Two critical lessons from Japan

For this quarter's letter, I have focused on two important lessons for investors, both of which were made tragically apparent given the recent series of events in Japan.

One lesson is the critical need to construct portfolios that expect the unexpected and anticipate the unanticipated. This is accomplished by implementing strict risk controls in each portfolio.

The second lesson relates to avoiding one of the costliest traps that ensnares investors—overconfidence.

Before getting into detail on these two lessons, let’s take a look at a quick recap of the first quarter.

Market performance in the first quarter

Markets in January and February reflected a continuation of last year's positive sentiment. This upbeat view on the part of investors was spurred by solid corporate profits and a broad consensus that while the global economy might not experience a strong recovery going forward, it would see some positive growth.

The month of March began with a fair dose of downside volatility. The earthquake and tsunami in Japan on March 11 took a dreadful toll in human lives and clearly reduced short-term prospects for the global economy.

The turmoil in North Africa, while pushing up the price of oil, also had a negative impact on markets due to concerns about the effect of that price increase on consumer demand.

But by the end of March, positive economic growth reports in the U.S. and Europe allowed most markets to recover their earlier losses. As a result of the last-minute rebound at the end of March, developed markets generally saw gains over the course of the entire first quarter.

These gains put investors on track for a solid performance in 2011.

Learning to live with uncertainty

It’s often been said that stock and bond markets operate efficiently since they incorporate all of the available information in the entire world at any given point in time.

For example, when sovereign debt problems emerged in Greece early last year, other European countries which had been seen as having similar potential problems experienced a sharp increase in the cost of insuring their debt.

Even though these countries had not actually run into problems, the market factored in this possibility as though it were inevitable. Market analysts spend many thousands of hours each year on these kinds of issues.

Given the depth and breadth of these analysts’ time and research, slowly developing problems such as a government debt crisis can usually be identified well before the actual crisis manifests itself.

Investors, however, cannot anticipate developments that are by their very nature unpredictable.

We've experienced at least four such events in the past year, and no one could have predicted any of these four events:

1. Last April's volcanic eruption in Iceland that spewed ash in the air, shut down 100,000 transatlantic flights and cost the airline industry $2 billion;
2. Also last April, the explosion of the Deepwater Horizon oil rig in the Gulf of Mexico;
3. Commencing last December, street protests resulting in changes of leadership in a number of countries in North Africa, leading directly to the current war in Libya;
4. And of course the earthquake, tsunami and nuclear-reactor crises in Japan.

In light of episodes like these, investors need to take away two key lessons.

Lesson One: Implement Strict Risk Controls (‘Expect the unexpected’)

The only practical way to deal with uncertainty and to manage the impact of unforeseen events is to build strict risk controls into portfolios, similar to those used by the most sophisticated pension funds.

While the risk of one-time incidents can't be eliminated entirely, we can limit the damage through diversification and risk management when negative events occur—whether it be a massive fraud such as Enron, sudden bankruptcies like Lehman Brothers, volcanic eruptions, oil rig explosions or earthquakes.

It is the advisor’s job to measure (and manage) each individual client’s exposure to companies, to industries, to regions and to sectors.

I thought it might be useful to provide an overview of my approach to risk management in portfolio construction.

There are three steps in this process.

Step 1: Identify a target mix the client can live with

First, we identify the target mix of stocks, bonds and cash that—based on historical precedent and current valuation levels—will, over time, have a high likelihood of providing the returns the client needs to achieve their long term goals with a level of volatility they can live with along the way.

Step 2: Diversify, Diversify and Diversify

Next we carefully diversify each client portfolio by placing limits on the exposure to any one company, industry, sector or region.

For investors who like to hold individual stocks, for example, a general rule of thumb states that the limit on one stock should not make up more than 5% of your overall equity holdings and no one bond should represent more than 3% of your fixed income exposure.

As well, no matter how optimistic we are about an industry, sector or region, its weight should never be significantly above its underlying weighting in the market index of which it is a component

Step 3: Stay balanced

For the final step, we conduct an in-depth analysis of each portfolio at least once a year.

Often, asset classes that do well will increase their presence in your portfolio and bump up against the risk control limits we’ve set.

At that point, portfolios may need to be rebalanced back to the target asset allocation. Some of the positions that have outperformed might be trimmed to stay within risk control limits.

Investors find this very difficult since they’re selling exactly those investments that have done the best.

This is the only way to stay truly diversified and control the risk that accompanies overexposure to any asset class.

And it's also the only way to get some protection from events that simply can't be anticipated.

Lesson Two: Avoid overconfidence...

One issue that arises with this controlled approach to portfolio construction is that over the short and mid-term, there will always be someone who's made a big bet that pays off and who is doing better than you as a result.

Because it eliminates big bets, a risk controlled approach to investing will seldom give you bragging rights at a cocktail party. Investors who take the big bet approach typically have a high degree of confidence in their investments.

After all, if you're absolutely certain about a company or industry, why bother to diversify?

For example, there are investors who believe there’s only one way for the price of oil to go, or one way for the price of gold to go.

Or their company or their sector is on a roll and there’s no way that anything’s going to stop them. In such cases, overconfidence is among the costliest and most dangerous traits an investor can possess.

As investors, we must acknowledge, address and overcome the risk of overconfidence in investment decisions. What causes us trouble isn’t necessarily the things we've identified as question marks or causes for concern.

Instead, portfolios crash and burn because of the things that we feel absolutely certain of—right until unanticipated occurrences catch us by surprise.

The world has always suffered through unexpected catastrophes, and always will. Despite this, economies have grown, companies have prospered and stock markets have generated positive returns.

The key to benefiting from this long term growth has been to diversify so that no single event can create permanent damage to your portfolio.

When it comes to long term investing, a slow and steady approach not only wins the race, but more importantly, it survives to cross the finish line.

As I’ve mentioned to my clients recently, we will work through these negative events. Investors with a balanced approach and a long term view will be well rewarded.

The approach to risk management I've described may not be fun or exciting in the short term, but the evidence suggests that over time it will serve an investor well, allowing them to achieve their goals with the least amount of anxiety along the way.

Conclusion

If you should have any questions pertaining to anything discussed in this letter, please call or contact me via e-mail.

Sincerely,

Andrew J. Fama, Principal

Andrew J. Fama Asset Management, LLC

Registered Investment Advisor

*Past performance is no guarantee of future results*

*Nothing contained in this quarterly newsletter should be construed as investment advice*