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Beyond Buy-and-Hold Investing

Diversification and prudent asset allocation are still important.

Veena A. Kutler and Annette F. Simon, 07/23/2009

This monthly series of articles describes the many steps and occasional missteps we have taken in building our financial advisory business, Garnet Group LLC. Currently, Garnet has eight staff members, more than 90 clients, more than $200 million in client net worth under advisement, and offices in Bethesda, Md., and Boston. Veena Kutler, CFA, and Annette Simon, CFP, are the managing principals in the Garnet office in Bethesda.

Last month we wrote about the 2009 NAPFA national conference in Washington, D.C. As we mentioned, many of the hallway conversations during that event focused on whether a buy-and-hold strategy works in today's economy and if it is time for advisors to move on to other investment approaches. It seems it's not just the advisors at that conference who are interested in this topic! We have also heard from a few readers who were asking the same questions about alternatives to buy-and-hold. Over the same time period we have discussed this topic with several of our clients who have questioned us about our investment philosophy and asked us to clarify just what we will or won't do to protect their assets in a downturn.

Given this seemingly high degree of interest, we thought a timely topic for this month's column would be our investment philosophy.

Investment Philosophy and the Markets
Our investment philosophy is based on diversification and appropriate asset allocation. Diversification to us means a broad mix of asset classes and securities. Our typical client portfolio holds 12-15 mutual funds. Underlying those funds are thousands of securities across multiple asset classes, helping to diversify away single company risk as well as single industry and asset class risk.

In terms of process, we determine each client's appropriate asset allocation by combining their return needs (based on cash flow planning) with their risk tolerance and preference, which are determined using both quantitative and qualitative measures. Once a client has agreed to the recommended asset allocation, we strongly encourage him or her to stick to that allocation over time unless something has changed in his or her underlying financial circumstances - regardless of market performance and world events. In order to maintain a relatively constant asset allocation, we typically rebalance to the model on a quarterly basis.

How does this strategy work in volatile markets?
In a volatile, but generally upwardly trending or flat market, this strategy works very well. Periodic rebalancing enhances returns by selling assets that have risen relative to those that are being purchased. Moreover, by sticking to allocations, clients avoid the whipsaw massacre caused by emotion-driven selling as markets fall and buying as they rise.

How about sharp and prolonged downturns such as the recent one we have experienced?
Markets plunged in the fall of last year and again early this year--the S&P 500 plunged nearly a terrifying 60% in a few months' time. The diversification benefit provided by asset allocation usually doesn't protect the portfolio as well during short periods as it does over full market cycles--especially during periods when every, or even most, asset classes are collapsing. This was certainly the case in the latest downturn. Small caps, mid-caps and large caps all fell, as did growth and value equities. With the rise in the dollar, international non-dollar-denominated securities declined dramatically when translated back into dollars. Many commodity prices including oil dropped, negating the benefit of commodities diversification. Bonds, which typically form the cushion of a portfolio, showed mixed results. Treasuries increased in price, but other securities including agencies, corporates, mortgage-backed, asset-backed, and municipal securities experienced spread widening resulting in price declines.

What's an Advisor to Do?
Recently a client told us that he felt that he had looked into the abyss back at the low point a few months ago and wasn't sure that he could handle it again. He wanted to know what we were doing to protect our clients going forward. Just saying that we were sticking to our strategy wasn't good enough. Other clients have expressed similar concerns. How many of you have heard these kinds of questions recently? We're guessing most of you.

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