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Fourth Quarter 2009 Quarterly Newsletter

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It's All In Your Head

You may have heard the story about a set of identical twin sons (David and Donald) who were born to very horrible parents. The alcoholic father was physically and mentally abusive to his family, and due to criminal acts, was sent to prison for life when the boys were six. Their mother was a heavy drug addict, and died when the boys were nine. The brothers were then separated and sent to different facilities, where they stayed until the age of majority. They never reconnected with each other. When the brothers were thirty, a researcher located both and interviewed them.

Donald was in prison as a result of various crimes. He was an alcoholic, a drug abuser and had the AIDS virus. He was a loner and had never held a steady job. When asked why he turned out the way he did, he responded that "with a childhood like mine, how could I have turned out any other way?"

David was a manager in a small consulting company. When he told the researcher about his early childhood, he was surprisingly positive and upbeat. He conveyed that those experiences formed his beliefs and habit structures from a young age -- primarily by being a guide to how he did not want to turn out. He figured he couldn't depend on anyone else to take care of him, so he took matters into his own hands and studied hard, received a scholarship to college, met his wife and built a beautiful, loving family. When summarizing the reasons for success, he again remarked about the important lessons he learned by striving to be totally different than his parents were. He summed it up by saying, "with a childhood like mine, how could I have turned out any other way?"

Investing is not totally dissimilar to the brothers' lives. Each investor lives through the same market environment, yet for some reason portfolio results differ dramatically. The Wall Street Journal and CNBC give the same information to all that read or listen. Shareholder reports and company analysis are equally available to all as well. The entire history of market movements can be located by anyone who cares about that information. Yet if 100 different investors receive access to the same historic and real time financial information, you will most likely get 100 different portfolio results.

Why does this occur? A financial behaviorist would tell you that it has to do with behavioral biases, which can be quite different among seemingly similar people. Most intelligent humans build biases during their lifetimes, and for the most part those biases do a good job in helping people cope and survive. Don't run with scissors. Don't stick your tongue on metal posts in sub-zero weather. Don't spit into the wind. These are all simple rules that prevent you from having to go through the same consequences time after time.

The problem occurs when people use these same biases to determine their investment decisions. Below are names and examples of five common biases that come into conflict with one's investment decisions:

1. Overconfidence Bias. It's great to have confidence in yourself. Pro athletes excel in this trait. Statistics show that the average driver believes they drive better than most others behind the wheel. However, in the investment world, believing that you, or even someone else, is a better stock picker than most of the others will quickly teach you a lesson, and even then you will probably need to repeat this lesson multiple times until you get it right.

2. Hindsight Bias. Peaks and troughs in the market seem obvious after the fact. Just about everyone knew that the housing bubble and easy access to mortgage credit would result in a historic bear market, right? Clearly, after the dust has settled, much of this is easy to see in hindsight. "How could I have been so stupid when it was so easy to see?" But very few are actually able to react before it happens, and those "experts" who do are relying upon luck more than anything else. This means that next time something happens the odds are against the same person making another lucky decision.

3. Familiarity Bias. Everyone likes familiar stuff. It gives them a false sense of control. So it is easy to see why most people prefer stocks with names they have heard of, or stocks from the US instead of a country they know little about. Consequently, average investors are poorly diversified, especially in small and international/emerging market asset classes.

4. Regret Bias. Once bitten, twice shy. "I lost money in tech stocks in 2000, and I'll never make that mistake again." Really? Never own a technology stock again? We once had a prospective client that told us they didn't like mutual funds because they had lost money when they owned one. Avoiding behavior that has caused past pain is a fairly good idea for most of life's circumstances, but certainly not in investing. Often, the asset class that has done the worst in the down cycle leads the way on the next up cycle. This behavior just makes the regret worse.

5. Self Attribution Bias. This occurs when one takes full credit for successes, but blames failures on outside influences. "All of the stocks/funds I wanted to buy went up, but everything my broker put me in went down." The bottom line is that it's your money, and you are responsible for all of it, regardless of why you make a certain move. Consequently, it helps when there are defined, strategic methodologies that are fully understood by both advisor and client.

Those are some of the reasons why people get vastly different investment results when using very similar information when making decisions -- in much the same way as Donald and David's upbringing. The trick is to end up with a portfolio that performs more like David's life than Donald's. How can you assure that you do? You have probably guessed the answer. You give yourself the best chance for a positive investment experience by using an RIA (Registered Investment Advisor), who has a fiduciary duty to always do what is in the best interest of their client. In addition, a fee-only compensation structure insures against conflicts of interest that arise with commission and fee-based advisors and guarantees that advice is truly independent.

Lastly, you should be using an objective, scientific investment approach that is time proven and backed by both empirical data and US trust law (Modern Portfolio Theory). By doing this, you can be certain to pass by the behavioral bias roadblocks that make life miserable for many investors. And in the end, when you review your positive long term investment results, you can say to yourself, "how could I have turned out any other way?"

Fourth Quarter 2009 Asset Class Returns



It was another positive quarter for most equity asset classes, capping off the second best single year of equity performance in the last decade (2003's bull market bounce was the best of the decade). Large out performed Small, and Growth beat Value across the board. The leaders remained the same as last quarter -- Domestic Real Estate and Emerging Markets. Annual returns of Emerging Markets look incredible, until you realize that these asset classes lost 60%-70% during the bear market. This is clearly a great example of a volatile asset class in both bull and bear market extremes. Bonds primarily had a down quarter with longer term rates inching upwards during the quarter.

Clearly, this bull market bounce has made investors feel a lot better than they felt at this same time last year. The heady returns since March will clearly not continue forever. As the economy continues to recover in fits and starts, and other economic issues such as huge deficits and healthcare legislation become more visible, we will undoubtedly have some period of consolidation. There is always a wall of worry that any bull market climbs, and clearly this one is no different. We believe that long term investors must stay invested in their proper asset class allocations in order to receive their risk adjusted rewards over full market cycles. Rebalancing plays an important part in this, and unquestionably the New Year will bring an opportunity to buy low and sell high by liquidating pieces of asset classes that have outperformed their norm, and buying others that have underperformed.

The combination of hot market returns and cold winter temperatures are sure to collide sometime during the first quarter of 2010. Hopefully the result will be a warm, cozy trend in both areas.

Sincerely,


Frederick F. Kramer IV, JD
Chief Investment Officer
DIXON HUGHES WEALTH ADVISORS LLC