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07/13/2009
What If?
By
Richard J.T. Lerch
We have just come through one of the worst periods on record for the equity and bond markets and, not surprisingly, we have been talking to many of our clients about what has been happening and what will happen in the future. We always enjoy hearing from our clients as it is an opportunity to hear your thoughts and concerns regarding the markets, the government, the economy and, most interestingly, the future. Why are the thoughts and questions about the future the most interesting? Because this is the subject we have the least ability to predict or, as Peter Bernstein put it, “We simply do not know what the future holds”.
Even though the future is unknowable, that does not mean we are irrational to think about, discuss, question and even take action based on what we think may happen. The key, however, is not to do any harm when taking action. Unfortunately, when emotions become involved, that is usually when the most harm is done. Therefore, part of our job is to help our clients avoid doing any harm. That is why it is worth reflecting on some of the “what if” questions you have been asking of us over the past three to six months:
• What if the economy is not improving as much as the market seems to be expecting?
• What if the housing market doesn’t recover for another 10 or more years?
• What if the government’s unprecedented level of borrowing to fund the much discussed stimulus, TARP, TALF, etc. programs results in higher interest rates, higher inflation and a sluggish economy similar to the stagflation of the 1970’s?
• What if the government imposes steep increases in business and individual taxes and regulations?
• What if the government’s taking control of major industries (automakers, banks, insurance and health care) doesn’t work?
• What if changes to energy policy, in pursuit of reducing global warming, leads to huge energy-cost increases?
• What if the pending health reform plan increases federal spending a further $1.3 trillion over 10 years?
All of these are very important questions and the Investment Committee has been discussing, debating and considering all of them on an ongoing basis. A strong argument can be made both for and against one or even all of the above scenarios happening. So, what is an investor to do given all of the looming uncertainties? Or, for those who are reading this letter, the better question is what is PMA doing to take advantage of and/or protect against all of these issues? The answer is we are doing what we’ve always done: we are following an investment strategy that makes sense, sticking to it in good times and bad without succumbing to the emotions that always seem to cause investors the most harm, and we are fine-tuning the asset allocation and level of risk in our highly diversified portfolios to make sure we are continuing to achieve the highest possible return with the least amount of risk.
Because neither we, nor any investment manager, can predict or control with certainty what the government, the economy or the markets will do, we focus on what we can control: risk, asset allocation and whom we hire to implement our investment strategy. So, how do we actually go about doing this? PMA’s investment approach is based on the following fundamental beliefs:
• For a given level of investment return, a portfolio with lower volatility is preferable.
• A broadly diversified portfolio is the best way to minimize sector, style, and asset class risks.
• There are only a handful of truly superior managers in each asset class.
• Careful analysis of quantitative and qualitative factors can identify those managers with superior investment skills who are likely to produce good risk-adjusted returns in the future.
• Our qualitative analysis includes face-to-face interviews with the manager of each fund candidate. No client’s money is placed in a fund until we have met personally with the manager or other representatives of the fund.
• Chasing returns and investment fads is not a prudent approach to investing and often leads to wealth destruction, not wealth creation. We did not invest in tech funds during the tech bubble and we did not invest in hedge funds or REITs during the leverage bubble.
• A focus on controlling risk, if thoughtfully applied, enables investors to participate in up markets and be protected during down markets.
We believe that no one can accurately and consistently predict where the market is going in the future. We also believe that no one can accurately predict which asset classes will have the best performance in the future (please see the enclosed Callan Periodic Table of Investment Returns to see how the performance of various asset classes varies dramatically from year to year). Therefore, we want to own all of them in a prudent weighting. We invest our clients’ assets in highly diversified and systematically constructed portfolios of both index and active mutual funds. The index funds provide vast diversification at a low cost and the active funds are managed by the best professionals in their respective asset class whose job it is to adjust their portfolios in anticipation of many of the questions listed earlier in this letter (please see Bill Gross’ Investment Outlook as an example of what one of our active managers is doing).
We have seen fads come and go. We have grown clients' assets when markets rise while protecting those same assets during the inevitable declines. We have avoided managers whose success turned out to be a product of nothing more than luck and excessive risk-taking, and stuck with managers whose brief downturn was a result of avoiding bubbles and sticking to their long-term investment philosophy. We have a long-term record of consistent investment performance, a coherent and intellectually sound investment process and a rigorous process of evaluating, selecting, and monitoring the managers we select.
In short, we (humans) cannot control the future but we can control risk and that is what PMA does. We do this through strategic and prudent asset allocation. We invest with the best and expect that the U.S. will survive, solve its problems and prosper - as will our clients.
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