Wealth Notes – 2/16/11

Last year, Cost Plus Inc. was one of the top performing stocks in the United States. It had a whopping return, 851% according to Morningstar. Incredible. Whenever I see a number like that I think, “Why didn’t I have all my money in that stock?”

And then I remember to take a look back and see what it would have been like to own that one stock over the past five or more years. The same company lost an average of more than 10% per year when using numbers for the last 10 years. The investment in the company lost more than 45% each year from 2005 to 2008—who wants to own a stock that does that? Last year, investors must have just been happy that the company stayed in business.

Part of this newsletter is to help you with your investment and financial planning decisions and how we partner with you in achieving your goals.

As investors, we look to earn money by holding different assets over time—stocks, bonds, real estate, natural resources and business interests. We expect that over time the assets will increase in value. Some assets might appreciate in a short period—like one year. Others, especially business interests, might take decades to fully achieve their value.

Along the way, some assets pay us income in the form of dividends or interest.

Each type of asset has unique characteristics, expected returns and ownership issues. Dividends from stocks are currently taxed differently than dividends from most bonds. Short-term capital gains require the payment of higher taxes than long-term capital gains. Commodity fund gains are likely to generate current income.

We build portfolios and run financial plans using expected returns over time. Generally, we recommend keeping money in cash or money market when it is expected to be used in the short-term. We prefer equities, bonds and maybe commodities funds over a longer time period to keep pace with inflation and seek to create additional wealth.

Recently, I took a course on the investment management process as it relates to accepted fiduciary standards. An organization called fi360 has been working towards developing global fiduciary practices and educating those who serve as fiduciaries.

The process seeks to create a model to achieve consistency and formality to help fiduciaries follow prudent practices when managing assets. Fiduciaries are those charged with the investment process and management for others. They can be people serving on investment committees of foundations, trustees of personal trusts or sponsors of 401(k) plans.

We act as a fiduciary for you when we manage your assets in our advisory accounts.

As such, we seek to develop portfolios to fit into your plans. Before we can do that, we need to follow the key steps of the investment process—1. Organize necessary documents and review significant goals you have 2. Formalize the information into a coherent plan 3. Implement solutions and 4. Monitor the investments, your plans and changing related issues, like tax and law updates.

This process is the one we have followed for many years. We cannot effectively manage your money if we do not know your goals, risk tolerances and prior experiences with investing.

Sometimes, we want to own securities that have the potential for huge gains in one year—like Cost Plus of 2010. But we do not want the years of significant losses to put all of our plans and money at risk of complete loss. The key question in building the portfolio becomes how much excess risk is it worth taking to try to get there?

One way to answer this question is to divide a portfolio into a “Policy” portfolio and a “Pricing” portfolio. Another set of terms used is the “Core” and “Explore.”

Policy portfolios seek to use historical asset class based returns to build portfolios. This asset allocation modeling looks at how well certain parts of the market did over the past and builds around that. Stocks expectations are usually around 10% on average, bonds 6% and cash 3%. International stocks are also around 10% in most of these models. These returns vary and are not guaranteed.

We set limits in the policy portfolio on how high or low certain asset classes can be. The equities (or stock) target might be 50%-70% of the portfolio. In great years we might be forced to reduce equities if that part gets over 70%. This worked well during the tech bubble and in the run-up to the 2008 market debacle.

The pricing portfolio represents the desire to select assets with different risk profiles. This could be investments in special situations, specific commodities, hedge funds, directly-owned real estate or private equity.

Prudent investment practices do not generally recommend significant portfolio percentages to go into pricing portfolios. The risk of loss outweighs the potential for gain.

As individual investors, you get to make the choice. Our planning starts with the policy portfolio. We run financial plans using widely studied asset classes with long-term averages of returns and volatility.

We can accommodate the desire to add pricing or exploring assets to the portfolio with input from you. We can add stocks that you know from your industry. My clients in the technology field often have a good idea of which company is performing well and selling more units.

There is nothing more exciting than watching a stock run and nothing more heartbreaking to watch it tumble. A $10,000 investment in Cost Plus ten years ago would be worth about $3,300 today – only about a third of the original investment. This information comes from Yahoo. The price on 12/31/2000 for one share was $29.38 and it was $9.70 on 12/31/2010. A simple investment in equal amounts in the S&P 500 and the US aggregate bond index returned 3.99% over the same time according to RBC’s published returns. Vanguard’s balanced index fund returned 4.13% over the same time period (see Vanguard.com).

At Cascade, we believe the fundamental rules of investing have not changed much over the past 100 years. We believe that diversified portfolios with multiple asset types, rebalanced regularly with close watch paid to each element yields results over time. We look forward to more discussions about your portfolios.

Rob Wrubel, CFP® is a Senior Investment Consultant with Cascade Investment Group, member FINRA & SIPC. Cascade Investment Group is not a tax or legal advisor. You should always consult with your tax advisor or attorney before taking any actions that may have tax consequences.