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By Jason Stipp | 12-19-2011 05:00 PM

Investors' Biggest Mistakes of 2011

Sanibel Captiva's Pat Dorsey discusses what investors might regret from 2011, and how they can avoid those mistakes in 2012.

Note: Pat Dorsey is the former director of equity research at Morningstar. He is now the president of Sanibel Captiva Investment Advisers.

Jason Stipp: I'm Jason Stipp for Morningstar. Some notable investors made big mistakes in 2011, but what were some of investors' biggest miscues and what should be on their radar for 2012. Pat Dorsey, president of Sanibel Captiva Investment Advisors has some ideas about that. He's here to share those with me today.

Thanks for joining me, Pat.

Pat Dorsey: Always happy to be here, Jason.

Stipp: So, it's pretty easy to look back of course at the end of the year and see what were some of the biggest mistakes the year before. But I think some important lessons can be garnered from this. I think that there were a lot of areas that people expected to do poorly, people expected to do well at this time last year. What were some of the most notable things that were on your radar?

Dorsey: Well, I think Treasuries obviously. I mean Treasuries just had an absolute blowout year. Yet I think if you survey most people at the beginning of this year and said, "Gee, you want to own U.S. Treasuries at, you know, a pretty low yield?" The response would likely be, "It's not what I want to own right now." But they've had a phenomenal year. The lesson there is that the best house in a bad neighborhood does pretty well. The U.S. is the least risky of many sovereign economies right now. So you've seen this sort of flight to quality. Also, things can often go on longer than you think.

Think back to the Internet bubble or the housing bubble. If you had sort of said, "I think those homes are getting a little pricey or those Internet stocks are getting a little pricey," at a reasonable level, they probably doubled or tripled from there. The same thing can be said for Treasuries. Saying a year or two ago, that I'm not getting paid for the risk I'm taking on, well, that was probably accurate, and probably over a longer-term horizon, that was the right decision. But acting rationally over the long-term horizon, can hurt over a short-term one.

Stipp: Realistically speaking though, if I've got this portfolio, and I can sit there and say, "Well, Treasuries maybe don't look like the greatest place to be right now, but I also see they benefit from a flight to quality," how do I make those two things come together for a portfolio plan? What should I do with Treasuries?

Dorsey: Well, think about how much longer they will benefit, and obviously don't take the past year's performance and project that out into the future. Just because bonds have had an awesome 12-year run as interest rates have declined, it doesn't mean that that same thing will be the case for the next 10 to 12 years. You always want to be looking forward instead of looking backward, and when you consider that many very well-capitalized U.S. equities--many of which had balance sheets stronger arguably on a debt/capital ratio than the U.S. government--are yielding 3.0% and 3.5% and increasing that payment at above the rate of inflation, then on relative basis Treasuries don't look so hot.

Stipp: So you mentioned the U.S. government and some of its problems and also we do know that the fundamentals in emerging markets have looked a lot better for a while. Emerging markets I'd say, if you sat here a year ago, that story still sounds great today about the fundamentals, and it sounded great last year. But if you invested in emerging markets and dumped a bunch of money in there, in January, you're not too much of a happy camper right now.

Dorsey: There's an old quote from Uncle Warren (Buffett) in Omaha that you pay a high price for a cheery consensus, and a year ago the consensus around emerging markets was quite cheery. They were growing very fast, their middle class was rising in purchasing power, and their sovereign balance sheets were very good. But all of that wonderful happiness was priced in. I would argue now I think now at 11-ish times earnings in the MSCI Emerging Market Index, there's a lot less happiness priced into emerging markets. So your forward-looking returns are likely to be materially better than they were in the past year.

In a way it's quite interesting to see that you're continuing to see mutual fund inflows into emerging markets, despite the really nasty year they've had. I actually find that quite fascinating, because typically what you see is when an asset class performances poorly over a year or two, you see fund flows coming out, not going in. So that's a bit counterintuitive to me. But again, the question is always, "What are you getting paid for the risk that you were taking?" Right now, you're getting paid pretty reasonably to take on the certainly higher risk of investing in emerging markets. You're getting better growth, but you're only paying 11 times earnings for it.

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