans in the same tax year. These improvements
took effect on January 1, 2002, but without additional tax
legislation, may disappear after the year 2010. Section
529 savings plans and prepaid tuition plans, Education
Savings Accounts, Roth IRAs, U.S. Savings Bonds, and
custodial accounts are all savings vehicles that are
worthy of consideration by individual investors, in our
view. Additionally, learning credits against Federal
income tax, as well as federal and private loans, may be
tapped for funding college and many other forms of
higher education. The main educational financing
vehicles are discussed below.
Section 529 Qualified Tuition Programs
Many state governments have created innovative college
savings programs designed to meet the needs of parents
and guardians to finance college educations. These plans
vary from state to state, and may take the form of a
savings plan or a prepaid tuition plan. It is possible to
invest in a plan outside the investors home state or even
to invest in multiple state plans; most states offer
resident and non-resident participation. Information on
each states plan is available through the College
Savings Plans Network (collegesavings.org), an affiliate
of the National Association of State Treasurers.
Section 529 Savings Plans:
The primary advantage of Section 529 savings plans is
that they are generally able to compound free of federal
and local income taxes when used for education-related
expenses, and thus they may grow faster than a taxable

3
Cerulli Associates, The Cerulli Report
TM
, The State of the College Savings
Market: 529 Plans in Perspective. Boston, MA: 2001 (cerulli.com/report-
529.htm)
3DJH 110
Planning for and Financing a College Education (cont.)
Regina B. Maher
Sharon Gibbons
investment. Section 529 plans can be used by most
investors, since there are usually no income limits. Such
plans have become more flexible and the proceeds can
generally be used at any college or university
nationwide. Parents, relatives, and friends can contribute
on behalf of a specific beneficiary. Some state plans also
offer an immediate state tax credit for annual
contributions.
The Tax Relief Act of 2001 enhanced the appeal of
Section 529 plans. Beginning in 2002, earnings
withdrawn from these accounts will be free from federal
taxes. Most states are expected to follow suit at the state
level, and benefactors will be permitted to roll funds
over to a different state plan once a year. In addition,
taxpayers can claim a Hope Scholarship Tax Credit or a
Lifetime Learning Credit (both are federal tax credits), in
the same year that a tax-free distribution is made from a
qualified tuition program, as long as the distribution is
not used for the same educational expenses for which the
credit was claimed.
Section 529 Savings Plans, some of which are managed
by professional asset managers, also appeal to affluent
investors since there are no applicable family income
limits, and since allowable contributions to these
accounts are sizable. If $100 per month is contributed to
a Section 529 Savings Plan each year for 18 years, and
earns 10% per annum, the account will grow to over
$60,000. Many of these plans allow a benefactor to
contribute up to $100,000 for each child, and the
definition of family member has been expanded to
include first cousins. In some states, the maximum
account balance (which may include a number of
contributors) for a specific beneficiary exceeds
$200,000. Unlike custodial accounts, which children
may assume control of at age 18, 21, or 25, these savings
plans remain under the control of the benefactor until the
funds are used for education.
Section 529 plans are still developing and established
financial institutions currently manage or are vying for
the management of these state-sponsored plans. One
variation on these plans is a college savings rewards
program. An organization called Upromise, has
established partnerships with corporations and brands
across the country, and consumers are encouraged to buy
products and services from these companies, receiving
rewards into 529 plans established for this purpose.
Family and friends are encouraged to set up accounts as
well, for the benefit of a particular beneficiary. Upromise
currently has approximately 100 participating
corporations such as AT&T, McDonalds, and Citibank.
These firms also contribute a portion of what each
benefactor spends (usually 1 or 2 percent) into a
designated account.
One perceived drawback of 529 plans has been a lack of
flexibility for the benefactor as to how the account is
managed and the types of asset classes which may be
included. To counter this perception, many states are
adding choices such as multiple age-based portfolios
with conservative, moderate, and aggressive asset
allocations. If Section 529 funds are not used for
education purposes, earnings become taxable at the
investors current federal income tax rate upon
withdrawal, with an additional 10% federal penalty tax
on accumulated earnings.
As of April 2002, 220,000 accounts have been opened in
the New York State Section 529 Savings Plan, with
approximately $1 billion funded. Contributors to the plan
receive an immediate New York State income tax
deduction. Single filers can contribute up to $5,000
annually, and $10,000 annually for joint filers. As of
January 1, 2002, withdrawals for qualified higher
education expenses are no longer subject to federal or
New York State income taxes. Total contributions to an
individual account cannot exceed $100,000 and the
maximum allowable account balance for any one
beneficiary is $235,000.
Tuition Credit Programs:
These plans allow the parent or benefactor to pay future
tuition today, thus locking in todays tuition cost levels,
effectively shielding the investor from increases in
tuition rates. Prior to the enactment of the Tax Relief
Reconciliation Act of 2001, only states were allowed to
offer tuition credits, and these programs were primarily
designed for students who planned to attend state
3DJH 111
Regina B. Maher
Sharon Gibbons
schools. Prepaid tuition plans can now be established by
any eligible educational institution, but withdrawals will
not be tax free for private institutions until 2004. Some
tuition credit programs allow the investor to switch funds
to a school outside of the host state, in some cases
resulting in a reduction of all or a portion of the in-state
benefits.
Two other factors to consider before initiating a prepaid
tuition plan include: (i) the fact that having the money in
the investors own portfolio may produce a rate of return
in excess of the projected tuition increases; and (ii) the
fact that contributions to a prepaid tuition plan may
affect a familys application for financial aid.
The Education Savings Account (Education IRA)
Despite having had the term IRA in its name, an
Education IRA is not connected with retirement.
Recently renamed Education Savings Account under
the new tax law, this investment vehicle was originally
established in 1998 to help individuals defray the costs
of higher education. The Tax Relief Act of 2001
increased the amount that can be contributed to an
Education Savings Account from $500 to $2,000 per
child (with no limit to the number of contributors).
Under the new legislation, this savings account may also
be used to pay for private elementary and high school
expenses. Annual contributions to an Education Savings
Account are non-deductible, but withdrawals will be tax
free when used for qualified education-related purposes.
The Education Savings Account can be invested in a
broad range of assets, as can a traditional IRA, with
flexibility as to how it is managed.
Income limits apply to Education Savings Accounts. The
phase-out for contributions to Education Savings
Accounts for married taxpayers filing jointly begins at
$190,000 in adjusted gross income. No contributions are
allowed if this income exceeds $220,000. Because
Education Savings Accounts are subject to income
limitations, one option may be to set up accounts in the
childs name. If the maximum amount of $2,000 is
contributed to an Education Savings Account each year
for 18 years, earning 10% per annum, the account will
grow to slightly less than $100,000.
An Education Savings Account is set up with a specified
beneficiary (under the age of 18) in mind. No additional
funds may be added to the account after the beneficiary
reaches age 18, but the account can continue to grow tax
free. In general, the funds have to be used for educational
purposes by the time the beneficiary reaches 30 years of
age. New exceptions apply to special-needs
beneficiaries. Contributions can be made after the
special-needs beneficiary reaches age 18, and the balance
in the account does not have to be distributed when he or
she reaches age 30.
Education Savings Accounts are not restricted to parents
and grandparents; anyone may make a contribution for a
specific beneficiary. As a result, more than one
Education Savings Account might exist for the same
beneficiary. Since the total contribution per year is
limited to $2,000 per beneficiary, multiple contributors
need to coordinate their efforts. The beneficiary of a
specific account may be changed, but only to another
family member of the beneficiary. If rolled over to a new
beneficiary, an Education Savings Account is allowed to
continue its tax-free status until the new beneficiary uses
it for education-related expenses.
Taxpayers are now eligible to make a contribution to
both an Education Savings Account and a qualified
tuition program (Section 529 plan) in the same tax year.
Distributions from an Education Savings Account are tax
free when they are: (i) used to pay for qualified
education expenses; and (ii) used in the same tax year in
which the withdrawal was made. Tax-free withdrawals
would have to be coordinated with (but no longer
preclude) the Hope Scholarship Tax Credit and Lifetime
Learning Credits (federal tax credits) as long as the same
expenses are not used for both.
Qualified education-related expenses include tuition and
fees, room and board (subject to certain limits and
provided that the student is a half-time student at least),
the cost of books, supplies, and equipment, and amounts
contributed to a qualified tuition program. If withdrawals
from the Education Savings Account exceed expenses,
excess withdrawals will be subject to income taxes and
to a 10% penalty. Similarly, if there are any funds left in
3DJH 112
Regina B. Maher
Sharon Gibbons
the account when the beneficiary reaches 30 years of
age, a distribution of the balance must be made within 30
days, and will also be subject to taxes and a penalty of
10%.
Above the Line Deductions for Higher Education
Expenses
Taxpayers meeting certain income limitations are
permitted to take a deduction for qualified higher
education expenses. However, the deduction cannot be
claimed in the same year as a Hope Scholarship Tax
Credit or Lifetime Learning Credit (federal tax credits)
for the same student.
In 2002 and 2003, taxpayers with adjusted gross income
not exceeding $65,000 ($130,000 in the case of married
taxpayers filing jointly) are entitled to a maximum
deduction for qualified higher education expenses of
$3,000 per year. In 2004 and 2005, this deduction
increases to $4,000, and taxpayers with adjusted gross
income not exceeding $80,000 ($160,000 for married
taxpayers filing jointly) will become entitled to a
reduced maximum deduction of $2,000.
Additional Investment Options
Traditional and Roth IRAs
Under the new tax legislation, the contribution limits to
all IRAs have been increased. In 2002, it is possible for
certain investors to set aside $3,000 annually per person
in Roth IRAs to compound on a tax-free basis. This
amount increases to $4,000 in 2005 and $5,000 in 2008.
It is possible to withdraw contributions to Roth IRAs on
a tax-free and penalty-free basis for use toward a childs
college education. Earnings in the account can be used
for college expenses without penalty, if taxes are paid on
the early withdrawals. Roth IRAs are subject to income
limitations.
Savings Bonds
U.S. Treasury securities can under certain conditions be
cashed in and used for educational purposes on a tax-free
basis. Tuition covered by Hope Scholarship Credit or
Lifetime Learning Credit (federal tax credits) cannot be
counted in determining exclusion of interest income.
Custodial Trust Accounts
It may be advantageous to shift ownership of certain
assets to the investors children. The income is taxed at
the childs rate (although for children under age 14, the
amount of unearned income that may be taxed at the
childs federal income tax rate is limited.) The simplest
way to accomplish the transfer of assets to children is by
establishing a custodial account through the Uniform
Gift to Minors Act (UGMA) or the Uniform Transfer to
Minors Act (UTMA) depending on the investors state of
residence and the types of assets selected to fund the
account. These tax-advantaged accounts enable the
investor to give money to a child (a minor), while at the
same time allowing the investor to maintain control over
how the money is spent and invested until the child
reaches the age of majority.
For children under age 14, the first $750 in earnings is
tax-free and the next $750 is taxed at the childs tax rate;
for older children, all earnings are taxed at the childs tax
rate. Although significant, these tax advantages are not
as compelling as the zero tax rates in a Section 529 plan
or in an Education Savings Account. A drawback to
these accounts is the lack of certainty that the funds will
be applied toward education expenses. These funds
transfer out of the custodians hands and over to the
child at age 18, 21, or 25 (depending upon the age at
which custodial accounts end in the investors state).
Another potential drawback for families of moderate
income is that since custodial accounts are considered a
students asset, they may render a family less eligible for
financial aid.
Zero Coupon Bonds
Investors can purchase zero-coupon bonds that are slated
to mature just as children reach college. Because the
yield to maturity is established at the time of purchase,
investors have the advantage of knowing exactly how
much the bonds will be worth when they mature.
Student Loans and Other Borrowing
If the cost of education is too high to be covered by
savings alone, or if the investors time horizon is too
short to accumulate sufficient funds for educational
expenses, other methods of funding may be considered.
3DJH 113
Regina B. Maher
Sharon Gibbons
These methods include federal loans such as (PLUS
loans, Stafford loans, or Sallie Mae loans), home equity
loans, or loans against the investors 401(k) plan.
Under the new tax legislation, the deduction for student
loan interest has been enhanced, but income limits apply.
In 2002 and 2003, the $3,000 deduction for interest paid
on qualified education loans will be phased out at
$65,000 for single taxpayers and $130,000 for married
taxpayers filing a joint return. There is no longer a limit
on the number of months for which the deduction can be
taken.
Federal loans are guaranteed by the government and can
provide an inexpensive way for students and parents to
borrow. Federal loans include Federal Stafford Loans,
Federal Perkins Loans, and Parent Loans for
Undergraduate Students (PLUS).
Federal Stafford Loans, available to undergraduate and
graduate students, are the most commonly utilized
education loans. There are limitations on the amount that
can be borrowed and the repayment term for these loans
ranges up to ten years. Stafford loans can be subsidized
by the government if it is determined that the loan is
need-based. In this case, the government pays the
interest on the loan while the student is in school and
during the grace period before the student begins paying
back the loan. Unsubsidized Stafford loans are available
to students who do not qualify for a subsidized loan. The
borrower is responsible for the interest on the loan as
soon as the loan is initiated.
Federal Perkins Loans are federally funded, bear a low
interest rate, and are awarded by individual participating
colleges based on the students need. Since each
participating school has a limited allocation of Perkins
funding, these loans are usually distributed selectively
where need can be shown.
Federal PLUS Loans are low-interest federally funded
loans for creditworthy parents of undergraduate students.
These loans can be used to pay for the full cost of a
students education.
Private loans can be used by students in addition to
federal loans. Interest rates on these loans may be as low
as the prime rate, depending upon the borrowers credit
rating, with a repayment term of up to 25 years. Sallie
Mae offers private loans such as the Signature Student
Loan and the Career Training Loan.
Learning Credits
Federal tax credits exist to recover a portion of tuition
and fees for taxpayers with modified adjusted gross
income below certain levels (geared to lower- and
moderate-income families). Tax credits, which are
subtracted from income taxes due on a dollar-for-dollar
basis, are generally more effective in reducing tax
expenses than tax deductions. The Hope Scholarship Tax
Credit provides up to $1,500 in federal tax credit per
year and per student and is available for the first two
years of a college education when the student is pursuing
a degree or another recognized educational credential.
Lifetime Learning Tax Credits offer one credit of up to
$1,000 per family per year; the credit extends beyond
college and is available for one or more courses. Both
credits cannot be claimed in the same tax year for the
same student. New tax legislation no longer restricts
taking one of these credits in the same year that an
Education IRA withdrawal is made.
Scholarship Information
Scholarship sources include government agencies,
private industry, trade organizations, labor unions, local
businesses, community associations, and non-profit
organizations. They may be based on academic
achievement, special talent, a specific career goal, or
perhaps financial need. While federal and state sources
may generally base their awards on need, some schools
are offering merit awards to attract better students and
ultimately raise the schools overall ranking. The
National Merit Scholarship Corporation, a non-profit
private organization, is another source for scholarships
based on merit.
Some scholarships can be applied for more than once
and not all scholarship applications apply only to the first
year of school. Employees may have access to company-
sponsored scholarship programs. The Internet is a
3DJH 114
Regina B. Maher
Sharon Gibbons
resource for available scholarship monies, offering
services that are either free
4
to online browsers or fee
based.
5
Scholarships are often tied to performance in
either academics or athletics, and can be rescinded under
certain conditions.
College grants offer advantageous financial assistance
because they are not tied to performance and do not have
to be repaid. Grants can be extended to students based
upon need or merit. The largest federal grant program,
Federal Pell Grants, is based on financial need. Federal
Supplemental Education Opportunity Grants (FSEOG)
are available to those with exceptional need.
Resources Available
College guides are a good first step in the selection
process. Colleges and universities are listed and often
rated according to various criteria, including academics,
sports, reputation, median test scores, location, cost,
available majors, extracurricular activities, and other
categories. Among other sources, guides include
Choosing the Right College, The New Best 331 Colleges
from Princeton Reviews Annual College Rankings, U.S.
News & World Reports: Americas Best Colleges, The
Fiske Guide to Colleges 2002, and Kiplingers.
The Testing Process: Kaplan, Princeton Review,
CollegePrep, and other groups offer test preparation
review courses for entrance exams. These test
preparation resources provide online self-tutoring
programs, classroom-based instruction at local centers,
and self-study guides.
Online college planning sites can aid in the college
selection process, educate students and parents about
financing options, and provide information on preparing
for entrance examinations.
6
College savings plan
calculators allow investors to estimate future education

4
Scholarship Experts, endorsed by Sallie Mae, is an example of a fee-based
Internet site which offers guidance on scholarships and adheres to a strict
code of privacy.
5
Scholarships.com and FastWeb.com are popular free internet services
according to New York Times article, For Resourceful Students, the Internet
Is a Key to Scholarships, dated March 31, 2002.
6
Wired Scholar, Sallie Maes go-to-college website, was designated by Forbes
magazine as the best of its kind online in Forbess Best of the Web Issue dated
June 25, 2001
costs and potential shortfalls, and devise a monthly
savings plan to cover future expenses. These calculation
tools take into consideration: present costs, average
annual cost increases, the number of years before the
student enters school, the type of school under
consideration, current savings levels, expected rates of
return on savings, and the expected number of years in
school.
For students who will have to travel a distance to school
or travel for educational purposes, two student travel
services, Council Travel (counciltravel.com), STA Travel
(statravel.com), and Student Universe
(studentuniverse.com) help parents/students find the best
fares for student travel. The Student Advantage Card
(from Council Travel) offers discounts on certain airfare
and ground transportation. AirTran Airways X-Fares
enables students to fly standby at reduced rates. The Blue
for Students card from American Express offers a
reduced flight program, as does Citibanks no-fee
platinum card for students.
Investors are reminded that Morgan Stanley does not
provide legal or tax advice. The investor should
consult his or her personal tax advisor or attorney for
matters involving taxation and tax planning and
his/her attorney for matters involving personal trusts
and estate planning, including the issues discussed
above and how they apply to the investors personal
situation.
3DJH 115
Regina B. Maher
Sharon Gibbons
Sources of Further Information
Books
The Best Way to Save for College, by Joseph F. Hurley, BonaCom
Publications, 2002.
Americas Best Colleges, U.S. News & World Report, 2002.
Choosing the Right College, by Intercollegiate Studies Institute, 2001.
The Fiske Guide to Colleges, by Edward B. Fiske, 2002.
Financing College, by Kristin Davis, Kiplingers, 2001.
Petersons College Money Handbook, Petersons Guides, 2001.
The Prentice Hall Guide to Scholarships and Fellowships for Math and
Science Students, by Mark Kantrowitz, Prentice Hall, 1993.
Government Brochures
US Department of Education. Funding Your Education, 2000-2001
US Department of Education. Looking for Student Aid
US Department of Education. The Student Guide, 2001-2002
Websites
Cerulli Associates (cerulli.com) New York Saves (nysaves.org)
College Board (collegeboard.org) Petersons (petersons.com)
College Savings Plans Network (collegesavings.org) Princeton Review (review.com)
Federal Student Aid (ed.gov/studentaid) SallieMae (salliemae.com)
FastWeb (fastweb.com) Saving for College (savingforcollege.com)
Fidelity (fidelity.com) Scholarship Experts (scholarshipexperts.com)
FinAid (finaid.org) Scholarships (scholarships.com)
Forbes (forbes.com) SmartMoney (smartmoney.com)
Free Application for Federal Student Aid (fafsa.ed.gov) STA Travel (statravel.com)
Internal Revenue Service (irs.gov) Upromise.com (upromise.com)
Kaplan (kaplan.com) US Department of Education (ed.gov)
Kaplan Test Prep (kaplantestprep.com) US News (usnews.com)
Kiplinger (kiplinger.com) US Treasury (ustreas.gov)
Motley Fool (fool.com) Wiredscholar (wiredscholar.com)
National Merit Scholarship Corporation (nationalmerit.org)
3DJH 116
Construction and Implementation 119
Qualitative Investment Factors 123
Investment Manager Selection Criteria 125
Evolution of the Core Equity Concept 127
Tax-Efficient Separate Account Management 132
The Interplay of Fear, Greed, and Rationality in Equity Investing 135
S&P 500 Industry Sector Composition 137
Financial Parenting 141
Venture Capital/Private Equity: Environmentally Conscious Investing 147
3DJH 117
Investment Philosophy: Construction and Implementation
John M. Snyder
John Snyder is a Private Wealth Management Vice
President managing discretionary and non-discretionary
assets for High Net Worth investors.
Successful investing, reduced to its most basic elements,
is a two-part affair. The first decision involves selection
of securities, the second decision has to do with abiding
by the first, often over a considerable period of time.
The security selection process is a skill requiring
relentless research, inquiry, and analysis. It is active, and
demands continuous monitoring to verify the original
decision. The skill is developed by mastering the
requisite business, accounting, and mathematical skills,
and utilizing them with good common sense.
The ability to abide by ones judgment is an attribute of
character, having to do with patience, faith, and the
strength to endure alarming, nonmaterial short-term
fluctuations. Though it is based on strength of
conviction, it can appear passive in the face of events
that seem to demand action. Examples of sticking to
ones guns are the patience of Job, the fortitude of
Penelope, and the profound late works of Beethoven,
composed after the loss of his hearing.
All of the legendary investors, including Ben Graham,
Warren Buffett, and Philip Fisher seem to have
possessed these parallel attributes, which, at first glance,
can appear disparate. Put another way, the two
disciplines, selection and conviction, are also sequential
and of unequal duration, as in the acquisition of a prize-
winning acorn and the harvesting of an oak at a later
date.
Consider some examples of the investment prowess of
Benjamin Graham, Philip Fisher, and Warren Buffett.
Benjamin Grahams business career spanned the Great
Depression, and his ultra conservative investment
strategy was influenced by it. Margin of Safety as the
Central Concept of Investment is the title of the last
chapter of his book, The Intelligent Investor, which is
addressed to investors as opposed to speculators.
Grahams methodology was quantitative and
mathematical. His calculations enabled him to find
companies selling at discounts to their liquidating value.
He invested primarily in such bargains and held them
tenaciously, sure in his evaluation, until their value was
recognized in the market.
For an example of his prowess, I am indebted to a
passage from John Trains The Money Masters: Graham
noticed that Northern Pipeline held $95 per share of
quick assets, although it was selling at only $65, at
which price it yielded 9%. Grahams partnership bought
a substantial interest in the company with the thought of
encouraging it to distribute the unneeded assets to its
shareholders. At the 1928 annual meeting, he arrived
with proxies for 38% of the shares and went on the
Board of Directors. In due course he was instrumental in
persuading the company to pay out $50 per share. What
was left was still worth more than $50 a share, bringing
the total value to $100, or a substantial profit over his
cost of $65.
What distinguished Graham as a great investor was his
ability to define value and his conviction on the ultimate
outcome, which he either patiently waited for or induced.
Philip Fisher developed a rigorous 15-point checklist
for the selection of a growth stock that he was willing to
hold for a long period. In addition, he devised a highly
effective informal strategy to corroborate his
conclusions. This method, which he terms scuttlebutt,
consisted of tapping into the business grapevine of
individuals who were customers, employees, former
employees, suppliers, or competitors of the company
people closely connected to its operations and not in the
business of buying and selling stocks. Once a company
met his muster, Fisher bought in with the intention of
holding indefinitely as long as the fundamentals did not
change.
An example of Philip Fishers prowess is his investment
in Motorola, which was accumulated over of a period of
months beginning in 1957. Mr. Fisher told me recently
that he still retains every share of his original investment
in Motorola, 40 years later. Each dollar invested in 1957
is now worth slightly more than $242, a 14.7%
compound annual rate of return. A relatively small initial
investment is now worth many millions. Mr. Fisher
modestly requested that we not publish the actual size of
his initial and current investment.
3DJH 119
Investment Philosophy: Construction and Implementation (cont.)
John M. Snyder
Philip Fisher differs substantially from Ben Graham in
his focus on discovering companies having the
possibility of sustainable growth for many years in the
future.
Warren Buffett, who spent two years at Grahams
company, Graham Newman, credits both Graham and
Fisher for contributing to the philosophy leading to his
own notable investment record. He once said that his
investment philosophy was 85% Ben Graham and 15%
Phil Fisher. Many observers feel that the Fisher influence
has increased with the evolution of Buffetts thought.
Warren Buffetts best known success is his investment in
Coca-Cola, which was initiated in 1988. By the end of
1989, he had invested a little over one billion dollars in
the company, substantially completing his position.
According to the 1996 Berkshire Hathaway Annual
Report, his year-end 1996 position was 200,000,000
shares, having a market value of approximately $10.5
billion, compared to a total cost of approximately $1.3
billion.
Buffett differs from Graham and Fisher in his focus on
the value of a business franchise that he can easily
understand. He does not invest in technology-based
growth stocks, preferring consumer, insurance, and
financial businesses whose future streams of earnings he
feels are more predictable.
Successful investing along the lines of these three
masters is not impossible for individual investors. Less
well-known than Buffetts triumph with Coca-Cola are
the many shrewd individuals, particularly in the state of
Georgia, that made the investment decision to buy Coca-
Cola long before 1988, added to their positions over the
years, and achieved returns superior even to Buffetts by
selecting well and by exercising patience.
Philip Fisher told me that numerous readers of his
Common Stocks and Uncommon Profits (first published
in 1958) have reported very good results achieved by
investing according to his principles. Probably the
scuttlebutt element of Fishers approach has benefited
many successful investors in regional companies (Coca-
Cola in Georgia, for instance) simply because an
awareness of the companies acumen was common
knowledge in the area and readily available to local
investors.
Of course, these successful local practitioners also
exhibited the requisite patience, a trait with which some
people seem to be factory-equipped. Others lack the gene
entirely.
Fortunate are those who happen to have grown up in the
geographical backyard of a Coca-Cola, and had the
perspicacity to invest in it. Practically speaking,
however, most people havent had that good fortune or
the time and inclination to master the discipline of
securities analysis. The problem then becomes that of
developing an intelligent investment philosophy within
the constraints of limited time.
The quest begins with the investor educating himself or
herself by studying classic investment literature to obtain
guidelines to historically successful strategies, most of
which boil down to stringent research combined with a
long-term investment mentality. The writings of
Graham, Fisher, and Buffett are a good start, and are
accessible to the layperson in the following publications:
The Intelligent Investor, by Benjamin Graham
(Harper & Row, 1973)
Common Stocks and Uncommon Profits and Other
Writing, by Philip A. Fisher (John Wiley & Sons,
Inc. 1996 paperback edition)
Berkshire Hathaway Annual Reports 19771996,
written by Warren Buffett. A two-volume set of
letters from the 19771996 annual reports are
available to nonshareholders at a charge by written
request to Berkshire Hathaway Inc., 3555 Farnam
Street, Omaha, NE 68131
An excellent book, in my view, about Warren
Buffett (who has not written one, and has indicated
that his annual reports adequately reflect his
philosophy) is: Buffett, the Making of an American
Capitalist, by Roger Lowenstein (Random House,
1995)
3DJH 120
John M. Snyder
The process of developing an investment philosophy can
be broken further into a few key disciplines:
I. Obtaining Facts for Selection and Subsequent
Monitoring of Investments
This begins with reading investment classics like those
listed above. It is supplemented with financial
publications such as The Wall Street Journal, Barrons,
Business Week, Forbes, The Economist, Outstanding
Investor Digest, and statistical sources such as Value
Line Investment Survey and the Standard & Poors
Monthly Stock Guide. Specific company research is
available from the research department of the institution
with whom the investor has an investing services
relationship. Much information is also available on the
Internet.
II. Informal Inquiries into the Operation of a
Company
This consists of talking and listening to persons with
direct knowledge of a company employees, suppliers,
customers, and others who have a working acquaintance
with its operations, and who are not in the securities
business. It is an effort to obtain relevant public
information about a company, particularly its
management, and is not an attempt to extricate illegal
inside information. This element of investing is easier
with companies in ones geographical region, but it is
becoming more feasible at a distance with the advent of
investor chat forums and other venues on the Internet.
III. Reflecting Upon and Knowing Ones Self
This is the part of the process that requires the
application of sufficient thoroughness, ruthless
introspection, and self-honesty in the selection process to
justify the resolution to be patient once the investment is
made. This is no small matter, as applying patience to a
bad decision could have very unfavorable results. It is an
area where acquaintance with philosophical values
reflected in enduring literature, art, and religion come
into play since the selection process depends first on
determining the truth so far as it can be known, followed
by the faith to abide by ones determination so that the
truth may out. In a fast-moving world where the
preference is for instant gratification, the requisite
disciplines may place the long-term investor in a lonely
position.
IV. Writing Down an Investment Philosophy
The last step in the process is to put in writing an outline
of ones plan. A plan might include some or all of the
following topics:
1. Characteristics of Investable Companies:
A business that can be easily understood
An enduring franchise
Steady history of revenue and earning increases
Strong finances
A leader in its industry
Management has significant stock ownership (eats its
own cooking)
Good management with long-term focus and
enlightened employee relations
Substantial investment in R&D and modernization
The CEO is a visionary genius in his or her field
2. Characteristics of Companies to be Avoided:
Participation in too many businesses to be easily
understood
Little stock ownership by management
Highly competitive business with no significant edge
Overcompensated officers
Poor employee relations
Excessive financial leverage
Erratic historical earnings
Overdependence on one supplier, one product, or one
customer
Insufficient R & D budget to remain competitive
Turnaround situation with too much uncertainty
3DJH 121
John M. Snyder
3. Methods of Financial Evaluation:
Debt issues credit rating
Degree of financial leverage
Magnitude of free cash flow
Price-earnings ratio reasonable in relation to past and
projected growth rates
Consistent stock repurchases
Dilution of outstanding stock options offset by share
repurchases
4. Sources of Investment Information:
Annual reports, 10-Ks, and 10-Qs
Mailing lists
Websites
Professional investment associations
5. Selection and Monitoring of Positions:
Cultivate contacts customers, employees, and
suppliers of companies in which the investor is
interested
Use the Internet to contact fellow shareholders and
other interested groups
Monitor the comments of large shareholders
Attend corporate annual meetings
Listen to quarterly conference calls reviewing
managements discussion of earnings
Attend company roadshows when in the investors
locality
Speak to Investor Relations personnel, who often
reflect the spirit and attitude of a company
Keep abreast of relevant scientific research at the
highest level the investor can understand
(publications such as Scientific American, Popular
Science, Consumer Reports, and the science section
of the newspaper can be useful)
Read publications of appropriate trade associations
6. Sell Disciplines:
When subsequent developments make it clear that the
original selection was a mistake
When, over time, there is a negative change in
fundamentals such as a mass exodus of key
personnel, new management reveals a short-term
orientation or self-serving policies, an inability to
maintain profit margins, technological obsolescence,
or the inability or a corporate unwillingness to fund
sufficient R&D to remain competitive
When an overwhelmingly superior investment
becomes available
These six steps outline many of the components of what
is involved in constructing an investment philosophy. In
some ways, the process is simple, as a few good choices
can be exceedingly profitable over time. The complexity
lies in the accuracy and good judgment required in the
selection process, and the considerable fortitude
necessary to stay with a good selection to reap the long-
term returns from investing.
In any case, the job seems simple when both the
selection and the abiding are well-executed. It has
generally been to the advantage of the successful High
Net Worth investor to have associated himself or herself
with an institution having a reputation of significant
competence and integrity. Equally important, has been a
relationship within that institution with a person or
persons who have shown the ability to discern value, and
who firmly uphold the discipline to stick with good
positions for long periods of time. This approach is
supported by the observations of Ben Graham, Philip
Fisher, and Warren Buffett. These prophets utterances
should be revisited with some degree of frequency, as
the virtue of patience resides in an area easily susceptible
to backsliding, and where periodic renewal is in order.
3DJH 122
Investment Philosophy: Qualitative Investment Factors
Thomas C. Frame
Perhaps 90% of investment literature and dialogue
focuses on the quantitative, mathematically certain
characteristics of securities. After all, accounting is the
language of business, and price earnings ratios, earnings
growth, return on equity, and margins are the tools of
investment analysis. At the same time, most successful
investors realize that the quantitative factors are merely
the starting point. Most of the really large returns, the
ten-baggers, accrue to those skilled in evaluating the
qualitative investment factors. Warren Buffett credits his
partner, Charlie Munger, with convincing him that it is
better to buy a great business at a good price than a
good business at a great price. Great businesses are
distinguished by the uncommon characteristics which are
not easily measured and not easily replicated.
While the qualitative factors are not complex, successful
investing requires an experienced evaluation of their
importance vis-a-vis the quantitative issues. It comes as
no surprise that the best companies in an industry
typically trade at a premium to the average. Yet, it is
possible over and over to find vastly superior companies
trading at modest premiums to average performers. With
this in mind, it is almost always a mistake to purchase
the statistically cheaper company, since the really great
ones are always expensive. The justifications for these
premiums are found in the qualitative factors. Some of
the most important are the following:
Management
To some extent, investing in any stock represents a leap
of faith for an investor who is in essence turning over
personal funds to the companys management. Buffett
has advised buying a business even an idiot could run,
because sooner or later, one will. A great management
team cannot make a mediocre business great, but its
value to an already good business is incalculable.
Absolute integrity is a must, but perhaps the best
yardstick is a long-term total commitment to enhancing
shareholder wealth. The investor should be especially
wary of the bureaucratic, caretaker management with
little regard for the long-term return to shareholders.
Particularly in financial companies, a strong culture of
management conservatism in lending and underwriting is
far more important than the appearance of adequate
reserves.
Longevity of management and founders with a stake in
the business are also a meaningful indicator. Jack Welch
often credits his having sufficient amounts of time to
implement important changes to General Electrics long-
term success. Would anyone question Bill Gates or Sam
Waltons dedication to the shareholders best interests?
Founder/entrepreneurs often offer one of the best
financial bargains, as their compensation typically is
minimal compared to their ownership interest. They act
like owners because they are. On the other hand,
handsome compensation packages in and of themselves
are not a negative. Jack Welch, Roberto Goizueta of
Coca-Cola, and Michael Eisner of Disney each have
been able to accumulate significant wealth while
delivering outstanding returns to shareholders.
In addition to a long-term track record, most executives
reveal a great deal in their annual letter to shareholders.
Their enthusiasm is readily apparent and the best seem to
demonstrate a palpable love for their business and a
candor for straightforward discussion of problems. The
investor who reads a number of annual reports can
quickly discern which are the outstanding management
teams. Buffett has talked of the tailor who is thinking
only of suit sizes when he meets the Pope. Reading an
annual letter from Al Zeien of Gillette or the late
Roberto Goizueta of Coca-Cola seems immediately to
reveal a passion for their business which is rarely found.
A prime example is Jack Welch describing GEs Six
Sigma program as a soul transforming experience for
GE employees. While it may not make the investor want
to work at GE, it demonstrates an intensity that
shareholders admire and appreciate.
Research and Development
Research and development of new products is critical for
sustaining superior performance from almost all
companies. It is also one area which is virtually
impossible to assess from quantitative reports and
requires extensive trust in management. Particularly in
the healthcare and technology fields, the average investor
3DJH 123
Investment Philosophy: Qualitative Investment Factors (cont.)
Thomas C. Frame
would have no way to determine what a company may
be working on for future products or how effective those
products are likely to be. The investor can only rely on
managements demonstrated success and technological
capabilities.
When properly implemented, the research and
development process should offer not only superior new
products but also additional pricing power, brand
leverage, and cost reduction potential.
Gillette has apparently spent over $750 million to
develop its new Mach 3 razor. Since its development
was shrouded in secrecy, investors can only rely on the
companys long-standing track record that the funds
were well spent. Similarly, investors can never truly
assess the drug pipeline of a Merck or Pfizer, but they
can be fairly confident that a number of potential
products are on the way.
Often, a superior research and development process
offers the additional benefit of causing current reported
results to be very conservative. Much of the cost of
significant new products from Intel and Microsoft is
likely expensed in this years numbers even though
revenues may not appear for several years. Astute
analysts noted several years ago the higher-than-normal
research expenses showing up at Pfizer. While it is
impossible to quantitatively evaluate the future films and
other products which are being developed by the Walt
Disney Company, their likely existence has probably as
much to do with the rationale for purchasing the stock as
any numerical criteria.
The Brand
Of the assets a company owns, brand strength is likely
the most powerful, yet the most difficult to achieve and
maintain. No single statistic provides insight into its true
value. Executives move on, machinery wears out, and
products become obsolete, but a brand can be maintained
as a basis for sustainable, profitable growth. Yet a brand
is far more than successful product positioning or clever
advertising. Good business managers know that a brand
should dominate all decisions and be protected at all
costs. They understand that strong brands are effects, not
causes. They are the result of attention to millions of
details relentlessly pursued by a dedicated culture.
Good brand managers have a clear idea of what they
want to represent to consumers. McDonalds is careful to
ensure that a Big Mac provides the same experience
worldwide. Disney employees know that when they refer
to The Mouse, an image is evoked of quality, family
entertainment that stands for something in the
consumers mind. Disney received a special exemption
from the international maritime authorities to paint the
lifeboats on its new cruise ships yellow to match
Mickeys colors. They live the brand. Protecting a brand
is sometimes painful: to maintain their brand Johnson &
Johnson quickly recalled all its Tylenol to reestablish
consumers trust and Intel replaced the Pentium chips
which contained an obscure flaw.
The brand which is well nurtured should offer both
strong pricing power and the volume growth which
makes displacement extremely difficult. In time, these
should become reflected in the companys numbers and
stock price performance.
Each of the above qualitative factors adds an important
dimension to the quantitative assessment of investments,
highlighting the longer-term endurable facets of an
investment. The investor is well served to remember that
precisely because of its precision, accounting is
inadequate to capture imprecise but far more important
investment criteria. Mastery of both realms is the key to
superior performance.
3DJH 124
Investment Philosophy: Investment Manager Selection Criteria
Jesse L. Carroll, Jr.
The principal factor in the success of most portfolio
managers is really not the particular technique, but the
skill of the manager using that technique.
Institutional Investing, by Charles W. Ellis
Technique, method, strategy, style, system: however one
labels the investment selection process, every authentic
investment manager generally abides by one. With the
current abundance of investment vehicles and styles, and
investors generally positive experiences with financial
assets, there seems to be no shortage of ways to manage
money. Even when the investor has focused his or her
search on a specific type of style and/or vehicle, he or
she must continue to search, with detail and discipline,
for the most appropriate investment manager.
For the High Net Worth individual investor, the primary
objective of investing has remained undisturbed over the
years for all practical purposes. The overwhelming
majority among this group invest to increase wealth
and/or to insulate their capital from the depredations of
inflation and taxes. This implies that capital should be
invested in some manner to maximize total real return
after taxes. Accordingly, an investment manager who
fails to take account of the potentially negative effects of
inflation and taxes, fails to recognize the true nature of
the individual investment world. As a result, his or her
investment methodology is severely disadvantaged.
In the October 15, 1997 Wood, Struthers & Winthrop
Quarterly Investor Letter, Stanley A. Nabi, Chairman of
their Investment Policy Committee, spelled out a highly
encompassing description of the right stuff required of
top calibre investment managers. He stated that:
Investing is a dynamic process that possesses
none of the limits of the physical sciences. It is a
discipline that demands a panoramic view of
substantially all of the relevant information
accumulated over the history of mankind. It
requires familiarity with science and technology,
an understanding of politics and international
relations, an appreciation of the role of social
psychology (and the hysteria of crowds), a grasp
of the various shadings of accountancy, a
generally accurate assessment of the
production/consumption factors that drive the
engines of the important economies of the world,
and the exacting sense to accord each of the
foregoing its proper value in the investment
equation. In short, it is a discipline beyond human
capacity to master totally.
Any reader of this superhuman job description has no
reason to wonder why indexing has grown so rapidly and
become such a popular alternative to active management,
particularly in the institutional arena.
Selection of an investment manager is, in some ways,
more manageable than the challenges Nabi describes
facing a full-time investment manager, yet selection is
still a difficult task. Selecting an investment manager is
analogous to a high-level executive search, backed up by
extensive analysis. Containing both qualitative and
quantitative factors, a useful framework for selecting a
manager can be summarized in the four Ps: people,
philosophy, process, and performance.
Investment Manager People Evaluation Criteria
The first area of inquiry, people, concerns the
organization supporting the managers investment
activity. Some of the key issues to address in evaluating
asset managers are set forth in the accompanying box.
What is the ownership structure?
What are the reporting lines?
What is the depth of the professional staff, including
portfolio managers, analysts, traders, and the
administrative support team?
Who is (are) the key decision maker(s)?
How is compensation determined?
How is the organization planning to handle the strains
created by growth in assets under management?
What succession plan, if any, is in place?
Investment Manager Philosophy Evaluation Criteria
The next area to probe, philosophy, is the heart and soul
of the managers technique. Correctly understanding a
managers philosophy may be the most difficult
challenge the High Net Worth individual investor faces
in selecting an investment organization or person to
manage his or her assets. This is the P where the
greatest value is added by the individual investor who
can devote the resources to research the issues described
in the accompanying box.
3DJH 125
Investment Philosophy: Investment Manager Selection Criteria (cont.)
Investment Manager Philosophy Evaluation Criteria
How does the manager define his or her philosophy?
Is the managers philosophy understandable and does
it make sense?
Has the managers philosophy been applied
consistently? What proof is there of a consistent
application of the philosophy?
Does the manager eat home cooking (manage his or
her own funds pari passu with his or her clients
funds)? If so, what percentage of the managers assets
are committed to his or her technique? If not, why?
Are all clients treated equally? If not, what are the
exceptions and why? Do these exceptions make
sense?
Does the manager attempt to time the market, or
remain fully invested at all times? Does the managers
philosophy fit the clients investment objectives?
What is the managers turnover rate? What portion of
the turnover is attributable to investment decisions,
harvesting of unrealized losses, and client requests for
withdrawals?
Investment Manager Process Evaluation Criteria
The third point of examination, process, concerns the
implementation of the managers technique. The
accompanying box furnishes a number of factors of use
in the evaluation of a managers investment management
process.
Can the process be clearly and simply articulated,
despite the complexities of the underlying discipline?
Can it be replicated by others in the event of a
manager departure?
Can the process be tracked and monitored for
investment style drift?
Are the fees charged reasonable?
What allowances does the manager make for new
business presentations, interacting with, and servicing
clients? Do clients have direct access to the manager
on an ongoing basis?
Where and how does the manager source investment
ideas?
What are the sources for research? What are the
buy/sell guidelines?
Investment Manager Performance Evaluation Criteria
The final area of inquiry, performance, is the statistical
yardstick for assessing a manager's technique. Some
components of this evaluation methodology are
contained in the accompanying box.
Are the published returns compliant with the standards
of the Association for Investment Management and
Research (AIMR)?
Does the record belong to one decision maker or
several?
What percentage of the managers accounts are
included in his or her composite investment returns?
How much variance is there within the managers
composite return results?
What is the appropriate benchmark for comparative
purposes?
What are the after-tax returns?
What are the risk-adjusted returns?
How frequently and under what format is performance
reported?
These four Ps, of people, philosophy, process, and
performance, are intended to provide the individual
investor with a set of filters to select, from among the
multitude of choices, the most appropriate investment
manager, given the investors specific objectives,
circumstances, and resources.
Even though wide currency, equity, and bond market
fluctuations may at times loom large in investors
consciousness, High Net Worth investors need to stay
focused on the true underlying issues: inflation, taxes,
and investment results. We believe establishing long-
term investment guidelines, determining the appropriate
strategic asset allocation, and using the four Ps for
investment manager selection are among the most
important means of enhancing the individual High Net
Worth investors chances of achieving his or her long-
term financial goals.
3DJH 126
Investment Philosophy: Evolution of the Core Equity Concept
Walter Maynard, Jr.
We believe a successful investment strategy for an
equity-oriented taxable investor should consider as one
of its primary objectives, the holding for three to five
years or more, of a diversified group of quality growth
stocks. This time period should allow for a reasonable
number of positive surprises as well as bridge any
normal period of down markets. The initial commitment
might include ten positions, out of perhaps 2530 in the
portfolio, which could be called core holdings: that is,
participations in companies with excellent business
prospects which can be held indefinitely for significant
long-term rewards. These stocks are generally expensive
in valuation terms. In the advanced stages of a bull
market, they may very well be selling at prices of two or
more times their expected long-term earnings growth
rates. Nevertheless, if experience is any guide, they will
be well worth paying up for. To illustrate the point,
assume a portfolio managed since the mid-1970s
contains within its list of core holdings three of unusual
duration, shown in the table below.
Table 1: Selected Core Holdings List
Shares Company
Purchase
Date Cost
Market
Value
12/31/98 Appreciation
Compound
Annual
Growth
Rate
13,200 Dayton Hudson 1/14/1976 $16,956 $699,144 41x 18%
32,000 Abbot Labs 8/19/1982 61,901 1,568,000 25x 22%
16,000 Johnson &
Johnson
8/19/1982 83,973 1,258,027 15x 18%
Source: MSDW Investment Group.
Dayton Hudson was purchased to participate in the already
well-defined growth of the Target discount chain. Abbott
Labs and Johnson & Johnson were then, as they are
generally viewed now, recognized leaders in health care
products. The timing of these purchases was clearly
favorable. In 1976, the U.S. equity market was still
recovering from its worst decline since the 1940s. August
19, 1982, was a day or two after then-Federal Reserve
Chairman Paul Volcker brought about a historic reduction
in short-term interest rates (then in the mid-teens), which
marked the beginning of a bull market in stocks and bonds.
At the same time, there are numerous examples of strong
relative performance among the leading growth stocks
bought in 1973 at record high prices of three or four times
their earnings growth rates. Many of these stocks fell by
5075% in 19741975, but after a sufficiently long
recovery period, the best companies among this group had
generated superior cumulative investment returns through
the late 1980s and during the 1990s. In his book, Stocks for
the Long Run, University of Pennsylvania Professor Jeremy
Siegel points out that an investor who purchased all Nifty
Fifty companies (including 20 or more which generated
lackluster returns) at peak prices in 1972 would have earned
12.5% annually on such a portfolio over the succeeding 25
years, only 20 basis points less than the S&P 500 index
over the same time period.
Genesis of the Core Holding Approach
In the 1950s and early 1960s, bank trust departments
comprised the largest category of institutional investors.
For these institutions, the primary investment objective
was to preserve capital while participating in the overall
growth of the economy. Serving this purpose was a
recommended list of core stocks from which trust
officers would construct client portfolios. The idea was
to have representation at all times across a wide
spectrum of the economy via a selection of established
blue-chip industry leaders. A typical list included such
names as AT&T, Alcoa, Eastman Kodak, Du Pont, Dow
Chemical, General Motors, RCA, General Electric,
General Foods, International Paper, IBM, Merck, J.P.
Morgan, Sears Roebuck, Union Carbide, and U.S. Steel.
These were all considered core stocks of the day.
Industry analysts at Wall Street firms provided
maintenance research on these holdings and sought to
uncover new opportunities that would add to investment
performance. Acceptance of a new name onto the trust
departments approved lists could create a torrent of
institutional commissions, particularly if this involved a
switch out of another holding. Gaining acceptance of
new names for these lists was difficult. Final decisions
were made by an investment committee whose members
were often veterans of the 1930s and 1940s. Committee
members were typically comfortable with virtually all
the names on these lists including deep cyclicals such as
Alcoa, Union Carbide, and US Steel, which had
3DJH 127
Investment Philosophy: Evolution of the Core Equity Concept (cont.)
Walter Maynard, Jr.
performed well in the 1950s and early 1960s. The
infrastructure of the U.S. economy was growing rapidly.
Smokestack companies were benefiting from major
technological advances. Import competition had not
begun to limit pricing power. In time, committee
members resistance to change was overcome, and a
gradual shift took place from well-known cyclical stocks
to core holdings that were believed to offer consistent,
fairly predictable growth.
IBM came to epitomize all the desirable characteristics
for a core holding in the 1960s and 1970s. It became the
single most essential stock to be bought and held in all
the bank trust departments and in the large internally
managed pension funds that had come to dominate the
institutional investment landscape. When IBM began to
falter and fell on hard times in the 1980s, the idea that
certain stocks could be bought and held indefinitely was
dealt a severe blow.
A greater degree of investment flexibility was also
facilitated by the decline in institutional brokerage
commission rates and the buildup of brokerage firms
institutional sales and trading departments, which
facilitated, first, block trading and then program trading
of entire portfolios. A further shift took place in the mid-
1980s and the 1990s, marked by the ascendance of
mutual funds as the dominant institutional investor
group. Superior performance became necessary to attract
investors, and portfolio turnover increased with little
regard to the associated tax consequences. Given the
diversity of styles pursued by equity mutual fund
managers, the core designation began to be applied to the
leading stocks in an industry group, rather than to a list
of stocks chosen for the portfolio as a whole. For
example, Microsoft and Intel ascended to the first rank
among the must-own technology stocks. Merck and
Pfizer achieved similar prominence in the
pharmaceutical sector.
On the eve of the twenty-first century, the investment
landscape is again undergoing change. Indexation and
the quest for high-quality exposure to global markets
have enhanced the appeal of large capitalization U.S.
equities. These stocks also offer liquidity and are
perceived to have reduced volatility relatively and the
resources to weather adverse operating conditions. At the
same time, High Net Worth investors have come to
appreciate the advantages of owning stocks in separate
accounts so as to avoid the tax consequences of high
turnover and to control the overall level of asset
management expenses. An additional motivation has
been the wide publicity given to Warren Buffetts long-
term investment success, achieved through buying and
holding Coca-Cola, Gillette, and other global brand-
name companies. Buffetts followers constitute a
growing constituency of separate account owners who
believe in the concentration of their investments among a
group of core holdings.
Characteristics of Core Holdings
What are the chief characteristics of core holdings? Fortune
magazines annual listing of most admired companies
provides some useful criteria: (i) innovativeness; (ii) quality
of management; (iii) employee talent; (iv) quality of
product/services; (v) long-term investment value; (vi)
financial soundness; (vii) social responsibility; and (viii) use
of corporate assets. The following table lists the overall
winners for 1997 and 1998:
Table 2: Fortune Magazines
Most Admired Companies
Rank 1997 1998
1 General Electric General Electric
2 Microsoft Coca-Cola
3 Coca-Cola Microsoft
4 Intel Dell
5 Hewlett Packard Berkshire Hathaway
6 Southwest Airlines Wal-Mart
7 Berkshire Hathaway Southwest Airlines
8 Disney Intel
9 Johnson & Johnson Merck
10 Merck Disney
Source: Fortune, March 2, 1998 and March 1, 1999.
What is interesting about these lists is that among Fortunes
10 Most Admired Companies, virtually all have large
capitalizations and apparently impressive records of growth
in earnings per share. Yet the criteria for selection are
primarily subjective rather than objective. These same
criteria could be used to evaluate most established public
companies. The following paragraphs list some analytical
3DJH 128
Walter Maynard, Jr.
Table 3: Per Capita Beverage Consumption in the 10 Most Populous Countries
China India
United
States Indonesia Brazil Russia Japan Mexico Germany Philippines
Population (in Millions) 1,294 960 272 203 163 148 126 94 82 71
Per Capita 1996 (8 oz. equiv.) 5 3 363 9 131 13 144 332 201 171
Per Capita 1997 (8 oz. equiv.) 6 3 376 10 134 21 150 371 203 130
Source: The Coca-Cola Company 1996 and 1997 annual reports.
criteria that we think have proven useful in identifying
fairly consistent predictability in sales and earnings
growth, an essential characteristic sought in a core equity
holding.
Ability to Manage Unit Growth and Build a National
Franchise. Kmart and McDonalds were considered the
classic unit-growth investments in the 1960s and 1970s,
when the markets for discount stores and fast food chains
were virtually untapped. Both companies were seen as
having visionary managements which seized on the
opportunity of creating national chains. In the 1990s,
Wal-Mart is considered by many as the pre-eminent
mass merchandiser, as a result of its emphasis on
operating efficiency and its ability to evolve steadily
more productive store formats. Home Depot is a recent
example of the successful exploitation of a new
merchandise concept, focusing on the do-it-yourself
market. The company is still considered to have
considerable opportunity for unit growth via
geographical expansion as well as from new store
formats. The Gap is another example of a strong unit
growth company which has achieved dominance among
apparel retailers.
Global Consumer Brand Franchise. Coca-Cola and
Gillette have had immense success in exporting
quintessential American consumer products around the
world. Despite the uncertainties created by economic and
financial developments in 19971999 in Asia and Latin
America, the long-term marketing opportunities for these
companies should remain substantial. For example,
Coca-Colas most recent figures, in Table 3 below, show
that among the 10 most populous countries in the world,
three of the top five still have per capita annual unit soft-
drink beverage consumption of 10 or fewer. Yet China,
with a per capita consumption of six, is now one of the
companys top-10 volume markets case sales there
grew 30% in 1997.
Similar opportunities seem to exist for other global
consumer brand companies, including Avon Products,
Philip Morris, Gillette, Procter & Gamble, Colgate
Palmolive, and Wrigley. While the economic turmoil
created by the financial crises of the late 1990s in Asia
and Latin America may have temporarily halted growth
in many of the affected countries, leading companies
such as these should have the resources to sustain
operations and to take advantage of pent-up demand
when the recovery process begins. As of early 1999,
Gillette had projected a return to 15% growth by late
1999, largely on the strength of the Mach 3 shaving
system, which began to be rolled out in developed
markets in 1998.
Developing and Managing a Large Installed Base for
an Expanding Product Line. IBM and Xerox pioneered
this concept in order to achieve long-term market
dominance in their respective specialties of mainframe
computers and office copiers. Each new generation of
equipment could be sold or leased into the installed base
with relative ease, displacing older, less-efficient units
which were redistributed elsewhere. By inventing and
effectively dominating the copier market, Xerox
achieved significant unit growth in its early years.
Ambitious projections of the office copier market
potential proved conservative, and Xerox stock seemed
to more than justify its early P/E of over 100 times
earnings.
In the late 1990s, it is not sufficient, in our view, to have:
(i) the ability to manage unit growth; (ii) a global
consumer brand franchise; or (iii) a large installed
product base. For ongoing success, a broader effort is
3DJH 129
Walter Maynard, Jr.
required, incorporating some or all of the following
characteristics.
An Enterprise Solution: Potential core investment
companies may demonstrate the ability to become a
single source for all of a large users needs by providing
the right combination of products and services for a
range of applications throughout the company. Failure to
anticipate and implement this strategy was considered
IBMs mistake in the 1980s. IBM management
apparently underestimated the potential for
minicomputers and PCs, while trying to preserve the
companys virtual monopoly on mainframe computers.
Today both IBM and Xerox offer enterprise solutions
and consequently are once again viewed as core
holdings.
Excellence in Research: Research ingenuity,
productivity, and cost effectiveness are considered
particularly important for technology and pharmaceutical
companies. For example, Intels ability to design ever
more powerful microprocessors, doubling in
performance every 18 months, has contributed to making
it the dominant supplier and mainspring of productivity
growth for the PC industry. It can be said that
Microsofts enterprise software solution strategy is really
a process of research, development, and testing with
minimal manufacturing expense. Intels faster processing
speeds would seem of little commercial value were it not
for Microsofts commensurately more productive
software. Microsoft Windows NT 2000 software for
networks and servers represents the most recent example
of the companys migration into steadily more
comprehensive and powerful applications, and the most
likely source of the companys next phase of revenue
and profitability growth.
For quite some time, Merck has been among the research
leaders in the pharmaceutical industry, and not
coincidentally, one of the largest and most successful
U.S. drug companies. Pfizers recent revenue and
earnings growth has also derived from a prolific research
program which has produced a series of very successful
drugs. While drug research tends to be precisely targeted,
a large enough budget can produce fortuitous results.
Pfizers Viagra was a by-product of human testing for a
cardiac drug. Minnesota Minings Post-it family of
products is a second example of a hugely successful
brand emanating by accident from a world-class research
effort.
Capacity for Self-Regeneration: Superior-quality
companies typically have the resources and staying
power to right themselves and correct their mistakes. For
example, in the late 1990s, Coca-Cola and Disney have
encountered periods of slower earnings growth, but both
are expected to rise to the challenge of regaining
momentum. Often, the key ingredient is a visionary
leader who is able to re-focus the company. General
Electric could have stagnated had not Jack Welch seen
the potential for GE Capital to become a significant
engine of growth. IBM successfully emerged from a
period of adversity and reached new levels of strong
performance under the guidance of Lou Gerstner. The
same results were generated at American Express under
Harvey Golub. These latter two individuals are
considered to have exceptional organizational and
marketing skills developed in prior management
consulting careers.
Timing of Core Purchases
Core stock relative valuations are almost always high. It
is important therefore for investors to anticipate positive
changes in company prospects well in advance. Specific
examples in one managers experience relate to the
timing of initial positions in Microsoft and Pfizer.
It was widely known in the fall of 1993 that Microsoft
had in development a major Windows operating system
upgrade which would greatly enhance PC speed and ease
of use. A PC with an Intel Pentium processor and
Windows 95 operating software would likely have
highly attractive price-performance characteristics. As it
happened, the Windows 95 introduction was
considerably delayed, and Microsofts stock price in late
1993 had already gone nowhere for almost two years.
Since the initial purchases in late 1993, Microsofts
strong stock price performance through early 1999 was
driven by powerful trends in PC demand, networking
and emerging commerce on the Internet.
The Pfizer purchase decision early in 1990 resulted from
a tragic circumstance at the time: a series of structural
3DJH 130
Walter Maynard, Jr.
failures in Shiley heart valves resulted in the deaths of
several hundred heart patients. Shiley was the leading
manufacturer of heart valves at the time, but a minor
subsidiary of Pfizer. These failures triggered over 100
expensive lawsuits. Although most pharmaceutical
analysts stopped recommending Pfizer, one analyst made
a compelling case that the companys strong balance
sheet and ample liability insurance were more than
adequate to handle the risk. Widespread uncertainty and
confusion concerning the companys prospects provided
an attractive opportunity to initiate a position in Pfizer
common stock. Over the succeeding years, Pfizers
strong research pipeline produced a series of very
successful drugs. As a result, earnings quadrupled and
the price-earnings multiple tripled, over the 19901999
period, with the stock assuming core status in many
portfolios.
In Table 4, we see what the results of these investments
would have been for one portfolio.
Table 4: Initial Positions in Microsoft and Pfizer
Company Purchase Date
Average
Purchase Price
Per Share
Market
Price
3/1/99 Gain
Microsoft 4/15/939/29/93 9.65 154 16.0x
Pfizer 2/26/904/11/90 7.59 135 17.8x
Success Factors in Core Equity Investing
This discussion focuses on specific attributes of large
U.S. companies which enable them to compete
effectively in global markets and maintain superior
growth rates in sales and earnings per share. It seems
hardly an accident that in 1998, the largest 25 stocks in
the S&P 500 accounted for 63% of the indexs 28.6%
gain, and that over the last five years, average earnings
growth of the 30 largest companies has been 19.5%
versus just 11.6% for all the companies in the index. In
an era when pricing power is often absent, economies of
scale are needed to drive down costs. Large companies
are important to their suppliers, and this gives them the
leverage to enforce price concessions. The most
successful large companies often are those which have
proven to be skilled acquirers, enabling them to add
businesses which strengthen existing units or gain entry
into promising new markets. For example, acquisition
strategy has been a critical element in General Electrics
success, and is likely one of the reasons why the
company has held first place two years in a row on
Fortunes Most Admired list.
Particularly in the advanced stages of bull markets, many
sectors and companies, including core holdings, trade at
extended valuation levels. In such periods, High Net
Worth investors in our view need to be rigorously
disciplined and discerning in the identification and
purchase of core equity positions. In the search for
companies whose intrinsic value and earning power will
continue to grow even during long episodes of flat or
declining equity prices, investors should look for: (i)
attractive business fundamentals; (ii) predictability of
revenue growth; (iii) management strength; and (iv) skill
in defending the companys profitability characteristics.
We believe the investors ability to evaluate these and
other characteristics of potential core equity holdings
will often be the differentiating factor between merely
mediocre investment results and superior long-term
returns.
Prices for the stocks mentioned in this article as of March 19, 1999, are as follow (Morgan Stanley Dean Witter Research ratings for the
stocks are included where applicable): Abbott Labs ($49, Neutral); Alcoa ($40, Underperform); American Express ($127, Strong Buy);
AT&T ($82, Strong Buy); Avon Products ($45, Outperform); Berkshire Hathaway ($77,800); The Coca-Cola Company ($68, Outperform);
Colgate Palmolive ($89, Outperform); Dayton Hudson ($69, Strong Buy); Dell Computer ($42, Outperform); Walt Disney ($35, Strong
Buy); Dow Chemical Company ($97, Outperform); E. I. Du Pont ($56); Eastman Kodak ($67, Neutral); General Electric ($110, Strong
Buy); General Motors ($89, Outperform); Gillette ($62, Outperform); Hewlett-Packard ($74); Home Depot ($65, Outperform); IBM
($177, Outperform); Intel ($121, Strong Buy); International Paper ($45, Neutral); J. P. Morgan ($124); Johnson & Johnson ($89,
Outperfom); Kmart ($17, Outperform); Merck ($86); Microsoft ($172, Outperform); Minnesota Mining and Manufacturing (3M) ($73,
Neutral); Pfizer ($143); Philip Morris ($41, Strong Buy); Procter & Gamble ($92, Outperform); Sears, Roebuck ($45, Outperform);
Southwest Airlines ($33, Strong Buy); The Gap, Inc. ($68, Neutral); U. S. Steel Group ($24, Neutral); Union Carbide ($44, Outperform);
Wal-Mart Stores ($98, Outperform); William Wrigley Jr. Company ($90); Xerox ($53, Outperform).
3DJH 131
Investment Philosophy: Tax-Efficient Separate Account Management
Paying taxes is one of lifes certainties. But for the
taxable investor, how much he or she pays can vary
widely depending on the tax efficiency of his or her
portfolio. Just as importantly, the after-tax return on a
portfolio, not the pre-tax return, will determine the
amount of wealth buildup the taxable investor achieves
over his or her lifetime.
Tax-efficient investment management has its roots in
legislative developments that have occurred over the last
30 years. After the Dow Jones Industrial Average
plummeted from the 1,000 mark in 1973 to below 600 in
1974, IRAs were introduced. Two years later, the Tax
Reform Act of 1976 was passed, resulting in the
introduction of open-end municipal bond funds and
variable life programs. Tax law revision in 1978 created
401(K) plans. Tax-exempt money market funds were
unveiled in 1979. In 1982, universal IRAs were rolled
out. The Tax Reform Act of 1986 reduced IRA
deductibility. Finally, as a result of the Taxpayer Relief
Act of 1997, Roth, Education, and conventional IRAs
were ushered in along with lower capital gains rates and
schedules.
1
As important as these legislative developments were,
they dealt for the most part with providing mechanisms
to defer pre-tax income for investment in accounts that
were not subject to tax until the funds are withdrawn,
typically at retirement. The mutual fund industry has
benefited handsomely from these developments, as it is
estimated that more than half of the entire mutual fund
industrys assets today are made up of some type of tax-
deferred account. But what about the financial assets the
taxable investor cannot shield from taxes? How does he
or she approach the problem of investing to achieve the
most attractive after-tax rate of return on funds that are
earmarked for long-term capital appreciation? Tax-
efficient separate account management may be one
solution to this dilemma.
As an illustration of the effect of taxes on portfolio returns,
assume three different hypothetical portfolios, Portfolio A,
Portfolio B and Portfolio C. After 12 months, each

1
Strategic Insight Overview, October 1998.
portfolio returned 12% pre-tax on a $1,000,000
investment. All three investors are in the 39.6% Federal
tax bracket (state taxes are not included). Each investor
assumed that he or she had posted an attractive 12% return
for the year. But after analyzing the derivation of the
respective 12% returns, a totally different conclusion is
drawn: Portfolios B and C fared much better than Portfolio
A, in fact, 31.9% and 44.3% better, respectively. Why?
The tax-efficiency of Portfolios B and C compared to
Portfolio A.
Calculated Portfolio Returns
Portfolio A Portfolio B Portfolio C
% $ % $ % $
Dividends 3.0 30,000 2.0 20,000 1.0 10,000
Short-Term Gains 7.0 70,000 0.0 0 0.0 0
Long-Term Gains 0.0 0 3.0 30,000 0.0 0
Unrealized Gains 2.0 20,000 7.0 70,000 11.0 110,000
Pre-Tax Return 12.0 120,000 12.0 120,000 12.0 120,000
Portfolio A Portfolio B Portfolio C
% $ % $ % $
Taxes Owed
Dividends at 39.6% 11,880 7,920 3,960
Short-Term Gains at 39.6% 27,720 0 0
Long-Term Gains at 20.0% 0 6,000 0
Total Taxes Due 39,600 13,920 3,960
After-Tax Return 8.0% 80,400 10.6% 106,080 11.6% 116,040
Tax Efficiency Ratio 67.0 88.4 96.7
Source: Portfolio Management Consultants, Inc.
In evaluating the preceding table, the ratio of the three
portfolios after-tax returns to their pre-tax returns, the
portfolios tax-efficiency ratio, is the key measure.
Portfolio A, with a pre-tax return of 12.0% and an after-
tax return of 8.0%, can be described as 67.0% tax
efficient. Similarly, the tax-efficiency of Portfolios B and
C is 88.4% and 96.7%, respectively. The determinant of
a portfolios tax-efficiency is the composition of the
return on investment from the various sources of returns.
The greater the contribution to total return from the most
tax-favored sources of returns, the more tax efficient the
portfolio.
3DJH 132
Investment Philosophy: Tax-Efficient Separate Account Management (cont.)
Tax-efficient separate account managers pursue high
after-tax returns by endeavoring to balance investment
considerations with tax consequences. The investment
decision should always dominate, but investment
decisions are never made without taking tax
ramifications into account. The goal of the tax-efficient
separate account manager is not to avoid taxes
altogether, but rather to maximize the after-tax return for
a portfolio over the long term.
Before turning to the techniques and strategies employed
by tax-efficient separate account managers, it is
worthwhile to consider the benefits of a tax-efficient
separate account management strategy over a long time
horizon. Referring to the pre-tax and after-tax returns of
hypothetical Portfolios A, B and C, the following graph
demonstrates the benefits from the deferral of tax
payments compounded over 20 years.
Growth of $1,000,000 at 12% Pre-Tax
Under Different Tax-Efficient Ratios
$0
$2
$4
$6
$8
$10
$12
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Portfolio
After-tax
return (%)
Tax Efficient
Ratio (%)
Value After 20
Years ($mm)
Portfolio A 8.0% 66.7% $4.66
Portfolio B 10.6% 88.4% $7.50
Portfolio C 11.6% 96.7% $8.98
12% return 12.0% 100.0% $9.65
Millions
Years
An analysis of the preceding graph shows the substantial
differences in wealth buildup between Portfolios A, B
and C. The tax efficiency of Portfolios B and C led to a
59.7% and 91.4% greater accumulation of capital than
the relatively tax inefficient Portfolio A.
What criteria should the taxable investor use to evaluate a
tax-efficient separate account manager? First and
Tax-Efficient Separate Account Management
Strategies and Techniques
Does the manager:
Manage with a long-term investment time horizon and a buy-
and-hold orientation?
Comment: By focusing on long-term investments, rather
than those offering mostly near-term payoffs, the realization
of capital gains is deferred and, possibly, avoided.
Minimize capital-gain-producing turnover?
Comment: Significantly reducing portfolio turnover that
results in realized capital gains is the most effective way to
improve after-tax returns and is considered the cornerstone
of tax-efficient investing.
Minimize income and dividends?
Comment: Minimizing income and dividends received
further reduces the effect of taxes since they are taxed at a
higher ordinary income tax rate.
Harvest unrealized short-term losses to reduce the tax impact
of realized long-term gains?
Comment: Harvesting capital losses allows the portfolio
manager to offset realized capital gains and/or to build a
cushion for offsetting future capital gains.
Utilize tax lot accounting technology?
Comment: Selling securities with the highest cost basis
(HIFO) minimizes capital gains realization.
Use leverage for cash withdrawals?
Comment: When the sale of securities with a low cost basis
is undesirable from a tax standpoint, borrowing may be an
attractive means of sourcing cash.
Contribute winners that outgrow the portfolio in which they
originated (because the increased weight exceeds the
managers comfort level) to an exchange fund, charitable
remainder trust, private foundation, or charitable institution?
Comment: Compared to a taxable sale of an appreciated
asset, a contribution to a charitable remainder trust may
increase the return from the asset to the donor (and the
charity, of course) through tax-free compounding. Similarly,
contributing appreciated securities to an exchange fund
allows the taxable investor to diversify into a broad portfolio
of U.S. equities and other non-marketable assets without
engaging in a taxable sale.
foremost is investment performance; the most tax-efficient
strategies are meaningless if the separate account
managers pre-tax returns are not competitive. Second,
assuming the taxable investor finds the prospective
3DJH 133
Investment Philosophy: Tax-Efficient Separate Account Management (cont.)
organizations investment philosophy, investment process,
and investment professionals impressive, he or she would
be well advised to look for the strategies and techniques
shown in the accompanying box. They provide a checklist
by which a tax-efficient separate account manger can be
evaluated.
2
Most of the articles written about tax-efficient investing
zero in on a managers turnover rate as the most critical
determinant of tax efficiency. While the turnover rate is
important, the taxable investor should understand that a
low turnover rate per se does not guarantee tax
efficiency. The authors of the article entitled, Tax-
Aware Equity Investing: Active Management of Taxable
Portfolios Is Challenging But Not Impossible make the
following observations:
In response to the challenges posed by taxes, many
managers seek to reduce or minimize portfolio
turnover. In our view, this strategy makes no sense
because there is not both good and bad
turnover. Even at low levels, turnover is bad if a
manager mindlessly realizes gains and incurs tax
liabilities without substantially increasing the
portfolios expected excess return. By contrast, even
at high levels, turnover can be good if realized gains
are offset by realized losses and/or a sufficient
increase in the expected excess return. By balancing
realized gains and realized losses, the tax-efficient
separate account manager defers net realized capital
gains and the immediate payment of taxes. The
rebalancing facilitated by the use of realized losses
allows the manager to sell overvalued positions and
reinvest in securities with higher expected returns.
3
In other words, what the tax-efficient separate account
manager needs to control is not his or her turnover but,
as one writer labels it, his or her gains realization rate.
4

2
Jesse L. Carroll, Jr., Investment Manager Selection Criteria, Asset
Allocation Principles, Second Half 1999.
3
Roberto Apelfeld, Gordon B. Fowler, Jr., and James P. Gordon, Jr., Tax-
Aware Equity Investing: Active Management of Taxable Portfolios Is
Challenging But Not Impossible, The Journal of Portfolio Management
(Winter 1996).
4
James P. Garland, The Attraction of Tax-Managed Index Funds, The
Journal of Investing (Spring 1997).
Just as the importance of turnover is overstated in the
management of taxable portfolios, the significance of
building up unrealized gains is underrated. Unrealized
gains represent that portion of the taxable investors
portfolio appreciation that has not been converted into
cash for reinvestment elsewhere. The longer the gains in
the taxable investors portfolio remain unrealized, the
more valuable they become because, as in the case with
IRAs, compounding occurs on a pre-tax basis. A tax-
efficient strategy that emphasizes the deferral of realized
gains can lead to not only superior after-tax returns but
also tax avoidance since, under present law in the case of
individuals, the deferred tax liability is forgiven at
death.
5
In the taxable investing game, what matters most is
the interrelationship between the taxable investors
pre-tax return and the tax efficiency of that return.
Some have described taxable investing as a losers
game. Those taxable investors who utilize a tax-
efficient strategy stand to lose the least to taxes and
win the most when the games all over.
6

5
Robert H. Jeffrey and Robert D. Arnott, Is Your Alpha Big Enough to
Cover Its Taxes, The Journal of Portfolio Management (Spring 1993).
6
Garland, op. cit.
3DJH 134
Investment Philosophy:
The Interplay of Fear, Greed, and Rationality in Equity Investing
John M. Snyder
It is useful to consider management of the tensions
existing between emotion and rationality in equity
investing because the implications for performance
appear material. We propose the idea that equity
investors swing continually between the emotions of
greed and fear.
Implicit in the greed/fear clich is the acknowledgment
that there can exist a suspension of rationality and
common sense, traits that normally provide some
intervening governance. What lies behind this temporary
madness to which many investors are susceptible? Let us
consider the relative significance of fear, greed, and
rationality.
It is to fear, a potent emotion, that we assign the highest
weight in relative significance. Fear causes a vessel that
is half full to suddenly appear half empty, a particularly
unpleasant shift when the perception applies to ones
investment portfolio. Fear is a primal emotion grounded
in the universal comprehension of lifes uncertainty. Few
of us fail to wince at Julius Caesars famous lines:
Cowards die many times before their deaths; the
valiant never taste of death but once.
Fear can be pushed aside, but it sleeps lightly. When it is
awakened, the investors mood can turn quickly to panic
and an immediate urge to run for cover, i.e., to lighten up
or sell out without too much regard for the ongoing value
of the assets being disposed.
Neath the suns rays our shadow is our comrade;
When clouds obscure the sun our shadow flees.
So Fortunes smiles the fickle crowd pursues,
But swift is gone wheneer she veils her face.
Ovid, Tristia, I.9,11
Greed, on the other hand, though one of the seven deadly
sins (covetousness, in Biblical terms), can be
comfortably agreeable when things are going ones way.
In market terms, this is when prices are rising, no
unpleasantness is on the horizon, and all glasses are seen
to be at least half full. The investment conclusion is often
to toss caution to the winds and to buy with no
apprehension regarding the valuation of the purchase.
Rationality is generally perceived to be an important
arbiter between greed and fear. Great lip service is paid
to reason and common sense, but they lack the visceral
intensity of the passions they are supposed to control,
and are sometimes no more effective than shouting
Stop! at a runaway horse. Thus, our expressed
weighting of rationality is, more often than not, at odds
with our actions, and reasons contribution to the
investment process is muted.
In addition to its usefulness in tempering opposing
emotions, reason provides the tools for valuing equities
by weighing the underlying fundamentals of a
companys business, its past performance, and, to an
extent, the probability of its future course.
Long-Term Investing, the Principal Casualty
A deep paradox has long existed in equity investing.
Numerous studies have shown that long-term exposure
to the equity markets provides superior relative returns
because market moves come at unpredictable intervals
(Please see Exhibit 1). One would expect that this well-
known fact would result in long-term equity investing
being the most popular strategy. That this has not been
the case is worthy of consideration.
Exhibit 1: Value of $100 Invested in the
S&P 500 Index from 1981 1999
Continually invested $1,082
Missed 10 best days 665
Source: Morgan Stanley Dean Witter Equity Research.
Why have so few individual investors been able to
pursue what appears to be the most rational strategy?
Could it be that the emotions of greed and fear regularly
overwhelm rational judgment and precipitate moves in
and out of the market at precisely the most inopportune
times?
3DJH 135
The Interplay of Fear, Greed, and Rationality in Equity Investing (cont.)
John M. Snyder
Indexing as Forced Long-Term Investing
It has not gone unnoticed that index investing,
particularly in the form of the S&P 500 index funds that
came into full flower in the mid to late 1990s, has
outperformed four-fifths or more of actively managed
equity mutual funds over this period. Consider the
possibility that a key element in S&P index performance
might be attributed to the long-term nature of index
investing, i.e., that component companies are not
changed unless they are either removed from or added to
the index. Average S&P 500 turnover, by virtue of this
charter provision, has been approximately 5% per year
from 1981 through 1998, although in the 19951999
period, nearly 180 companies were replaced in the S&P
500 index.
It is worth considering whether some meaningful
component of the superior performance of the S&P 500
index should be attributed to the low turnover, long-term
time element intrinsic to the concept.
Combining the Intrinsic Time Discipline of Indexing
with the Science of Intelligent Stock Selection
If a significant proportion of the performance of index
funds can be attributed to the long holding period and
minimal turnover intrinsic to their investment strategy,
this may point the way to a superior investment approach
for discerning and disciplined investors.
It is broadly accepted that the human emotions
associated with equity investing are strong and difficult
to govern. It has also been demonstrated that index
investing, by definition, enforces some degree of long-
term discipline that helps contain and control these
emotions.
It may be asked whether an intelligent investor can
create, at appropriate valuations, a portfolio of
companies having a true competitive edge in their
industries by virtue of superior product, franchise, and
management, thus establishing a reasonable chance of
outperforming a mechanically selected index.
The chances of such an outcome might be increased by
adhering to a long-term discipline as if the rationally
chosen portfolio were governed by an index-like
charter that specified that no changes would be made
unless there were material changes in the prospects of
the individual holdings.
Such is the course that has been followed by the handful
of this centurys great investors, including Warren
Buffett, Philip Fisher, Philip Carret, and many of the
investment disciples of Benjamin Graham. These
individuals seem to have transcended the greed/fear
syndrome and generated high and tax-efficient returns on
intelligently selected stocks held for long periods of
time.
We think it is well within the capability of the High Net
Worth investor, with access to superior research and
astute guidance, to adopt a similar rational approach to
equity investing. We see no reason that the individual
investor should be left with sub-par performance by
emotional and visceral reactions that can be channeled to
more productive ends. It seems a mechanical index
should not be able to outperform intelligent selection just
because it is intrinsically long-term in nature.
In our view, the investor should allocate to risk-free
fixed income investments if possible within a tax-
advantaged ownership structure his or her insurance
against catastrophic events, and give well-chosen
equities sufficient time to prosper.
Perceive at last that thou hast in thee something
better and more divine than the things which cause
the various effects, and, as it were, pull thee by the
strings.
The Meditations of Marcus Aurelius, Book XI, 19.
3DJH 136
Investment Philosophy: S&P 500 Industry Sector Composition
Lily Rafii
The S&P 500 index, one of the most widely used
benchmarks of U.S. equity performance, consists of 500
stocks chosen for market size, liquidity, and industry
group representation. Since its inception in 1957, the
index has undergone a dramatic change in composition.
The scope and nature of the change, however, have been
most evident over the 19951999 time frame as
technology companies have become the largest industry
component of the composite index.
During the 1980s and 1990s as a whole, the S&P 500
index was characterized by two major changes, a
transition from a heavy index concentration in energy
companies to a concentration in technology companies,
and an increasingly stronger index in terms of
profitability. The fact that technology companies now
dominate the index as a whole can be attributed to
several factors.
First, technology has played an increasingly large role in
the economy and financial markets as a result of greater
penetration of technology-related products and services
and the markets assessment of the future prospects for
the companies that provide them.
Second, the profitability of established technology
companies is high. For instance, AOL earnings were up
440% in 1998 and an average of 513% from 1997
through 1999. Its one-year shareholder return of 486%
beat all the 499 remaining companies in the index, and
its three-year total return is 1,348%.
1
Morgan Stanley
Dean Witter strategist Leah Modigliani has noted that
without technology stocks, the S&Ps total return for
1999 would have been only 7.5% versus 21.0% with
technologys contribution.
2
Third, valuations for technology companies are high and
market values are large. Because the S&P 500 is
weighted according to market value, each stock is
represented in proportion to its total value, or market
capitalization. As a result, the more a given stock gains,

1
Business Week, March 29, 1999.
2
Morgan Stanley Dean Witter, U.S. Investment Perspectives, January 5,
2000.
the greater its share in the S&P. This allows rising stocks
such as Microsoft to take up an expanding proportion of
the index.
It can be seen from Exhibit 1 that over the last 20 years,
there has been a notable decline in the energy sectors
proportion of the S&P 500 index, from 27% to 6%, and a
significant rise in the proportion of technology, from
10% in 1980 to 30% in 1999. In effect, technology has
displaced energy in the index as the most influential
sector.
Exhibit 1: S&P 500 Industry Sector Composition
1980 1986 1990 1994 1997 1998 1999
Basic Materials 8% 7% 7% 7% 5% 3% 3%
Capital Goods 11 11 10 10 9 8 8
Communication Services 6 8 9 9 6 8 8
Consumer Cyclicals 10 14 11 12 9 9 9
Consumer Staples 8 12 17 16 16 15 11
Energy 27 12 13 10 8 6 6
Financials 5 10 8 11 17 16 13
Health Care 6 7 10 9 11 12 9
Technology 10 9 7 10 13 19 30
Transportation 2 2 1 1 1 1 1
Utilities 6 8 7 5 3 3 2
Source: Donaldson, Lufkin & Jenrette; 1998 and 1999 data are from
Morgan Stanley Dean Witter Equity Research.
It is interesting to note that just as technology has
dominated business headlines in the late 1990s, the
market focused on energy issues in the late 1970s and
early 1980s. Twenty years ago, the market was fixated
on oil prices as a result of OPEC actions and political
instability in some large oil-producing countries; the
giant oil companies were the financial markets chief
vehicle for responding to these conditions. Today,
technology and the Internet make headlines daily and, to
a certain extent, the market appears to believe that
economic destiny lies in the hands of the technology
companies. E-commerce has grown over 460% in one
year, from $235 million at the end of the third quarter of
1998 to $1.1 billion at the same time in 1999.
3
Advertising by Internet companies grew by 291% to $1.4
billion through the first nine months of 1999.
4

3
ING Barings Research, December 19, 1999.
4
Competitive Media Reporting.
3DJH 137
Investment Philosophy: S&P 500 Industry Sector Composition (cont.)
Lily Rafii
Exhibit 2 illustrates the shift of leadership in the S&P by
showing the top 10 companies which comprised the
index on December 31, 1980, and on December 31,
1999.
Exhibit 2: Comparative Leadership within S&P 500
(1980 1999)
December 31, 1999 Market Value % of Cum. %
Company Rank $ Millions Index of Index
Microsoft Corp 1 604,078 4.92 4.92
General Electric 2 507,734 4.14 9.06
Cisco Systems 3 366,481 2.99 12.04
Wal-Mart Stores 4 307,843 2.51 14.55
Exxon Mobil 5 278,218 2.27 16.82
Intel Corp 6 274,998 2.24 19.06
Lucent Technologies 7 234,982 1.91 20.97
Intl Bus. Machines 8 194,447 1.58 22.55
Citigroup 9 187,734 1.53 24.08
America Online 10 169,606 1.38 25.47
Top 10 Total Market Cap. $3,126,121
December 31, 1980 Market Value % of Cum. %
Company Rank $ Millions Index of Index
Intl Bus. Machines 1 39,604 4.27 4.27
American Tel. & Tel. 2 35,676 3.85 8.12
Exxon Corp 3 34,856 3.76 11.87
Standard Oil 4 23,365 2.52 14.39
Schlumberger, Ltd. 5 22,331 2.41 16.80
Shell Oil 6 17,990 1.94 18.74
Mobil Corp 7 17,163 1.85 20.59
Standard Oil of Cal. 8 17,020 1.84 22.42
Atlantic Richfield 9 15,030 1.62 24.04
General Electric 10 13,883 1.50 25.54
Top 10 Total Market Cap. $236,918
Source: Standard & Poors Quantitative Services Group;
www.spglobal.com.
Of the top 10 stocks in the S&P today, six are
technology companies. In 1980, seven of the top 10
companies in the index were oil companies. Notably, the
only energy company that remains in the top 10
presently is Exxon.
5
In 1980, IBM was the only
technology company on the list. Microsoft has been on
top of the list since 1998; before then, it made its first
appearance in the top 10 in 1995 as the first
technology company to appear on the list after IBM.
Only over the last four years has technology had a
substantial presence on the list. The index is very
sensitive to the performance of these massive companies,
with the 10 largest stocks in the index today driving
about 25% of index performance. The proportion of the
total index represented by the top 10 names has remained
remarkably stable over the last 20 years, even in light of
the striking difference in market values.
The price momentum of technology companies on the
list is clear, as five out of the six technology companies
on the list outperformed the S&P overall, and thus the
average S&P company. In 1999, Cisco Systems,
America Online, Microsoft, Intel, Lucent, and
International Business Machines increased by 131%,
96%, 68%, 39%, 36%, and 17%, respectively,
6
while the
S&P increased by about 21% in total return terms (price
appreciation plus dividends). The 5-year annualized S&P
500 return is 29%, the 10-year annualized return is 18%,
and the 20-year annualized return is about 17%, which
partially reflects technology companies improving
profitability in recent years.
7
Exhibit 3 indicates that
technology was not only the best performing sector year-
to-date in 1999 and year-over-year, but also that it
accounted for almost half of the composites year-over-
year return and more than the entire market return year-
to-date. Microsoft alone accounted for over 10% of the
S&Ps performance.
8

5
Exxon and Mobil completed a merger on November 30, 1999.
6
Trailing 12 months, from December 31, 1998 to December 31, 1999.
7
Standard & Poors Research and Bloomberg L.P.
8
Leah Modigliani, Morgan Stanley Dean Witter, U.S. Investment
Perspectives, January 5, 2000.
3DJH 138
Lily Rafii
Exhibit 3: S&P 500 Sector Total Return Performance
Relative
Performance
Contribution to
S&P 500
Performance
Rank y-t-d y-o-y y-t-d y-o-y
Basic Materials 8% -13% 7% 2%
Capital Goods 11 11 24 11
Communication Services 3 11 12 11
Consumer Cyclicals -4 6 3 11
Consumer Staples -18 -21 -36 4
Energy 12 -9 20 5
Financials -10 -11 -13 9
Health Care -16 -25 -24 1
Technology 25 47 110 47
Transportation -16 -26 -2 0
Utilities -9 -29 -2 0
S&P 500 5 28 100 100
Data are as of September 30, 1999.
Source: Lehman Brothers U.S. Equity Performance Attribution Quarterly.
The S&P 500 reflects a representative sample of leading
companies in leading industries. While the U.S.
technology sector has demonstrated innovation, sales and
profit growth, and stock market performance, there has
been discussion that the rate at which technology
companies have been added to the index may indicate
S&Ps bias toward companies that outperform. Morgan
Stanley Dean Witter strategist Peter Canelo has written
that the new S&P 500 represents the best of U.S.
corporations, a younger, stronger index with a definite
bias toward profitability and the result is changing the
trajectory of earnings growth for the index to double
digits. H. Vernon Winters, Chief Investment Officer at
Mellon Private Capital Management, says when [the
S&P] chooses new companies, they pick better, more
successful companies, and that gives the index more of a
growth orientation.
9
Fast-growing technology companies, such as Yahoo!,
were added to the index in 1999;
10
for 1999 as a whole
ten technology companies were added, out of 42 total
changes, displacing companies such as RJR Nabisco,
Browning-Ferris, and Rubbermaid. Peter Canelo has
indicated that since 1995, there have been nearly 180
changes in the index and only 330 of the companies that
were on the list then, remain now. Never in the history of
the S&P 500 have there been more alterations.
11
A technology-heavy S&P 500 index also implies
increased volatility. Technology stocks tend to be more
volatile, and can contribute to sharp swings in the
market. For instance, the S&P 500 lost 2.1% of its value
in one day when Intel reported earnings below analysts
expectations for the third quarter.
12
The inclusion of
technology companies in the S&P 500 is seen as
representing the growing perception of the Internet-
centric future of many businesses. Their inclusion may
indeed make the S&P 500 more reflective of the overall
economy and financial environment. However, as a
result, the index may be susceptible to the greater
volatility that characterizes the prices of technology
companies upon which the markets high expectations
for the future depend.

9
Business Week, March 24, 1997.
10
Yahoo was added in on December 7, 1999.
11
MSDW U.S. Investment Perspectives, January 20, 2000.
12
Business Week, October 25, 1999.
3DJH 139
Lily Rafii
The criteria that Standard & Poors uses to select stocks for the S&P 500 include market size, liquidity, and industry
sector. Set forth in Exhibit 4 are the general guidelines for adding or eliminating companies from the Index.
Exhibit 4: General Guidelines for Additions/Deletions to the S&P 500
Criteria for Additions Criteria for Deletions
Market Value: The S&P 500 is a market-value
weighted index.
Industry Group Classification: Companies
selected for the S&P 500 represent a broad range
of industry segments within the U.S. economy.
Capitalization: Ownership of a companys
outstanding common shares is carefully analyzed
in order to screen out closely held companies.
Trading Activity: The trading volume of a
companys stock is analyzed on a daily, monthly,
and annual basis to ensure ample liquidity and
efficient share pricing.
Fundamental Analysis: Both the financial and
operating condition of a company are rigorously
analyzed. The goal is to add companies to the
Index that are relatively stable and will keep
turnover in the Index low.
Emerging Industries: Companies in emerging
industries and/or new industry groups (industry
groups currently not represented in the Index) are
candidates for the Index as long as they meet the
guidelines listed above.
Merger, Acquisition, LBO: A company is
removed from the Index as close as possible to
the actual transaction date.
Bankruptcy: A company is removed from the
Index immediately after Chapter 11 filing or as
soon as an alternative recapitalization plan that
changes the companys debt/equity mix is
approved by shareholders.
Restructuring: Each companys restructuring
plan is analyzed in depth. The restructured
company as well as any spin-offs are reviewed
for Index inclusion or exclusion.
Lack of Representation: A company can be
removed from the Index because it no longer
meets current criteria for inclusion and/or is no
longer representative of its industry group.
Source: Standard & Poors Research; www.spglobal.com.
3DJH 140
Investment Philosophy: Financial Parenting
This generation is the I Want generation. They
have been educated to entitlement and programmed
for discontent.
1
Brat-lash. Affluenza. These are just two of the recent
buzzwords relating to children of the super-wealthy
Baby Boomer generation. These young people have
earned the stereotype of lazy, arrogant individuals who
are doomed to waste any potential they may once have
had. Many investors have posed the question How do
we prevent our wealth from ruining our children? in the
hopes of finding a plan of action to dispel this stereotype
as nothing more than myth.
The cornerstone of any capitalist society is a system of
incentives to succeed and better oneself. The Baby
Boomers were exposed to the concepts of hard work,
frugality, and sacrifice by their Depression-era parents.
These concepts appear to have paid off, and the self-
made millionaire generation is projected to leave behind
some $40 trillion over the next 50 years.
2
Rich people have problems, too.
3
All parents, regardless of the level of their net worth,
pvalues and prudent financial discipline. Wealthy parents
are faced with added challenges challenges that must
be faced in a constantly evolving fashion as a child
matures. Those of lesser means experience built-in
lessons of hard work and frugality that the wealthy must
also somehow endeavor to transmit. The stresses
associated with handling a significant inheritance can
cause other problems unique to High Net Worth families
and create circumstances that trust-fund children must be
prepared for.
Financial parenting does not mean simply imparting
fiscal responsibility to ones children. Financial
parenting consists of a complex blend of teaching

1
Parenting in a Commercial Culture, by Center for a New American
Dream. More than Money-Issue 24, Winter 1999-2000.
2
Sharing the Wealth, by Beth Fitzgerald, The Star-Ledger, June 7, 2000.
3
prudent asset allocation, asset growth and protection
disciplines, philanthropy, and capital stewardship. As
with standards and lessons of character, ethics, and
morals, the principles of appropriate investing and the
value and disposition of money should be introduced at
an early age and reinforced over time.
Exhibit 1: Parental Interplay
The Value of Values
Parents
The Value of Investing
Source: MSDW Private Wealth Management
The Value Of Values
As parents, we must set standards, model values,
unveil character, and provide a safe haven for our
kids when they fail. Having experienced this, our
children will reflect back to us the lessons they
learned, no matter how much or how little money
they have.
4
Effective money management is not about asceticism,
but rather about prioritizing wants and needs based upon
established values and available resources. When a child
has enough money that he or she could live comfortably
without ever working, how does one raise that child with
motivation? When the child has enough to spend
wastefully, how does one teach limits and frugality?
When parents have the means to bail him or her out of
any adverse situation, how can the child learn that all
actions have consequences?

4
Correspondence with Brother John M. Walderman, C.F.C., President,
Rice High School, New York, NY, January 26, 2000.
3DJH 141
Investment Philosophy: Financial Parenting (cont.)
We might value racial diversity, yet choose to live
in neighborhoods of only one race. We might believe
in public education, yet send our children to private
school. We might espouse earning a living, yet live
on an inheritance.
5
The old adage The apple doesnt fall far from the tree
highlights one of the most important points for raising
good kids: Education by example. Intentionally or
unintentionally, parents often end up raising children
who resemble their parents. Successful, motivated,
value-oriented parents tend to raise children who exhibit
similar traits. The converse is true as well; parents who
tend to spoil their children, buy them whatever they
wish, or live reckless lives themselves often have
difficulties expecting better values from their children.
Recommend virtue to your children; it alone, not
money, can make them happy.
6
It is important to maintain an age-appropriate, open
dialogue between parents and children about the familys
financial affairs. The University of Michigans Institute
for Social Research has found that the influence of the
family is significant on a childs financial discipline.
Fully 72% of the teenagers polled by the Institute said
they learned financial discipline from their parents, and
79% indicated that they plan to handle their finances in a
manner similar to their parents.
7
Adults often choose to
surround themselves with people who share their values.
Children do not have the luxury of choosing their
parents; rather, they are subject to their parents
influence for 18 years, whether the parents are good role
models or not. Given the strength of that influence,
parents need to strive to serve as good role models for
their offspring.
Parents can demonstrate through their own actions the
importance of earning a living and can expose their
children to the reality of the workplace by bringing them
to work. When deciding whether to make purchases, for

5
No Easy Solutions, by Anne Slepian, More Than Money-Issue 24,
Winter 1999-2000.
6
Ludwig van Beethoven, The Heiligenstadt Testament, October 6, 1802.
7
Yankelovich Partners, 1999.
the family or for the child, parents can think out loud,
explaining their decision-making process to the child in
language he or she can understand. If children perceive
parents as spending money arbitrarily, they will not
understand the concept of spending limits or the value of
budgets.
Whenever it is in any way possible, every boy and
girl should choose as his or her life work some
occupation which he or she should like to do
anyhow, even if he or she did not need the money.
8
Parents should seek to personally play an active
educational role in their childrens lives. In a number of
instances, highly affluent children may reflect the same
degree of impoverishment as underprivileged children,
sometimes due to the absence of strong positive parental
influence. Parents need to give thought to balancing the
desire to work and accumulate greater wealth (with
which to provide for their children) versus the necessity
to spend quantity as well as quality time in the home to
provide a stable and constructive domestic environment
for their children. Many aspects of a childs upbringing
can be put at risk by parental neglect, not to mention by a
high caretaker turnover rate.
Many of todays parents learned valuable lessons about
the nature of and the necessity for hard work, and can
vividly recall the satisfaction derived from their first
paper route, lemonade stand, or lawn-cutting job. In
similar fashion, todays children can learn many of their
most important lessons through experience. Part-time
jobs provide an education in money management and
time management. Through starting a small business,
children can learn budgeting and working capital
principles. Such experience offers children the
opportunity to learn the value of hard work and to
experience firsthand the satisfaction of personal
accomplishment beyond mere financial compensation.
This can also help many affluent children to find a sense
of independence and overcome the feeling that they are
riding the coattails of their successful parents or
grandparents.

8
Irish Blessing
3DJH 142
Anything in life worth having is worth working
for.
9
Parents can also provide opportunity for hands-on
learning through simple devices such as a reasonable
weekly allowance, a pre-paid phone card, a budgeted
shopping trip and limits on computer time usage. When
the child knows in advance what his or her resources are,
he or she can learn to prioritize and build a framework
for short-, medium- and long-term goals. When faced
with the consequences of poor financial decisions,
children may in stages learn to think about and deal with
the ramifications of their decisions. For example, if a
parent agrees to split the reasonable cost of something
the child wishes to buy, but the child falls short of his or
her portion, the child may learn that this can be a deal-
breaker. This way, the lessons of real-world money
matters may not come as a shock to them, and their first
experience with negative consequence will not be
something like a downgraded credit rating due to unpaid
utilities bills. Children of means are better off if they can
learn not only that their wealth provides them with many
options and opportunities, but also that having money
does not grant them license to behave irresponsibly.
They need to learn by trial and error that when you
drop things they fall.
10
At the beginning of this millennium, the estimated
spending power of 16- to 24-year olds is projected to
exceed $100 billion per annum.
11
Children need to
understand the tradeoffs and opportunity costs inherent
in financial decisions and the value of establishing a
good reputation with creditors. By putting their progeny
into appropriate sink or swim situations from an early
age where the consequences are relatively small and a
safety net can be in place parents can allow children
to gain important experience that leads to mature
decision making.

9
Andrew Carnegie, excerpt from The American Dreams Collection, by Jim
Bickford.
10
Whos Spoiled?, by Brigid McMenamin, Forbes June 12, 2000.
11
U.S. Census Bureau, 1999.
If children live with sharing, they learn to be
generous.
12
Given the rapid accumulation rate of their wealth, some
highly-affluent individuals are finding that they have
more money than they can spend. Many parents are
moving toward giving back to the community by way
of philanthropy in hopes of setting an example and
instilling within their children a sense of responsibility.
The Boston College Social Welfare Research Institute
predicts that a golden age of philanthropy is dawning
[due in part to] economic and emotional incentives to
devote financial resources to charitable purposes.
13
Goodness is the only investment which never
fails.
14
Besides aiding in the development of values-driven
children, philanthropy benefits the children in other
ways. According to Sal Salvo, one of the co-founders of
the Institute for Family Wealth Counseling:
The children of successful entrepreneurs end up
with poor self-esteem because they dont think they
can measure up to their successful parentsThey
will never be able to do what their parents did
because they will never be hungry like their
parents. Someone will always look at them and
think, If your parents werent successful, you
wouldnt be successful. But philanthropy
helps.
15
In addition to training their children to make socially
responsible decisions with the family wealth, parents can
encourage their offspring to actively participate in
family volunteerism. Volunteerism can enhance an
understanding of moneys utility by demonstrating the

12
Children Learn What They Live, by Dorothy Nolte.
13
Millionaires and the Millennium: New Estimates of the Forthcoming
Wealth Transfer and the Prospects for a Golden Age of Philanthropy, John
J. Havens and Paul G. Schervish, Social Welfare Research Institute Boston
College, 1999.
14
Henry David Thoreau, excerpt from The Book of Positive Quotes, by
John Cook, Fairview Press, 1997.
15
3DJH 143
principle that all personal satisfaction is not financially
derived. Most children are giving and idealistic by
nature; community service will reinforce charitable
behavior.
The Value Of Investing
If money is your hope for independence, you will
never have it. The only real security that a person
will have in this world is a reserve of knowledge,
experience, and ability.
16
If they can help shape a childhood full of lessons and
experiences that lead to a strong value set, parents should
be comfortable in the knowledge that their sons and
daughters are capable of making prudent financial
decisions. Sudden access to significant wealth provides
many wonderful options for the recipient, but also brings
with it great responsibility and stress unless a stronghold
of knowledge and preparation has been built.
If you are going to build the Empire State Building,
the first thing you need to do is dig a deep hole and
pour a strong foundation. If you are going to build a
home in the suburbs, all you need to do is pour a 6-
inch slab of concrete. Most people, in their drive to
get rich, are tring to build an Empire State Building
on a 6-inch slab
17
In training children to become investment-savvy adults,
parents are usually the primary teachers. A Yankelovich
study found that 88% of teens did not understand the
concept of compound interest, while 85% were
unfamiliar with mutual funds.
18
Children can accompany
their parents on trips to the bank and/or meetings with
their investment advisor. Most financial institutions
provide marketing materials for youthful readers; the
Federal Reserve Bank even has comic books outlining
the workings of the banking system and the NYSE has
literature and videos depicting capital markets and how
they work.

16
Henry Ford
17
Rich Dad Poor Dad, by Robert T. Kiyosaki.
18
Yankelovich Partners, 1999.
Every child matures at a different rate, so activities and
conversation should be tailored to the childs specific
level of maturity and comprehension. Besides taking
children to financial meetings, parents can groom their
children on a smaller scale by judiciously including them
in the familys financial decision-making process. If a
major business decision is being made, Mom or Dad
might explain to the child the underlying logic behind
the decision. Understanding basic operations such as
removing funds from one investment and placing them
in another can contribute to a young childs
conceptualization of finance.
The only source of knowledge is experience
19
In the investment world, hands-on experience remains an
important learning tool. Parents may take advantage of
the current media frenzy surrounding financial markets
by introducing the child to prudent investing. By gifting
shares or allowing the child to choose stocks that have
some particular meaning in his or her life, parents can
impart some sense of the real-world risks and rewards of
investing. While the parent may officially enact the
trade, allowing the child to research investment ideas and
track investment performance will harness a young
persons enthusiasm and great capacity for new
experiences.
Many elementary and high schools have begun to offer
courses or activities that bolster money management
skills. The Stock Market Game permits students in
grades 4-12 to actively manage a mock stock portfolio
and compete against their peers from around the U.S.
Programs such as those run by the Future Business
Leaders of America can enhance financial education
through lectures and trips to financial markets, such as
the New York Stock Exchange. DECA, a national
association of marketing education for students, aims to
merge national leadership development activities with
classroom instruction. Actual hands-on experience with
money is also important for a childs financial growth.
Children and young adults need something tangible to

19
Albert Einstein
3DJH 144
see, feel and understand. The concept of money is
elusive and abstract to many children, no matter how
much they have. Letting a child see physical currency,
giving them a piggy bank, or showing them how to enter
amounts into their own check register can help to make
money seem more real and perhaps thus easier to handle.
If man or woman empties their purse into their
head, no one man can take it away from them. An
investment in knowledge always pays the best
interest.
20
It is very important to encourage maturing young adults
to follow their own interests in their investments rather
than expecting them to either mimic their parents stock
picks or to slavishly follow the strategies of their

20
Benjamin Franklin, Poor Richards Almanac.
parents financial advisors. All too often, as noted above,
they are defined in terms of their parents success and
their familys wealth. If parents succeed in teaching their
children respectable values, they should have no qualms
in allowing these upstanding young men and women to
follow their character and reason in prudent investment.
Financial learning is a lifelong pursuit; parents need to
lay the groundwork for integrity, guide the development
of their childrens understanding of finance and its
resources, and then stand back and watch them succeed.
Teach about money. If theres a lot of it around and
likely always will be, kids should know how to deal
with the stuff. Sort of like growing up on a boat and
knowing how to swim.
21

21
Whos Spoiled?, by Brigid McMenamin, Forbes June 12, 2000.
3DJH 145
Resources Available to Parents
Books
How to Talk So Kids Will Listen & Listen So Kids Will Talk, by Adele Faber, Avon Books, 1999.
Kids, Money & Values, by Patricia Schiff Estess, Betterway Publications, 1994.
Money Doesnt Grow on Trees: A Parents Guide to Raising Financially Responsible Children, by Neale S.
Godfrey, Fireside, 1994.
A Penny Saved: Teaching Your Children the Values and Life Skills They Will Need to Live in the Real World, by
Neale S. Godfrey, Fireside, 1996.
Inspired Philanthropy, by Tracy Gary, Chardon, 1993.
Why the Wealthy Give, by Francie Ostrower, Princeton University Press, 1997.
Wealth Preservation and Estate Planning, by Jonathan G. Blattmachr, Regnery, 2000.
Street Wise: A Guide for Teen Investors, by Janet Bamford, Bloomberg Press, 2000.
Leading with the Heart, by Mike Krzyzewski, Warner Books, 2000.
Investing with Your Values: Making Money & Making a Difference, by Hall Brill, Jack Brill and Cliff Feigenbaum,
Bloomberg Press, 1999.
The Stewardship of Private Wealth: Managing Personal & Family Assets, by Sally S. Kleberg. McGraw Hill, 1997.
Privileged Ones (Children of Crisis, Volume 5), by Robert Cole, Little, Brown, & Co., 1982.
Money Matters for Teens Workbook, by Larry Burkett, Moody Press, 1998.
The Totally Awesome Money Book for Kids and Their Parents, by Adriane Berg, Newmarket Press, 1993.
The Kids Guide to Money: Earning It, Saving It, Spending It, Sharing It, by Steve Otfinoski, Scholastic Trade,
1996.
Children Learn What They Live, by Dorothy Nolte, Workman Publishing, 1998.
Rich Dad Poor Dad, by Robert T. Kiyosaki, Warner Books, 1997.
Internet Sites
www.morganstanley.com
www.nyse.com
www.federalreserve.gov
www.frugal-moms.com
www.inheritance-project.com
www.kidsource.com
family.go.com
www.kidsbank.com
www.deca.org
www.moneymentors.net
www.jumpstartcoalition.org
www.100hot.com/finance/full screen.html
www.kiplinger.com/kids
www.smg2000.com
www.coolbank.com
www.kidsenseonline.com/home.html
www.plan.ml.com/family/teachers/ resource.html
Games
Monopoly
Monopoly Jr.
Game of Life
Payday
The Allowance Game
The Stock Market Game
Mall Madness

Organizations
Morgan Stanley Dean Witter
Future Business Leaders of America
Boy Scouts and Girl Scouts
Boys and Girls Clubs
New York Stock Exchange
Jump Start Coalition
Federal Reserve System
3DJH 146
Venture Capital/Private Equity
Environmentally Conscious Investing
Diana Propper de
Callejon
EA Capital
(212) 482-0671
Diana is a co-founder and managing director of EA
Capital. EA Capital is a financial firm specializing in
advanced technologies in energy, transportation and
agriculture, providing financial and strategic advisory
services to private equity investors, as well as to venture-
stage companies. EA Capital is the sponsor of the
Critical Resources Fund, a venture fund that will make
investments in technology companies that provide
efficiency and productivity solutions in the energy and
transportation industries.
Over the past decade, Venture Capital and Private Equity
investing have become more or less established
components of investment portfolios, with allocations to
this investment class ranging from 3% and 12% of total
assets.
1
Concurrently, investors interest in Socially
Responsible Investing (SRI) has reached new heights.
2
We believe a framework exists for venture
capital/private equity investment that targets new
technology opportunities for the environmentally
conscious investor.
Given that more than two trillion dollars are invested in
funds that use social, environmental, and ethical criteria
to select stocks, it may be a natural progression that SRI
investors from pension funds, foundation
endowments, and state treasurers to financial advisors
and individual investors might also seek opportunities
in the realm of venture capital/private equity.
3
The surge
in SRI investing with most large financial institutions
now offering clients SRI funds is in part due to the
debunking of an early myth that socially and
environmentally screened investments always result in
lower financial returns. A survey conducted by Credit
Suisse in early 2000 found that the worlds largest SRI

1
Private equity can be defined as investments made into privately held
companies. Venture Capital is a subset of private equity typically representing
earlier stage investments. Due to the early stage and illiquidity of investments,
venture capital presents more risk than later stage private equity or investing
in public securities.
2
See Socially Responsible Investing, A Values-Based Approach in Morgan
Stanley Private Wealth Management First Quarter 2000. SRI investing is
typically refers to investments in public companies.
3
Even many technology laden SRI funds held their own following the market
downturn in 2000. For example, the Domini Social Equity Fund returned
18.06% annually for the last five years, and the S&P 500 returned 18.33%.
mutual funds averaged higher returns than the S&P 500
Index.
4
It is our contention that changes are afoot that are
creating a widening universe of investment opportunities
that can deliver competitive venture capital returns and
that are aligned with the goals of SRI investors.
Exhibit 1
Total Venture Capital Invested in US
7.16
9.42
19.00
59.20
103.00
14.00
0
20
40
60
80
100
120
1995 1996 1997 1998 1999 2000
$ Billions
Source: Venture Economics
What History Has Taught Us
Skeptics may refer to the mixed returns and/or failures
that came from a narrow category of environmentally-
based venture capital/private equity investments made in
the late 1980s and early 1990s. These investments were
largely focused in the waste management, pollution
control, and related remediation technologies. The
companies targeted for investment at that time were
dependent on government intervention, in the form of
regulations and/or subsidies, to create markets. These
markets did not develop for a multitude of reasons,
including certain government regulations/tax incentives
that were either never formulated or expired.
Consequently, the business models and revenue streams
of the targeted companies crumbled, as did financial
returns to investors. Additionally, the environmental
technologies would require several years of continued
research and development before becoming viable. In

4
Even many technology laden SRI funds held their own following the market
downturn in 2000. For example, the Domini Social Equity Fund returned
18.06% annually for the last five years, and the S&P 500 returned 18.33%.
3DJH 147
Environmentally Conscious Investing (cont.)
Diana Propper de
Callejon
EA Capital
(212) 482-0671
some instances, it would be up to ten years before
investors could exit these investments, further depressing
returns. Even the successful environmental investments,
which delivered annual returns of 8% to 12%, were
underperformers relative to similar investments in other
industry groups such as telecommunications.
5
While
perhaps a noble endeavor, these environmental
enterprises were not well suited to venture capital and as
a result fell out of favor, with environmental activities
becoming limited to philanthropy.
A new profitable framework for investing in venture
capital and the environment is coming to the fore, one
that focuses on major market and business opportunities
with a clear and speedy path to liquidity. In this
approach, venture capital/private equity investments are
made in companies that increase natural resource
efficiency and productivity. Opportunities are driven by
customer demand and powerful market forces and not by
regulatory fiat. Environmental benefits may be a
byproduct, but no longer the primary focus of investors
or of the venture capital recipient. We believe such
opportunities currently exist in a number of industries
across the spectrum of energy, agriculture,
transportation, chemicals, biotech, and industrial process
industries. A look at current opportunities in energy-
related technologies may illustrate this best.
Advances in Energy-Related Technologies
Several forces are driving an unprecedented
transformation in the energy industry. Similar to
telecommunications in the 1980s, energy markets are
being deregulated. Although the process may not be
perfectly smooth, it is allowing commercial and
residential customers to increasingly choose their electric
power providers. As a result, utilities are striving to
differentiate themselves in the marketplace, and
attempting to improve customer service and relations.
These industry changes and challenges are creating
fertile ground for the development and
commercialization of a suite of new technologies that are
attracting a growing amount of venture capital.

5
Venture funds that made early investments in the environment include
Technology Funding Inc., First Analysis Venture Capital, and Advent
International.
At the same time, the demand for power quality and
reliability in the US is growing dramatically. With an
economy increasingly reliant on high technology,
computers, and the Internet, the financial risks of the
countrys energy problems are increasing. Because there
has been little investment in new power plants and in the
countrys power transmission and distribution
infrastructure, US businesses are said to be losing as
much as $30 billion annually due to more frequent
blackouts, power disruptions, and poor-quality power.
6
New technologies are being developed to meet the needs
of corporations. The primary goal of increased energy
production may be accompanied by lessened resource
consumption and waste generation, thus providing
environmental benefits. Below we describe the emerging
technologies in some detail.
Distributed Generation (DG): Typically built as
smaller scale power plants located close to or at the point
of use, distributed generation technologies provide
primary power or backup power to the electric power
grid. Customers can operate their mini power plant
alongside, in place of, or as back up to the electricity
grid. This flexibility protects customers against extreme
price volatility, improves reliability, and allows for
recovery of waste heat for other operational needs. DG
technologies in various stages of commercialization
include microturbines, fuel cells, stirling engines
(external heating of a sealed working fluid or gas), and
flywheels. The environmental benefits of DG include
reduced emissions of air pollutants (e.g., Sulfur Dioxide)
and climate change gases (e.g., CO2), as well as energy
efficiency improvements where heat recovery is a
possibility.
Metering, Monitoring and Control (MMC)
Technologies: In an effort to provide higher-quality
services to customers and to differentiate themselves
in the marketplace, energy service providers are
offering their customers more control over their
energy usage via MMC technologies. Technologies

6
The Electric Power Research Institute. (The problems with the USs electricity
infrastructure are now most apparent in, although not limited to, California.)
3DJH 148
Diana Propper de
Callejon
EA Capital
(212) 482-0671
are currently being commercialized that allow
customers to track the price of energy, real time.
Customers are provided with the information needed
to reduce energy consumption during periods of
peak pricing.
Renewable Energy: The markets for renewable
energy are expanding. Because of wind and solar
energys zero air pollution profile, environmentally
concerned consumers have an interest in purchasing
green electrons from their electricity provider.
Further, in a deregulated power market, wholesale
power generators will not always be able to pass
along increased fuel costs to customers. Recent price
spikes in natural-gas-fired power plants illustrate the
importance of diversification among fuel types.
Wind and solar energy, both of which have
experienced substantial reductions in cost structure,
offer a compelling alternative to fossil fuel power
generation, in our view. Wind power is the fastest-
growing form of electric generation in the world and
electricity output from wind is expected to grow
dramatically in the US in the next few years, albeit
off a small base. Solar energy is increasingly
competitive in remote applications where the grid
may not be accessible, and in some cases is even
competitive with the grid. The photovoltaics (PV
devices use semiconductor materials to convert
sunlight directly into electricity) market has been
growing well above 20% for the past ten years and
now represents over $1 billion in annual sales.
Recent innovations in the energy industry have increased
the quality of emerging companies and boosted venture
capital investing in energy technologies. Venture
investments jumped from $150 million in 1998, to $300
million in 1999, and reached $1.2 billion in 2000.
7
Investors include: energy specialized venture funds such
as those managed by Nth Power Technologies, Inc.,
Arete, and Advent International; mainstream Silicon

7
Venture Economics. Examples of companies that have received venture
investing over the last five years are Capstone, Proton Energy, Evergreen, and
AstroPower.
Valley venture capital firms; later-stage private equity
firms such as Beacon Energy Partners and Bear Stearns;
and individual investors. Success in this area has
prompted other venture capital and private equity firms
to launch new energy-focused funds, as is the case with
the Carlyle Groups recently launched $220 million
energy fund.
8
Exhibit 2
Total Corporate Energy Venture Capital Disbursed in US
1995 2000 ($ Millions)
0
500
1,000
1,500
2,000
2,500
1995 1996 1997 1998 1999 2000
0
5,000
10,000
15,000
20,000
Companies
Disbursement Year
$MM
Capital Disbursed
Companies
Source: Venture Economics
Venture investors have realized excellent venture
returns, profitably exiting their investments either
through the public markets or via sales to large
corporations. While the energy-focused venture funds do
not publicize their returns, our research shows that some
funds have had internal rates of return of 60% to over
100% on an annualized basis.
Last year, alternative energy companies secured close to
$1 billion through IPOs and secondary offerings.
Corporations are actively seeking out new energy
technologies that will strengthen their competitive

8
The downturn in the public markets has affected the sheer number of IPOs
and their valuations, and this trend is likely to persist for some time. In our
opinion, what is of most importance and critical to the success of new energy
technology companies and their venture investors is that diverse exit paths for
investors have been established over the last five years. These exit paths are
unlikely to go away given that the US will be spending billions of dollars in the
next ten years to upgrade our energy infrastructure.
3DJH 149
Diana Propper de
Callejon
EA Capital
(212) 482-0671
position within their respective markets. In general,
corporate venture capital investments have been
increasing rapidly. Corporate venture capital increased
from $372 million disbursed to 119 companies in 1995
to $18.95 billion disbursed to 1,947 companies in 2000.
In the energy sector, Royal Dutch Shell, BP Amoco,
Pacific Gas and Electric, Texaco, Cinergy, GE Power
Systems, and Caterpillar are but a few examples of
corporations that have intensified their venture investing
and acquisition activities.
Exhibit 3
Corporate Energy Venture Capital Examples
Corporate Investors Investments Type of Investments $ Amounts
(millions)
Texaco ECD Energy/Power $62.0
General Electric Plug Power Power/Fuel cell $37.5
Caterpillar ActivePower Power
reliability/backup
$5.0
Enron Meter
Technology
Electronic meters for
commercial and
residential customers
$5.0
Kawasaki Evergreen Solar power
manufacturer
$4.0
Source: EA Capital Research
Conclusion
Gone are the early days of investing in environmental
pure plays which were out of touch with market forces
and industry fundamentals. The environmental company
of the 21st Century will probably not have a green or
eco label attached to it. We believe that venture
capital/private equity investments have the potential to
deliver environmental benefits along with the good
financial returns seen in SRI investing. The successful
early stage investor should first identify market driven
opportunities, and then select the opportunities that can
best meet the investors environmental goals. To a large
extent, resource efficiency and productivity technologies
are at the center of the convergence between strong
financial returns and environmental upside.
This investment framework is finding success in the
energy industry, and we believe similar and abundant
opportunities exist across the spectrum of the
transportation, chemicals, biotech, agriculture, and
industrial process industries.
www.eacapital.com
www.epri.com Electricity Technology Roadmap, the
Electric Power Research Institute, 1999.
http://www.iea.org/weo/index.htm World Energy
Outlook, International Energy Agency (IEA), 2000.
http://www.undp.org/seed/eap/activities/wea/ World
Energy Assessment, United Nations Development
Programme and WEC, 2000.
http://www.rmi.org/sitepages/pid171.asp Energy
Surprises for the 21st Century, by Amory Lovins and
Chris Lotspeich, Rocky Mountain Institute, 1999.
http://www20.cera.com/ 2020 Vision: Global Scenarios
for the Future of the World Oil Industry, Cambridge
Energy Research Associates (CERA), 2000.
3DJH 150
Common Stock and Uncommon Profits Phillip A. Fisher 153
The Intelligent Investor Benjamin Graham 154
The Art of Speculation Philip L. Carret 156
The Battle for Investment Survival Gerald M. Loeb 158
The Essays of Warren Buffett Warren E. Buffett 160
Manias, Panics, and Crashes Charles P. Kindleberger 162
Capital Ideas Peter L. Bernstein 164
Reminiscences of a Stock Operator Edwin LeFvre 167
Extraordinary Popular Delusions and
the Madness of Crowds Charles Mackay 170
Confusin de Confusiones Joseph de la Vega 173
Lombard Street: A Description of the Money Market Walter Bagehot 177
Where Are the Customers Yachts? Fred Schwed, Jr. 182
Irrational Exuberance Robert J. Shiller 187
The Go-Go Years: The Drama and Crashing Finale of
Wall Street's Bullish 60s John Brooks 195
Pioneering Portfolio Management David F. Swensen 202
3DJH 151
Classic Investment Readings: Philip A. Fisher
Common Stocks and Uncommon Profits
The Fifteen Points to Look For in a Common Stock
Philip A. Fisher is considered by many investment
professionals to be one of the most influential authors of
all time on equity investing. In his 1957 book, Common
Stocks and Uncommon Profits, Phil Fisher outlines his
Fifteen Points to Look for in a Common Stock.
1. Does the company have products or services with
sufficient market potential to make possible a sizable
increase in sales for at least several years?
2. Does the management have a determination to
continue to develop products or processes that will
still further increase total sales potentials when the
growth potentials of currently attractive product
lines have largely exploded?
3. How effective are the companys research and
development efforts in relation to its size?
4. Does the company have an above-average sales
organization?
5. Does the company have a worthwhile profit margin?
6. What is the company doing to maintain or improve
profit margins?
7. Does the company have outstanding labor and
personnel relations?
8. Does the company have outstanding executive
relations?
9. Does the company have depth to its management?
10. How good are the companys cost analysis and
accounting controls?
11. Are there other aspects of the business, somewhat
peculiar to the industry involved, which will give the
investor important clues as to how outstanding the
company may be in relation to its competition?
12. Does the company have a short-range or long-range
outlook in regard to profit?
13. In the foreseeable future, will the growth of the
company require sufficient equity financing so that
the larger number of shares then outstanding will
largely cancel the existing stockholders benefit
from the anticipated growth?
14. Does the management talk freely to investors about
its affairs when things are going well, but clam up
when troubles and disappointments occur?
15. Does the company have a management of
unquestionable integrity?
Copyright 1996 by Philip A. Fisher. Used by
permission from John Wiley & Sons, Inc.
3DJH 153
Classic Investment Readings: Benjamin Graham
The Intelligent Investor
Benjamin Graham is considered by many the father of
Value Investing. In Warren E. Buffetts 1983 preface to
Grahams seminal work, The Intelligent Investor
(originally published in 1949), he writes: The sillier the
markets behavior, the greater the opportunity for the
businesslike investor. Following Benjamin Grahams
precepts will help the investor profit from folly rather
than participate in it. Set forth below are some
underlying principles of equity investing that Graham
addresses in his book (the principles were edited solely
for modern context). They will likely be construed as
highly conservative by all but the most dyed-in-the-wool
value investors. Some of the ratios may need to be
adjusted for current market condition.
The rate of return sought should be dependent on the
amount of intelligent effort the investor is willing and
able to bring to bear on the task of equity investing. The
minimum return goes to the passive (defensive) investor,
who wants both safety and freedom from concern. The
maximum return is generally realized by the alert and
enterprising investor who exercises maximum
intelligence and skill.
The selection of common stocks for the portfolio of the
defensive investor should be a relatively simple matter.
Set forth below are four rules to be followed:
1. There should be adequate though not excessive
diversification. This might mean a minimum of ten
different issues and a maximum of about thirty.
2. Each company selected should be large, prominent,
and conservatively financed. Indefinite as these
adjectives must be, their general sense is clear.
3. Each company should have a long record of
continuous dividend payments.
4. The investor should impose some limit on the price
he or she will pay for an issue in relation to its
average earnings over, say, the past seven years.
The activities especially characteristic of the enterprising
investor in the common-stock field may be classified
under four headings:
1. Buying in low markets and selling in high markets.
2. Buying carefully chosen growth stocks.
3. Buying bargain issues of various types.
4. Buying into special situations.
The equity investment criteria set forth in the seven
categories below have been established especially for the
needs and the temperament of defensive investors. These
criteria would eliminate the great majority of common
stocks as candidates for the portfolio, and in two
opposite ways. On the one hand, they would exclude
companies that are (i) too small; (ii) in relatively weak
financial condition; (iii) with a deficit stigma in their ten-
year record; and (iv) not having a long history of
continuous dividends. By contrast, the sixth and seventh
criteria are exclusive in the opposite direction, by
demanding more earnings and more assets per dollar of
price than the popular issues will supply.
3DJH 154
Classic Investment Readings: Benjamin Graham (cont.)
1. Adequate Size of the Enterprise: The minimum size
criterion is arbitrary, especially in the matter of size
required. The idea is to exclude small companies
which may be subject to more than average
vicissitudes, especially in the industrial field. There
are often good possibilities in such enterprises, but
they are not considered to be suited to the needs of
the defensive investor.
2. Sufficiently Strong Financial Condition: For
industrial companies, current assets should be at
least twice current liabilities a so-called two-to-
one current ratio. Also, long-term debt should not
exceed the net current assets, also known as working
capital.
3. Earnings Stability: The company should have shown
some earnings for the common stock in each of the
past ten years.
4. Dividend Record: The company should have had
uninterrupted payments for at least the past 20 years.
5. Earnings Growth: The company should have shown
a minimum increase of at least one-third in per-share
earnings in the past ten years, using three-year
averages at the beginning and end.
6. Moderate Price/Earnings Ratio: The current price
should not be more than 15 times average earnings
of the past three years.
7. Moderate Ratio of Price to Assets: The current price
should not be more than 1.5 times the book value
last reported. However, multiples of earnings below
15 could justify a correspondingly higher multiple of
assets. As a rule of thumb, it is suggested that the
product of the price/earnings multiple times the ratio
of price to book value should not exceed 22.5. This
figure corresponds to 15 times earnings and 1.5
times book value. It would admit an issue selling at
only 9 times earnings and 2.5 times asset value, and
so forth.
The predictive approach to investing could also be called
the qualitative approach, since it emphasizes prospects,
management, and other nonmeasurable, albeit highly
important, factors that go under the heading of quality.
The protective approach may be called the quantitative
or statistical approach, since it emphasizes the
quantifiable relationships between selling price and
earnings, assets, dividends, and other measures of value.
Those who emphasize prediction will endeavor to
anticipate fairly accurately just what the company will
accomplish in future years in particular, whether
earnings will show pronounced and persistent growth.
These conclusions may be based on a very careful study
of such factors as supply and demand in the industry
or volume, price and costs.
Those who emphasize protection are always especially
concerned with the price of the issue at the time of study.
Their main effort is to assure themselves of a substantial
margin of indicated present value above the market price
this margin could be used if necessary to absorb
unfavorable developments in the future.
Copyright 1949 by Benjamin Graham. Used by
permission from Harper & Row, Publishers Inc.
3DJH 155
Classic Investment Readings: Philip L. Carret
The Art of Speculation
Philip Louis Carret founded the first mutual fund,
the Pioneer Fund, in 1929. Even until his death at
101 years old, Mr. Carret was revered by Warren Buffett
as having the best long-term investment record of
anyone in America. Originally written in 1930 when
Carret was an apprentice at Barron's, The Art of
Speculation is replete with timeless insights into the art
and science of investing, many of which are excerpted
below.
Speculation may be defined as the purchase or sale of
securities or commodities in expectation of profiting by
fluctuations in their prices.
Just as water always seeks its level, answering the pull of
gravity, so in the securities market prices are always
seeking a level of values. Speculation is the agency by
which the adjustment is made.
The speculator is the advance agent of the investor,
seeking always to bring market prices into line with
investment values, opening new reservoirs of capital to
the growing enterprise, and shutting off the supply from
enterprises which have not profitably used that which
they already possessed.
The road to success in speculation is the study of values.
The successful speculator must purchase or hold
securities which are selling for less than their real value,
and avoid or sell securities which are selling for more
than their real value.
In fact, speculation is inseparable from investment. The
investor must assume some degree of speculative risk;
the intelligent investor will seek a certain measure of
speculative profit.
The obvious fact about security prices to any student of
the market is that they fluctuate.
For practical purposes, the occurrence of ripples and
waves in price movements is unpredicable. To attempt to
trade on such movements is mere gambling, with the
odds against the trader by a considerable margin. It is
astounding that thousands of otherwise intelligent
persons persist in trying to make money this way.
The general state of business does not forecast the course
of stock prices except in the apparently paradoxical
fashion that great prosperity affords an advantageous
time for selling stocks, and extreme business depression
an opportunity for purchase.
Economic history never repeats itself exactly.
An overdose of rising stock prices has the same ultimate
effect as an overdose of any stimulant.
Bull markets and bear markets last long enough so that
the average trader is likely to forget by the time the
climax is approaching that any other sort of movement is
possible.
Stock prices respond to unpredictable human impulses.
Most traders are optimists by nature and therefore buyers
rather than sellers of stocks. A long-continued bull
market both feeds the optimism of the trading public and
provides increasing resources which the optimist can
utilize. The greater the momentum which a bull market
acquires, the longer does it take the economic breaks to
bring it to a stop.
3DJH 156
Classic Investment Readings: Philip L. Carret (cont.)
A study of economic fundamentals shows that a trader in
stocks may sometimes profitably continue to hold stocks
after standard business indices have given warning
signals. Clearly a bull market does not stop precisely
where the doctrinaire economist or statistician supposes
that it should. Beyond a certain point which can be
designated with some assurance, a bull market
nevertheless resembles the octogenarian who is living on
borrowed time. It may have months or years yet to live
but it is increasingly a poor risk.
It is possible to make an outline of the factors which the
speculator consciously or unconsciously considers in
arriving at a conclusion regarding the intrinsic value of
an industrial stock:
1. The outlook for the industry
(a) Prospects for long-range growth
(b) Prospects for the immediate trend of profits
(i) Probable price movement of principal
commodities and/or other inputs
(ii) State of competition
2. Position of the company in the industry
(a) Relative size in comparison with competitors
(b) Relative rate of growth in comparison with
competitors
3. Condition of the company
(a) Record of earnings and trend
(b) Working-capital position and trend
(c) Capital structure
A vital fact about any business is its normal profit
margin. Theoretically, high profit margins invite
competition; low profit margins are sometimes safer.
Business success is largely a matter of management.
Methods of doing business are constantly changing. The
management of an enterprise must be alert to sense these
changes, to adopt those which are improvements over
old methods.
Twelve Commandments for Speculators
The speculator will never be a success if he or she attempts
to follow any set of rules blindly. There will always be
exceptions; he must apply his or her intelligence keenly in
any given situation. Twelve precepts for the speculative
investor may be stated as follows:
1. Never hold fewer than ten different securities
covering five different fields of business.
2. At least once in six months reappraise every security
held.
3. Keep at least half of the total fund in income-
producing securities.
4. Consider yield the least important factor in
analyzing any stock.
5. Be quick to take losses, reluctant to take profits.
6. Never put more than 25% of a given fund into
securities about which detailed information is not
readily and regularly available.
7. Avoid inside information as you would the plague.
8. Seek facts diligently, advice never.
9. Ignore mechanical formulas for valuing securities.
10. When stocks are high, money rates rising, and
business prosperous, at least half a given fund
should be placed in short-term instruments.
11. Borrow money sparingly and only when stocks are
low, money rates low or falling, and business
depressed.
12. Set aside a moderate proportion of available funds
for the purchase of long-term options on stocks of
promising companies whenever available.
One of the essential qualifications of the successful
speculator is patience. It may take years for the market in
a given stock to reflect in any large degree the values
which are being accumulated behind it.
There is no reason why the stockholder should terminate
a commitment, unless strongly convinced that stock
prices in general have far outrun values.
Copyright 1930 by Phillip L. Carret. Used by permission
from John Wiley & Sons, Inc.
3DJH 157
Classic Investment Readings: Gerald M. Loeb
The Battle for Investment Survival
In his 1995 Forward to Gerald M. Loebs The Battle for
Investment Survival (written in 1935), John Rothchild
wrote: When Gerald Loeb wrote his memorable book,
investors could be divided into two camps: the Buy-and-
Holders and the Skittish Traders. In Gerald Loebs day,
the Skittish Traders had a much larger following than
the Buy-and-Holders, with Loeb as the principal
spokesperson for moving in and out of the market:
cutting losses, taking profits and running, and getting
out while the getting was good. Benjamin Grahams
book, Security Analysis, published the same year, has
become the Buy-and-Holders Bible. Like Benjamin
Graham and Warren Buffett, Loeb realized that stocks
were the only real chance a person had to increase
wealth, but he didnt think the way to do it was to sit
back and be patient and wait for true values to be
reflected in the prices. Loeb believed in taking quick
profits, buying and selling at key points, and taking
advantage of trends. However, Benjamin Grahams book
continues to have a large following today, whereas
Loebs classic book has, until its recent republication,
all but disappeared from the scene. As a full-blown
description of how a prolonged bear market can affect
investors, their psychology, and their modus operandi,
The Battle for Investment Survival is an invaluable
resource. The fact that Loebs point of view was once so
widely accepted and now is so widely discredited makes
it worthy of some attention. A selected number of
Gerald Loebs timeless insights are excerpted below.
Any earner who earns more than he or she can spend is
automatically an investor. The real objective of
investment is fundamentally to store excess current
purchasing power for future use.
What success investors eventually have is governed by
their abilities, the stakes they possess, the time they give
to it, the risks they are willing to take, and the market
climate in which they operate.
Diversification is a necessity for the beginner. On the
other hand, the really great fortunes were made by
concentration. The greater your experience, the greater
your capability for running risks, and the greater your
ability to chart your course yourself, the less you need to
diversify.
Nothing is more difficult than consistently and fairly
profiting in Wall Street.
Market values are fixed only in part by balance sheets
and income statements; much more by the hopes and
fears of humanity; by greed, ambition, acts of God,
invention, financial stress and strain, weather, discovery,
fashion, and numberless other causes impossible to be
listed without omission.
One must devote some time every day to the subject of
investment. Nothing is more logical, yet nothing is more
surprising to most people. One should devote either a
generous amount of time, or no time at all. Halfway
measures are impossible.
Commitments should not be closed haphazardly or
allowed to remain open without justification.
Concentration of investments in a minimum of stocks
insures that enough time will be given to the choice of
each so that every important detail about them will be
known.
The investor should particularly scrutinize companies
that cannot show enough cash income to invest in plant
3DJH 158
Classic Investment Readings: Gerald M. Loeb (cont.)
expansion, needed growth in working capital, and
dividends, without resort to continual new financing.
Investors rarely sense what to do when they discover
something accurate and important. It always was and
always will be the power to understand and the ability to
act that turns information into profits.
For practical reasons, one necessarily has to make
compromises. The factors that make an ideal investment
are never all present at the same time.
A willingness and the ability to hold funds uninvested
while awaiting real opportunities is a key to success in
the battle for investment survival.
People like to take profits and dont like to take losses.
They also hate to repurchase something at a price higher
than they sold it. Human likes and dislikes will wreck
any investment program. Only logic, reason,
information, and experience can be listened to if failure
is to be avoided.
The most important single factor in shaping security
markets is public psychology. The psychology which
leads people to pay forty times earnings for a stock under
one set of conditions and refuse to buy the same shares
under another set of conditions at ten times earnings is
such a powerful and vital price-changing factor that it
can overshadow actual earnings trends as an influence on
stock prices.
Accepting losses is the single most important investment
device to insure safety of capital. It is also the action that
most people know the least about, and that they are least
liable to execute. It is a great mistake to think that what
goes down must come back up.
The way to successful investment lies much more in
learning how to utilize your best thoughts and minimize
your worst inclinations, rather than in being better at
selection or better at timing than the average.
The beginner needs diversification until he or she learns
the ropes. For those who are accomplished, most
accounts have entirely too much diversification of the
wrong sort and not enough of the right. The greatest
safety lies in putting a significant portion of your eggs in
one basket and watching the basket.
The better the quality of an investment, the better the
chance to survive if the road grows really rough.
Remember, life is a succession of cycles. Day and night.
Hot and cold. Good times and bad. High prices and low.
Dividends increased and dividends cut. So dont expect
your investments to be the exception to the rule.
One of the greatest causes of loss in security transactions
is to open a commitment for a particular reason, and then
fail to close it when the reason proves to be invalid.
Of all the factors that affect the success of a corporation,
none exceeds the competence of management. One
aspect of management worth noting is the extent to
which the officers own their own shares.
What might a bull market do to your investment
thinking? We tend to: (i) congratulate ourselves on being
astute investors; (ii) think how foolish we were to have
been so conservative, and how much better off we would
be if we had taken greater risks; and (iii) start stretching
and reaching for quick profits under the guise of a more
aggressive investment approach, which is nothing more
than a risky, speculative approach.
Have a firm foundation of the strongest and best
common stocks of companies which are moving ahead
and which have shown an ability to do well under all
sorts of conditions.
Stick steadfastly to your long-term investment plan, not
modified by the fears or exuberance of the moment.
There are three ways of making money. One is to sell
your time. The second is to lend your money. The third
is to risk your money.
The next time you think you see a bargain, take it as a
red signal to look further and see if you have missed an
important weakness.
If you want to sell some of your stocks and not all,
invariably go against your emotional inclinations and sell
first the issues with losses, small profits, or none at all.
Always get rid of the weakest and keep your best issues
for the last.
This book is called The Battle for Investment Survival
because protecting and increasing capital is in fact a
battle.
Copyright 1935 by Gerald M. Loeb. Used by permission
3DJH 159
Classic Investment Readings: Warren E. Buffett
The Essays of Warren Buffett:
Lessons for Corporate America
A student of Benjamin Graham at Columbia Business
School in the 1950s and a native of Omaha, Nebraska,
Warren E. Buffett, is renowned as the chairman of
Berkshire Hathaway Inc. and one of the worlds
legendary investors. As set forth in the introduction to
Lawrence A. Cunninghams The Essays of Warren
Buffett: Lessons for Corporate America (Cardozo Law
Review, 1997), readers of Buffetts annual letters to
shareholders have gained an enormously valuable
education. The letters distill in plain words the basic
principles of sound business practices: selecting
managers and investments, valuing businesses, and
using financial information profitably. As Cunningham
puts it, the writings are broad in scope, and long on
wisdom. In the interest of education, Buffett has posted
copies of the annual letters since 1977 to the companys
website at www.berkshirehathaway.com. With 20 Letters
to Shareholders and the Berkshire Hathaway Owners
Manual totaling 437 pages in the aggregate, until now,
Buffetts writings existed in a form that was neither
easily accessible nor organized in any thematic way.
Over the past three years, Cunningham, a corporate
governance professor at Yeshiva Universitys Cardozo
School of Law in New York City, selected, edited,
arranged, and introduced these writings. When asked at
the 1998 Berkshire Hathaway Annual Meeting about the
best book to read on Berkshires investment style,
Warren Buffett replied, Larry Cunningham has done a
great job at collating our philosophy. It is far better than
any of the biographies written to date. If I were to pick
one book to read this would be the one. Following are
selected insights from The Essays of Warren Buffett.
Investment success should be measured by analyzing the
long-term progress of companies, rather than the month-
to-month movements of their stocks.
When evaluating common stocks as a potential
investment, the investor should approach the transaction
as if he or she were buying into a private business. Key
evaluative criteria include: (i) the economic prospects of
the business; (ii) the people in charge of running it; and
(iii) the price to be paid.
When a management with a reputation for brilliance
tackles a business with a reputation for poor fundamental
economics, it is the poor reputation of the business that
remains intact.
Investment success will not be produced by formula-
driven approaches, computer programs, or technical
signals flashed by the price behavior of stocks and
markets. Rather, an investor will succeed by coupling
good business judgment with an ability to insulate his or
her thoughts and behavior from the super-contagious
emotions that swirl about the marketplace.
The investor should be quite content to hold a security
indefinitely, so long as the prospective return on equity
capital of the underlying business is satisfactory,
management is competent and honest, and the market
does not overvalue the business.
For many investors, it is preferable to achieve a return of
X while associating with people whom the investor
strongly likes and admires, than realize 110% of X by
exchanging these relationships for uninteresting or
unpleasant ones.
3DJH 160
Classic Investment Readings: Warren E. Buffett (cont.)
The less the prudence with which others conduct their
affairs, the greater the prudence with which the investor
should conduct his or her own affairs.
An investor should ordinarily hold a small piece of an
outstanding business with the same tenacity that an
owner would exhibit if he or she owned all of that
business.
A policy of portfolio concentration may well decrease
risk if it raises, as it should, both the intensity with which
an investor thinks about a business and the comfort level
he or she must feel about its economic characteristics
before buying into it.
The goal should be to find an outstanding business at a
sensible price, not a mediocre business at a bargain price.
The best business to own is one that over an extended
period can employ large amounts of incremental capital
at very high rates of return. The worst business to own is
one that must, or will, do the opposite that is,
consistently employ ever-greater amounts of capital at
very low rates of return.
Asset-heavy businesses generally earn low rates of
return rates that often barely provide enough capital
to fund the inflationary needs of the existing business,
with nothing left over for real growth, for distribution to
owners, or for acquisition of new businesses. A
disproportionate number of great business fortunes built
up during the inflationary years arose from ownership of
operations that combined significant intangible assets of
lasting value with relatively minor requirements for
tangible assets.
The investor should focus on businesses he or she
understands. That means they must be relatively simple
and stable in character. The investor should favor
businesses and industries unlikely to experience major
change. The investor should search for operations that he
or she believes are virtually certain to possess enormous
competitive strength 10 or 20 years from now.
An investor can pay too much for even the best of
businesses. The overpayment risk surfaces periodically
and may at times be quite high for the purchasers of
virtually all stocks. Investors making purchases in an
overheated market need to recognize that it may often
take an extended period for the value of even an
outstanding company to catch up with the price they
paid.
The investor does not have to be an expert on every
company, or even many. What is important is the ability
to evaluate companies within the investors circle of
competence. The size of that circle is not very important;
knowing boundaries, however, is vital.
The investors goal should simply be to purchase, at a
rational price, a part interest in an easily-understandable
business whose earnings are virtually certain to be
materially higher five, ten, and twenty years from now.
Stockholders as a whole and over the long term must
inevitably underperform the companies they own
because of the heavy transaction and investment
management costs they bear. If American business, in
aggregate, earns about 12% on equity annually, investors
usually end up earning significantly less.
Investors should seek to hold shares in companies whose
operations they understand, time horizons they share,
and successes and failures they measure as they measure
themselves.
In selecting an investment, an investor should adopt the
same attitude one might find appropriate in looking for a
spouse: it pays to be active, interested, and open-minded,
but it does not pay to be in a hurry.
In investing, just as in baseball, to put runs on the
scoreboard one must watch the playing field, not the
scoreboard.
Tax-paying investors will realize a greater sum from a
single investment that compounds internally at a given
rate than from a succession of separately realized
investments compounding at the same rate.
Copyright 1997 by Lawrence A. Cunningham. Used by
permission from Lawrence A. Cunningham.
To order The Essays of Warren Buffett, contact Professor
Lawrence A. Cunningham: (i) by email at cunning@ymail.yu.edu;
(ii) by mail at Cardozo Law School, 55 Fifth Avenue, New York,
NY 10003; (iii) by telephone at 212-790-0435; or (iv) by Internet
at www.Amazon.com.
3DJH 161
Classic Investment Readings: Charles P. Kindleberger
Manias, Panics, and Crashes:
A History of Financial Crises
In his classic treatment of historical financial crises,
published in 1978, Charles P. Kindleberger outlines the
components of distress in economic systems that lead to
panic behavior in the markets. By investigating the most
notable financial crises since 1618, Professor
Kindleberger offers analysis of various influences that
can engender a crisis, cause it to propagate, and
transform it into an international emergency. Further, he
offers insight on remedies, including how the carefully-
timed involvement of an international lender of last
resort can serve to limit the severity of a financial crisis
and help to speed the recovery of financial markets
afterward.
Kindlebergers observations are of particular interest
again today as the world faces what some would
maintain is only the early stage of a full-fledged global
financial crisis. The following are excerpts from the book
highlighting some of the most thought-provoking
concepts Kindleberger presents.
Since 1987 there has been an enormous outpouring of
literature, for and against bubbles in financial markets.
A good number of economic theorists have dismissed
this sort of work as being outside the bounds of
economics: it conveys suggestions of irrationality,
whereas for them, economics rests solidly on the axiom
that humanity is rational, knows its mind, and
maximizes, or at least optimizes, its utility or well being.
Kindleberger takes up the cudgels against those whose
attachment to the notion of rational human behavior is so
rigid that they cannot recognize irrationality and
destabilizing speculation when it is in front of their
faces.
Kindleberger places great emphasis on those few critical
moments when the evocation of the Golden Rule
becomes essential when a lender of last resort must
have the courage, as well as the resources, to step into
the breach and attempt to stem the tide that leads to ruin.
Rational action in economics does not imply that all
actors have the same information, the same intelligence,
or the same experience and purposes. Moreover, the
fallacy of composition brings it about from time to time
that individual actors all act rationally, but in
combination produce an irrational result.
The theory of rational expectations assumes that
expectations adjust to events through the application of
some widely understood economic model; it implies that
expectations change more or less instantaneously in
response to some discrete event. That is not the way it
looks in financial history. Expectations in the real world
may change slowly or rapidly, and different groups may
wake up to the realization sometimes at different rates
and sometimes all at once that the future will be
different from the past.
The period of distress may be drawn out over weeks,
months, even years, or it may be concentrated into a few
days. But a change in expectations from a state of
confidence to one lacking confidence in the future is
central.
Propagation of manias runs through many linkages,
including trade, capital markets, flows of hot money,
changes in central bank reserves of gold or foreign
exchange, fluctuations in prices of commodities,
securities, or national currencies, changes in interest
rates, and direct contagion of speculators in euphoria or
gloom.
3DJH 162
Classic Investment Readings: Charles P. Kindleberger (cont.)
The panic feeds on itself, as did the speculation, until
one or more of three things happen: (i) prices fall so low
that people are again tempted to move back into less
liquid assets; (ii) trading is cut off by setting limits on
price declines, shutting down exchanges, or otherwise
closing markets; or (iii) a lender of last resort succeeds in
convincing the market that money will be made available
in sufficient volume to meet the demand for cash.
The detailed story of every banking crisis in our history
shows how much depends on the presence of one or
more outstanding individuals or entities willing to
assume responsibility and leadership.
A lender of last resort should always come to the rescue,
in order to prevent needless deflation, but always leave it
uncertain whether rescue will arrive in time or at all, so
as to instill caution in other speculators, lenders,
regulators, and countries.
Boom, distress, and panic are transmitted between
national economies through a variety of connections: (i)
arbitrage in commodities or securities (and marking up
or down prices in one market when they change in
another, without actually buying and selling); (ii)
movements of money in various forms: specie, bank
deposits, bills of exchange, interest rates changed
through uncovered arbitrage, cooperation among
monetary authorities; and (iii) readily neglected pure
psychology.
The dominant argument against the view that panics can
be cured by being left alone is that they almost never are
left alone. The authorities feel compelled to intervene. In
panic after panic, crash after crash, crisis after crisis, the
authorities or some responsible citizens try to bring the
panic to a halt by one device or another.
It follows from the international propagation of financial
crises, from the efficacy under certain circumstances of
lending in the last resort, and from the historical record,
that a case can be made for an international lender of last
resort. With no world government, no world central
bank, and only weak international law, the question of
where last-resort lending comes from is a crucial one.
The historical record suggests that it comes from the
leading financial center of the world, often assisted by
other countries. It suggests further that when there is no
such lender, as in 1873, 1890, and 1931, depression
following financial crisis is long and drawn out this,
in contrast to episodes when there is a lender of last
resort and the crisis passes like a summer storm.
For most of the financial crises covered from 1720 to
1988, both national and international, a lender of last
resort did swing into action in response to the pressures
of the market, though often protesting all the way. The
role was not always dispatched with efficiency, so that a
refined analysis would categorize the aftermath of crises
not only by the presence or absence of a lender of last
resort, but also by how well the role was discharged.
Second, the aftermath of a depression depends not just
on how the crisis was handled, but on a host of other
variables, especially the factors affecting long-term
investment: (i) population growth; (ii) the existence of a
frontier; (iii) demands arising from military conflict; (iv)
exports; (v) the presence or absence of innovations that
are or are not fully exploited, and the like.
Despite these difficulties, Kindleberger is prepared to
make the case, tentatively, that a lender of last resort
does shorten the business depression that follows
financial crisis. The evidence turns mainly on 1720,
1873, 1882 in France, 1890, 1921, and 1929. In none of
these was a lender of last resort effectively present. The
depressions that followed them were much longer and
deeper than others.
This by no means constitutes a conclusive demonstration
that intervention of a lender of last resort in a panic
softens the depression that follows. Too many other
factors are at work, both long- and short-term, and the
occasions when a panic has been allowed to run its
course are so few that the material is not abundant
enough for strong conclusions. At most there remains a
presumption, but not a strong one, that halting a
cumulative deflation helps shorten the depression that
follows.
A wider claim is made for lenders of last resort: that they
make it possible to avoid financial crises altogether. The
record shows that financial crises were less frequent in
Britain after 1866 and in the United States after 1929. In
addition, the record can be interpreted to reveal that they
were less terrifying.
The existence of a lender of last resort, while it may
exacerbate speculation, calms anxieties when speculation
occurs.
Copyright 1978, 1989, 1996 by Charles P. Kindleberger.
Used by permission from John Wiley & Sons, Inc.
3DJH 163
Classic Investment Readings: Peter L. Bernstein
Capital Ideas
The revolutionary financial innovations described in Peter
Bernsteins book help investors deal with uncertainty. They
provide benchmarks for determining whether expectations
are realistic or fanciful, and whether risks make sense or
are imprudent. They establish norms for determining how
well a market is accommodating the needs of its
participants. They have reformulated such familiar
concepts as risk, return, diversification, insurance, and
debt. Moreover, these innovations have quantified these
concepts and have suggested new ways of employing them
and combining them for optimal results. Although many of
the individuals described in Capital Ideas may not be widely
known among the investing public, their profound insights
now touch virtually every decision that investors make.
The accompanying paragraphs profile several of the
individuals whose insights have shaped financial markets
and ways of thinking about markets. Harry Markowitz
expounded the wisdom of optimizing the trade-off between
risk and return, and William Sharpe showed how to
accomplish this task. Franco Modigliani and Merton Miller
emphasized the critical role played by arbitrage in
determining the value of securities. Paul Samuelson and
Eugene Fama advised investors that, in an unpredictable
market, they had better not venture forth unprepared.
Todays financial markets reflect the effects of thinking that
began and/or was rediscovered in the 1970s, in academia
rather than in the financial industry. These theories, and
their practical applications, are based on two basic laws of
economics: (i) there can be no reward without risk; and (ii)
gaining an advantage over skilled and knowledgeable
competitors in a free market is extraordinarily difficult. The
daily movements of security prices reveal how confident
investors are in their expectations, what time horizons they
envisage, and what hopes and fears they are communicating
to one another.
The French economist, Louis Bachelier, completed the first
effort to employ theory, including mathematical techniques,
to explain why the stock market behaves as it does.
Bachelier postulated that the probability of a rise in price at
any moment is the same as the probability of a fall in price,
because the price considered most likely by the market is
the true current price: if the market judged otherwise, it
would quote not this price, but another price, higher or
lower. The Efficient Market Hypothesis is based on the
notion that stock prices reflect all available information
about individual companies and about the economy as a
whole. The Efficient Market Hypothesis draws upon the
work of Bachelier, for it assumes that information is so
rapidly reflected in stock prices that no single investor can
consistently know more than the market as a whole knows.
Investors who opt for a buy-and-hold strategy say that all
they can forecast is that stocks represent a good investment
over the long run. No one investor can win if all investors
receive all the necessary information, understand it
completely, and act on it at once. Profitable trading depends
on imperfections, which develop only when other investors
either are slower to receive information, draw erroneous
conclusions from it, or delay acting on it.
In a short paper titled Portfolio Selection, published in
the March 1952 issue of the Journal of Finance, Harry
Markowitz set forth one of the most famous insights in
modern finance and investment. Markowitz stated that
investors cannot hope to earn high returns unless they are
willing to accept the risk involved, risk being defined as
facing the possibility of losing as well as the possibility of
winning. Markowitz also posited that diversification
depends more on the way individual assets perform relative
to one another than it does on how many assets the investor
owns. The portfolio that conforms to Markowitzs rule and
that he commends to the investor is a so-called efficient
portfolio. It is a portfolio that offers the highest expected
return for any given degree of risk, or that has the lowest
degree of risk for any given expected return.
3DJH 164
Classic Investment Readings: Peter L. Bernstein (cont.)
Markowitzs other highly original contribution was his
insistence on distinguishing between the riskiness of an
individual stock and the riskiness of an entire portfolio. The
riskiness of a portfolio depends on the covariance of its
holdings, not on the average riskiness of the separate
investments. A combination of very risky holdings may still
comprise a low-risk portfolio so long as they do not move
in lockstep with one another that is, so long as they have
low covariance. Investors face the difficult challenge of
making reliable estimates of variability for each individual
security. They also have to estimate the expected return for
each individual security, a challenging task under any
circumstances. These two challenges pale in comparison
with the task of determining how each of the many
securities under consideration will vary in relation to every
one of the others. Harry Markowitz aims for a precision in
the specification of both motives and of expectations which
it seems unlikely that most investors can reasonably be
expected to possess or express coherently.
James Tobins powerful contribution to portfolio theory
was a fortuitous outgrowth of his concerns over economic
policy and the ravages caused by depressions and
inflations. Tobins Separation Theorem rejects the
conventional method of designing a separate portfolio
specifically for each investor. Rather, Tobin prescribes
identical equity portfolios for all investors, regardless of
objective or risk aversion. Tobins work enables the
investor to identify the single portfolio of risky securities
on Markowitzs efficient frontier that dominates all the
other possible combinations of efficient portfolios. Despite
the advance that Tobins innovation made possible, it did
nothing to ease the daunting task of performing the
thousands, if not millions, of calculations prescribed by
Markowitz. Tobin helped the investor to make the strategic
choice from the efficient frontier, but that did nothing to
make defining the frontier any easier.
William Sharpe developed an effective method for
overcoming the calculational difficulties inherent in the
day-to-day application of Markowitzs theories of
diversification and efficient portfolios. Sharpes major
breakthrough came in 1964, with what is known as the
Capital Asset Pricing Model. CAPM combines so many
strands of theoretical innovation that it remains the
keystone in investment theory, theories of market behavior,
and the allocation of capital in both private and public
enterprises. The major characteristic of Sharpes model is
the assumption that the returns of various securities are
related only through common relationships with some basic
underlying factor. There is no doubt that individual stocks
respond most directly to the stock market as a whole. The
unique price variability characteristics of a stock itself tend
to disappear when as few as a dozen individual stocks are
combined into a portfolio. Then, diversification effects
overpower the individual attributes of the stocks, and more
than 90 percent of the portfolios variability is explained by
the broad market index. The primary role of the Capital
Asset Pricing Model (CAPM) is to predict expected returns,
or to place a valuation on risky assets. The expected returns
come in three parts. First, a stock should be expected to
earn at least as much as the risk-free rate of interest
available on Treasury bills. Second, as stocks are a risky
asset, the market as a whole should actually earn a premium
over the risk-free rate. Third, an individual stocks beta
its volatility relative to the portfolios volatility will then
determine how much higher or lower the expected returns
of that stock will be relative to what investors expect from
the market as a whole.
Sharpe also pointed out that the market never explains 100
percent and often no more than 30 percent of a
stocks performance. A stock reflects the unique
characteristics of the company that issues it, the industry in
which the company operates, and whether the stock is
owned primarily by institutions or by individuals. Sharpe
defines unsystematic risk as that part of an assets
variability that is independent of what happens in the
market. Sharpe insisted that unsystematic risk has little or
no impact on the value of a stock. Sharpes system of
analyzing the correlation between the behavior of a
portfolio and the behavior of the market as a whole, reveals
a lot about how portfolio managers are doing their job. It
provides a measure of how much risk they are taking with
their clients money and reveals whether their results are
consistent with that risk. The track record of some
managers who looked like winners at first glance might
turn out to be just the consequence of their concentrating in
risky stocks in a bull market.
Paul Samuelson, considered one of the greatest economists
of the modern era, places great emphasis on the importance
of information. No investor in stocks, no buyer of
commodities for future delivery, and no lender or borrower
can possibly arrive at a decision without information of
some kind. Samuelson has explored how human behavior
shapes expectations and how expectations shape
speculative prices. Most human beings have stable, well-
defined preferences, and they make rational choices
consistent with those preferences. Rational expectations
theory assumes that investors take a view of the future that
is thoughtful rather than visceral, even if not necessarily
accurate. Samuelson has also devoted intellectual effort to
distinguishing between the difficulty of predicting the
prices of individual securities, and the difficulty of
predicting the behavior of entire markets.
Eugene Fama aimed at consolidating what was known
about the behavior of stock prices into a comprehensive
theory to explain why prices appear to fluctuate randomly.
The idea that most investors are likely to do no better than
average, even when armed with the best information, and
3DJH 165
Classic Investment Readings: Peter L. Bernstein (cont.)
are likely to do worse than average without the best
information, was what made professional investors so
antagonistic to the academic theories. In Famas writings,
an efficient market is not necessarily a rational market, nor
is the information it reflects always accurate. In their
enthusiasm, or in their collective gloom, investors
sometimes end up agreeing among themselves that certain
stocks are somehow worth far more, or far less, than their
intrinsic values. Although reality will ultimately assert
itself, an efficient market is one in which no single investor
has much chance, beyond luck, of consistently outguessing
all the other participants.
Apparently the most rigorous, and also the most influential,
method for determining intrinsic value was published in
1938 by John Burr Williams. His contribution to financial
thinking, the Dividend Discount Model, defines intrinsic
value as that value justified by earnings and dividends,
discounted back to the present at an appropriate interest
rate. Williams also questioned why a rational investor
would buy a stock in the first place. According to Williams,
the investor expects the stock to rise in price, but that is
only a hope. For the price to rise, other investors must
change their minds about the value of the stock and bid up
its price, and there is no guarantee that they will perceive
the stock any differently from the investor who is still
considering whether or not to buy it.
Merton Miller and Franco Modigliani studied how a
corporation should select securities to issue, to arrive at an
optimal balance between debt and equity the claims of
creditors versus the claims of stockholders. Investors are
continually making judgments about the streams of income
they expect corporations to produce over time for their
owners and creditors, judgments about the uncertainty
surrounding those future income streams, and judgments
about the relative riskiness and relative earning power of
each corporation relative to other corporations. Although
the owners of a company that borrows money are in a
riskier position than the owners of a debt-free company, the
value of that companys bonds and stock, taken as a
totality, still depends on the company's overall expected
earning power and the basic risks the company faces.
Followed to its ultimate conclusion, the Modigliani-Miller
theorem says that the value of the corporation will be the
same whether the corporation pays a big dividend, a small
dividend, or no dividend at all.
Jack Treynor refers to the anticipated spread between risky
and risk-free returns as the risk premium. Treynors
contribution to the theory of finance was to devise a method
for predicting the risk premium and to demonstrate its
overarching importance in the behavior of capital markets
as well as in portfolio selection. The investors option to
hold assets in cash, or, to be more precise, in a liquid asset
like Treasury bills that provides a return known with
certainty in advance, is critically important. With the choice
of a risk-free asset always available to them, investors will
buy risky assets only if they can expect a return greater than
the risk-free return. Stephen Ross developed an interesting
extension of CAPM in 1976, in a concept known as
Arbitrage Pricing Theory. APT differs from CAPM in
important ways. CAPM specifies where asset prices will
settle, given investor preferences for trading off risk for
expected returns, but it is silent about what produces the
returns that investors expect. It also identifies only one
factor as the dominant influence on stock returns. APT fills
those gaps by providing a method to measure how stock
prices will respond to changes in the multitude of economic
factors that influence them, such as inflation, interest rate
patterns, changing perceptions of risk, and economic
growth. Through the use of arbitrage, APT also provides
investors with strategies for betting on their forecasts of the
factors that shape stock returns. Finally, the construction of
APT enables it to avoid the rigid and often unrealistic
assumptions required by CAPM.
Barr Rosenberg delved into what determines a managers
residual returns, defined as returns that vary from what
CAPM predicts. Many analysts had assumed that residual
returns were either the result of noise and random forces, or
the result of an active decisions by the manager to compose
a portfolio that differed from the market. Rosenberg sensed
that what appeared to be random was not necessarily
random. Rosenberg put forth the idea that the risk of
owning a stock must be related to more than just the
behavior of the stocks price. In the end, risk and stock
price behavior will reflect such fundamental aspects of the
company as its industry, its size, its financial condition, its
cost structure, the diversification of its customer group, and
its record of growth.
Arguably one of the first pure index funds was set up by
James Vertin in 1973 at Wells Fargo as a commingled fund,
open to any and all trust accounts. The fund would track the
performance of the 500 stocks of Standard & Poors
Composite Index, which then accounted for about 65
percent of the total marketable equity market in the United
States. His colleague, William Fouse, designed another
product that has become increasingly important: tactical
asset allocation, a method of calculating separately the
expected returns for the stock market, the bond market, and
the markets for cash equivalents such as Treasury bills.
Investors assets are shifted to the market or markets that
appear relatively most attractive. Tactical asset allocation
differs from so-called market timing in two ways. First, it is
a scientific method of allocating assets. Second, the idea is
to buy undervalued assets and to sell overvalued assets and
to wait until the market corrects the perceived
misvaluations.
Copyright 1992 by Peter L. Bernstein.
Published by Simon and Schuster, Inc.
3DJH 166
Classic Investment Readings: Edwin LeFvre
Reminiscences of a Stock Operator
While never personally involved in the markets, Edwin
LeFvre, a journalist, columnist, novelist, and short-
story writer, spent several weeks interviewing Jesse
Livermore, a Wall Street trader. As a result of those
interviews, LeFvre crafted a true classic a book that,
because of its unique content or expository style, remains
widely read and has been appreciated generations after
its publication. Originally published in serialized form in
the Saturday Evening Post before being published in
book form in 1923, Reminiscences of a Stock Operator is
filled with observational gems about the markets and
trading. Investors who can absorb and follow the lessons
spread throughout Reminiscences can enhance their
insights as traders. Some investors have even found that
the book has more to teach them about themselves and
other investors than years of experience in the market.
Reminiscences captures the details of influence in the
mind of a trader the recollections of mistakes made,
the lessons learned, and the insights gained by
portraying the experience and thoughts of its
protagonist, Larry Livingstone, LeFvres pseudonym
for Jesse Livermore.
I noticed that in advances as well as in declines, stock
prices were apt to show certain habits. You can spot, for
instance, where the buying is only a trifle better than the
selling. A battle goes on in the stock market and the tape
is your telescope. You can depend upon it seven out of
ten cases. There is nothing new in Wall Street. Whatever
happens in the stock market today has happened before
and will happen again.
There is always a reason for fluctuations, but the tape
does not concern itself with the why and wherefore. It
does not go into explanations. The reasons for what a
certain stock does today may not be known for two or
three days, or weeks, or months. Your business with the
tape is now not tomorrow. The reason can wait. But
you must act instantly or be left. You will remember that
Hollow Tube went down three points the other day while
the rest of the market rallied sharply. That was the fact.
On the following Monday you saw that the directors
passed the dividend. That was the reason. They knew
what they were going to do, and even if they did not sell
the stock themselves they at least did not buy it. There
was no inside buying; no reason why it should not break.
I always made money when I was sure I was right before
I began. What beat me was not having brains enough to
stick to my own game that is, to play the market only
when I was satisfied that precedents favored my play.
There is the plain fool, who does the wrong thing at all
the wrong times everywhere, but there is the Wall Street
fool, who thinks he must trade all the time.
The desire for constant action irrespective of underlying
conditions is responsible for many losses in Wall Street,
even among the professionals. A stock operator has to
fight a lot of expensive enemies within himself.
3DJH 167
Classic Investment Readings: Edwin LeFvre (cont.)
They say there are two sides to everything. But there is
only one side to the stock market; and it is not the bull
side or the bear side, but the right side. My losses have
taught me that I must not begin to advance until I am
sure I shall not have to retreat. But if I cannot advance I
do not move at all. A man must believe in himself and his
judgement if he expects to make a living at this game.
If a stock does not act right, do not touch it; because,
being unable to tell precisely what is wrong, you cannot
tell which way it is going. No diagnosis, no prognosis.
No prognosis, no profit. But not even a world war can
keep the stock market from being a bull market when
conditions are bullish, or a bear market when conditions
are bearish. And all a man needs to know to make money
is to appraise conditions.
The big money was not in the individual fluctuations but
in the main movements that is, not in reading the tape
but in sizing up the entire market and its trend. After
spending many years in Wall Street and after making and
losing millions of dollars I want to tell you this: It never
was my thinking that made the big money for me. It was
always my sitting. Men who can both be right and sit
tight are uncommon. I found it one of the hardest things
to learn. But it is only after a stock operator has firmly
grasped this that he can make big money. It is literally
true that millions come easier to a trader after he knows
how to trade than hundreds did in the days of his
ignorance.
Disregarding the big swing and trying to jump in and out
was fatal to me. Nobody can catch all the fluctuations. In
a bull market your game is to buy and hold until you
believe that the bull market is near its end. To do this
you must study general conditions and not tips or special
factors affecting individual stocks. Then get out of all
your stocks; get out for keeps! Without faith in his own
judgement no man can go very far in this game. It is the
big swing that makes the big money for you.
To buy on a rising market is the most comfortable way
of buying stocks. The point is not so much to buy as
cheap as possible or to go short at top prices, but to buy
or sell at the right time. When I am bearish and I sell a
stock, each sale must be at a lower level than the
previous sale. When I am buying, the reverse is true. I
must buy on a rising scale. I do not buy long stock on a
scale down, I buy on a scale up.
A man cannot expect the market to absorb fifty thousand
shares of one stock as easily as it does one hundred. He
will have to wait until he has a market there to take it.
There comes the time when he thinks the requisite
buying power is there. When that opportunity comes he
must seize it. As a rule he will have been waiting for it.
He has to sell when he can, not when he wants to. To
learn the time, he has to watch and test. It is no trick to
tell when the market can take what you give it. But in
starting a movement it is unwise to take on your full line
unless you are convinced that conditions are exactly
right. Remember that stocks are never too high for you to
begin buying or too low to begin selling. But after the
initial transaction, do not make a second unless the first
shows you a profit. Wait and watch.
All stock-market mistakes wound you in two tender
spots your pocketbook and your vanity. Losing
money is the least of my troubles. A loss never bothers
me after I take it. I forget it overnight. But being wrong
not taking the loss that is what does the damage to
the pocketbook and to the soul.
The speculators chief enemies are always boring from
within. It is inseparable from human nature to hope and
to fear. In speculation when the market goes against you,
you hope that every day will be the last day and you
lose more than you should had you not listened to hope
to the same ally that is so potent a success-bringer to
empire builders and pioneers, big and little. And when
the market goes your way you become fearful that the
next day will take away your profit, and you get out
too soon. Fear keeps you from making as much money
as you ought to. The successful trader has to fight these
two deep-seated instincts. He has to reverse what you
might call his natural impulses. Instead of hoping he
must fear; instead of fearing he must hope. He must fear
that his loss may develop into a much bigger loss, and
hope that his profit may become a big profit.
3DJH 168
Classic Investment Readings: Edwin LeFvre (cont.)
A trader, in addition to studying basic conditions,
remembering market precedents and keeping in mind the
psychology of the outside public as well as the
limitations of his brokers, must also know himself and
provide against his own weaknesses. There is no need to
feel anger over being human. I have come to feel that it
is as necessary to know how to read myself as to know
how to read the tape.
You can transmit knowledge that is, your particular
collection of card-indexed facts but not your
experience. A man may know what to do and lose money
if he does not do it quickly enough.
Observation, experience, memory and mathematics
these are what the successful trader must depend on. He
must not only observe accurately but remember at all
times what he has observed. He cannot bet on the
unreasonable or on the unexpected, however strong his
personal convictions may be about mans
unreasonableness or however certain he may feel that the
unexpected happens very frequently. He must bet always
on probabilities that is, try to anticipate them.
The appeal in all booms is always frankly to the
gambling instinct aroused by cupidity and spurred by a
pervasive prosperity. People who look for easy money
invariably pay for the privilege of proving conclusively
that it cannot be found on this sordid earth.
Speculation in stocks will never disappear. It cannot be
checked by warnings as to its dangers. You cannot
prevent people from guessing wrong no matter how able
or how experienced they may be. Carefully laid plans
will miscarry because the unexpected and even the
unexpectable will happen. Disaster may come from a
convulsion of nature or from the weather, from your own
greed or from some mans vanity; from fear or from
uncontrolled hope.
The speculators deadly enemies are: ignorance, greed,
fear and hope. All the statute books in the world and all
the rules of all the exchanges on earth cannot eliminate
these from the human animal.
The experience of years as a stock operator has
convinced me that no man can consistently and
continuously beat the stock market though he may make
money in individual stocks on certain occasions. No
matter how experienced a trader is, the possibility of his
making losing plays is always present. Wall Street
professionals know that acting on inside tips will break
a man more quickly than famine, pestilence, crop
failures, political readjustments, or what might be called
normal accidents. There is no asphalt boulevard to
success in Wall Street or anywhere else.
Copyright 1993, 1994 by Expert Trading, Ltd. Forward
1994 by John Wiley & Sons, Inc. Originally published in
1923 by George H. Doran and Co. Used by permission
3DJH 169
Classic Investment Readings: Charles Mackay
Extraordinary Popular Delusions
and the Madness of Crowds
Extraordinary Popular Delusions and the Madness of
Crowds by Charles Mackay was originally published in
1841 under the title Memoirs of Extraordinary Popular
Delusions. The tales told in this volume cover events that
happened about three hundred years ago, but the accounts
sound like only yesterday, or maybe even today. That
explains why this book has held the attention of investors
for so long the more things change, the more they seem
to stay the same. Most features of market behavior today
are little different from market behavior in the seventeenth
century. Delusions was the favorite book of well-known
American Financier Bernard Baruch and, by most
accounts, Mackays lessons helped Baruch preserve his
immense wealth through the crash of 1929. Although
Mackays research and some of his anecdotal evidence
have been questioned, no amount of scholarly debunking
is likely to extinguish the fondness of investors for
Extraordinary Popular Delusions. As long as people stake
money on their ability to outsmart the majority opinion,
they will cherish the thought that the majority periodically
becomes deranged.
Money Mania: The Mississippi Scheme
The personal character and career of one man are so
intimately connected with the great scheme of the years
1719 and 1720 that a history of the Mississippi madness
can have no fitter introduction than a sketch of the life of its
great author, John Law. Born in Edinburgh in the year
1671, John Law was neither a knave nor a madman, but one
more deceived than deceiving, more sinned against than
sinning. He was thoroughly acquainted with the philosophy
and true principles of credit. He understood the monetary
question better than any man of his day; and if his system
fell with a crash so tremendous, it was not so much his fault
as that of the people amongst whom he had erected it.
On the 5th of May, 1716, a royal edict was published, by
which Law was authorized, in conjunction with his
brother, to establish a bank under the name of Law and
Company, the notes of which should be received in
payment of the taxes. His many years of studying finance
and trade guided him in the management of his bank. He
made all his notes payable at sight, in the coin current at
the time they were issued. This last was a masterstroke of
policy, and immediately rendered his notes more valuable
than the government notes backed by precious metals. The
latter were constantly liable to depreciation by the unwise
tampering of the government. A thousand livres of silver
might be worth their nominal value one day, and reduced
to one-sixth the next, but a note of Laws bank retained its
original value. In the course of a year, Laws notes rose to
a fifteen per cent premium, while the billets detat, or
notes issued by the government as security for the debts
contracted by the extravagant Louis XIV, were at a
discount of no less than seventy-eight and a half per cent.
The comparison was too great in favour of Law not to
attract the attention of the whole kingdom, and his credit
extended itself day by day.
Law then commenced the famous project which handed his
name down to posterity. He proposed to the regent to
establish a company that should have the exclusive
privilege of trading to the great river Mississippi and the
province of Louisiana. The country was supposed to
abound in precious metals, and the company would be
supported by the profits of their exclusive commerce. The
frenzy of speculating began to seize upon the nation, as
Laws bank had effected so much good, that any promises
for the future which he made were readily believed. Amid
the intoxication of success, both Law and the regent forgot
the maxim Law had so loudly proclaimed before, that a
banker deserved death who made issues of paper without
the necessary funds to provide for them. The system
continued to flourish till the commencement of the year
1720, but no sooner did the breath of popular mistrust blow
steadily upon it, than it fell to ruins, and none could raise it
up again.
Without enough specie to redeem all the notes the people
wanted to exchange, Law attempted in vain to raise
confidence in the notes again, by depreciating the value of
coin five, then ten per cent below paper. Payments of the
bank were at the same time restricted to one hundred livres
in gold, and ten in silver, but with no effect. People
continued to hoard precious metals and transport them out
of the country, so in this emergency, Law hazarded the
3DJH 170
Classic Investment Readings: Charles Mackay (cont.)
experiment of forbidding the use of specie altogether.
Instead of restoring the credit of the paper, as was
intended, it destroyed it completely, and drove the country
to the very brink of revolution. The value of shares in the
Louisiana, or Mississippi stock, had fallen very rapidly,
and few indeed were found to believe the tales that had
once been told of the immense wealth of that region. Law
himself, in a moment of despair, determined to leave the
country where his life was no longer secure.
The South-Sea Bubble
The South-Sea Company was originated by the celebrated
Harley, Earl of Oxford, in the year 1711, with the view of
restoring the public credit, which had suffered by the
dismissal of the Whig ministry, and of providing for the
discharge of the army and navy debentures, and other parts
of the floating debt. A company of merchants took this
debt upon themselves, and the government agreed to
secure them for a certain period the interest of six per cent.
To provide for this interest, the duties upon wines,
vinegar, India goods, wrought silks, tobacco, whale-fins,
and some other articles, were rendered permanent. The
monopoly of the trade to the South Sea was granted, and
the company, being incorporated by an act of parliament,
assumed the title by which it has ever since been known.
Even at this early period of its history, the most visionary
ideas were formed by the company and the public of the
immense riches of the eastern coast of South America.
Everybody had heard of the gold and silver mines of Peru
and Mexico; everyone believed them to be inexhaustible,
and that it was only necessary to send the manufacturers of
England to the coast to be repaid a hundredfold in gold
and silver ingots by the natives.
The kings speech at the opening of the session of 1717
made pointed allusion to the state of public credit, and
recommended that proper measures should be taken to
reduce the national debt. The two great monetary
corporations, the South-Sea Company and the Bank of
England, made proposals to parliament. The name of the
South-Sea Company was continually before the public.
Though their trade with the South American States
produced little or no augmentation of their revenues, they
continued to flourish as a monetary corporation. Their stock
was in high request, and the directors, buoyed up with
success, began to think of new means for extending their
influence. The Mississippi scheme of John Law, which so
dazzled and captivated the French people, inspired them
with an idea that they could carry on the same game in
England. The anticipated failure of his plans did not divert
them from their intention. Wise in their own conceit, they
imagined they could avoid his faults, carry on their schemes
forever, and stretch the cord of credit to its extremest
tension, without causing it to snap asunder. It was while
Laws plan was at its greatest height of popularity, that the
South-Sea directors laid before parliament their famous
plan for paying off the national debt, and although the Bank
of England had a similarly attractive plan, parliament
resolved to use the South-Sea Companys proposal.
The companys stock rose with the most astonishing
rapidity during the whole time that the bill in its several
stages was under discussion. Every exertion was made by
3DJH 171
Classic Investment Readings: Charles Mackay (cont.)
the directors and their friends to raise the price of the stock.
The most extravagant rumors were in circulation. Treaties
between England and Spain were spoken of, whereby the
latter was to grant a free trade to all her colonies. The
inordinate thirst of gain that had afflicted all ranks of
society was not to be slaked even in the South Sea. Other
schemes, of the most extravagant kind, were started. The
share-lists were speedily filled up, and an enormous traffic
carried on in shares, while, of course, every means were
resorted to, to raise them to an artificial value in the market.
Sensible men beheld the extraordinary infatuation of the
people with sorrow and alarm. There were some, both in
and out of parliament, who foresaw clearly the ruin that was
impending. On the 11th of June, the day the parliament
rose, the king published a proclamation, declaring that all
these unlawful projects should be deemed public nuisances,
and prosecuted accordingly.
The bubble was then full-blown, and began to quiver and
shake preparatory to its bursting. The South-Sea
Companys stock fell rapidly. Their bonds were in such
discredit, that a run commenced upon the most eminent
goldsmiths and bankers, some of whom, having lent out
great sums upon South-Sea stock, were obliged to shut up
their shops and abscond. The Bank finding they were not
able to restore public confidence and stem the tide of ruin
without running the risk of being swept away with those
they intended to save, declined to carry out the agreement
into which they had partially entered. No sooner had the
nation awakened from its golden dream, than a popular
and even a parliamentary clamor demanded its victims.
Tulipomania
The tulip so named, it is said, from a Turkish word,
signifying a turban was introduced into western Europe
about the middle of the sixteenth century. Rich people at
Amsterdam sent for the bulbs direct to Constantinople,
and paid the most extravagant prices for them. The first
roots planted in England were brought from Vienna in
1600. Until the year 1634 the tulip annually increased in
reputation, until it was deemed a proof of bad taste in any
person of fortune to be without a collection of them. The
rage for possessing them soon caught the middle classes of
society, and merchants and shopkeepers, even of moderate
means, began to vie with each other in the rarity of these
flowers and the preposterous prices they paid for them.
One would suppose that there must have been some great
virtue in this flower to have made it so valuable in the eyes
of so prudent a people as the Dutch; but it has neither the
beauty nor the perfume of the rose hardly the beauty of
the sweet, sweet-pea, neither is it as enduring as either.
The demand for tulips of a rare species increased so much in
the year 1636, that regular markets for their sale were
established on the Stock Exchange of Amsterdam, in
Rotterdam, Harlaem, Leyden, Alkmar, Hoorn, and other
towns. The stock-jobbers, ever on the alert for a new
speculation, dealt largely in tulips, making use of all the
means they so well knew how to employ to cause
fluctuations in prices. At first, as in all these gambling mania,
confidence was at its height, and everybody gained. The
tulip-jobbers speculated in the rise and fall of the tulip stocks,
and made large profits by buying when prices fell, and selling
out when they rose. Many individuals grew suddenly rich. A
golden bait hung temptingly out before the people, and one
after the other, they rushed to the tulip marts, like flies around
a honey-pot. Nobles, citizens, farmers, mechanics, sailors,
livery persons, servants, even chimney-sweeps and old
clothesdealers, dabbled in tulips. People of all grades
converted their property into cash, and invested it in flowers.
Houses and lands were offered for sale at ruinously low
prices, or assigned in payment of bargains made at the tulip-
mart. Foreigners became smitten with the same frenzy, and
money poured into Holland from all directions.
At last, however, the more prudent began to see that this
folly could not last forever. Rich people no longer
bought the flowers to keep them in their gardens, but to
sell them again at 100 percent profit. It was seen that
somebody must lose fearfully in the end. As this
conviction spread, prices fell, and never rose again.
Confidence was destroyed, and a universal panic seized
upon the dealers. Many who, for a brief season, had
emerged from the humbler walks of life, were cast back
into their original obscurity. Substantial merchants were
reduced almost to beggary, and many a representative of
a noble line saw house fortunes ruined beyond
redemption. The commerce of the country suffered a
severe shock from which it was many years before it
recovered.
Copyright 1841 by Charles Mackay. Used by permission
3DJH 172
Classic Investment Readings: Joseph de la Vega
Confusin de Confusiones
Whoever comes to know Joseph Penso de la Vegas
Confusin de Confusiones will recognize at once that he is
concerned with a literary oddity. Here is a book written in
Spanish by a Portuguese, published in Amsterdam, cast in
dialogue form, embellished from start to finish with biblical,
historical, and mythological allusions, and yet concerned
primarily with the business of the stock exchange as early as
1688, when Confusin de Confusiones was first issued.
De la Vega makes the reader acquainted not only with the
history of speculation on the exchange, but also with the
various types of speculative transactions used at that time.
The security chiefly involved was the stock of the Dutch East
India Company, an enterprise that had been launched in
1602 and that had prospered handsomely. Each share of
stock of the East India Company had a market value at that
time of more than 17,000 guilders.
In seventeenth-century Amsterdam, speculators thought in
terms of the difference between an agreed price for stock,
and what would be the prevailing value at the stipulated time
of transaction. Perhaps this approach combined with the
high unit value encouraged the development of devices for
speculation.
For students of economic and business history, the volume
has been of signal value. No other book deals as extensively
as this one with the trading in stocks at Amsterdam, and
nowhere else in the world of the seventeenth century was
there so mature a business of this sort as existed then at
Amsterdam. Through a perusal of de la Vegas book, one
learns how rapidly the trading in stocks became
sophisticated.
First Dialogue:
Beginnings of the Stock Exchange
In the first dialogue, I deal with the beginnings and the
etymology of the stock exchange, with the wealth of the
Company, the considerable extension of the speculation, and
the meaning of the premium business, while I make some
allusion to the swindling maneuvers.
PHILOSOPHER: And what kind of business is this about
which I have often heard people talk but which I neither
understand nor have ever made efforts to comprehend?
SHAREHOLDER: I really must say that you are an ignorant
person, friend Greybeard, if you know nothing of this
enigmatic business which is at once the fairest and most
deceitful in Europe, the noblest and the most infamous in the
world, the finest and the most vulgar on earth. It is a
quintessence of academic learning and a paragon of
fraudulence; it is a touchstone for the intelligent and a
tombstone for the audacious, a treasury of usefulness and a
source of disaster. The best and most agreeable aspect of the
new business is that one can become rich without risk.
SHAREHOLDER: In 1602 a few Dutch merchants founded a
company. The wealthiest people [in the country] took an
interest in it, and a total capital of sixty-four and a third tons of
gold was raised. Several ships were built and in 1604 were sent
out to seek adventure Quixote-like in the East Indies. Their
successful voyages, their victorious conquests, and the rich
return cargoes meant that Caesars veni, vidi, vici was
surpassed and that a tidy profit was made, which became a
stimulus to further undertakings. The first distribution of the
profit was postponed till 1612 in order to increase the
Companys capital. Then the administration distributed 57.5
per cent, while in 1613 the dividends amounted to 42.5 per
cent, so that the shareholders, after having had their capital
paid back to them, could enjoy any further return as so much
velvet.
PHILOSOPHER: I think I have fully grasped the meaning of
the Company, its shares, its principles, its reputation, its
splendor, its initiation, its progress, its administration, the
distribution of profits, and its stability.
SHAREHOLDER: Every year the financial lords and the big
capitalists enjoy the dividends from the shares that they have
inherited or have bought with money of their own. They do not
care about movements in the price of the stock. Since their
interest lies not in the sale of the stock but in the revenues
secured through the dividends, the higher value of the shares
forms only and imaginary enjoyment for them, arising from
the reflection that they could in truth obtain a high price if they
were to sell their shares.
A second class of participants is formed by merchants who
buy a share on expectations of favourable news from India or a
peace treaty in Europe. They sell these shares when their
anticipations come true and the price rises.
Gamblers and Speculators belong to a third class who have put
up wheels of fortune. Some who are in difficulties try to free
themselves through the following argument: the buyer is not
obligated to pay for that which is bought if he loses in the
purchase. Such operations take place in the deep and
dangerous waters of the stock exchange, where the swimmers
calculate that if the water is reaching up to their necks, they
can at best only save their lives. [And the most amusing] thing
is that, sometimes before six months have passed, those
3DJH 173
Classic Investment Readings: Joseph de la Vega (cont.)
persons whose money was taken away from them make deals
again with those involved in their former business transactions.
PHILOSOPHER: I cannot deny that, in spite of my natural
inclination, I would try my fortune [on the exchange] if three
great obstacles did not prevent me. First obstacle: I question
whether I should go on board such an endangered ship, to
which every wind means a storm and every wave a shipwreck.
Second obstacle: With my limited capital, I could win only if I
[were willing to] renounce my reputation frivolously. But to
feel degraded without being compensated by wealth, such a
thought is vain and insane. Third obstacle: Preoccupation with
this business seems to me unworthy of a philosopher; since
everyone knows the humble character of my surroundings,
there would be nobody to give me credit and to have
confidence in my beard.
SHAREHOLDER: Even without going into technicalities, I
can overcome your doubts. The first danger is removed,
because [I can tell you that] there are ropes which secure the
vessel against shipwreck and anchors which resist the storm.
Give opsies, or premiums, and there will be only limited risk
to you, while the gain may surpass all your imaginings, and
hopes. In the light of these precautionary measures, the second
objection becomes void. The third drawback, namely, that it is
not proper for a philosopher to speculate, must not concern
you, for the exchange resembles the Egyptian temples where
every species of animal was worshipped.
Footnote to opsies above: The Dutch call the option business
opsies, a term derived from the Latin word optio, which
means choice, because the payer of the premium has the
choice of delivering the shares to the acceptor of the premium
or of demanding them from him or her.
Second Dialogue: Instability of Prices
In the second dialogue, I explain to you the instability of prices
and the reasons therefore, give advice for a successful
speculation, point out the causes of the ups and downs, talk
about the fears of the bears and the courageous attitude of the
bulls.
SHAREHOLDER: Take note and realize that there are three
causes of a rise in the prices on the exchange and three of a
fall: the conditions in India, European politics, and opinion on
the stock exchange itself. For this last reason, the news [as
such] is often of little value, since counteracting forces [may]
operate in the opposite direction.
MERCHANT: People who get involved in this swindle seem
to contain in their bodies an inner light that advises them. [By
your account] these stock-exchange people are quite silly, full
of instability, insanity, pride and foolishness. They will sell
without knowing the motive; they will buy without reason.
SHAREHOLDER: They are very clever in inventing reasons
for a rise in the price of the shares on occasion when there is a
declining tendency, or for a fall in the midst of a boom. It is
particularly worth remarking that in this gambling hell there
are two classes of speculators. The first class consists of the
bulls. The second faction consists of the bears. The bulls are
like the giraffe which is scared by nothing. They love
everything, they praise everything, they exaggerate everything.
They are not impressed by a fire or disturbed by a debacle. The
bears, on the contrary, are completely ruled by fear,
trepidation, and nervousness. Rabbits become elephants,
brawls in a tavern become rebellions, faint shadows appear to
them as signs of chaos.
3DJH 174
SHAREHOLDER: The fall of prices need not have a limit,
and there are also unlimited possibilities for the rise. Therefore
the excessively high values need not alarm you.
PHILOSOPHER: It is considered particularly wise to talk to
the purchasers and to converse with the sellers, to weigh
opinions and reasons, and to take the most advantageous
course after these efforts.
SHAREHOLDER: While philosophy teaches that different
effects are ascribable to different causes, at the stock exchange
some buy and some sell on the basis of a given piece of news,
so that here one cause has different effects. [Given the
situation, I suppose that I should not be] surprised that some
speculators consider a certain piece of news favorable, others
unfavorable. Facts are changed by emotions, and they appear
to each person in a different light.
Third Dialogue: Transactions and Business Practices
In the third dialogue, I explain to you various transactions, to
teach you some of the rules [of the game], and to clarify some
of the business practices. I talk about the equity of the
contracts, the time of delivery, the place of the transference of
the shares, the delay in the settlement of the accounts, and the
varieties of brokers, their conscientiousness, their risks, and
their temerity.
SHAREHOLDER: Honesty, cooperation, and accuracy are
admirable and surprising. But to make payments for
obligations which according to the Exchange usances do not
exist, when your credit is not endangered and your reputation
not likely to suffer that is not liberality, but insanity; it is not
punctuality, but prodigality; not courage, but the foolishness of
Don Quixote. [I would also remark that] a 20 per cent drop in
the stock prices is not large enough to be considered a serious
blow. You do not have to despair and to bemoan your fate, for,
as the price may drop twenty per cent overnight, it may also
rise fifty per cent in the same period.
SHAREHOLDER: What is hardly believable (because it
seems to be complete fancy rather than over-exaggeration) is
the fact that the speculator fights his own good sense, struggles
against his own will, counteracts his own hope, acts against his
own comfort, and is at odds with his own decisions.
SHAREHOLDER: Sometimes, when a decided trend prevails,
it is possible to execute an order with the greatest promptness.
But there are also cases where crafty people sense the direction
of the investors purpose and inject such confusion into the
investors operations that the investor can execute the order
only with [unanticipated] disadvantage and difficulty.
SHAREHOLDER: Some clerks have discovered that the
speculation in ordinary shares (which are called large or paid-
up shares) was too hazardous for their slight resources. They
began, therefore, a less daring game in which they dealt in
small shares. For while with whole shares one could win or
lose 30 gulden of Bank money for every point that the price
rose or fell, with the small shares one risked only 3 gulden for
each point. This branch of trade has been increasing during the
last five years to such an extent (and mainly with a certain
group which is as boisterous as it is quick-witted) that it is
engaged in by both sexes, old men, women, and children.
Therefore the means devised to reduce hazards has in fact
made the dangers more widespread.
SHAREHOLDER: If one were to lead a stranger through the
streets of Amsterdam and ask him where he was, he would
answer, Among speculators, for there is no corner [in the
city] where one does not talk shares. Some gamble for the fun
of it, some for vanity, many are spendthrifts, many find
satisfaction in their occupation, and quite a few [just] make a
living [at the stock exchange].
Fourth Dialogue: Speculation on the Exchange
In the fourth dialogue I describe the most speculative part of
the business, the climax of the Exchange transactions, the
acme of Exchange operations, the craftiest and most
complicated machinations which exist in the maze of the
Exchange and which require the greatest possible cunning.
SHAREHOLDER: Only a description of the most speculative
part of the business is now left to me, the climax of the
Exchange transactions. Some 10 or 12 persons get together at
the Exchange and form a ring. When this ring thinks it
advisable to sell shares, the means for prudently carrying out
this purpose are given much thought. The members initiate
action only when they can foresee its result, so that, apart from
unlucky incidents, they can reckon on a rather sure success.
The following are twelve tricks of the bears ring:
SHAREHOLDER: The first trick [of the bears ring] is to
prevent numerous extensions of the contract by which the
great financiers buy shares for cash and sell them on term,
contenting themselves with [a spread in price equivalent to]
the interest on the money invested; the ring arranges sales for
later dates at the same price at which the shares are being sold
for cash; in the hope of a greater profit, they do not pay
attention to the loss of interest.
3DJH 175
Secondly, a broker in whom the syndicate has confidence is
given the order to buy secretly a batch of shares from an
[avowed] bull, without revealing his real principal. But he sells
the very same shares with a good deal of publicity, while it is
shouted out that even the bulls are making sales. As the broker
wants to sell to one bull the same shares he has bought from
another bull, the first one sees that the story about the sales of
the latter is true. Alarmed, the second bull sells his shares also.
Thirdly, the syndicate of the bears sells some blocks of shares
for cash to one of the wealthy people who live on the
hypothecation of stocks. As it is known that the latter [as a
matter of course] sell at once for future delivery the shares
which they have bought for cash, the syndicate bids its broker
[charged with the execution of the maneuver], before the
fixing of the prices [of the day], to send a message very
secretly to the agent of every business firm [represented on the
Exchange], a communication which will soon be an open
secret, to the effect that the great capitalist has received
important news and that alarmed by it he intends to sell stocks.
Fourthly, at the beginning of a campaign, the syndicate
borrows all the money available at the Exchange and makes it
apparent that it wishes to buy shares with this money.
Afterwards, however, large sales are executed. Thus two birds
are killed with one stone. First, the Exchange is supposed to
believe that the original plan is altered because of important
news; secondly, the bulls are prevented from finding money
for hypothecating their shares.
The fifth stratagem [of the syndicate] consists in selling the
largest possible quantity of call options in order to bring
pressure on the payers of premiums to sell the stocks if they
exercise their right to call.
The sixth stratagem is to enter into as many put contracts as
possible, until the receivers of the premiums do not dare to buy
more stock.
The seventh stratagem is to recognize that the bulls are in need
of shares to survive the siege; and so [the bears] give them
money. Then [the bears] sell the hypothecated shares again,
and with the difference between what they receive on the sales
and what they loan on the shares, they are able to engage in
further call and put operations.
The eighth trick [of the syndicate of the bears] is the following:
if it is of importance to spread a piece of news which has been
invented by the speculators themselves, they have a letter
written and [arrange to have] the letter dropped as if by chance
at the right spot. The finder believes himself to possess a
treasure, whereas he has really received a letter of Uriah which
will lead him into ruin.
Ninthly, the syndicate encourages a friend whose judgment is
esteemed, whose connections are respected, and who has
never dealt in shares, to sell one or two lots of stock while the
risk of loss is borne by the group. The notion [lying behind this
maneuver] is the belief that anything new attracts attention,
and that therefore the decision of this person [to sell] will
produce astonishment and will have important consequences.
The tenth trick [of the syndicate] is to whisper into the ear of
an intimate friend (but loud enough to be heard by those who
lie in wait for it) that he should sell if he wants to make money.
Eleventhly, in order to insinuate that their own concern is
founded on grave consideration and does not refer exclusively
to the situation of the Company, the bears sell government
obligations.
Finally, the ring practices a twelfth maneuver. In order to be
well-informed about the tendency of the market, even the
bears [before launching their big operation] begin with
purchases and take all items [offered]. If the shares rise in
price, they pocket the quick profit; if the prices fall, however,
they sell at a loss, content to have ascertained the weakening
tendency. Moreover, the interest which the timid public takes
in their proceedings is already useful to them, since the public
thinks that conditions must be serious when the speculators
sell at a loss. This is one of the most powerful available
stratagems for influencing the wavering elements.
MERCHANT: Do the poor bulls have no means [of defense]
against these maneuvers?
SHAREHOLDER: One of the neatest tricks which take place
in these circles is for some of the bulls to pose as bears. This is
done for two reasons. First, because the opponents [the real
bears] imagine that, if they [are able to] buy a share from
among those held back and concealed, the other party [that of
the bulls] has changed its ideas and, instead of building silver
bridges for them, seek to drag them down. Secondly, these
speculators resort to such a trick in order, in sudden
conjunctures, to sell without producing a panic. As it is taken
for granted that these [particular] speculators undoubtedly
belong to the Contremine, the bulls rally around furiously in
order to buy the shares offered by the first group, on the
assumption that they have to stand by their opinions and have
to make sacrifices for them.
Copyright 1995 John Wiley & Sons, Inc.
Used by permission.
3DJH 176
Classic Investment Readings: Walter Bagehot
Lombard Street: A Description of the
Money Market
In London, Lombard Street runs a total length of about
two blocks in a southeasterly direction from the Bank of
England. The street derived its name from the bankers
and money changers from northern Italy who came to
London centuries ago and who were as artistic in the
creation of the instruments of finance as their
compatriots were creative with the instruments of fine
art.
Walter Bagehot was born in 1826 and lived for only 51
years. He came from a banking family, but writing was
his passion. He was recognized as one of Englands
greatest essayists as well as one of her most
distinguished economists, and his collected works fill
five large volumes. After succeeding his father as head of
the family banking business, he subsequently succeeded
his father-in-law as editor of The Economist magazine.
His importance was so great in understanding and
articulating developments in the world of finance that
Gladstone referred to him as Permanent Chancellor of
the Exchequer.
Lombard Street is a compilation of articles that Bagehot
wrote for The Economist during the 1850s and that
subsequently appeared in book form in 1873.
Personalities, sociology, political considerations, and
anecdotes appear all through the analysis.
Bagehots objective in these technical perorations was to
make clear to his contemporaries that the financial
system comprised far more than the currency issued by
the Bank of England. Bagehot invented crisis
management; after nearly 150 years, his wise words are
still the prescription of choice for containing financial
crises, as well as a handbook for avoiding them.
I venture to call this Essay Lombard Street, and not the
Money Market, because I wish to deal with concrete
realities. The briefest and truest way of describing
Lombard Street is to say that it is by far the greatest
combination of economical power and economical
delicacy that the world has ever seen.
English money is borrowable money. Our people are
bolder in dealing with their money than any continental
nation, and even if they were not bolder, the mere fact
that their money is deposited in a bank makes it far more
obtainable. A million in the hands of a single banker is a
great power; he can at once lend where he will, and
borrowers can come to him, because they know or
believe that he has it. But the same sum scattered in tens
and fifties through a whole nation is no power at all: no
one knows where to find it or whom to ask for it. A place
like Lombard Street, where in all but the rarest times
money can be always obtained upon good security or
upon decent prospects of probable gain, is a luxury
which no country has ever enjoyed with even
comparable equality before.
* * * * *
3DJH 177
Classic Investment Readings: Walter Bagehot (cont.)
An individual of large wealth, however intelligent,
always thinks, more or less I have a great income,
and I want to keep it. If things go on as they are I shall
certainly keep it; but if they change I may not keep it.
Consequently every change of circumstance is
considered a bore, and is thought about as little as
possible. But a new person, who has his or her way to
make in the world, knows that such changes are
opportunities; he or she is always on the lookout for
them, and always heeds them when they are found. The
rough and vulgar structure of English commerce is the
secret of its life; for it contains the propensity to
variation, which, in the social as in the animal, is the
principle of progress. In this constant and chronic
borrowing, Lombard Street is the great go-between. It is
a sort of standing broker between quiet saving districts of
the country and the active employing districts.
The objects which you see on Lombard Street, and in
that money world which is grouped about it, are the
Bank of England, the Private Banks, the Joint Stock
Banks, and the bill brokers. The distinctive function of
the banker, says Ricardo, begins as soon as he uses
money of others; as long as he uses his own money he is
only a capitalist.
All London banks keep their principal reserve on deposit
at the Banking Department of the Bank of England. The
Bank of England thus has the responsibility of taking
care of it. But those who keep immense sums with a
banker gain a convenience at the expense of a danger.
They are liable to lose them if the bank fails.
Any depreciation, however small even the liability to
depreciation without its reality is enough to disorder
exchange transactions. They are calculated to such an
extremity of fineness that the change of a decimal may
be fatal, and may turn profit into loss. Accordingly,
London has become the sole great settling-house of
exchange transactions in Europe, instead of being
formerly one of two. This foreign deposit is evidently of
delicate and peculiar nature. It depends on the good
opinion of foreigners, and that opinion may diminish or
change into a bad opinion.
All of our credit system depends on the Bank of England
for its security. On the wisdom of the directors of that
Joint Stock Company, it depends whether England shall
be solvent or insolvent. This may seem too strong, but it
is not. The directors of the Bank are, therefore, in fact, if
not in name, trustees for the public, to keep a banking
reserve on their behalf; and it would naturally be
expected either that they distinctly recognized this duty
and engaged to perform it, or that their own self-interest
was so strong in the matter that no engagement was
needed.
Three times since 1844 the Banking Department of the
Bank of England has received assistance, and would
have failed without it. But still there is a faith in the
Bank, contrary to experience, and despising evidence.
No one in London ever dreams of questioning the credit
of the Bank, and the Bank never dreams that its own
credit is in danger.
Such a reserve as we have seen is kept to meet sudden
and unexpected demands. Speaking broadly, these extra
demands are two kinds one from abroad to meet
foreign payments requisite to pay large and unusual
foreign debts, and the other from at home to meet sudden
apprehension or panic arising in any manner, rational or
irrational.
The Bank of England must keep a reserve of legal
tender to be used for foreign payments if itself fit, and
to be used in obtaining bullion if itself be unfit. In order
to find such great sums, the Bank of England requires the
steady use of an effectual instrument. That instrument is
the elevation of the rate of interest.
A domestic drain is very different. Such a drain arises
from a disturbance of credit within the country, and the
difficulty of dealing with it is greater, because it is often
caused, or at least often enhanced, by a foreign drain.
Times without number the public have been alarmed
mainly because that the Banking reserve was already
low, and that it was daily getting lower. The two
maladies an external drain and an internal often
attack the money market at once. What then ought to be
done? In opposition to what might be at first sight
3DJH 178
supposed, the best way for the bank of banks, who have
the custody of the bank reserve to deal with a drain
arising from internal discredit, is to lend freely. The first
instinct of everyone is contrary. There being a large
demand on a fund which you want to preserve, the most
obvious way to preserve it is to hoard it to get in as
much as you can, and to let nothing go out which you
can help. But every banker knows that this is not the way
to diminish discredit. This discredit means, an opinion
that you have not got any money, and to dissipate that
opinion, you must, if possible, show that you have
money: you must employ it for public benefit in order
that the public may know that you have it. The time for
economy and for accumulation is before. A good banker
will have accumulated in ordinary times the reserve he or
she is to make use of in extraordinary times.
A panic grows by what it feeds on a panic, in a word,
is a species of neuralgia, and according to the rules of
science you must not starve it. The holders of the cash
reserve must be ready not only to keep it for their own
liabilities, but to advance it most freely for the liabilities
of others. We must look first to the foreign drain, and
raise the rate of interest as high as may be necessary,
unless you can stop the foreign export, you cannot allay
the domestic alarm.
There should be a clear understanding between the Bank
and the public that, since the Bank holds our ultimate
banking reserve, they will recognize and act on the
obligations which this implies that they will replenish
it in times of foreign demand as fully, and lend it in
times of internal panic as freely and readily, as plain
principles of banking require.
Deposit banking is of this sort. Its essence is that a very
large number of persons agrees to trust a very few
persons, or some one person. Banking would not be a
profitable trade if bankers were not a small number, and
depositors in comparison an immense number. But to get
a great number of persons to do exactly the same thing
always is very difficult, and nothing but a very palpable
necessity will make them on a sudden begin to do it. And
there is no such palpable necessity in banking.
A system of note issues is therefore the best introduction
to large system deposit banking. No nation as yet has
arrived at a great system of deposit banking without
going first through the preliminary stage of note issue,
and of such note issues the quickest and most efficient in
this way is one made by individuals resident in the
district, and conversant with it. And this explains why
deposit banking is so rare. Such a note issue as has been
described is possible only in a country exempt from
invasion, and free from revolution.
Nothing can be truer in theory than the economical
principle that banking is a trade and only a trade, and
nothing can be more surely established by a larger
experience than a Government which interferes with any
trade injures that trade. The best thing undeniably that
Government can do with the Money Market is to let it
take care of itself. But, a Government can only carry out
this principle universally if it observes one condition: it
must keep its own money.
Many persons believe that the Bank of England has some
peculiar power of fixing the value of money. They see
that the Bank of England varies its minimum rate of
discount from time to time, and that, more or less, all
other banks follow its lead, and charge much as it
charges; and they are puzzled why this should be. There
is at the bottom, however, no difficulty in the matter. The
value of money is settled, like that of all other
commodities, by supply and demand, and only the form
is essentially different.
This is the meaning of the saying John Bull can stand
many things, but he cannot stand two per cent: it means
that the greatest effect of the three great causes is nearly
peculiar to England; here, and here almost alone, the
excess is deposited in banks; here, and here only, are
prices gravely affected. In these circumstances, a low
rate of interest, long protracted, is equivalent to a total
depreciation of the precious metals. The rise in prices
must, therefore, be due to an increased demand, and the
first question is, to what is that demand due? We believe
it to be due to the combined operation of three causes
3DJH 179
cheap money, cheap commodities prices, and improved
credit.
As far as prosperity is based on a greater quantity of
production, and that of the right articles as far as it is
based on the increased rapidity with which commodities
of every kind reach those who want them its basis is
good. Human industry is more efficient, and therefore is
more to be divided among mankind. But in so far as that
prosperity is based on a general rise of prices, it is a rise
only in name; whatever anyone gains on the articles
which are to be sold, they lose on the articles which are
to be bought, and so everyone is just where they started.
And in so far as the apparent prosperity is caused by an
unusual plentifulness of loanable capital and a
consequent rise in prices, that prosperity is not only
liable to reaction, but certain to be exposed to reaction.
The same causes which generate this prosperity will,
after they have been acting a little longer, generate an
equivalent adversity. In consequence, a long-continued
low rate of interest is almost always followed by a rapid
rise in that rate.
Every great crisis reveals the excessive speculations of
many houses which no one before suspected, and which
commonly indeed had not begun or had not carried very
far those speculations, till they were tempted by the daily
rise of price and the surrounding fever.
At the very beginning of adversity, the counters in the
gambling mania, the shares in the companies created to
feed the mania, are discovered to be worthless; down
they all go, and with them much of credit. The good
times of high price almost always engender fraud. All
people are most credulous when they are most happy;
and when much money has just been made, when some
people are really making it, there is a happy opportunity
for ingenious mendacity. Almost everything will be
believed for a little while, and long before discovery, the
worst and most adroit deceivers are geographically or
legally beyond the reach of punishment.
When we understand that Lombard Street is subject to
severe alternations of opposite causes, we should cease
to be surprised at its seeming cycles. We should cease
too to be surprised at the sudden panics. During the
period of reaction and adversity, just even at the last
instant, of prosperity, the whole structure is delicate. The
peculiar essence of our banking system is an
unprecedented trust between human and human: and
when that trust is much weakened by hidden causes, a
small accident may greatly hurt it, and a great accident
for a moment may almost destroy it. Now too that we
comprehend the inevitable vicissitudes of Lombard
Street, we can also thoroughly comprehend the cardinal
importance of always retaining a great banking reserve.
Whether the times of adversity are well met or ill met
depends far more on this than on any other single
circumstance. If the reserve be large, its magnitude
sustains credit; and if it be small, its diminution
stimulates the gravest apprehensions.
In ordinary times the Bank is only one of many lenders,
whereas in a panic, it is the sole lender, and we want, as
far as we can, to bring back the unusual state of a time of
panic to the common state of ordinary times.
The Bank of England has to keep the sole banking
reserve of the country; has to keep it through all changes
of the money market, and all turns of the Exchanges; has
to decide on the instant in a panic what sort of advances
should be made, to what amounts, and for what dates. On
one vital point, the Banks management has been
excellent. It has done perhaps less bad business,
certainly less very bad business, than any bank of the
same size and the same age. There has never been a
suspicion that it was worked for the benefit of any one
person, or any combination of persons.
There is a cardinal difference between banking and other
forms of commerce; you can afford to run much less risk
in banking than in commerce, and you must take much
greater precautions. The business of a banker therefore
cannot bear so many bad debts as that of a merchant, and
he must be much more cautious to whom he gives credit.
Real money is a commodity much more coveted than
common goods: for one deceit which is attempted on a
manufacturer or a merchant, twenty or more are
3DJH 180
attempted on a banker. Adventure is the life of
commerce, but caution, I had almost said timidity, is the
life of banking.
At every moment there is a certain minimum which I
will call the apprehension minimum, below which the
reserve cannot fall without great risk of diffused fear;
and by this, I do not mean absolute panic, but only a
vague fright and timorousness which spreads itself
instantly, and as if by magic, over the public mind. Such
seasons of incipient alarm are exceedingly dangerous,
because they beget the calamities they dread. What is
most feared at such moments of susceptibility is the
destruction of credit; and if any grave failure or bad
event happens at such moments, the public fancy seizes
on it, there is a general run, and credit is suspended. The
Bank reserve then never ought to be diminished below
the apprehension point. And this is as much as to say,
that it never ought very closely to approach that point;
since, if it gets very near, some accident may easily bring
it down to that point and cause the evil that is feared.
The cardinal rule to be observed is that errors of excess
are innocuous but errors of defect are destructive. Too
much reserve only means a small loss of profit, but too
small a reserve may mean ruin. I know it will be said
that in this work I have pointed out a deep malady, and
only suggested a superficial remedy.
A system of credit which has slowly grown up as years
went on, which has suited itself to the course of business,
which has forced itself on human habits, will not be
altered because theorists disapprove of it, or because
books are written against it.
No one who has not long considered the subject can have
a notion how much this dependence on the Bank of
England is fixed in our national habits. And every
practical personevery person who knows the scene of
actionwill agree that our system of banking, based on
a single reserve in the Bank of England, cannot be
altered, or a system of many banks, each keeping its own
reserve, be substituted for it.
This being so, there is nothing but to make the best of
our banking system and to work it in the best way that it
is capable of. A fixed proportion of the liabilities, even
when that proportion is voluntarily chosen by the
directors, and not imposed by law, is not the proper
standard for a bank reserve. Liabilities may be imminent
or distant, and a fixed rule which imposes the same
reserve for both will sometimes err by excess, and
sometimes by defect.
We must therefore, I think, have recourse to feeble and
humble palliatives such as I have suggested. With good
sense, good judgment, and good care, I have no doubt
that they may be enough.
Copyright 1999 John Wiley & Sons, Inc.
Used by permission.
3DJH 181
Classic Investment Readings: Fred Schwed, Jr.
Where Are the Customers Yachts?: A
Good Hard Look at Wall Street
Fred Schwed, Jr., was a professional trader who had the
good sense to get out of the market after losing a bundle
(of mostly his own money) in the 1929 crash. Some years
later, he published a childrens book titled Wacky the
Small Boy. Wacky became a bestseller, and Schwed
went on to draw further on his experience by writing
Where Are the Customers Yachts? His publisher said of
him, Mr. Schwed has attended Lawrenceville and
Princeton and has spent the last ten years on Wall Street.
As a result, he knows everything there is to know about
children.
Wall Street, reads the sinister old gag, is a street with
a river at one end and a graveyard at the other. This is
striking, but incomplete. It omits the kindergarten in the
middle, and thats what this book is about. The chief
concern of this book will be with an examination of the
nonsense a commodity which keeps sluicing in
through the weeks and years with the irresistible
constancy of the waters of the rolling Mississippi. Books
about Wall Street fall into two categories which may
respectively be called the admiring, or Oh, My!
School, and the vindictive, or Turn the Rascals Out
School.
Figures, as used in financial arguments, seem to have the
bad habit of expressing a small part of the truth forcibly,
and neglecting the other part. It seems that the immature
mind has a regrettable tendency to believe, as actually
true, that which it only hopes to be true. In this case, the
notion that the financial future is not predictable is just
too unpleasant to be given any room at all in the Wall
Streeters consciousness.
Some Wall Streeters manage to shed these dreams of
conquests, coups, and power, for themselves or for the
people they advise, given sufficient years. But the
ultimate dream they almost never shed; that there is a
secret, meaningful, and predictable pattern, in the rise
and fall of financial enterprises that a close study of
this and that will prove something; that it will tell the
initiate when there will be a rally or give the speculator a
better than ever chance of making a killing. All these
things are demonstrably unpredictable.
The broker influences the customer with his or her
knowledge of the future, but only after convincing
himself or herself. It may have been observed that while
arguing my case against the validity of financial
predictions, I have not touched on the most spectacular
example the late nineteen-twenties, the supreme
miscalculation of this century, which Mr. Westbrook
Pegler always refers to as the era of wonderful
nonsense. There is a feeling in some quarters that even
in the late twenties there were crafty Wall Streeters who
knew the market was too high. Sure there were, but it
didnt do many of them much good.
The conservative banker is an impressive specimen,
diffusing the healthy glow which comes of moderation in
eating, living, and thinking. Your truly conservative
banker cannot be stampeded into unwary speculations by
the hysteria of a boom. After these great and established
3DJH 182
Classic Investment Readings: Fred Schwed, Jr. (cont.)
bankers come all sorts of lesser bankers. The lesser
bankers are under the unfortunate necessity of saying
yes more frequently. This is because the ideal
borrowers (people who dont need the money) do not
come to them. Their clients need the money, and the
lesser bankers must occasionally get it for them, or else
close up shop and, God forbid! go home and relax. Like
most other Wall Streeters, bankers suffer from the
inability to do nothing. Some strategists have to write
weekly, and even daily, market letters. This is a tough
way to make a living. It not only requires the constant
making of predictions, but it requires putting the
predictions down on paper for anyone interested to check
up on. Sometimes these letters come back with a jug of
mustard and a forcible suggestion that the writer apply
the mustard to his or her letter and eat it.
When conditions are good, the forward-looking
investor buys. But when conditions are good, stocks
are high. Then, without anyone having the courtesy to
ring a warning bell, conditions get bad. Stocks go
down, and the margin clerk sends the forward-looking
investor a telegram containing the only piece of financial
advice he will ever get from Wall Street, which has no
ifs or buts in it.
When the student looks, however closely, at a graph of
the Dow Jones averages, all he or she sees for certain is a
history of past performances clearly and conveniently
depicted. That one can, by examining the line already
drawn, make a useful guess at the line not yet drawn,
must be predicated on the hypothesis that history
repeats itself. History does in a vague way repeat itself,
but it does so slowly and ponderously, and with an
infinite number of surprising variations. All I was ever
able to conclude from my informal studies was that chart
reading is a complex way of arriving at a simple
theorem, to wit: when they have gone up for a
considerable time, they will continue to go up for a
considerable time; and the same holds true for going
down.
A customer may be loosely defined as anyone who is
willing to put up some money. The simplest way of
getting wealthy customers is to be born unto them.
Otherwise, customers are obtained by much the same
mysterious methods whereby doctors get patients and
lawyers clients. This is done by circulating around and
impressing people with ones talents.
A lot of us who clearly are not magicians pool our
money and hire a set of professional experts to do the
guessing. They may not quite be magicians, but they
have everything that should be necessary experience,
reputation, trained staffs, inside information, and
unlimited resources for research. Since the amount we
pool together is quite large, we can afford to pay them
fortunes for their ability. Paying them fortunes will be a
great bargain for us, provided only that they come across
with the ability. There has been a deal of thoughtful,
searching legislation enacted against mutual fund abuses,
and all of it favors the investor. The sad thing is that
there can be no legislation against stupidity.
The notion of selecting the best securities still deserves
a close scrutiny. Those classes of investments considered
best change from period to period. The pathetic fallacy
is that what are thought to be the best are in truth only
the most popular the most active, the most talked of,
the most boosted, and consequently, the highest in price
at that time. Here we have the basic trouble with
selecting the best securities for a fixed portfolio. In
fact, here we have the basic trouble with all security
selection for whatever purpose. Implacably, this
universal habit of buying the popular securities works for
bad results over a period of time. It must tend to get the
buyer in nearer the top than the middle.
Once upon a time there were two small mutual funds,
managed by the late John W. Pope, which were of such
stuff as dreams are made on. To be exact, the time was
that impossible period in finance, 19291931.
Everything about these companies was the opposite of
all other mutual funds, including the fact that they made
big money while the others were losing big money.
Everything about the intellect and philosophy of the
youthful Mr. Pope was the reverse of what I have
explained a Wall Streeter must be. His statement of
3DJH 183
condition as of December 31, 1930, was extremely
simple. All the money was in cash and short-term
instruments, which, strangely enough, was precisely
where it should have been. This statement also contained
an incredible sentiment, to this effect:
It is the belief of the management of this
corporation that a diversified list of carefully
selected securities, held over a period of time, will
not increase in value.
John Pope came to his untimely death in 1931. He was
still a very young man a sort of Keats or Shelley of
finance. It can now never be known whether his amazing
record could have been sustained; whether indeed he
would have continued to be, as he was then, the brilliant
exception that proves the rule. In all discussions of short
selling that are meant for public consumption, everyone,
whether pro or con, agrees that bear raiding is outside the
pale of decent human activity. Bear raiding is the further
ruthless slaughtering of prices by selling short at a time
when prices are already cruelly disorganized by actual
economic calamity. That is raiding at what is considered
its worst. Other operations of the raider are somewhat
more technical and less spectacular. One is the effort to
depress a certain stock a few points in the hope of
triggering some stop-loss orders. If this is accomplished,
the stock would sell yet lower, at least briefly, which
gives the raider a chance for profit. Even if no stop-loss
orders are uncovered, the sight of declining prices on the
ticker tape usually frightens some holders into selling.
That, at least, is the bears hypothesis. A more extensive
operation, looking for a larger profit, is to help depress
stocks to the point where margin calls will be sent out.
In attempting to find out just what, if anything, was good
in the good old days, it is necessary to determine when
the good old days were. It would be more correct and
more honest to recognize that the good old days were
simply boom days. In our moments of sober thought we
all realize that booms are bad things, not good. But
nearly all of us have a secret hankering for another one.
There has evolved a considerable saga of the deeds and
derring-do of the Great Speculators of the good old days.
The individuals under discussion are those who made,
and often lost, their fortunes in stocks, trading them,
manipulating them, cornering them, and generally
performing razzle-dazzle with them. This excludes such
persons as Rockefeller and Carnegie who were primarily
engaged in such realistic businesses as oil and steel
their Wall Street interests grew only secondarily from
that.
The inability to grasp ultimate realities is the outstanding
mental deficiency of the speculator, small as well as
great. The speculator is an incurable romantic and
usually egotistical. His or her mind is fast, active, and
resourceful, and, in a peculiarly limited way, shrewd.
That is, he or she is shrewd in everything save that he or
she is constantly, day by day, laying himself or herself
open to the possibility of being ruined. The speculator
seems to believe, with Mother Goose, that a treetop is
the proper place for a cradle. When they are speculating,
how much of what the speculators are doing is wisdom
and foresight and experience, and how much is sheer
guessing? Certainly they never admit to themselves that
they are making guesses, or they would have to quit the
business at which they have so much fun. If they are
acting on guesses or hunches, as I suspect they are, they
are the worlds best rationalizers in finding profound
reasons for their hunches.
Admittedly, it is preposterous to suggest that stock
speculation is like coin flipping. I know that there is
more skill to stock speculation. What I have never been
able to determine is how much more? In Thakerays
Vanity Fair there is a masterly description of a ruined
speculator, which demonstrates that the genus has not
altered an iota in over a century. Old Mr. Sedley was not
a realist, either. He felt strongly that that scoundrel
Napoleon had escaped from Elba and rallied all France
to his banner chiefly for the purpose of making it
impossible for him, Mr. Sedley, to meet his obligations
on settlement day. Most of the great speculators either
ended their days in penury or came sickeningly close to
it one or more times. An interesting exception was Hetty
Green, who never took a backward step. She started rich
and soon got richer, and after that she got progressively
more wealthy.
3DJH 184
For the loosest use of a pronoun in the English language
I nominate they, as in the common Wall Street
expressions, They are accumulating the coppers,
They are taking profits, and They wont let this
market run away until after the election. Who are
they? They are either the great speculators and
manipulators, or the daemons of the nether world, or
both.
So much has been written and argued about
manipulation of stocks that I am reluctant to add much
more. The business is based on the fairly sound
hypothesis that the public is chiefly interested in buying
stocks that are going up. Thus the manipulators select
a stock that they think is underpriced and that has a good
story for a tip to go with it, and they try to see to it that
it goes up. They also spread the tip, of the truth of
which they have carefully convinced themselves, and
which may indeed turn out to be true.
Manipulation, like other frowned-on practices I have
cited, is not an easy road to fortune. I recall a
correspondence of many years ago. A pool manager,
having been supplied with large funds by a pool of a
dozen investors to hoist a certain stock, was having no
success whatever. The pool manager had bought plenty
of stock and the stock was still down. The pool manager
wrote a letter to each of the members of the pool,
explaining at length the hard luck that had been
encountered and asking them each for an additional
contribution of fifty thousand dollars. With this, the pool
manager assured them, the chestnuts could be pulled out
of the fire and a handsome profit would be substituted
for an apparent loss. One of the replies read as follows:
Dear :
Enclosed please find the check for Fifty
Thousand Dollars ($50,000) which you requested in
yours of the 15th. It was not really necessary for
you to assume an apologetic tone. I am sure that
you have done your skillful best in this matter, and I
am sufficiently experienced to understand that you
have encountered reverses which could not be
foreseen. Trusting that our enterprise will turn out
in the profitable way that you outline, I remain,
Sincerely,

P.S. That is what I would have written, you
(! deleted !), if I had been sucker enough to enclose
my check for $50,000.
Investment and speculation are said to be two different
things, and the prudent investor is advised to engage in
the one and avoid the other. This is something like
explaining to the troubled adolescent that Love and
Passion are two different things. He or she perceives that
they are different, but they dont seem quite different
enough to clear up his or her problems.
Investment and speculation have been so often defined
that a couple more faulty definitions should do no harm,
the science of economics having reached a point where
further confusion is impossible. Thus, Speculation is an
effort, probably unsuccessful, to turn a little money into
a lot. Investment is an effort, which should be successful,
to prevent a lot of money from becoming a little.
The underlying principle of the genuine investment
counsel seems to be sound and important. It is a
mundane one, i.e., it has to do with how the counselors
are paid off. They receive a stated fee for giving advice;
they do not get their pay in commissions or profits on
trades, as most brokers and dealers do. This reduces the
wealthy persons problems to two:
(1) Is there such a thing as consistently useful
financial advice?
(2) If there is, which investment counselor can
supply it?
For no fee at all, I am prepared to offer to any wealthy
person an investment program which will last a lifetime
and will not only preserve the estate but greatly increase
it. Like other great ideas, this one is simple:
3DJH 185
When there is a stock-market boom, and everyone
is scrambling for common stocks, take all your
common stocks and sell them. Take the proceeds
and buy conservative bonds. No doubt the stocks
you sold will go higher. Pay no attention to this
just wait for the depression which will come sooner
or later. When this depression or panic
becomes a national catastrophe, sell out the bonds
(perhaps at a loss) and buy back the stocks. No
doubt the stocks will go still lower. Again pay no
attention. Wait for the next boom. Continue to
repeat this operation as long as you live, and youll
have the pleasure of dying rich.
A glance at financial history will show that there never
was a generation for whom this advice would not have
worked splendidly. But it distresses me to report that I
have never enjoyed the social acquaintance of anyone
who managed to do it. It looks as easy as rolling off a
log, but it isnt. The chief difficulties, of course, are
psychological. It requires buying bonds when bonds are
generally unpopular, and buying stocks when stocks are
universally detested. I suspect that there are actually a
few people who do something like this, even though I
have never had the pleasure of meeting them.
Consider the case of a family which has, besides a
modest earned income, $100,000 to invest. Just now it
seems that they ought to be able to glean from this an
average yield of a few thousand dollars a year, with
reasonable safety. Suppose the family invests the money
at this rate. Their chief problem now, I suggest, is not so
much to watch their investments as to watch themselves.
So long as they can attune their material needs and their
social dignity to that income, they can retain that
reasonable safety. The greatest of investment mistakes is
in trying for too high a return with its attendant tragic
risk. There is also a reverse side to this picture. This is a
tendency on the part of fiduciaries (including trustees,
executors, and lawyers) to play so safe with a clients
funds that they just dont perform any useful service at
all.
This book has thus far skirted two juicy topics Wall
Street behavior and the many steps that have been taken
to regulate it. This should work no hardship on the
inquiring student because there are reams of printed
material on these subjects. This book has chiefly tried to
paint a picture of thousands of erring humans, of varying
degrees of good will, solemnly engaged in the business
of predicting the unpredictable. It has been further
suggested that to this effort most of them bring a certain
cockeyed sincerity. The burned investor certainly prefers
to believe that he or she has been robbed rather than
having been a fool on the advice of fools.
One of the chief points on the agenda of the S.E.C. has
been to work toward the ideal of a completely informed
investing public. However, just as a fanciful exercise in
paradox, let us consider what would happen if on some
miraculous dawn the entire investing public woke up to
find itself completely informed. That would certainly
be the end of an orderly market, for a panic, either bull
or bear, would ensue. Everybody would know whether to
buy or sell, and whichever it was, everybody would try
to do the same thing at once. And there would be no one
to complete the other side of the trade! Orderly markets,
like horse races, exist on differences of opinion.
In conclusion, I must remind you that I work in Wall
Street and assure you that my organization is of course
quite different from anything I have described here.
Perhaps what you are looking for is a long-range
comprehensive investment program, conservative yet
liberal, which will protect you from the effects of
inflation and also deflation, and which will allow you to
sleep nights. In this case just stop in my office and let us
recommend a program. I will see to it personally that
your inquiries are referred to the Head of our Crystal-
Ball Gazing Department.
3DJH 186
Classic Investment Readings: Robert J. Shiller
Irrational Exuberance
Irrational Exuberance is a broad study, drawing on a
wide range of published research and historical
evidence, of the enormous recent stock market boom.
Why did the U.S. stock market reach such high levels by
the turn of the millennium? What changed to cause the
market to become so highly priced? What do these
changes mean for the market outlook in the opening
decades of the new millennium? Are powerful
fundamental factors at work to keep the market high or
to push it even higher, even if there is a downward
correction? Or is the market high only because of some
irrational exuberancewishful thinking on the part of
investors that blinds them to the truth?
To answer these questions, Irrational Exuberance
harvests relevant information from economics,
psychology, demography, sociology, history, and
behavioral finance. The stock market at the dawn of the
new millennium displays the classic features of a
speculative bubble: a situation in which temporarily high
prices are sustained largely by investors enthusiasm
rather than by consistent estimation of real value.
Among the unanticipated consequences of the investment
culture is that many of the tens of millions of adults
invested in the stock market act as if the price level is
going to keep rising at its current rate. Even though the
stock market appears based on some measures to be
higher than it has ever been, investors behave as though
it can never be too high, and that it can never go down
for long.
The conventional wisdom holds that the stock market as
a whole has always been the best investment, and always
will be, even when the market is overpriced by historical
standards. Most investors also seem to view the stock
market as a force of nature unto itself. They do not fully
realize that they themselves, as a group, determine the
level of the market. People are optimistic about the stock
market. There is a lack of sobriety about its downside
and the consequences that may very well ensue as a
result.
The Stock Market Level in Historical Perspective
By historical standards, the U.S. stock market has soared
to extremely high levels in recent years. Yet if the
history of high market valuations is any guide, the public
may be very disappointed with the performance of the
stock market in coming years. The Dow Jones Industrial
Average stood at around 3,600 in early 1994. By 1999, it
had passed 11,000, more than tripling in five years, a
total increase in stock market prices of over 200%. Over
the same period, basic economic indictors did not come
close to tripling. U.S. personal income and gross
domestic product rose less than 30%, and almost half of
this increase was due to inflation. Corporate profits rose
less than 60%. Between 1994 and 1999, the total average
real price increase of homes in ten major U.S. cities was
only 9%.
3DJH 187
Classic Investment Readings: Robert J. Shiller (cont.)
Similarly, after 1901, there was no pronounced
immediate downtrend in real equity prices, but for the
next decade, prices bounced around or just below the
1901 level and then fell. By June 1920, the stock market
had lost 67% of its June 1901 real value. The average
real return (including dividends) was 4.4% a year in the
ten years following June 1901, 3.1% a year in the fifteen
years following June 1901, and -0.2% a year in the
twenty years following June 1901.
Another instance of a high price-earnings ratio, 32.6,
occurred in September 1929, the high point of the market
in the 1920s and the second highest ratio of all time. The
real S&P Composite Index did not return to its
September 1929 value until December 1958. The
average real return in the stock market (including
dividends) was -13.1% a year for the five years
following September 1929, -1.4% a year for the next ten
years, -0.5% a year for the next fifteen years, and 0.4% a
year for the next twenty years.
Yet another instance of a high price-earnings ratio
occurred in January 1966, when the price-earnings ratio
reached a local maximum of 24.1. Real stock prices
would not be back up to the January 1966 level until
May 1992. The average real return in the stock market
(including dividends) was -2.6% a year for the five years
following January 1966, -1.8% a year for the next ten
years, -0.5% a year for the next fifteen years, and 1.9% a
year for the next twenty years.
Precipitating Events: The Internet, the Baby Boom,
and Other Events
Most historical events, from wars through revolutions,
do not have simple causes. When these events move in
extreme directions, as price-earnings ratios have in the
recent stock market, it is usually because of a confluence
of factors, none of which is by itself large enough to
explain these events.
Set forth below is a list of factors that may help explain
the present speculative market, mostly factors that have
had an effect on the market that are not warranted by
rational analysis of economic fundamentals.
1. The Internet and the World Wide Web have
invaded investors homes during the second half of
the 1990s, making the population intimately
conscious of the pace of technological change. The
occurrence of profit growth, coincident with the
appearance of a new technology as dramatic as the
Internet, can easily create an impression among the
general public that the two events are somehow
connected. Publicity linking these twin factors was
especially strong with the advent of the new
millenniuma time of much optimistic discussion
of the future.
2. In many areas of activity, the U.S. appears to
occupy a leadership position, and therefore it starts
to seem only natural that confidence in the premier
capitalist system would translate into confidence in
the market, and that the U.S. stock market should be
the most highly valued in the world.
3. The bull market has been accompanied by a
significant rise in materialistic values. It is
plausible that materialistic feelings might influence
investors demand for stocks, which have long held
out at least the possibility of amassing substantial
and quick riches.
4. Republican lawmakers in the 1980s and 1990s
were much more pro-business than their
Democratic predecessors. In 1997, the top capital
gains tax rate was cut from 28% to 20%.
5. The Baby Boom in the United States was marked
by very high birth rates during the years 1946-66,
and so there are in the year 2000 (and will be for
some time) an unusually large number of people
between the ages of 35 and 55. One theory justifies
high price-earnings ratios as the result of these
Boomers buying stocks to save for their eventual
retirement and bidding share prices up relative to the
earnings they generate. According to the other
theory, it is their spending on current goods and
services that boosts stocks, through a generalized
positive effect on the economy: high expenditures
mean high profits for companies.
3DJH 188
6. CNBC, CNNfn, and Bloomberg Television have
produced an uninterrupted stream of financial
news, much of it devoted to the stock market.
7. Analysts now appear to be reluctant to
recommend that investors sell anything. One
reason often given for this reluctance is that a sell
recommendation might incur the wrath of the
company involved.
8. Changes over time in the nature of employee
pension plans have encouraged people to learn
about, and eventually accept, stocks as investments.
The most revolutionary change in these institutions
in the United States has been the expansion of
defined contribution pension plans at the expense of
defined benefit plans.
9. The stock market boom has coincided with a
peculiar growth spurt in the mutual fund industry
and a proliferation of advertising for mutual funds.
In 1982, there were 6.2 million equity mutual fund
shareholder accounts in the United States, about one
for every ten U.S. families. By 1998, there were
119.8 million such shareholder accounts, or nearly
two accounts per family.
10. High inflation is perceived as a sign of economic
disarray, of a loss of basic values, and a disgrace to
the nation, an embarrassment before foreigners. Low
inflation is viewed as a sign of economic prosperity,
social justice, and good government. It is not
surprising, therefore, that a lower inflation rate
boosts public confidence, and hence stock market
valuation.
11. The higher equity turnover rate may be
symptomatic of increased interest in the market.
According to a study by the SEC, there were 3.7
million online accounts in the United States in 1997;
by 1999 there were 9.7 million such accounts.
12. There has been a dramatic increase in gambling
opportunities in the United States in recent years.
Gambling suppresses natural inhibitions against
taking risks. A spillover from gambling to financial
volatility may come about because gambling, and
the institutions that promote it, yield an inflated
estimate of ones own ultimate potential for good
luck, a heightened interest in how one performs
compared with others, and a new way to stimulate
oneself out of a feeling of boredom or monotony.
Amplification Mechanisms: Naturally Occurring
Ponzi Processes
Investors, their confidence and expectations buoyed by
past price increases, bid up stock prices further, thereby
enticing more investors to do the same, so that the cycle
repeats again and again, resulting in an amplified
response to the original precipitating factors. Investors
belief in the resilience of the market seems to stem from
a generalized feeling of optimism and assurance, rather
than from a belief in the long-run stability of prices.
People seem to think that they have discovered a safe
and lucrative investment, one that cannot lose.
In the most popular version of the feedback theory, one
that relies on adaptive expectations, feedback takes place
because past price increases generate expectations of
further price increases. In another version of the
feedback theory, feedback takes place because of
increased investor confidence in response to past price
increases. Economists have proposed a theory of habit
formation that may also serve to amplify stock market
responses. In their model, people become slowly
habituated to the higher level of consumption that they
can expect from a more highly valued stock market. It is
difficult to prove that a simple mechanical price
feedback model, producing heightened investor attention
and enthusiasm, is actually a factor in financial markets.
Speculative feedback loops that are in effect naturally
occurring Ponzi schemes do arise from time to time
without the contrivance of a fraudulent manager.
Perceived long-term risk is down. Expected returns are
not down, despite a highly-priced market. Emotions and
heightened attention to the market create a desire to get
into the game. Such is irrational exuberance in the
United States.
3DJH 189
The News Media
The history of speculative bubbles begins roughly with
the advent of newspapers. Significant market events
generally occur only if there is similar thinking among
large groups of people, and the news media are essential
vehicles for the spread of ideas. A confluence of factors
may cause a significant market change, even if the
individual factors themselves are not particularly
newsworthy. The role of news events in affecting the
market seems often to be delayed, and to have the effect
of setting in motion a sequence of public attentions.
These attentions may focus on images or stories, or on
facts that may already have been well known. The facts
may previously have been ignored or judged
inconsequential, but they can attain newfound
prominence in the wake of breaking news. These
sequences of attention may be called cascades, as one
focus of attention leads to attention to another, and then
another.
On October 28, 1929, the Dow fell 12.8% in one day.
The second-biggest drop in history (until 1987) occurred
the following day, when the Dow dropped 11.7%. Far
more significant than news about fundamentals among
the newspaper stories on Monday, October 28, 1929, are
clues to the importance attached in peoples minds to the
events of just a few days earlier, when the stock
exchange experienced a record decline in share prices.
That was the so-called Black Thursday, October 24,
1929, when the Dow had fallen 12.9% within the day but
recovered substantially before the end of trading, so that
the closing average was down only 2.1% from the
preceding close. This event was no longer news, but the
memory of the emotions it had generated was very much
part of the ambience on the following Monday.
There was news on the Wednesday before Black
Thursday that there had been a major drop in the market
(the Dow closed on Wednesday down 6.3% from
Tuesdays close) and that total transactions had had their
second highest day in history. The most significant
concrete news stories in the newspapers seem
consistently to have been about previous moves of the
market itself. There is no way that the events of the stock
market crash of 1929 can be considered a response to
any real news stories. We see instead a negative bubble,
operating through feedback effects of price changes, and
an attention cascade, with a series of heightened public
fixations on the market. The stock market crash had
substantially to do with a psychological feedback loop
among the general investing public from price declines
to selling and thus further price declines, along the lines
of a negative bubble. The Brady Commission wrote in
their summary the following explanation for the 1987
Crash:
The precipitous market decline of mid-October was
triggered by special events: an unexpectedly high
merchandise trade deficit which pushed interest rates
to new high levels, and proposed tax legislation
which led to the collapse of the stocks of a number
of takeover candidates. This initial decline ignited
mechanical, price-insensitive selling by a number of
institutions employing portfolio insurance strategies
and a small number of mutual fund groups reacting
to redemptions. The selling by these investors, and
the prospect of further selling by them, encouraged a
number of aggressive trading-oriented institutions to
sell in anticipation of further market declines. These
institutions included, in addition to hedge funds, a
small number of pension and endowment funds,
money management firms, and investment banking
houses. This selling, in turn, stimulated further
reactive selling by portfolio insurers and mutual
funds.
The Brady Commission was saying, in effect, that the
crash of 1987 was a negative bubble. The important
point is that it was the changed nature of the feedback
loop, not the news stories that broke around the time of
the crash, that was the essential cause of the crash. The
media can sometimes foster stronger feedback from past
price changes to further price changes, and they can also
foster another sequence of events, referred to as an
attention cascade.
New Era Economic Thinking
Stock market expansions have often been associated with
popular perceptions that the future is brighter or less
uncertain than it was in the past. The term new era has
3DJH 190
periodically been used to describe these times. The
public is interested in expansive descriptions of future
technologyfor example, in what amazing new
capabilities computers will soon havenot in gauging
the level of U.S. corporate earnings in coming years.
In a sense, the high-tech age, the computer age, and the
space age seemed just around the corner in 1901, though
the concepts were expressed in different words than
would have been used in early 2000. People were upbeat
in 1901, and in later years, the first decade of the
twentieth century came to be called the Age of
Optimism, the Age of Confidence, or the Cocksure Era.
The 1920s were a time of rapid economic growth and, in
particular, of the widespread dissemination of some
technological innovations, such as automobiles, that had
formerly been available only to the wealthy. Prof. Irving
Fisher at Yale, who has been described as one of
Americas most eminent economists, argued that the
U.S. stock market was not at all overvalued. He was
quoted as saying just before the peak in 1929 that stock
prices have reached what looks like a permanently high
plateau.
New era thinking also seemed, judging from media
accounts, to undergo a sudden surge in the mid-1950s.
The idea that Irving Fisher had presented in the 1920s as
a reason for optimism, that businesses were able to plan
better for the future, was floated again as a new idea in
the 1950s. The increase in the use of consumer credit
was also cited, as it had been in the 1920s, as a reason to
expect prosperity.
In 1996, one observer, writing in a Business Week article
entitled The Triumph of the New Economy, listed five
reasons that the market is not crazy: increased
globalization, the boom in high-tech industries,
moderating inflation, falling interest rates, and surging
profits.
Speculative bubbles and their associated new era
thinking do not end definitively with a sudden, final
crash. People today remember the stock market crash of
1929 as occurring in one or two days. In fact, after that
crash, the market recovered almost all of its lost ground
by early 1930. Ends of new eras seem to be periods
when the national focus of debate changes and can no
longer be upbeat. Often, the ends of bull markets appear
to be caused by concrete events unrelated to any
irrational exuberance in the stock market. Notable among
these are financial crises, such as banking or exchange
rate crises. These financial crisis stories illustrate the
complicated factors that sometimes capture the attention
of economic and financial analysts. Discussions may
focus on these factors and pull attention away from the
large changes in public opinion that are reflected in
speculative prices.
Psychological Anchors for the Market
In considering lessons from psychology, it must be noted
that many popular accounts of the psychology of
investing are simply not credible. Investors are said to be
euphoric or frenzied during booms or panic-stricken
during market crashes. In both booms and crashes,
investors are described as blindly following the herd like
so many sheep, with no minds of their own. Most people
are more sensible during such financial episodes than
these accounts suggest.
Solid psychological research does show that there are
patterns of human behavior that suggest anchors for the
market that would not be expected if markets worked
entirely rationally. Quantitative anchors give indications
for the appropriate levels of the market that some people
use as indications of whether the market is over- or
underpriced and whether it is a good time to buy, and
moral anchors, which operate by determining the
strength of the reason that compels people to buy stocks,
a reason that they must weigh against their other uses for
the wealth they already have (or could have) invested in
the market.
Much of the human thinking that results in action is not
quantitative, but instead takes the form of storytelling
and justification. Some of the attraction to gambling,
despite odds that are often openly stacked against
gamblers, apparently has to do with narrative-based
thinking. Gamblers use a different vocabulary than do
3DJH 191
probability theorists, preferring the words luck or lucky
day, and rarely uttering the words probability or
likelihood. These stories can convey a sense of meaning
and significance to events that are in fact purely random.
Herd Behavior and Epidemics
A fundamental observation about human society is that
people who communicate regularly with one another
think similarly. Part of the reason peoples judgments are
similar at similar times is that they are reacting to the
same informationthe information that was publicly
available at that time. But rational response to public
information is not the only reason that people think
similarly, nor is the use of that public information always
appropriate or well reasoned. People simply think that all
the other people could not be wrong.
People have learned that when experts tell them
something is all right, it probably is, even if it does not
seem so. People are ready to believe the majority view or
to believe authorities even when they plainly contradict
matter-of-fact judgment.
Word-of-mouth communications, either positive or
negative, are an essential part of the propagation of
speculative bubbles, and the word-of-mouth potential of
any event must be weighed in judging the likelihood of
that event to lead to a speculative bubble. One reason
why the contagion of ideas can sometimes happen
rapidly, and why public thinking can experience such
abrupt turnarounds, is that the ideas in question are
already in investors minds.
Efficient Markets, Random Walks, and Bubbles
The argument for the efficient markets hypothesis does
not suggest that the stock market cannot go through
periods of significant mispricing lasting years or even
decades.
After the fact, it is known that the run-up in the stock
market from 1920 to 1929 was a colossal mistake and
that the drop from 1929 to 1932 was another colossal
mistake. Virtually nothing actually happened over either
of these intervals to the dividend present value.
Fluctuations in stock prices, if they are to be
interpretable in terms of the efficient markets theory,
must instead be due to new information about the long-
run outlook for real dividends. The invocation of
efficient markets theory to imply that the late 1990s
upspike in the stock market is a routine and accurate
response to genuine news is simply not correct.
Investor Learningand Unlearning
Besides the efficient markets-random walk argument,
another rationalization for the exuberance in the market
is that the public at large has learned that the long-term
value of the market is really greater than they had
thought it was, and higher than conventional indicators
would have suggested it should be. According to this
view, people have realized that, in light of historical
statistics, they have been too fearful of stocks. Armed
with this new knowledge, investors have now bid stock
prices up to a higher level, to their rational or true level,
where the stocks would have been all along had there not
been excessive fear of them.
A best-selling book in 1924 by Edgar Lawrence Smith
made a number of historical comparisons of investments
in stocks versus bonds and found that stocks always
came out ahead over long holding periods, in both
periods of rising general prices (inflation) and periods of
declining general prices (deflation). The fact that is
widely cited is that in the United States there has been no
thirty-year period over which bonds have outperformed
stocks. The supposed fact is not really true, since, as
Jeremy Siegel himself points out in his book Stocks for
the Long Run, stocks underperformed bonds in the
period 1831-61.
In Glassmans and Hassetts book, Dow 36,000: The
New Strategy for Profiting from the Coming Rise in the
Stock Market, they stress that investors have not finished
learning that diversified holdings of stocks are not risky
and that they will continue to bid up stock prices in
coming years as the lesson really sinks in. They claim
that A sensible target date for Dow 36,000 is early
2005, but it could be reached much earlier.
3DJH 192
It has been shown that stock price declines are not that
transitory, that they can persist for decades, and thus that
even long-run investors should see risk in stock market
investments. There is also reason to believe that much of
the enthusiasm for mutual funds is a sort of investor fad
that has not been caused by any real learning.
Stocks can go down, and stay down for many years.
They can become overpriced and underperform for a
decade or several decades. The public is said to have
learned that stocks must always outperform other
investments, such as bonds, over the long run, and
therefore, long-run investors will always do better in
stocks. Evidence also exists that investors do largely
think this. But again, they have gotten their facts wrong.
Stocks have not always outperformed other investments
over decades-long intervals, and there is no reason to
think they must in the future.
Speculative Volatility in a Free Society
The high recent valuations in the stock market have
come about for no good reasons. The market level does
not, as so many imagine, represent the consensus
judgment of experts who have carefully weighed the
long-term evidence. The market is high because of the
combined effect of indifferent thinking by millions of
people, very few of whom feel the need to perform
careful research on the long-term investment value of the
aggregate stock market, and who are motivated
substantially by their own emotions, random attentions,
and perceptions of conventional wisdom.
The sense of victory of capitalist economies that
developed after some of Americas close competitors
abroad began to falter after 1990 is not likely to persist
indefinitely. What then is the rough scorecard for the
likely future of the twelve precipitating factors in the
opening years of the twenty-first century? Two (the
Internet boom and the expansion of stock trading
opportunities) will probably increase in strength, two
(the Baby Boom and perceived victory over foreign
economic rivals) will decrease, and the others will likely
stay about the same. The conclusion is that no overall
change in these twelve factors can be confidently
predicted, and that, if constancy of the precipitating
factors implies constancy of the market level, then
returns will remain confined to the low dividend yield
recently exhibited by stocks.
The list of factors that could potentially interrupt
earnings growth is of course very long. Some of them are
set forth below, with no presumption that any of these is
more or less likely as of the turn of the New Millennium:
a decline in consumer demand, a dearth of new
development opportunities, failures of major
technological initiatives, heightened foreign competition,
a resurgent labor movement, an oil crisis, a corporate tax
increase, newly discovered problems with the longer-run
consequences of downsizing and incentive-based
compensation for employees, a decline in employee
morale and productivity, a war, a terrorist attack or even
a new terrorist threat that hampers business activities, an
industrial accident that suggests that certain technical
processes are more dangerous than previously thought,
heightened regulatory or antitrust activity, increased
foreign tariffs or import quotas, a depression abroad,
stricter environmental standards, class-action lawsuits
against corporations, a suddenly erratic monetary policy,
systemic problems due to a failure of major banks or
financial institutions, a widespread computer system
problem, large-scale weather problems, natural disasters,
and epidemics.
If market expectations for earnings growth are realized,
and if U.S. gross domestic product growth is 4% a year,
then after-tax corporate profits share of gross domestic
product will be over 12% in 2010, a value almost twice
as high as any time since 1948. Resentment against the
United States and its strong free enterprise system has
moral overtones too; people in many other countries that
are not quite as strong economically wonder if their
relative lack of economic success might not be due to
their greater concern as societies and as individuals with
equity, fairness, and human values.
What should investors do now? The natural first step
may be, depending on current holdings and specific
circumstances, to reduce holdings of U.S. stocks. One
3DJH 193
should at the very least diversify thoroughly. Individuals
should consider increasing their savings rates. According
to the latest Investment Company Institute/Employee
Benefits Research Institute study, more than two-thirds
of 401(k) pension plan balances were in the stock market
in 1996. Authorities who are responsible for pension
plans (in the businesses that sponsor them or in the plans
themselves) should come out much more strongly
against putting all or almost all of ones plan balance
into the stock market.
It would be a serious mistake to adopt the policy,
proposed by some, of replacing the current Social
Security system with a defined contribution plan for
retirement, investing plan balances in the stock market,
or even a plan that would give individuals a choice of
investment categories. Such a plan would replace the
current societal commitments to the elderly with a hope
that financial markets will do as well as in the past.
Adopting such a plan at a time when the market is at a
record high relative to fundamentals would be an error of
historic proportions.
The genesis of a speculative bubble, such as the one we
are in now, is a long, slow process, involving gradual
changes in peoples thinking. Small changes in interest
rates will not have any predictable effect on such
thinking; big changes might, but only because they have
the potential to exert a devastating impact on the
economy as a whole. A time-honored way of restraining
speculation in financial markets is for intellectual and
moral leaders to try to call the attention of the public to
over-and underpricing errors when they occur.
It is plausible that by concealing a large short-term price
change from the public eye, it may be possible to head
off public overreaction to the price change, and so
prevent a longer-term price trend from developing in
response to the vivid memory of a really large one-day
change. Investors need to be encouraged by experts to
understand that true diversification largely means
offsetting the risks that they are already locked into. This
means investing in assets that help insure their labor
incomes, in assets that tend to rise in value when their
labor income declines, or at least that do not tend to
move in the same direction. It also means investing in
assets that help insure the equity in their single-family
homes, in assets that tend to rise in value when their
home value declines. Since labor income and home
equity account for the great bulk of most peoples
wealth, offsetting the risks to these assets is the critical
function of risk management.
The problems posed for policy makers by the tendency
for speculative markets to show occasional bubbles are
deep ones. The nature of the bubbles is sufficiently
complex and changing that one can never expect to
document the particular role of any given policy in
securing the objective of long-term economic welfare.
Policies that interfere with markets by shutting them
down or limiting them, although under some very
specific circumstances apparently useful, probably
should not be high on the list of solutions to the
problems caused by speculative bubbles. Speculative
markets perform critical resource-allocation functions,
and any interference with markets to tame bubbles
interferes with these functions as well. It is impossible to
protect people completely without denying them the
possibility of achieving their own fulfillment. Society
cannot be completely protected from the effects of waves
of irrational exuberance or irrational pessimism
emotional reactions that are themselves part of the
human condition. Most of the thrust of national policies
to deal with speculative bubbles should take the form of
facilitating more free trade, as well as greater
opportunities for investors to take positions in more and
freer markets.
3DJH 194
Classic Investment Readings: John Brooks
The Go-Go Years:
The Drama and Crashing Finale of
Wall Streets Bullish 60s
What is mainly interesting today for readers of John
Brooks is how different the market of the current era
feels from the market of the 1960s. There were very few
foreign markets, very few bonds, and almost no
computers. On the other hand, the SEC, the NYSE, and
the Establishment loom large in Brooks account. The
Go-Go Years reduces fairly neatly to a series of morality
tales about the most outlandish events of the 1960s. How
tame they now all seem! They have lost their ability to
shock. The reader Brooks imagines himself to be
speaking to is the same shockable character who has
vanished from the financial world over the past thirty
years. Who on Wall Street these days thinks twice about
speculation? Who disapproves of large corporate
takeovers? (The above is from the foreword by Michael
Lewis)
The following is an excerpt from John Brooks The
Go-Go Years, which was published in 1973.
In the second quarter of 1970, a portfolio consisting of
one share of every stock listed on the Big Board was
worth just about half of what it would have been worth at
the start of 1969. The high flyers that led the market of
1967 and 1968conglomerates, computer leasing
companies, far-out electronics firms, franchiserswere
down 80, 90, or 95 percent. As of April 22, 1970, an
investment in Ling-Temco-Vought at 170 was worth 15;
in Four Seasons Nursing Centers at 91 was worth 33
(and would shortly be all but worthless); in Data
Processing at 92 was worth 11; in Parvin-Dohrman at
142 was worth 19; and in Resorts International at 62 was
worth 7.
Before the crash in 1929, the financial sages had insisted
repeatedly that there couldnt be another panic like that
of 1907 because of the protective role of the Federal
Reserve System; before the crash of 1969-70, a later
generation observed repeatedly that there couldn't be
another panic like that of 1929 because of the protective
role of the Federal Reserve System and the Securities
and Exchange Commission. In each case, a severe
market break had taken place about eight years earlier (in
1921 and 1962, respectively), followed by a period of
progressively more unfettered speculation. In each case,
huge, shaky financial pyramids, built on a minimum
equity base, had been erected by financiers eager to take
maximum advantage of the publics insatiable appetite
for common stocks. Before 1929, they had been called
investment trusts and holding companies; in the 1960s,
they were called mutual funds and conglomerates. In
each case, there had been a single market operator to
whom the public assigned the star role of official seer. In
the 1920s, the man to whom the public ascribed almost
supernatural power to divine the future prices of stocks
had been Jesse L. Livermore. In the middle 1960s, it was
Gerald Tsai.
In Wall Street there has always been extraordinary
enterprise, generosity, courage, villainy on a grand scale,
the drama of success and failure, even now and again a
3DJH 195
Classic Investment Readings: John Brooks (cont.)
certain nobility. In the nineteen sixties, Wall Street still
had a stimulating tendency, as it had had for a century
and more, to project humanity (and specifically
American humanity) on a wide screen, larger than life; to
be a stage, perhaps one of the last, for high, pure, moral
melodrama on the themes of possession, domination, and
belonging.
The nineteen sixties in Wall Street were the nineteen
twenties replayed in a new and different keydifferent
because the nineteen sixties were more complex, more
sophisticated, and more democratic.
On the last day of 1969, Wall Street was in an euphoric
New Years Eve mood. The attention of buoyant
investors was turning from blue chips to more
speculative issuesBrunswick, Sperry-Rand, Hupp,
Ampex, Transitron. Gerald M. Loeb, one of the last men
on Wall Street to have vivid memories of 1929, was
saying a couple of weeks later, If you want to sleep and
smile when the wonder shares return to reality, now is
the time to break away from the crowd.
On January 5, 1962, the S.E.C. came out with its report
on its investigation of the American Stock Exchange,
accusing a dominant group of having passed the
essential power at the Amex back and forth among
themselves for a decade; criticizing, in general and
particular, this groups discipline over specialists and
floor traders; demanding swift action to end the
manifold and prolonged abuses of the decade past; and
threatening once again to move in and assume command
if the Amex should fail to clean its own house. Later in
the year, a brilliant and spotless new president, Edwin D.
Etherington, was brought in, and an entire new Amex
constitution was written and ratified that conformed
largely to the recommendations of the S.E.C. and the
Gustave L. Levy committee.
After the severe stock market decline in 1962, the man
Wall Street turned to was chairman of the S.E.C.,
William Lucius Cary. The appointment proved to have
been a brilliant one. Cary brought to the organization a
vigor and a drive that it had lacked for years.
In 1966, the S.E.C. brought, and for the most part
eventually won, a civil complaint against Texas Gulf
Sulphur and thirteen of its directors and employees
charging that they had made improper use of inside
information about a Canadian ore strike, in a case that
shook Wall Street to its foundations.
The Senate passed a measure authorizing $750,000 to the
S.E.C. for a two-year Special Study of the Securities
Marketssuch a study as had not been undertaken for a
generation.
All in all, the Special Study was a blueprint for a fair and
orderly securities market, certainly the most
comprehensive such blueprint ever drawn up. The law
that was finally passedthe Securities Acts
Amendments of 1964had two main sections, one
extending S.E.C. jurisdiction to include a large number
of over-the-counter stocks, and the other giving the
government the authority to set standards and
qualifications for securities firms and their employees.
The loss of power and influence of the Old
Establishment was partly its own fault. This change
brought with it a new ethical climate. It was a style a
little less dournot less materialistic or grasping but
more candid and humorous about the materialism as well
as the manner; a style not less interested in the trappings
and icons of culture, but undoubtedly by tradition more
capable of enjoying culture; a style with more of a bent
for justice and less of an acceptance of caste. And it
probably wasalthough this would be hard to provea
style more inclined to dash and daring as opposed to
respectability, less concerned about preservation of
values and appearances and more sympathetic toward
speculation and outright gambling.
The term go-go came to designate a method of
operating in the stock marketa method that was, to be
sure, free, fast, and lively. The method was characterized
by rapid in-and-out trading of huge blocks of stock, with
an eye to large profits taken very quickly, and the term
was used specifically to apply to the operation of certain
mutual funds, none of which had previously operated in
anything like such a free, fast, or lively manner.
3DJH 196
The year 1966 found Wall Street slowly and reluctantly
beginning to recognize itself as a marketplace for the
millions rather than an lite club with a limited
membership. That summer, the S.E.C. forced a
recalcitrant New York Stock Exchange to relax slightly
the ironclad monopoly implied in its cherished Rule 394,
which forbade members, except in rare instances, to
transact business in listed stocks off the Exchange; under
the amended rule, they were allowed to deal off the
Exchange in cases where they could not fill an order at a
fair price on it.
By the end of August 1966, the Dow Jones Industrial
Average, which had started the year at near 1,000, was
hovering around 790. Certain groups not only resisted
the downward trend but actually bucked it. Among those
in the most favored group, Ling-Temco-Vought was up
almost 70 percent for the year, City Investing was up
about 50 percent, Litton Industries and Textron were up
between 15 and 20 percent, while International
Telephone and Telegraph and Gulf and Western
Industries were up by smaller percentages but were
poised for huge rises early in 1967. The group, of course,
was the one that comprised the new corporate
wunderkinder of the stock market, the conglomerates.
During their most flourishing years (roughly 1966-1969),
the conglomerateurs were said to represent a forward-
looking form of enterprise characterized by freedom
from all that is hidebound in conventional corporate
practice.
In 1958, James Ling gained entry to Wall Street when
White, Weld and Company undertook a private
placement of Ling Electronics convertible bonds. In
1959, he took over Altec, University Loudspeakers, and
Continental Electronics; in 1960, Temco Electronics and
Missiles; in 1961, Chance Vought Corporation. In 1965,
Ling-Temco-Vought ranked number 204 on the Fortune
directory of the largest U.S. industrial companies; in
1967, 38; finally in 1969, 14. In 1968, Ling embarked on
his most ambitious venture and the one that along with
other factors, would eventually bring about his downfall.
It was the acquisition of Jones and Laughlin Steel, for a
cash tender of $425 million; the largest ever made by
one company for another.
In 1955, Meshulam Riklis took over a firm called Rapid
Electrotype; in 1957 he merged it into another called
American Colortype; and the combination, which was to
be Riklis key corporate vehicle thereafter, was named
Rapid-American Corporation. By 1962, Rapid-American
controlled McCrory Corporation, a combine of retail
stores, and Glen Alden, a consumer-products company.
Eventually Riklis came to control a complex with sales
of $1.7 billion, including such well-known companies as
International Playtex, B.V.D., Schenley Industries,
Lerner Shops, and RKO-Stanley Warner Theatres.
Charles Bluhdorn was a secret conservative, more
cautious and calculating than he wanted to seem. In
1957, just past thirty, he bought control of an automobile
parts manufacturing company called Michigan Bumper.
It entered the nineteen sixties with sales of $8.4 million
and a small annual deficit. Eight years and more than
eighty corporate deals later, his enterpriseGulf and
Western Industrieswould have sales of $1.3 billion
and net annual income of $70 million. In the first part of
1965, his was still essentially a small car-parts firm; but
that year he managed to borrow $84 million to buy
control of New Jersey Zinc Company. After that,
acquisitions followed at a dizzying rate: E.W. Bliss,
Desilu Productions, South Puerto Rican Sugar,
Consolidated Cigar. Undoubtedly Bluhdorns acquisition
masterpiece was Paramount Pictures in 1966. He also
made takeover overtures to Armour and to Pan American
Airways.
But the conglomerate movement also had serious and
dangerous consequences within the world of
corporations. With Litton openly aiming at acquiring
fifty companies a year and with dozens of lesser
conglomerates eager for entry into the great world of
conglomerate colossi, hardly any company anywhere in
the country that had its stock on the market could feel
safe from a takeover attempt at any time. Some
companies became battle-scarred veterans of the
conglomerate wars. Allis-Chalmers weathered serious
takeover attempts by Ling-Temco-Vought, Gulf and
3DJH 197
Western, and White Consolidated, one right after the
other.
Not until virtually the whole business community had
been aroused in 1969 by the attempts of Resorts
International (formerly Mary Carter Paints) to take over
Pan American World Airways, and of brash Leasco Data
Processing to forcibly marry Chemical Bank, would the
temporarily chastened conglomerates lose some of their
appetite for prey bigger and more prestigious than
themselves.
What came to be regarded as the classic defense was
mounted in 1969 by B.F. Goodrich, the celebrated old-
line rubber company, to foil a takeover attempt by
Northwest Industries (clothing, pesticides, steel, and for
a time, the nations only profitable commuter railroad,
the Chicago and North Western). It changed its
accounting methods. It achieved not one quickly planned
merger of its own, but two. It bought newspaper ads to
revile Northwest and its tactics. It changed its charter to
provide for staggering the terms of its directors.
Goodrich vigorously used its influence to get
government intervention in both its home state, Ohio,
and in Washington.
Conglomerates headquarters were mostly on the two
coasts, and often enough, their corporate victims resided
in the cities in between. The result was the repeated
reduction of many mid-American cities oldest
established industries, from many independent ventures
to subsidiaries of conglomerates based in New York or
Los Angeles. Pittsburgh, for one, lost about a dozen
important corporations through conglomerate mergers.
But the era was on its way to its end when, in January of
1968, it was shown for the first time that conglomerate
managementeven the best of itcould lose track
entirely of the progress or regress of the far-flung
enterprises it ostensibly controlled and thus fail utterly of
its function.
Nineteen sixty-eight was to be the year when speculation
spread like a prairie firewhen the nation, sick and
disgusted with itself, seemed to try to drown its guilt in a
frenetic quest for quick and easy money. It was a market
in which the leaders were neither old blue chips, like
General Motors and American Telephone, nor newer
solid stars, like Polaroid and Xerox, but stocks with
names like Four Seasons Nursing Centers, Kentucky
Fried Chicken, United Convalescent Homes, and
Applied Logic. The fad, as in 1961, was for taking short,
profitable rides on hot new issues through firms such as
Charles Plohn; an underwriter known as Two-a-Week
Charlie for the number of new low-priced issues he
brought out.
Beginning on June 12, 1968, the securities markets were
closed tight every Wednesdaya measure not used since
1929in order to give securities firms back offices a
regular midweek breather in which to make a stab at
catching up.
Beginning on January 2, 1969, the exchanges resumed a
five-day trading week with 2 p.m. closings. It was
explained later that the Wednesday closings had been
abandoned not because they had accomplished their
purpose, but because they had failed to do so; too many
brokerage firms, rather than using them to catch up, had
simply treated them as holidays. Starting early in July,
the exchanges began lengthening their daily trading
hours, in thirty-minute stages, until closing time was
back to 3:30 p.m.
By 1969, institutional investors had effectively taken
over the New York Stock Exchange business. At the
beginning of the decade, their share of total trading
volume had been less than a third; now they had 54
percent of total public-share volume and 60 percent of
total public-dollar volume.
The rise of institutional investing had brought into being
a new kind of high-risk brokerage operation, the block
positioner. There were other, less salutary,
developments. Many of the mutual funds themselves
were taking advantage of the permissive climate by
indulging in a form of sleight-of-hand that gave their
asset value the same kind of painless, instant, and
essentially bogus boost as merger accounting could give
3DJH 198
to conglomerate earnings. The sleight-of-hand involved
the use of what was called letter stock.
Letter stock was not registered with the S.E.C., and
therefore could not legally be resold until it had been
through such registration; for practical purposes, it was
unmarketable. It was soldlegallythrough an
investment letter (whence the term, letter stock) in
which these terms were set forth and the buyer agreed
not to resell, pending registration.
Funds did what was the common practice in accounting
for letter stock: they took the market price as their base
and marked it down by one-third to allow for the shares
non-registration. It should be noted that this was several
times as much as the fund had just paid for them. With
no change in the market price of the stock, and with no
specific news as to the firms business prospects, the
fund made what appeared on the books it displayed
proudly to the investing public to be an investment
yielding an instant profit.
To round out the inventory of the various symptoms of
dementia that afflicted the 1968-1969 stock market
there were the hot new issues.
In stock-market history, a new-issues craze is always the
last stage of a dangerous boom. In 1961 they were tiny
scientific companies put together by little churches of
glittery-eyed young Ph.D.s, their company names
ending in onics. In 1968-1969, what a promoter
needed to launch a new stock was to have a storyan
easily grasped concept, preferably related to some
current national fad or preoccupation, that sounded as if
it would lead to profits. A cunning investor could
presumably get a piece of this action by buying stocks
such as Four Seasons Nursing Centers, United
Convalescent Homes, International Leisure, Responsive
Environments, Bonanza International, or National
Student Marketing Corporation.
The beginning of the year 1970 corresponds roughly to
the late spring of 1929. In each case, there were warning
signals across the land of a coming economic recession.
In each case, a steep decline in second-rank stock
issuesa sort of hidden crash, since it didnt show up in
the popular averageswas already underway. In each
case, speculation continued to flourish, and in each case,
the Federal Reserve, torn between trying to dampen
speculation and inflation on the one hand and trying to
head off recession on the other, was frantically pressing
its various monetary levers to little effect.
But there was at least one big difference. Where in 1929
the stock market became the national craze as it had
never been before, in 1970, the investor mood was one
of fatalism, and the decline in trading volume would
become as great a problem for Wall Street as the decline
in stock prices.
Between the end of 1968 and October 1, 1970, the assets
of the twenty-eight largest hedge funds declined by 70
percent. Among offshore fund management companies,
in mid-October 1970, the week before Gramco
Management suspended redemptions, Gramco stock,
which had once sold at 38, was then available for 1. In
June 1972, a block of preferred shares of Investors
Overseas Services changed hands in Geneva at one cent
a share.
Reform follows public crises as remorse follows private
ones. In December 1970, Congress passed and President
Nixon signed into law a bill creating a Securities
Investor Protection Corporation. The Stock Exchange set
about reforming itself internally. In March 1972, its
members voted to reorganize its governing structure
along more democratic lines by replacing the old thirty-
three-person, heavily insider-dominated board with a
new board comprising twenty-one members, ten of them
from outside Wall Street, and a new salaried chairman to
supercede the traditionally unpaid, nominally part-time
chairmen of the past.
From the September 1929 peak to the nadir of the Great
Depression in the summer of 1932, the Dow Jones
Industrial Average dropped from 381 to 36, or just over
90 percent. From the December 1968 peak to the May
1970 bottom, the same index dropped from 985 to 631,
or about 36 percent. One analyst compiled a list of thirty
leading glamour stocks of the nineteen sixtiesten
3DJH 199
leading conglomerates including Litton, Gulf and
Western, and Ling-Temco-Vought, ten computer stocks
including IBM, Leasco, and Sperry Rand, and ten
technology stocks including Polaroid, Xerox, and
Fairchild Camera. The average 1969-1970 decline of the
ten conglomerates, the analyst found, had been 86
percent; of the computer stocks, 80 percent; of the
technology stocks, 77 percent. The average decline of all
thirty stocks in this handmade neo-Dow had been 81
percent.
In 1929 there were, at the most, four or five million
Americans who owned stock; in 1970, there were about
31 million. Losses, then, of $300 billion in a year and a
half, spread over more than 30 million investorssuch
were the bitter fruits of the go-go years; of the
conglomerates and their promoters talk of synergism
and of two and two making five; of the portfolio wizards
who wheeled and dealt with their customers money; of
the works of bottom-line fiction written by the creative
accountants; of the garbage stock dumped on the market
by two-a-week underwriters; of the stock salespeople
who acted as go-betweens for quick commissions; of the
mutual funds that got instant performance by writing up
the indeterminate value of unregistered letter stock.
In the latter nineteen sixties, the capital structure of Wall
Street itself became unsafe and unsound to a degree that,
when hard times struck, was revealed as nothing less
than a scandal. Not until 1970 did the first Wall Street
firm raise money for its operations from outside by
selling its own stock to the public, and it took a change
in the New York Stock Exchanges constitution to make
such a sale possible. The S.E.C. and the Stock Exchange
had allowed Wall Street firms to comply with the net
capital ruleimposed for the protection of the firms
themselves as well as that of their customerswith
capital that was essentially a mirage.
Capital troubles began to crop up in the backlash of the
1968 paperwork crisis.
Early in 1970, as the continuing decline in prices and
volume made the situation for brokers progressively
worse, a wave of brokerage mergers arose. McDonnell
and Company closed its doors; in Los Angeles, Kleiner,
Bell withdrew from the brokerage business; and Hayden,
Stone and Company, an eighty-four-year-old giant not
far from the core of the Wall Street Establishment,
shortly thereafter erupted into the first phase of the crisis
that almost brought Wall Street low for good.
Several more firms, the largest of them Blair and
Company, went under in June and July. By the last week
of August three more firmsRobinson and Company,
First Devonshire Corporation and Charles Plohn and
Companywere suspended for capital deficiencies and
went into liquidation.
One of the largest crises involved Goodbody and
Company, for decades a pillar of the brokerage
communityits co-founder in 1891 had been the
legendary Charles H. Dow. Merrill Lynch was brought
in to take on Goodbody.
In 1970, F.I. du Pont joined forces with two other
brokerage houses, Glore, Forgan and Staats, and Hirsch
and Company, to form a new organization to be called
F.I. du Pont-Glore, Forgan and Company. In the last
week of April, an agreement was reached that Ross Perot
and his colleagues would lend $55 million, in exchange
for at least 80 percent control of F.I. du Pont.
A study of mutual funds by Irwin Friend, Jean Crockette,
and Marshall Blume of the faculty of the Wharton
School, published in August 1970, by the Twentieth
Century Fund, resulted in the startling conclusion that
equally weighted or unweighted investment in New
York Stock Exchange stocks would have resulted in a
higher rate of return than that achieved by mutual funds
in the 1960-1968 period as a whole.
If Wall Streets nineteen sixties were in many ways a
replay of its nineteen twentiesrefuting the optimism of
those who believe that reform can make social history
into a permanent growth situation rather than a cyclical
stockits go-go years were also utterly characteristic of
the larger trends of their own time, reflecting and
projecting all the lights and shadows of a troubled,
confused, frightening decade the precise like of which
3DJH 200
had never been seen before and surely will not be seen
again.
Full disclosure in the nineteen sixties market was largely
a failure, giving the small investor the semblance of
protection without the substance. And that failure raised
the question of just how much full disclosure can ever
accomplish. Rules can be tightened, as many were
during the decade and more will be in the future; but as
surely as night follows day, the tricksters of Wall Street
and its financial tributaries will be ever busy topping the
new rules with new tricks, and there is no reason to
doubt that the respectable institutions will again play
Pied Piper by catching the quick money fever the next
time it is epidemic.
All that notwithstanding, Wall Street is changing in a
democratic direction. After it graduated, around the
beginning of this century, from being chiefly an arena
for the depredations of robber barons and the
manipulations of sharp traders in railroad bonds, Wall
Street became not only the most important financial
center in the world but also a national institution. In the
nineteen twenties it was in a real sense what Wall
Streeters always cringed to hear it called, a private club.
In the nineteen sixties, despite declining aristocratic
character and political influence, it was still those things,
playing out week by week and month by month its
concentrated and heightened version of the larger
national drama. But after the convulsion with which the
decade and that particular act in the drama ended, its
days in the old role seemed to be numbered.
Copyright 1973 by John Brooks. Used by permission
from John Wiley & Sons.
3DJH 201
Classic Investment Readings: David F. Swensen
Pioneering Portfolio Management
The following is an excerpt from David F. Swensens
Pioneering Portfolio Management. Mr. Swensen is the
Chief Investment Officer at Yale University, where he
has managed the universitys endowment for more than
15 years. All opinions expressed herein are those of the
author and do not necessarily reflect those of Morgan
Stanley.
From the Forward by Charles D. Ellis
David Swensen and his team meet regularly with nearly
100 current investment managers; analyze many, many
potentially interesting proposals; conduct due diligence
on large numbers of prospective new managers; examine
each managers investment performance versus
expectations; and run Monte Carlo simulations to
stress test the portfolio under various possible market
scenarios to work out the probable impact of both
intended and unintended risks.
One secret of Yales success has been David Swensens
ability to engage the committee in governance and not in
investment management. Contributing factors include:
selection of committee members who are experienced,
hard-working, and personally agreeable; extensive
documentation of the due diligence devoted to preparing
each investment decision; and full agreement on the
evidence and reasoning behind the policy framework
within which specific investment decisions will be made.
David Swensen was concerned that a how-to book
might make it look too easy. He felt that other
institutions (particularly those with smaller endowment
funds) might be attracted by the impressive results
achieved in the past several years for Yale. They might
not have the internal staff or the organizational structure
and discipline required to sustain commitments through
the good and bad markets that are encountered in the
financial arena. David Swensen knows that sustained
commitment is necessary for success with out-of-the-
mainstream portfolio structures.
Introduction
Investing with a time horizon measured in centuries to
support the educational and research mission of societys
colleges and universities creates a challenge guaranteed
to engage the emotions and intellect of fund fiduciaries.
A rich understanding of human psychology, a reasonable
appreciation of financial theory, a deep awareness of
history, and a broad exposure to current events all
contribute to the development of well-informed portfolio
strategies. Asset allocation relies on a combination of
top-down assessment of asset class characteristics and
bottom-up evaluation of asset class opportunities.
Among the many important investment activities that
require careful oversight, maintaining policy asset
allocation targets stands near the top of the list. Far too
many investors spend enormous amounts of time and
energy constructing policy portfolios, only to allow the
allocations they established to drift with the whims of the
market. The process of rebalancing requires a fair degree
of activity, buying and selling to bring underweight and
overweight allocations to target.
3DJH 202
Classic Investment Readings: David F. Swensen (cont.)
A second theme concerns the prevalence of issues that
interfere with the successful pursuit of institutional
goals. Nearly every aspect of funds management suffers
from decisions made in the self-interest of the decision
makers, not in the best interests of the fund. The wedge
between principal goals and agent actions causes
problems at the highest governance level, causing some
fiduciary decisions to fail to serve the interests of a
perpetual life endowment fund. Individuals desire
immediate gratification, leading to overemphasis of
policies expected to pay off in a relatively short time
frame. Every aspect of the investment management
process contains real and potential conflicts between the
interests of institutional funds and the interests of the
agents engaged to manage portfolio assets.
Market timers and security selectors face intensely
competitive environments in which the majority of
participants fail. While private markets provide a much
greater range of mispriced assets, investors fare little
better than their marketable security counterparts as the
extraordinary fee burden typical of private equity funds
almost guarantees delivery of disappointing risk-adjusted
results.
The staff resources required to create portfolios with a
reasonable chance of producing superior asset class
returns place yet another obstacle in the path of
institutions considering active management strategies.
Promising investments come to light only after thorough
culling of dozens of mediocre alternatives. Hiring and
compensating the personnel needed to identify out-of-
the-mainstream opportunities imposes a burden too great
for many institutions to accept.
Establishing and maintaining an unconventional
investment profile requires acceptance of uncomfortably
idiosyncratic portfolios, which frequently appear
downright imprudent in the eyes of conventional
wisdom.
Investment and Spending Goals
The high-risk, high-return investment policy best suited
to serve asset preservation conflicts with the low-risk,
low-return investment approach more likely to produce
stable distributions to the operating budget. While
fiduciary principles generally specify only that the
institution preserve the nominal value of a gift, to
provide true permanent support, institutions must
maintain the inflation-adjusted value of a gift.
In a period of high inflation accompanied by bear
markets for stocks and bonds, spending at a level
independent of the value of assets creates the potential to
damage the endowment fund permanently. Spending
policies specify the trade-off between protecting
endowment assets for tomorrows scholars and providing
endowment support for todays beneficiaries. Sensible
policies cause current-year spending to relate to: (i)
prior-year endowment distributions; and (ii)
contemporaneous endowment values, with the former
factor reducing fluctuation in operating budget flows by
providing a core on which planners can rely and the
latter factor protecting purchasing power by introducing
sensitivity to market influences.
Yale Universitys spending policy relates current-year
spending to both the current endowment market value
and the previous level of spending from endowment.
Under Yales rule, spending for a given year equals 70
percent of spending in the previous year, adjusted for
inflation, plus 30 percent of the long-term spending rate
applied to the endowments current market level.
By reducing the impact on the operating budget of the
inevitable fluctuations in endowment value caused by
investing in risky assets, spending rules that employ an
averaging process insulate the academic enterprise from
unacceptably high year-to-year swings in support.
Because sensible spending policies dampen the
consequences of portfolio volatility, portfolio managers
gain the freedom to accept greater investment risk with
the expectation of achieving higher return without
exposing the institution to unreasonably large
probabilities of significant budgetary shortfalls. The
distinction between current income and capital
appreciation can be too easily manipulated to provide a
sound foundation for spending policy.
3DJH 203
Target spending rates among endowed institutions range
from a surprisingly low 1.25 percent of the endowment
to an unsustainably high 10.0 percent of the endowment.
More than 90 percent of institutions employ target rates
between 4.0 percent and 6.0 percent, with nearly half
using a 5.0 percent rate. The appropriate rate of spending
depends on the risk and return characteristics of the
investment portfolio, the structure of the spending
policy, and the preferences expressed by trustees
regarding the trade-off between stable budgetary support
and asset preservation.
Investment Philosophy
Recognizing that decisions regarding the relative
importance of asset allocation, market timing, and
security selection lie within an investors purview serves
as an important starting point for policymakers. Instead
of passively accepting the overwhelming importance of
asset allocation, knowledgeable investors treat each
source of return as a significant independent factor in
generating portfolio returns.
Focus on asset allocation relegates market timing and
security selection decisions to the background, reducing
the degree to which investment results depend on
mercurial, unreliable factors. For sensible investors,
defining an institutions policy portfolio constitutes the
central activity of investment management. Selecting the
asset classes for a portfolio constitutes a critically
important set of decisions, contributing a large measure
to a portfolios success or failure. Identifying appropriate
asset classes requires focus on functional characteristics,
considering each assets potential to deliver returns and
mitigate portfolio risk.
Maintaining an equity bias and following diversification
principles provide the foundation for building strong
investment portfolios. Market timers who increase the
risk profile of a portfolio by overweighting a risky asset
at the expense of lower-risk positions face a different
challenge. Fiduciaries must consider the advisability of
moving risk beyond policy portfolio levels. Serious
investors avoid the temptation of attempting to time
markets.
An inverse relationship exists between efficiency in asset
pricing and the appropriate degree of active
management. Passive management strategies suit highly
efficient markets, such as U.S. Treasury bonds, where
market returns drive results and active management adds
very little to returns. Active management strategies fit
inefficient markets, such as private equity, where market
returns contribute very little to ultimate results and
investment selection provides the fundamental source of
return. Active managers willing to accept illiquidity
achieve a significant edge in seeking high risk-adjusted
returns. Because market players routinely overpay for
liquidity, serious investors may benefit by avoiding
overpriced liquid securities and locating bargains in less
widely followed, less liquid market segments.
The pursuit of value-oriented strategies enhances
opportunities to achieve security selection success. Value
can be purchased, by identifying assets trading below
fair value, or created, by bringing unusual skills to
improve corporate operations. Value investors tend to
operate with a margin of safety unavailable to less
conservative investors.
By identifying high-return asset classes, not highly
correlated with domestic marketable securities, investors
achieve diversification without the opportunity costs of
investing in fixed income. The most common high-return
diversifying strategy for a U.S. investor involves adding
foreign equities to the portfolio. Studies of long-term
returns in the United States ignore the fact that investors
in foreign markets have experienced less favorable
outcomes, sometimes with dramatically worse results.
Because cash represents a poor asset class for investors
with long time horizons, market timing strategies
employing cash pose particularly great dangers to
endowment assets. If investors mistakenly overweight
cash and underweight higher expected return assets,
subsequent rallies in long-term asset prices might cause
permanent impairment of value.
Investors hoping to profit in the short run from
rebalancing trades face nearly certain long-run
disappointment. Over long periods of time, portfolios
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that are allowed to drift tend to contain ever increasing
allocations to risky assets, as higher returns cause riskier
positions to crowd out other holdings. The fundamental
purpose of rebalancing lies in controlling risk, not
enhancing return. Rebalancing trades keep portfolios at
long-term policy targets by reversing deviations resulting
from asset class performance differentials. Disciplined
rebalancing activity requires a strong stomach and
serious staying power.
Rising equity prices provide a similar set of challenges.
In a sustained bull market, rebalancing appears to be a
losing strategy as investors constantly sell assets
showing relative price strength. Years go by without
reward other than the knowledge that the portfolio
embodies the desired risk-reward characteristics. Like
many other contrarian pursuits, rebalancing frequently
appears foolish as momentum players reap short-term
rewards from going with the flow.
Markets with inefficiently priced assets ought to be
favored by active managers; markets with efficiently
priced assets should be approached by active managers
with great caution. Over time, managers in efficient
markets gravitate toward closet indexing, structuring
portfolios with only modest deviations from the market.
U.S. Treasury securities, arguably the most efficiently
priced asset in the world, trade in staggering volumes in
markets dominated by savvy financial institutions. The
spread between first- and third-quartile results for active
managers measures an astonishingly small 1.2 percent
per annum for the decade ending December 31, 1997.
Large-capitalization equities represent the next rung of
the efficiency ladder, with a range of 2.5 percent
between top and bottom quartiles. Less efficiently priced
international equities show a range of 2.9 percent per
annum. Real estate, venture capital, and leveraged
buyouts exhibit dramatically broader dispersions of
returns. For the ten-year period ending December 31,
1997, real estate returns show a range of 4.7 percent
between the first and third quartiles, while leveraged
buyouts and venture capital exhibiting even more
extreme 13.0 and 21.2 percent per annum spreads.
Selecting top-quartile managers in private markets leads
to much greater rewards than in public markets.
Ironically, identifying superior managers in the relatively
inefficiently priced private markets may in fact prove
less challenging than in the efficiently priced marketable
securities markets. Greater inefficiency in the market
environment for an asset class may not lead to greater
average success. Private markets provide a case in point.
Median results for venture capital and leveraged buyouts
dramatically trail those for marketable equities, despite
the higher risk and greater illiquidity of private investing.
Over the decade ending December 31, 1997, investment
performance deficits relative to the S&P 500 amounted
to 5.9 percent annually for venture capital and 1.4
percent annually for leveraged buyouts, numbers that
would be even higher after risk adjustment. In order to
justify including private equity in the portfolio, investors
must believe they can select top-quartile managers.
Anything less fails to compensate for the time, effort,
and risk entailed in the pursuit of nonmarketable
investments.
Errors of underinclusion and overinclusion tend to bias
manager performance data, limiting the usefulness of
consultants reports in understanding active management
results. Underinclusion occurs when managers disappear
without a trace; overinclusion results when new entrants
contribute their historical results to the database.
Compilations of returns data sometimes include only
results of managers active at the time of the study.
Discontinued products and discredited managers
disappear, coloring the returns data with an optimistic
tint. The potential also exists for overinclusion to exert
further upward pressure on reported results. Since only
successful managers rise to the level necessary to gain
the attention of the consulting industry, adding complete
records of new entrants produces an upward bias in
reported results.
Survivorship bias in the distributions of active manager
returns fundamentally alters investor attitudes toward
active management. Data indicating that the majority of
managers beat the index encourage investors to play the
active management game, while numbers showing that a
preponderance of managers fail to match index returns
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discourage active management. The positive tilt
introduced by survivorship bias no doubt leads to
excessive confidence regarding active management
strategies.
Illiquidity tends to foster appropriate long-term investor
behavior. Rather than relying on liquid markets to trade
out of mistakes, investors in illiquid securities enter into
long-term arrangements, purchasing part ownership in a
business with which they have to live. As a consequence,
increased care, thoroughness, and discipline represent
hallmarks of successful investors in less liquid assets.
Consistent investment success follows most reliably
from pursuing value-based strategies, in which investors
acquire assets at prices below fair value. Investors
wishing to implement value-oriented programs require
unusual skill, intelligence, and energy. Without a
significant edge relative to other market participants,
investors face likely failure. Moreover, value
opportunities tend to be out of favor with mainstream
investors, demanding courage of conviction to initiate
and maintain contrarian positions. On the other hand,
mindless contrarian investing poses dangers to
portfolios. Sometimes popular companies deserve
premium valuations. Sometimes out-of-favor companies
fail to recover, justifying the markets discounted
valuation.
In fact, value investors seek to purchase companies at a
discount to fair value, not to purchase distressed assets
per se. Superb opportunities to purchase assets at prices
significantly below fair value tend to be hidden in deeply
out-of-favor market segments. At market bottoms, the
broad consensus so loathes certain asset types that
investors brave enough to make commitments find their
sanity and sense of responsibility questioned. Managers
searching among unloved opportunities face greater
chances of success, along with almost certain tirades of
criticism in the event of failure.
An investment philosophy defines an investors
approach to generating portfolio returns, describing in
the most fundamental fashion the tenets that permeate
the investment process. Market returns stem from three
sourcesasset allocation, market timing, and security
selectionwith each source of return providing a tool
for investors to use in attempting to satisfy institutional
goals. Asset allocation should seek to create a diversified
portfolio with equity-oriented asset classes that behave in
a fundamentally different fashion from one another,
providing an important underpinning to the investment
process.
Market timing causes investors to hold portfolios that
differ from policy targets, jeopardizing a funds ability to
meet long-term objectives. Often driven by fear or greed,
market timing tends to detract from portfolio
performance. Many investors practice an implicit form of
market timing by failing to maintain allocations at long-
term policy targets. Risk control requires regular
portfolio rebalancing, ensuring that portfolios reflect the
investors preferences.
Active security selection plays a prominent role in nearly
all institutional investment programs, despite the poor
relative results posted by most investors. Investors
increase the probability of success by focusing on
inefficient markets, which present the greatest range of
opportunities. Accepting illiquidity pays outsized
dividends to the patient long-term investor, while
approaching markets with a value orientation provides a
margin of safety. Even if investors approach active
management programs with intelligence and care,
efficiency in pricing assets creates great difficulty in
identifying and implementing market-beating strategies.
Asset Allocation
Defining and selecting asset classes constitute the initial
steps in producing a portfolio. Investors begin by
selecting asset classes which promise to meet
fundamental investment goals. Many portfolios require
assets likely to generate equity-like returns, such as
domestic and foreign equities, absolute return strategies,
and private equity. To mitigate equity risks, portfolios
also may include assets such as fixed income and real
estate.
Asset class distinctions rest on broad differences in
fundamental character: debt versus equity, private versus
3DJH 206
public, liquid versus illiquid, domestic versus foreign,
inflation-sensitive versus deflation-sensitive. While
market participants disagree on the appropriate number
of asset classes, fewer may very well be better. Portfolio
commitments must be large enough to make a difference.
Committing less than 10 percent of an investors assets
to a particular type of investment may make little sense.
The recently issued Treasury Inflation-Protected
Securities (TIPS) probably should not be classified as
fixed-income securities. Traditional fixed income assets
respond to unanticipated inflation by declining in price,
as the future stream of fixed payments becomes worth
less. In contrast, inflation-indexed bonds respond to
unexpected price increases by providing a higher return.
When two assets respond in opposite fashion to the same
critically important variable, those assets belong in
different asset classes.
Careful investors define asset classes in terms of
function, relating security characteristics to the role
expected from a particular group of investments. In the
case of fixed income, the introduction of credit risk, call
risk, and currency risk tend to diminish disaster-hedging
attributes. As a separate asset class, high-quality foreign
bonds hold little interest. The combination of low,
bondlike expected returns and foreign exchange
exposure negate any positive attributes associated with
non-domestic fixed income.
Although the asset allocation process necessarily
involves quantitative tools, unless statistical analysis
rests on reasonable judgment, the resulting portfolio
stands little chance of meeting investors needs.
Quantitative analysis provides essential underpinnings to
the portfolio structuring process, forcing investors to
take a disciplined approach to portfolio construction. For
example, the systematic specification of inputs for an
asset allocation model clarifies the central issues in
portfolio management.
Mean-variance optimization identifies efficient
portfolios, which for a given level of risk have the
highest possible return. Using inputs of expected return,
expected risk, and expected correlation, the optimization
process evaluates various combinations of assets,
ultimately identifying superior portfolios. An efficient
portfolio dominates all others producing the same return
or exhibiting the same risk. In other words, for a given
risk level, no other portfolio produces a higher return
than the efficient portfolio. Similarly, for a given return
level, no other portfolio exhibits lower risk than the
efficient portfolio. Note that the definition of efficiency
as implied in this context relates entirely to risk and
return. Mean-variance optimization fails to consider
other asset class characteristics.
Practitioners generally assume that normal, or bell-
curve-shaped, distributions describe asset class
characteristics, allowing complete specification of the
distribution of returns with only a mean and a variance.
Although using normal distributions facilitates
implementation of mean-variance analysis, security
returns may include significant nonnormal
characteristics, limiting the value of the conclusions.
Unconstrained mean-variance results usually provide
solutions unrecognizable as reasonable portfolios. Mean-
variance optimization significantly overweights
(underweights) those assets that have large (small)
estimated returns, negative (positive) correlations and
small (large) variances. Correlations specify the manner
in which the returns of one asset class tend to vary with
the returns of other asset classes, quantifying the
diversification power of combining asset classes that
respond differently to forces that drive returns.
Evidence suggests that the distributions of security
returns might not be normal, with markets exhibiting
more extreme events than would be consistent with a
bell-shaped curve distribution. A general rule of thumb is
that every financial market experiences one or more
daily price moves of four standard deviations or more
each year. And in any year, there is usually at least one
market that has a daily move greater than ten standard
deviations. In fact, investors may care more about
extraordinary situations, such as the 1987 stock market
crash, than about outcomes represented by the heart of
the bell-shaped curve distribution.
3DJH 207
Mean-variance optimization assumes that expected
return and risk completely define asset class
characteristics. The framework fails to consider other
important attributes, such as liquidity and marketability.
In fact, the inclusion of less liquid assets in a mean-
variance framework raises material issues. Most
frequently, mean-variance optimization involves analysis
of annual series of return and risk data. The analysis
implicitly assumes an annual rebalancing of portfolio
allocations. That is, if stocks have moved above target
and bonds below, then on the relevant anniversary date,
investors sell stocks and buy bonds, restoring target
allocations. Clearly, less marketable assets, such as
private equity and real estate holdings, cannot be
rebalanced annually in a low-cost, efficient manner.
The way in which asset classes relate to each other may
not be stable. Most investors rely heavily on historical
experience in estimating quantitative inputs, yet
continuous structural evolution is sufficient to cause
historical correlations to be of questionable use in
building portfolio allocations. Even more disturbing,
market crises tend to cause otherwise distinct markets to
behave in a similar fashion. In the final analysis, both the
fundamental shortcoming and the basic attraction of
quantitative analysis stem from reducing a rich set of
asset class attributes to a neat, compact package of
precisely defined statistical characteristics. Because the
process involves material simplifying assumptions,
adopting the unconstrained asset allocation point
estimates produced by mean-variance optimization
makes little sense.
The limitations of mean-variance analysis argue for
inclusion of qualitative considerations in the asset
allocation process. Judgment might be incorporated by
applying reasonable constraints to particular asset class
allocations. Limiting asset allocation responses by
constraining asset class movements represents a sensible
modification of the optimization process. Care must be
taken, however, to avoid using asset class constraints
simply to fashion a reasonable-looking portfolio. Taken
to an extreme, placing too many constraints on the
optimization process causes the model to do nothing
other than reflect the investors original biases.
Return and risk expectations constitute the heart of any
quantitative assessment of portfolio alternatives. While
historical experience represents a reasonable starting
point in developing a set of forward-looking data,
investors seeking to create truly useful conclusions must
move beyond simply plugging historical numbers into
the mean-variance optimizer. Mean reverting behavior in
security prices implies that periods of abnormally high
returns follow periods of abnormally low returns, and
vice versa. If prices tend to revert to the mean, then
return expectations must be adjusted to dampen
expectations for high fliers and boost forecasts for poor
performers. Structural changes in markets force analysts
to weight recent data more heavily, de-emphasizing
numbers reflecting earlier, sometimes dramatically
different environments.
In running mean-variance optimization, data on expected
returns provide the most powerful determinant of results,
demanding the greatest share of the quantitative
modelers attention. Forecasts of the variances constitute
the second most significant collection of variables, while
assumptions regarding correlations prove least critical to
the process. Fortunately, the most intuitive variables
expected returns and variancesprove to be more
important to the modeling process than the less intuitive
correlations.
Over the long sweep of time, as fixed income investors
found returns eroded by spells of unanticipated inflation,
bonds provided mediocre real returns of 1.2 percent per
annum with risk, as measured by the standard deviation
in annual returns of 6.5 percent. At the beginning of the
New Millennium, the Yale University Investment office
assumes an expected real return of 2 percent for bonds,
with risk (standard deviation) of 10 percent.
Combining mean-reverting tendencies with the
observation that the equity risk premium seems to
decline secularly justifies an assumption for U.S. equity
returns of 6 percent in real terms, with a standard
deviation of 20 percent. Foreign developed markets
return levels are assumed to be 6 percent real, with risk
of 20 percent, matching expectations for U.S. equities,
while corresponding closely to historical levels for
3DJH 208
developed foreign markets. Expected real returns of 8
percent compensate holders of emerging market equities
for accepting increased risk of 30 percent standard
deviation of returns.
Alternative assets exist outside established markets. No
benchmark returns provide guidance to investors seeking
to model asset characteristics. Past data, limited in scope,
generally describe active manager returns, with results
inflated by substantial survivorship bias. Absolute return
investing is dedicated to exploiting inefficiencies in
pricing marketable securities. Absolute return managers
attempt to produce equity-like returns uncorrelated to
traditional marketable securities through pursuit of
investments in event-driven and value-driven strategies.
Event-driven strategies, including merger arbitrage and
distressed security investing, depend on the completion
of a corporate finance transaction such as a merger or
corporate liability restructuring. Value-driven strategies
employ offsetting long and short positions to eliminate
market exposure, relying on market recognition of
mispricings to generate returns. Absolute return
investments generally involve transactions with
relatively short time horizons, ranging from several
months to a year or two.
Real estate markets provide dramatically cyclical
returns. Real estate embodies characteristics of both debt
and equity. Lease payments, the contractual obligations
of tenants, resemble fixed income instruments, while the
propertys residual value contains equity-like attributes.
Because real estate data come predominantly from
infrequently conducted appraisals, reported returns fail to
capture true economic volatility.
Private equity consists primarily of venture capital and
leveraged buyout participations, assets that respond to
market influences in a manner similar to marketable
equities. In fact, both venture and buyout investments
resemble high-risk equity assets. Since fundamental
characteristics of private investments created through
financial engineering suggest strong similarity to
marketable security counterparts, the argument for
segregating such private assets rests primarily on
differences in liquidity.
A stronger justification for treating private equity as a
distinct asset class stems from value-added management
by investment principals. Superior potential for value
creation, combined with liquidity and structural
differences, supports treatment of private equity as a
distinct asset class. Illiquidity and higher risk in private
assets demand a substantial premium over domestic
equitys expectations of 6 percent returns with 20 percent
risk. Assuming that private equity investments generate
12.5 percent returns with a risk level of 25 percent
represents an appropriately conservative modification of
the historical record of 19.1 percent returns accompanied
by a 20.0 percent risk level.
Under normal circumstances, bond returns exhibit high
positive correlation to stock returns. With unexpected
inflation, the long-term correlation between stocks and
bonds proves to be low, providing substantial
diversification to the portfolio. During periods of
deflation, low or negative correlation between stocks and
bond helps to diversify portfolio assets.
Despite mean-variance optimizations potential for
positive contribution to portfolio structuring, dangerous
conclusions may be reached if poorly considered
forecasts enter the modeling process. Investors relying
on backward-looking data in cyclical markets invite
whipsaw. In the deeply cyclical real estate market,
historical data suggest high allocations at market peaks
(when returns have been high and risks low) and low
allocations at market troughs (when returns have been
low and risks high).
Interpreting simulated results requires a combination of
quantitative and qualitative judgment. Some portfolios
fall from consideration on the basis that they are
dominated by others that have lower probabilities of
failing to meet each of the goals. Other portfolios fail
because they satisfy one goal at the expense of the other.
Simulations liberate mean-variance analysis from
another of its practical limitations: the use of one-year
investment periods. Theoretically, mean-variance
optimization ought to be conducted for periods
commensurate with the investment horizon of the
investor. Three-year, five-year, or even ten-year periods
3DJH 209
would be appropriate for most long-term investors.
Unfortunately, data limitations force the use of annual
periods. Reasonably long time series of data do not exist
for many asset classes, including foreign equities, real
estate, venture capital, and leveraged buyouts. Without a
long time series, investigators lack a sufficient number of
independent three-year, five-year, or ten-year data points
to draw robust conclusions.
Failure to achieve investment goals defines portfolio risk
in the most fundamental way. Goals, and risks following
therefrom, must be described in a manner allowing
investors to understand the trade-offs between various
portfolios. By evaluating portfolios in terms of
probabilities of maintaining purchasing power and
providing stable returns patterns, investors understand
and choose among possibilities defined in the context of
criteria directly relevant to the investors own objectives.
Portfolios generated through a combination of mean-
variance optimization and forward-looking simulation
suffer from a number of limitations. The results depend
on assumptions regarding future returns, risks, and
covariances. If the quality of return and risk assumptions
happened to represent the greatest hurdles, conclusions
reached through quantitative analysis would still be quite
robust. More serious problems stem from instability in
the risk and covariance characteristics of asset classes.
Questions regarding the nature of distributions of
security returns and the stability of relationships between
asset classes pose serious challenges to quantitative
modeling of asset allocation.
Portfolio Management
The degree of risk assumed in pursuit of investment
returns constitutes the core issue in investment
management. By determining which risky assets are held
and in what proportions, the asset allocation decision
resides at the center of portfolio management
discussions. If investors allow actual portfolio holdings
to differ materially from asset class targets, the resulting
portfolio fails to reflect the risk and return preferences
originally expressed through the asset allocation process.
By holding assets in proportion to policy targets, and
generating asset class returns commensurate with market
levels, investors improve their odds of achieving
investment goals without slippage.
Dealing with the over- or under-allocation resulting from
illiquid positions creates a tough challenge for the
thoughtful investor. Portfolio managers willingly accept
the risks associated with active management, expecting
that investment skill will ultimately provide positive
results. But because the expected excess returns arrive in
unpredictable fashion, if at all, the actively managed
asset class might suffer from periods of material
underperformance, opening a gap between reality and the
hoped-for active management result. Leverage, both
explicit and implicit, poses another challenge to faithful
implementation of policy asset allocation targets.
Inherent in certain derivatives positions, leverage lurks
hidden in many portfolios, coming to the light only when
investment disaster strikes.
Most market participants treat risk with little
sophistication. Portfolio managers spend enormous
amounts of time, energy, and resources on asset
allocation projects, implement the recommendations, and
then let portfolio allocations drift with the markets. After
establishing asset allocation policies, risk control
requires regular rebalancing to policy targets.
Movements in the prices of financial assets inevitably
cause asset class allocations to deviate from target levels.
For instance, a decline in U.S. stock prices and an
increase in bond prices leads stocks to be underweight
and bonds to be overweight relative to target, causing the
portfolio to have lower than desired expected risk and
return characteristics. To restore the portfolio to target
allocations, rebalancing investors purchase stocks and
sell bonds.
Investors debate the frequency with which portfolios
should be rebalanced. Some follow the calendar,
transacting monthly, quarterly, or annually. Owners of
private assets must modify rebalancing activity. At any
point in time, illiquid holdings of venture capital,
leveraged buyouts, and real estate are unlikely to match
targeted levels. Cash, bonds, and absolute return
investments provide reasonable temporary alternatives
for private asset underallocations.
3DJH 210
The strategy of investing underallocations of private
assets in fundamentally similar marketable securities
holds superficial appeal. For instance, while attempting
to build a venture capital portfolio, allocation shortfalls
might be invested in a portfolio of small technology
stocks. Unfortunately, the strategy exposes investors to
the risk that venture partnerships call funds when
technology stocks trade at depressed levels, causing sales
to be made at an inopportune time. Using short-duration,
lower-risk assets to substitute for generally higher-return
private assets decreases expected portfolio return and
risk levels; the opposite result occurs when reducing
marketable security positions to accommodate a private
equity overweighting.
Rebalancing ensures that investors face the risk profile
embodied in the policy portfolio. By allowing portfolio
allocations to drift with the whims of the market,
portfolio risk and return characteristics change
unpredictably. In fact, over long periods of time, without
rebalancing, portfolio allocations move toward the
highest return asset, increasing the overall risk level of
the portfolio. Deviations from benchmark returns
represent an important source of portfolio risk. Among
the powerful ways in which asset classes might differ
from benchmarks are with respect to size, sector, and
style.
Purposeful, thoughtful strategic bets might generate risk-
adjusted excess returns for the portfolio. Strategic
portfolio biases add value only if implemented in a
disciplined fashion, after thoughtful analysis, with an
appropriately long investment horizon.
Strong biases within asset classes may reward strong-
willed, adventuresome investors, but they pose serious
danger to investors with weak hands. The temptation to
fire underperforming managers often proves too great to
resist. When underperformance stems from an
underlying portfolio bias, the fund exposes itself to a
potential whipsawfiring a manager with the wind in its
face and hiring a manager with the wind at its back, all
done just as the wind is about to change.
By following standard Wall Street practice of referring to
many reinvestment strategies as arbitrages, market
participants obtain a false sense of security. Websters
Dictionary defines arbitrage as the often simultaneous
purchase and sale of the same or equivalent security (as
in different markets) in order to profit from price
discrepancies. While occasional mispricings of futures
contracts for stocks and bond relative to cash markets
provide fleeting arbitrage opportunities, other so-called
arbitrages do not involve the same or equivalent
security, thereby exposing assets to substantial risk.
When active management results appear too good to be
true, they probably are. As much as people want to
believe that success comes from intelligence and hard
work, good fortune generally plays at least a supporting
role. Investors must have sufficient confidence in
investment strategies to increase commitments when
inevitable setbacks occur.
Placing asset allocation targets at the center of the
portfolio management process increases the likelihood of
investment success by ensuring that portfolios rest on the
stable foundation of policy targets. Disciplined
rebalancing techniques provide the basis for creating
portfolios that reflect articulated risk and return
characteristics. Attractive investment opportunities
frequently contain elements of illiquidity, introducing
some rigidities into a portfolios asset allocation. By
forcing investors to hold positions inconsistent with
targeted levels, illiquid assets force overall portfolio
characteristics to deviate from desired levels, creating
challenges for disciplined rebalancing activity.
While successful active management programs
eventually create value, investors face the interim
possibility of experiencing periods of underperformance.
Many sensible investment strategies require time
horizons of three to five years, introducing the likelihood
that even ultimately successful decisions appear foolish
in the short run. When market prices move against
established positions, investors with strong hands add to
holdings, increasing the benefit from active
management. Conversely, sensible investors trim
winning positions, preventing excessive exposure to
recently successful strategies. Leaning against the wind
3DJH 211
proves to be an effective risk-control measure. Many
high-profile investment disasters in recent years involve
losses stemming from leverage lurking beneath the
surface of portfolio management activities. Avoiding
disaster requires thorough understanding of the sources
and magnitude of exposure to leverage in an investment
fund.
Traditional Asset Classes
Bonds contribute diversification. Under normal
circumstances, the stabilizing influence of bond positions
comes at the opportunity cost of low relative returns.
When conditions fail to meet expectations, bonds
diversify. Unexpected inflation damages fixed income,
while unanticipated deflation causes bonds to shine.
Marketable equities are the primary driver of investment
returns in traditional portfolio schemes, providing the
long-run gains necessary to support institutional
activities. Ownership of interests in corporate enterprises
generates superior results for patient investors with
sufficiently long holding periods.
The efficiency of pricing in fixed income markets leaves
little room for successful active management.
Government bonds trade in the most competitive market
in the world, allowing no opportunity for active
managers to create an edge. Large-capitalization U.S.
equities operate in a similarly efficient environment,
presenting few, if any, opportunities for value-added
management. Smaller-capitalization domestic stocks
trade in less efficient markets, affording thoughtful
investors the possibility of beating the market. Since the
evolution of overseas financial markets lags the
development of the U.S. investment industry, less
heavily researched foreign securities often present
superior active management opportunities. Owners of
marketable securities incur costs imposed by agency
activity, as the stewards of corporate assets pursue self-
interest at the expense of providers of debt and equity
capital.
The role that fixed income plays depends critically on
the economic and financial environment that investors
face, with bonds exhibiting the strongest diversifying
characteristics in periods of unanticipated inflationary or
deflationary price changes. Investors frequently own
more fixed income than necessary to protect against
hostile financial environments, leading to behavior that
undermines the fundamental purpose of holding bonds.
Confronted with a larger-than-ideal allocations to fixed
income, investment managers often seek to enhance
returns by accepting credit, option, and currency risk.
Although under normal circumstances, risky bonds
might generate superior returns, investors face likely
disappointment in times of financial stress.
Historical returns amount to 3.8 percent per annum for
cash, which reduces to a paltry 0.7 percent year after
adjustment for inflation. If investors operate with time
horizons of several years, cash constitutes a risky asset.
Holding-period returns become uncertain as investors
roll over maturing cash instruments into new investments
at then-market rates. In contrast, when employing a five-
year investment horizon, the five-year zero coupon bond
with its fixed nominal return represents the risk-free
asset.
Some investors argue that cash provides necessary
liquidity for endowment funds, ignoring the massive
amounts of liquidity resident in institutional portfolios.
Interest income, dividend payments, and rental streams
provide liquid cash flows, facilitating the ability of the
investment fund to meet spending distribution
requirements. Natural turnover of assets provides another
source of funds. Bonds mature, companies merge, and
private assets become liquid, serving as sources of cash
flow for the institution. Manager sell decisions create yet
another set of liquidity events.
Although bond owners occasionally outperform
stockholders, sometimes for extended periods, equity
positions deliver superior returns over sufficiently long
time frames. The portfolio construction process for long-
term investors begins with the presumption of a heavy
commitment to equities. The principal justification for
incurring expected opportunity costs by investing in
bonds and real estate stems from the diversification they
provide when marketable equities perform poorly. At the
other end of the return continuum, venture capital and
leveraged buyouts claim a place in institutional
3DJH 212
portfolios by promising returns in excess of marketable
equities. As the core asset, equity holdings set the
standard for evaluating other assets.
From an investors perspective, the fundamental
difference in choosing among companies in the global
marketplace lies in the currency exposure associated
with owning stocks of foreign companies, suggesting a
separation of domestic from foreign holdings. Further
division between developed markets and emerging
markets allows investors to calibrate exposure to the
fundamentally riskier less developed markets.
Over long periods of time, domestic stocks tend to track
inflation, protecting holders from price-level-induced
declines in asset purchasing power. Corporate
profitability constitutes the basic force driving returns to
holders of marketable equities. Investors pursuing active
management of marketable equities find few
opportunities to exploit among larger-capitalization
domestic securities, leading prudent investors to passive
management of the more efficiently priced assets.
Mispricings become more prevalent in the less-well-
followed small-capitalization and foreign security
markets, with the emerging markets providing the richest
set of active management opportunities. By focusing
management efforts in arenas with the greatest degree of
opportunity, investors increase the likelihood of
producing market-beating results.
Success favors rigorous, fundamental, bottom-up
approaches to assessing forward-looking estimates of
investment cash flows. Seeking to acquire assets at
below fair value, disciplined investors combine
quantitative techniques with informed market judgment,
creating concentrated portfolios designed to generate
handsome risk-adjusted returns. By seeking to identify a
clear, compelling set of strengths prior to initiating a
relationship with an active manager, investors increase
the likelihood of success. Managers choose to approach
investing somewhere along the bottom-up/top-down
continuum. Bottom-up investment involves selecting
stocks based solely on the relative attractiveness of
individual securities; top-down investing incorporates
only high-level macro factors in portfolio structuring.
Other important dimensions of active management
include fundamental versus technical, value versus
growth, quantitative versus judgmental, and concentrated
versus diversified. The positioning of investment
management firms along each of these vectors drives
portfolio performance in fundamental ways.
Extreme growth and extreme value strategies each rest
on naive foundations, exposing practitioners to serious
dangers. Both approaches focus on the past, ignoring
forward-looking information important to determining
security prices. Value investors examine the relationship
between market price and historical cost of assets (book
value) or between market price and historical earnings.
Extreme growth strategies embody similar flaws.
Projecting continuation of historical growth rates into the
future ignores powerful mean reverting tendencies.
Reasonable security selection techniques rely on
forward-looking approaches, attempting to uncover what
will happen.
By providing substantial levels of return over extremely
long periods of time, equity holdings benefit patient
investors willing to hold positions through thick and thin.
Although equity ownership provides the bedrock for
constructing institutional portfolios, investors often
exhibit excessive enthusiasm for equities after extended
stretches of superior relative performance. While owning
equity securities provides enormous benefits to steadfast
investors, the stock markets long-term performance
comes with occasionally troubling volatility and
sometimes extended spells of miserable returns. By
limiting stock market exposures to levels that fund
managers can maintain comfortably, investors avoid the
whipsaw of buying high and selling low, and ensure
receipt of the benefits of long-term exposure to equity
markets.
Alternative Asset Classes
Alternative asset pricing lacks the efficiency typical of
traditional marketable securities, leading to opportunities
for astute managers to add substantial value in the
investment process. Only by generating superior active
returns do investors realize the promise of investing in
alternative assets.
3DJH 213
Absolute return investing, a relatively new asset class,
consists of inefficiency-exploiting marketable securities
positions exhibiting little or no correlation to traditional
stock and bond investments. Absolute return positions
provide equity-like returns, yet also possess powerful
diversifying characteristics. Merger arbitrage represents
a core event-driven absolute return strategy, with results
related to the managers ability to predict the probability
that a deal will close, its likely timing, and the expected
value of the consideration for the transaction. Even
though for short time periods, absolute return strategies
may show high correlation to marketable equities, over
reasonable investment horizons, assets driven by
fundamentally different factors produce fundamentally
different patterns of returns.
Value-driven absolute return strategies rest on the
managers ability to identify undervalued and overvalued
securities, establish positions, and reduce market
exposure through hedging activity. While value-driven
investment strategies share with event-driven approaches
the lack of correlation with traditional marketable
securities, investors face a longer time horizon for value-
driven portfolios. Expected holding periods for merger
arbitrage and distressed securities correspond to the
anticipated date of corporate combination or bankruptcy
resolution, implying a reasonably short duration for
event-driven strategies. In contrast, value-driven
positions lack the clear valuation realization triggers
present in event-driven investing. To the consternation of
fund managers, undervalued stocks frequently decline in
price, while overvalued positions often rise in value,
leading to poor performance relative to expectations.
Like other alternative assets, absolute return investments
lack an investible benchmark, forcing investors to look
elsewhere for defining characteristics of the asset class.
Because of a limited institutional history, absolute return
investing poses even greater challenges to the
understanding of its quantitative attributes than do real
estate, leveraged buyouts, and venture capital. In terms
of survivorship bias, absolute return suffers from the
combination of relative immaturity and a fairly high
degree of liquidity. Immaturity suggests a substantial
amount of flux, as managers posting attractive risk-
adjusted returns enter the realm of institutional
acceptability, adding distinguished records to the store of
absolute return knowledge. Liquidity allows easy entry
and exit, creating instability beneath the surface of the
pool used to evaluate manager returns.
Without useful historical data, investors turn to the
underlying characteristics of the investment strategies
that make up the asset class, hoping to develop a set of
return, risk, and covariance attributes without guidance
from a robust series of past performance numbers. After
adjusting for fees and incentive compensation, investors
employing a combination of event-driven and value-
driven strategies might reasonably expect nominal
returns of 10 percent to 12 percent, more or less
equivalent to the long-term return to domestic equities,
with lower risk and essentially no correlation.
Real estate holdings play a special role in investors
portfolios, providing protection against unanticipated
increases in inflation. Asset prices of high-quality, well-
located, fully leased buildings respond directly to
inflation as the cost of replacing properties increases
along with rising price levels. Income flows rise as
leases mature and new leases incorporate inflationary
increases, insulating real estate owners from the
debilitating effects of unexpected inflation on fixed
payment streams. Under normal circumstances, real
estate and bonds lend a measure of stability to portfolios,
as high levels of current cash flow in the form of rent
and interest payments moderate the fluctuations in price
required to adjust for changes in expected returns. Over
long periods of time, the provision of year-to-year
volatility dampening comes at a substantial cost. Only
because inflationary or deflationary conditions
occasionally surprise investors do diversifying assets
play a major role.
Unanticipated inflation benefits real estate positions and
damages bond holdings, while unexpected deflation
helps bond positions and hurts real estate holdings. Like
all other private asset classes, real estate lacks a broad
collection of properties defining an investible benchmark
for investors. Unlike venture capital and leveraged
buyouts, market observers benefit from access to
3DJH 214
information on the performance of large numbers of
individual real estate properties.
In any event, the true volatility of the real estate property
index likely exceeds the observed standard deviation of
returns, which are dampened by the appraisal-based
means that investors employ to value real estate assets.
Lacking a ready market for pricing assets, investors hire
appraisers to assess market values, using discounted cash
flows, comparable sales, and replacement cost as
valuation metrics. Conducted infrequently, often by the
same firm year after year, the appraisal process smoothes
the observed series of prices, understating true volatility.
For the two decades ending in 1998, REITs provided an
11.4 percent annualized return relative to a 9.4 percent
result for a broad-based collection of privately held
properties. The superior REIT results, likely driven by
the positive impact of leverage, came at the price of
higher volatility of 16.4 percent standard deviation of
returns relative to a 6.9 percent risk level for the
unlevered property index.
Regardless of the observed differences in behavior
between public and private holdings of real estate, in the
final analysis REITs represent real estate. Long-term
investors favor REITs when portfolios trade at a discount
to private market value, avoiding high-priced private
assets, and sell REITs when shares trade at a premium,
pursuing relatively attractive private properties. Real
estate lends itself to active management because
mispricings create opportunities for nimble investors to
take advantage of market anomalies.
Properly selected investments in leveraged buyouts and
venture capital contain the potential to generate high
returns relative to other equity alternatives, providing a
means to enhance overall portfolio results. The superior
private equity returns come at the price of higher risk
levels, as investors expose assets to greater financial
leverage and more substantial operating uncertainty.
Private company managements tend to operate with
longer time horizons and lower risk aversion, pursuing
strategies that promote creation of enterprise value at the
expense of personal job security. Because private deals
generally require management to take material
ownership stakes, interests of outside owners and
operating management align. Leveraged buyouts respond
to many of the same factors that influence marketable
securities. In fact, buyouts often simply represent
turbocharged equity, with leverage magnifying the
results good or bad produced by a particular
company.
Although early-stage venture capital lacks the superficial
similarities that leveraged buyouts share with marketable
equities, strong links exist between venture investing and
the stock market. Market action influences the price at
which venture investors enter an investment and plays an
even more critical role in the price at which investors
exit successful positions. In their most basic form,
venture and buyout investing represent a riskier means of
obtaining equity exposure. The high leverage inherent in
buyout transactions and the early-stage nature of venture
investing cause investors to experience greater
fundamental risk and to expect materially higher
investment returns.
If two otherwise identical companies differ only in the
form of organization one private, the other public
the infrequently valued private company appears much
more stable than the frequently valued publicly traded
company. Although both companies react in identical
fashion to fundamental drivers of corporate value, the
less volatile private entity boasts superior risk
characteristics based solely on mismeasurement of the
companys true underlying volatility. While a fair
portion of the observed diversification provided by
private equity stems from the infrequent valuations
accorded illiquid assets, some of the lack of correlation
between marketable and private assets results from
value-added strategies that private firms pursue.
Pure financial engineering holds little interest for serious
private equity investors, since providing financing
represents a commodity-like activity with low barriers to
entry. Private investors offering only capital operate in
an extremely competitive market with reasonably
efficient pricing mechanisms. Private equity
opportunities become particularly compelling when
managers pursue well-considered value-added strategies.
3DJH 215
Head-to-head comparisons of historical risk and return
data for marketable equities and private investments
likely overstate the attractiveness of private assets by
understating true risk levels. Infrequent valuations of
private positions cause smoothing of results, reducing
the observed volatility of private equity. The telling
comparison between buyout returns and equivalent-risk
marketable security returns indicates that the vast
majority of investors in buyout partnerships failed to
earn results to compensate for risk.
The relatively short span of institutional private equity
investment activity weakens any general conclusions
drawn from the available data set. Venture capital and
leveraged buyout returns beginning in 1980 represent
samples drawn from an unusual capital market
environment. Leveraged buyout transactions, for
example, occur almost entirely under conditions of
declining interest rates and rising equity valuations,
fanning the wind at the back of private equity investors.
Since available data fail to include extended periods
providing a poor backdrop for private investing,
observed results paint an inflated picture of private
equity potential, overstating likely future performance.
Burdened by staggering fees and characterized by well
above marketable equity risk levels, a broad collection of
private equity funds would likely produce returns far
from sufficient to compensate for the risk incurred.
Investors justify the inclusion of private equity in
portfolios only by selecting top-quality managers
pursuing value-added strategies with appropriate deal
structures. The character of a private equity funds
investment principals constitutes the most important
criterion in evaluating the merits of a buyout or venture
investment. Driven, intelligent, ethical individuals
operating in a cohesive partnership possess an edge
likely to translate into superior investment results. On the
other end of the spectrum, individuals willing to cut
corners operationally, intellectually, or ethically
place an investors money and reputation at risk.
Comprehensive due diligence requires substantial effort.
Personal and professional references provided by the
prospective fund managers provide an initial set of
contacts. Because of the inevitable selection bias in a
hand-picked reference list, sensible investors seek
candid, confidential assessments from other individuals,
including former business colleagues, professional
relationships, and personal acquaintances. Over time,
investors develop networks that facilitate reference
checking, increasing confidence in the quality of
decision making. Careful investors make skeptical calls,
actively looking for potential issues. Going through the
motions by conducting superficial checks adds nothing
to the due diligence process.
Investment Advisers
Identifying a portfolio that merely beats the market fails
to define success, because managers must choose
securities that generate returns sufficient to cover
management fees, transactions costs, and market impact
and beat the market. Only when compelling evidence
suggests that a strategy possesses clear potential to beat
the market should investors abandon the passive
alternative. Top-notch managers invest with a passion,
working to beat the market with a nearly obsessive
focus. Many extraordinary investors spend an enormous
amount of time investigating investment opportunities,
continuing to labor long after rational professionals
would have concluded a job well done. Great investors
tend to pursue the game not for profit but for sport.
Due diligence on the principals of an investment
management organization provides critical input into the
manager selection process. Spending time with manager
candidates allows assessment of whether the manager
exhibits the characteristics of a good partner. Extensive
reference checking, questioning individuals on manager-
supplied lists, confirms or denies impressions gathered
earlier in the due diligence process. Contacts with people
outside of an official reference list, including
competitors, provide opportunities to evaluate the quality
of a prospective managers business dealings and
integrity level.
Investment Process
Most aspects of investment philosophy embody an
intuitive appeal, allowing groups to adopt and follow
sensible principles without great difficulty. Among the
3DJH 216
less challenging principles are maintaining an equity
bias, adopting appropriate diversification policies, and
structuring investment relationships to align interests.
Two important tenets of investment management
contrarian thinking and long-term orientation create
great difficulties for governance of endowment funds.
Unless carefully managed, group dynamics frequently
thwart contrarian activities and impose shorter-than-
optimal time horizons on investment activity. The
management of perpetual life assets, explicit recognition
of the discontinuity between personal and institutional
time frames and adequate continuity in management and
governance provide the only practical response.
Investors seeking short-term success will likely be
frustrated by markets too efficient to offer much in terms
of easy gains. As investors successfully exploit one
short-term inefficiency, it must be replaced by another
attractive position followed by another, and yet another,
ad infinitum. Judging long-term pools of assets by
trailing twelve-month performance numbers induces the
wrong kind of thinking, emphasizing short-term
consensus-oriented investing. Varying too far from the
group consensus exposes the manager to the risk of
being labeled unconventional. If the institution fails in its
unusual approach, the policy will likely be abandoned
and the investment staff will likely be looking for new
positions. In contrast, had the institution failed with a
standard institutional portfolio, policies may still be
abandoned, but investment professionals would likely
remain gainfully employed.
Significant differences between successful investment
operations and other well-run business activities cause
the application of standard corporate management
techniques to fail in the investment world. Most
businesses grow by feeding winners. Putting resources
behind successful products generally leads to larger,
increasingly impressive gains. Ruthless cuts of failed
initiatives preserve corporate resources for more
attractive strategies. In contrast, investment success
generally stems from contrarian impulses. Winners
should be viewed suspiciously, with consideration given
to reducing or even eliminating previously successful
strategies.
Contrarian investing represents more than a reflex action,
causing investors to buy the dips. In fact, going against
the grain will likely appear foolish in the short run as
already cheap assets become cheaper. causing the true
contrarian to appear fundamentally out of sync with
investors more successfully in tune with the market.
Unfortunately, overcoming the tendency to follow the
crowd, while necessary, proves insufficient to guarantee
investment success. By pursuing ill-considered,
idiosyncratic policies, market players expose portfolios
to unnecessary, often unrewarded risks. While courage to
take a different path enhances chances for success,
investors face likely failure unless a thoughtful set of
investment principles undergirds the courage.
Responsible fiduciaries best serve institutions by
following basic investment principles, avoiding the
temptation to pursue policies designed to satisfy specific
individual agendas.
Policy decisions concern long-term issues that inform the
basic structural framework of the investment process.
Strategic decisions represent intermediate-term moves
designed to adapt longer-term policies to more
immediate market opportunities and institutional
realities. Trading and tactical decisions involve short
time horizon implementation of strategies and policies.
Decision makers spend too much time on relatively
exciting trading and tactical decisions at the expense of
the more powerful, yet more mundane policy decisions.
A decision-making process designed to place appropriate
emphasis on policy decisions increases an investors
chances of winning.
In many ways, establishing policy asset allocation targets
represents the heart of the investment process. No other
aspect of portfolio management plays as great a role in
determining an investors ultimate performance, and no
other statement says as much about the character of an
investor. Establishing a framework focused on policy
decisions represents the most fundamental obligation of
investment fiduciaries. Asset allocation targets ought to
be reviewed once (and only once) per year. An annual
review allows managers to make changes necessary to
move portfolios in desired directions. Perhaps more
important, limiting policy discussions to the assigned
3DJH 217
meeting diminishes the possibility of damage from ill-
considered moves made in response to the gloom or
euphoria characterizing current market conditions. In the
absence of a disciplined process for articulating
investment recommendations, decision making tends to
become informal, even casual. Written recommendations
provide a particularly useful means of communicating
investment ideas. The process of drafting memos often
exposes logical flaws or gaps in reasoning. Knowledge
that a critical audience of colleagues and committee
members reviews investment memos stimulates careful,
logical exposition of proposals.
Copyright 2000, The Free Press. Used by permission.
3DJH 218
The inIormation and opinions in this report were prepared by Morgan Stanley & Co. Incorporated ('Morgan Stanley). Morgan Stanley has no obligation to
tell you when opinions or inIormation in this report change. Morgan Stanley and its aIIiliate companies are involved in many businesses that may relate to
companies mentioned in this report. These businesses include market making and specialized trading, risk arbitrage and other proprietary trading, Iund
management, investment services and investment banking.
This report is based on public inIormation. Morgan Stanley makes every eIIort to use reliable, comprehensive inIormation, but we make no representation
that it is accurate or complete. We are not oIIering to buy or sell the securities mentioned or soliciting an oIIer to buy or sell them.
Morgan Stanley, Morgan Stanley DW Inc., aIIiliate companies, and/or their employees may have an investment in securities and derivatives oI securities oI
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The securities discussed in this report may not be suitable Ior all investors. Investors must make their own investment decisions based on their own
investment objectives and Iinancial position. Morgan Stanley recommends that investors independently evaluate each issuer, security or instrument
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rates or Ioreign exchange rates, changes in the price oI securities or other indexes in the securities markets, changes in operational or Iinancial conditions oI
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necessarily a guide to Iuture perIormance.
This publication is disseminated in Japan by Morgan Stanley Japan Limited and/or Morgan Stanley Nippon Securities Limited; in Singapore by Morgan
Stanley Dean Witter Asia (Singapore) Pte., regulated by the Monetary Authority oI Singapore; in Australia by Morgan Stanley Dean Witter Australia
Limited A.B.N. 67 003 734 576, a licensed dealer, which accepts responsibility Ior its contents; in certain provinces oI Canada by Morgan Stanley Canada
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in the United States by Morgan Stanley & Co. Incorporated and Morgan Stanley DW Inc., which accept responsibility Ior its contents; and in the United
Kingdom, this publication is approved by Morgan Stanley & Co. International Limited, solely Ior the purposes oI section 21 oI the Einancial Services and
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Additional inIormation on recommended securities is available on request.
Managing Editor
Regina B. Maher
(regina.mahermorganstanley.com)
3DJH 219
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Asset Allocation Principles

A Resource for Private Investors

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