Many in the media have laid the blame for recent stock market volatility at Greece’s door.

The fact is that, economically at least, what happens to Greece just doesn’t matter much to the rest of the world. Why? According to the World Bank, the total economic output of Greece is less than 2% of the European economy and only 0.6% of the world economy.(1) The economy of the Dallas-Fort Worth metropolitan area is the same size as Greece. Houston’s economy is bigger.(2)

With that perspective, the Greek debt situation doesn’t seem as alarming for U.S. investors as many of the news headlines have made it out to be. A Greek debt default would be no more likely to sink the U.S. economy than a Dallas- or Houston-based default would be to sink Europe.

That said, it would be more serious if a Greek default precipitated defaults in other countries — Spain, Italy, Ireland, Hungary and Portugal being those most often named. The economies of Ireland, Hungary and Portugal are no more significant than Greece, but taken together Spain and Italy make up 20% of Europe’s economy, and 6.8% of the world. A default in Spain and Italy would be much more serious than a default in Greece.

Spain and Italy, however, are far stronger than Greece. Greece is simply a third-world country that, having vastly overspent for years, has no hope of ever repaying its debts. Apparently Greece had to manufacture fraudulent figures even to gain admission into the EU.(3) Spain and Italy, in contrast, are core EU members whose economies are much stronger and more resilient.  Thus, the odds that Spain or Italy will default on their sovereign debt at this time seem remote.

Also bear in mind that even a government default in an economic basket-case like Greece would not mean that all sovereign debt would go unpaid. Recent publications suggest that even with no EU assistance the Greek government could repay all but about a quarter of its debt. Even worst-case, debt strain in Spain and Italy is far less severe.

This is not to deny that there is real investment risk in Europe. Indeed, the European debt situation is likely to result in austerity programs across the continent that will somewhat reduce European economic activity for the next few years. And reduced economic activity in Europe will probably reduce economic activity around the world, simply because the Europeans will be buying fewer products and services. It’s reasonable to expect the market to factor these considerations into stock prices, as it apparently has lately.

But ultimately the question is, what should you do about the European debt situation as an investor? Sell European stocks? Sell all stocks? Sit tight?

If you have a well thought out, well-diversified portfolio, my recommendation is to sit tight. Current stock prices already reflect all the information that is known today. Remember that the markets don’t go down on bad news. They go down when news is worse than expected. Stock market participants already expect a worsening European economy, and stock prices reflect that prospect too. So while markets may go down further this summer, there is no guarantee that they will. In the short term markets are unpredictable. They could turn around at any moment and start back up. If you dumped all your stocks just before a market recovery, where would that leave you?

Remember why you are in the stock market in the first place. The best reason to invest in stocks is for long-term inflation protection. Inflation seems dormant now … but it could pick up at any time. Personally I think that rising inflation will become a significant concern within the next two to three years, fueled by all of the government budget deficits around the world.

And remember why you own European stocks. All the data available indicate stocks worldwide provide good diversification. Stocks in all countries have their good times and bad times, but spreading one’s assets around the world has been shown to increase long-term return while reducing portfolio volatility. That’s a hard combination to beat.

Assuming your allocation to European stocks is part of a sensible plan that continues to reflect your long-term goals, I recommend you hold onto them. Now is not the time to bail.

 I enjoyed reading Jason Zweig's most recent column, "Holding Brokers To a Higher Standard,” in The Wall Street Journal, and I think you will too.

 Under current regulations, Registered Investment Advisor firms like Posey Capital are subject to the fiduciary standard, which means we must put clients' highest interests before our own, and we must tell you about any conflicts of interest we may have. In contrast, most brokers and insurance agents are only subject to the suitability standard. If two equally "suitable" products are available and one earns the broker a higher commission (read: may cost you more),  he or she can recommend the costlier product ... and then keep mum about the conflict of interest. Really.

Currently under hot discussion in Congress is whether all financial intermediaries -- advisors, brokers and agents alike -- should be subject to the same standards. However the debate is resolved, Posey Capital will continue to consider our clients' highest interests first. We intentionally accept no commissions for any solutions we recommend -- that's $0.00. I think it's a lot easier to simply not have any conflicts of interest than to worry about disclosing them. It's my legal obligation, but it also just makes good sense. As one individual commenting on the WSJ article observed, "It really is too simple to be this complicated."

I’ve had it. I’m calling out an all-too-popular financial fallacy these days. It goes like this: “Stocks? Diversification? Who needs ‘em! Just look at the last ten years. 'The Lost Decade.' The S&P 500 Index was down for the whole decade. Stocks did nothing for us.”

Did stock investors really experience a “Lost Decade” from January 2000–December 2009? No. Where did this fallacy come from, then? It came from the mistaken belief that the S&P 500 Index represents all stocks.

Let’s get a grip. Sure the S&P 500 was down slightly from 2000–2009. But is the S&P 500 the only way to invest in stocks? Not by a long shot. The S&P 500 is an index of 500 largest US stocks. It leaves out over 8,000 publicly traded stocks. Consider the following:

As you can see, during this so-called Lost Decade there were plenty of positive returns to be captured around the world – and even here in the USA. The stock investor who wisely diversified across an appropriate range of the many stocks available via sensible, low-cost mutual funds (such as those available from Dimensional Fund Advisors) did not experience a Lost Decade. To illlustrate, a portfolio with 70 percent in the four equally weighted domestic stock asset classes and 30 percent in four equally weighted international asset classes would have ended the decade up by about 75 percent.

What does this mean? It means the investor who invested in stocks over the past ten years and didn't make money has only himself to blame. It means the S&P 500 is not the only stock asset class. It means that, despite its many recent obituaries in the popular investment press, diversification is alive and well.

This is not to say that you should invest all your money in stocks (far from it!), or dump all your money into far-flung asset classes you don't understand. Investing well is complicated, and you may need an expert financial advisor to help you build an intelligent portfolio of stocks and fixed income holdings that make sense for you. But don't give up on long-term, well-diversified investments. 

I ended my last blog by referencing an interesting study that demonstrated we humans tend to err on the side of optimism in our lives. Generally, a positive outlook is good for you. It’s probably helped many parents raise their teenaged children to adulthood, for example, without changing the locks on them even once.

But when it comes to expected returns on your investments, it’s best to be as realistic as possible. “The faith in fancifully high returns isn’t just a harmless fairytale,” says Wall Street Journal columnist Jason Zweig in a recent article exploring what financial experts had to say on the subject of market returns. He examined the expectations of trustee-level investors, economic professors, seasoned investment advisors and fellow financial journalists, and received opinions on hoped-for long-term market returns (after inflation, expenses and taxes) ranging from an anemic 0.5 percent per year to a feverish 22 percent per year.  

Overall, the data suggest that most investors’ expectations are too high. Way too high. Zweig cited a 2009 nationwide survey that indicated investors were expecting annual U.S. market returns of 13.7 percent during the next 10 years. He quipped, “What are we smoking, and when will we stop?”

OK, then what sort of long-term return expectations would be realistic for stocks? Lacking a crystal ball, single digits seem a far more prudent assumption than anything even close to double-digits -- especially if inflation stays as low as it is now.

Here’s why. According to financial economics, stock returns are driven by the “equity premium,” which is the amount stocks earn above the risk-free rate of one-month Treasury bills. The risk-free rate, in turn, is the rate earned above inflation. Translating that into a simple equation, it looks approximately like this:

Rate of Inflation + Risk-Free Rate + Equity Premium =
Expected Stock Returns

So what numbers do we plug in? As described above, current inflation rates are around 2.7 percent. Historically, the risk-free rate has earned about 0.7 percent. (It’s a relatively small return, precisely because it’s essentially risk-free.) Conservatively, the equity premium has hovered at around 4.8 percent over long time periods. So plugging in these numbers:

2.7 percent + 0.7 percent + 4.8 percent = 8.2 percent

Will your expected returns be exactly 8.2 percent? Of course not. For one, the math is based on historical returns, and nobody can predict the future so accurately. In addition, most investors temper their equity investments with fixed income, which offers a more stable ride, but also lowers expected returns.

The point is, particularly if inflation stays so low, the average rate of return on stocks over the next 20 years won’t be anywhere near 22 percent. It probably won’t approach the average U.S. investor's expectation of 13.7 percent over the next decade, either. 

Does 8.2 percent sound low to you? If so, consider that this is 5.5 percent more than the current 2.7 percent rate of inflation. That means, with a long-term, compounded rate of return of 8.2 percent for the equity portion of your portfolio, you should still be able to beat inflation by quite a lot and build real wealth through appropriate portfolio construction strategies. In future blogs, I’ll cover some of these techniques. 

In Part I of this blog, I covered the importance of a fee-only pricing structure as one of the two most important components in how my wife Šárka and I chose to define success when founding Posey Capital Management. In this Part II, I’ll address the second component: applying a passive investing strategy.

Passive investing seems deceptively simple, and yet it is the most disciplined and sophisticated way I know of to expect to achieve your investment goals.

·    Active investors -- Hope to beat the market by trying to make wily predictions about where stocks, sectors or the market as a whole is headed next. They try to buy future winners and sell future losers. 

·    Passive investors -- Assume that it is too hard to make these kinds of predictions in a generally efficient market. Besides, the increased costs of trying are highly likely to outweigh any benefits. Instead, the passive investor seeks to act on matters that are within his or her control: (1) fine-tuning the amount of market risk/reward in the portfolio to match personal investment goals, and (2) equally important, doing so as cost-effectively as possible.

To me, passive investing makes a whole lot of sense. But it doesn’t make for catchy headline news. The strategy doesn’t change much based on market whims, so maybe it’s not exciting enough to report on regularly. Like most people, I had to discover it on my own by looking past the popular press and big-name fund managers.  

My personal path to passive came through a Morningstar analysis I was conducting in the early 1990s, while still an active investment advisor. I came across a Dimensional Fund Advisors (DFA) fund that looked good to me, so I placed a buy order. Or, more precisely, I tried to place an order. I was shocked to learn that, to purchase DFA funds, I first had to be on their approved advisor list, which required that I attend their two-day educational seminar. Oh and, by the way, I would have to pay my own travel expenses.

When we founded Posey Capital, my corporate goal was to establish a rigorous, intellectual approach to investing based on analytics rather than hunches. I wanted a strategy that would withstand the test of time and various market conditions. So, despite — or maybe because of — the unusual requirements, I wanted to know more about DFA’s “odd” approach. Šárka and I decided to attend the seminar.

It turned out to be one of the single most intellectually stimulating experiences in my life. I learned how DFA builds its fund solutions according to decades of academic inquiry into the science behind capital markets, asset allocation and passive investing. No wonder they first wanted me to understand what they were about.

I realized I had found a strategic alliance with a mutual fund company that would enable me to pursue my corporate goal. Next, I was faced with a decision. I was convinced that passive investing was the right way to go, and that I could use DFA funds and a few other resources to do it. But how was I going to communicate the strategy to clients? I didn’t guess most folks would be interested in a two-day seminar. My compromise solution was to devise a presentation (really, a conversation) I can typically do in about three hours, to educate clients on how passive investing works, and why I recommend it.

I chose this approach before I knew for sure if it would work as a business strategy. Would investors commit to this level of education? For me, it was a choice I felt I had to make, because I strongly believe that taking the time to help my clients understand how and why they’re investing is in their best interest. More than a decade later, it’s a choice I would make all over again, in exactly the same way.

Whether or not you’re the resolution type, the arrival of a fresh new year offers as good an excuse as any to revisit life goals. What does “success” mean to you and yours? Allow me to share how my wife Sarka and I defined it for ourselves when we founded Posey Capital Management.

Before Posey Capital I started life as an accountant/CFO, became a corporate tax lawyer and launched my investment advisor career from within the insurance industry. These weren’t bad ways to earn a good living, and the years of experience gained during that time certainly helped us shape our firm into an effective and multifaceted service provider.

During my days as a lawyer, I discovered, you’re always in contention with someone. That’s because there’s always another side to every negotiation, and your job is to ensure that your side prevails. As an advisor, there isn’t – or at least shouldn’t be – “another side.” You can advocate for your client, conflict-free. I like that a lot, and so that’s one important way I have defined “success” for my firm.

There are a couple of ingredients I’ve found key to fulfilling my role as client advocate, helping clients define and pursue their own definitions for success. These are:

1.       Delivering our services in a fee-only pricing structure

2.       Applying the principles of passive investing to your investment portfolio

The Importance of Fee-Only

The two most common ways financial intermediaries are compensated for helping you invest are commission versus fee-only. Here’s an illustration that summarizes the differences between the two models.

With fee-only pricing, we are compensated for the advice we provide. As your portfolio grows, so does our compensation, which means our incentives are generally aligned with your own: to seek portfolio growth. In contrast, if we were to receive commissions for trades completed or products provided, we would be paid whether your portfolio shrunk, grew or remained the same. It’s also possible to be a fee-based advisor, primarily compensated through fees, but also paid commissions under certain circumstances. When Sarka and I were filling out the regulatory paperwork for establishing Posey Capital, we got to Section 13 of the Form ADV, Part II, where it asked us to disclose whether we received additional compensation from non-clients while dispensing advice to our clients. In other words, were we receiving any commissions along with our fees?

Hold the phone,” we said to each other. If we’re going to do what’s best for our clients, how can we check “Yes” to having outside interests? Shouldn’t our only source of compensation be from the clients we serve; i.e., fee-only? On the other hand, checking “No” meant that several promising opportunities from my existing book of business would have to be abandoned.

As a new firm, passing up likely business isn’t a decision made lightly. But it’s what we did … and do. Let’s not bring over any commission-based business, we agreed. We checked the “No,” box and we’ve never looked back. We’ve lived fee-only happily ever after. In my next blog, I’ll describe how adopting a passive investment strategy represents another key to my personal definition for success. In the meantime, I hope you and your family enjoy a happy, healthy 2010.

True or false: Investing in the stock market is riskier than heading to the bank and purchasing a CD?

Actually, this is a trick question because the answer is: It depends! It depends on what you mean by “risk.” When investing over the long haul, there are two types of risk to consider.

Investment Risk

When you invest in the stock market, your holdings might go up (reward) or they might go down (risk). These gains or losses show up as real dollars that you can see in your monthly account statements, and they can be exciting or scary to watch, depending on which way they’re headed. That’s investment risk.

Hands down, it is absolutely true that you face a lot more of this type of investment risk by participating in the stock market than by purchasing CDs or similar kinds of “fixed income,” where a penny saved is highly likely to be a penny earned. For better or worse, your CD’s monthly statement will pretty much look the same every month.

On the other hand, by investing in the stock market, you are expected (although not guaranteed) to earn more real return than from purchasing fixed income such as CDs — if you stay the course and stoically accept the required investment risk. Historically, that equity risk premium has been around 5 percent per year.

Compare this to inflation, which has been around 3 percent per year … and which brings me to my next point.

Inflation Risk

While stocks are more vulnerable to investment risk, fixed income is far more vulnerable to inflation risk, or the risk that the purchasing power of your money will decrease over time in the face of inflation.

Think of it like a leaky bucket, in which the drops of water being added (such as CD interest) aren’t enough to compensate for the hole in the bottom (inflation). Or, for a real example of how inflation impacts your spending power, consider the price of postage. It cost you $0.06 in 1970 versus today’s $0.44 to deliver the same letter.

Inflation risk can wreak havoc on your wealth. There are periods, sometimes lengthy and severe, during which purchasing power is so diminished by inflation that “safe” investments actually yield significant negative real returns when measured with their ability to keep pace with inflation. In addition, inflation risk is insidious, because the damage doesn’t show up us obviously negative numbers in your monthly returns statements. Dimensional Fund Advisors’ CEO David Booth provides a fascinating presentation on the subject, which I recommend you view for more details and specific data-driven illustrations on the subject.

Let’s return to our true/false question: Are stocks “riskier” than CDs? As is so often the case, the truth seems to lie between the two extremes. The best way to manage risk is by building a well-diversified portfolio that controls for inflation risk with equities and dampens investment risk with fixed income.

If you were strolling through the park and a clown wearing purple and yellow polka-dots wheeled past you on his unicycle, you’d probably notice him, right? If you were on a cell phone at the time, think again.

A study published in a recent issue of Applied Cognitive Psychology discovered that 75 percent of the cell phone users in the study suffered from “inattentional blindness.”(1) In other words, three quarters of them did not report seeing the clown.  Now, imagine if you put these same people behind the wheel of an SUV.

Regardless what you think about cell phone use, the study also illustrates how hard it is to keep track of everything at once. Juggling your child’s band practice with picking up cold medicine for your ailing spouse, working over the lunch hour on that critical paperwork, meeting the cable repair company “sometime between 1 pm and 3 pm,” and … Well, you get the idea.

How much time and energy do you have left for thoughtful reflection about your investments?  If you’re like most people, you end up having to make important long-term decisions about your money while surrounded by short-term distractions. To make matters worse, financial news often leaves people feeling as if they must react whenever something particularly good or bad happens in the markets.

Sure, I have my own life’s distractions just as anyone else does, and I enjoy spending time with my wife and our young son every chance I get. But as an independent investment advisor, I am able to devote my entire professional career to keeping clients’ best financial interests at heart, even when they may be incredibly busy with truly important things in their lives, such as taking care of their family or pursuing their personal and professional interests. For example, I can take the time that my clients cannot always find, to carefully consider their investing in a larger context. Wealth management is about more than simply creating piles of money. It also should include planning to spend that money before and during retirement; mitigating unforeseen risks through appropriate insurance coverage; considering the family or philanthropic legacy you hope to build; and more. It’s a career that I love, and I wouldn’t trade it in for the world.

While we’re on the subject of cars, I’d also like to follow up on a blog I posted in late September, in which we offered tips on purchasing cars with minimum hassle. One of our tactics was to distribute a “request for proposal” or “bid” to a variety of dealers in the region before spending our time meeting with them personally. This helped us compare and contrast dealers in an apples-to-apples way, without having to drive all over town. Here’s a fax/e-mail template you can use for this purpose.

I wish you a safe, distraction-free driving experience, for both your car and your wealth!

Does your retirement plan take inflation into account?  Since Vietnam, inflation has averaged 4.6% per year.  This may not sound like much, but since 1969 the purchasing power of a dollar has dropped by more than eighty percent.

Moreover, an interesting strand of economic research suggests that a retirement planner should also take into account "keeping up with the Joneses" - that is, spending even more in retirement to keep improving your lifestyle along with everyone else.  The historical rate of inflation, alone, understates the challenge investors face in funding a comfortable retirement.

If you're interested in a technical article that explains the details for you, read on...

International stocks are an important component of a well-diversified stock portfolio. Based on world market capitalization, sixty percent of a U.S. investor’s stock portfolio might be allocated to international stocks. A number of other considerations argue for reducing that exposure, however. While no fail-safe formula defines the best combination of U.S. and international stocks, the available evidence suggests that the traditional portfolio of 70% U.S. stocks and 30% international stocks has historically offered enhanced long-term returns with reduced risk, and probably is at least a well-reasoned starting point for most U.S. stock portfolios. To learn why, click here.