The evolutionary process hardwired humans with the ability to assess information quickly.  Growls emanating from behind a bush = head the other direction.  What suited us for survival, however, many times causes us to make counterproductive financial decisions.  We are afflicted with numerous biases that cause us to overrule our rational selves.  Our investment committee spends a fair amount of time contemplating these biases and evaluating our decison making process to make sure that we are not falling into traps set by our human behavior.  Here are a few common behavioral biases that you may recognize in yourself (although it is our experience that they’re easier to recognize in others!):

Loss Aversion.  Investors prefer an uncertain larger loss rather than realizing a certain smaller loss.  This bias causes the investor to hold losing investments too long and to take increasing risks to try to gain back unrealized losses.  To counter this bias, make sure to evaluate an investment on its expected return rather than by the price you paid for it.

Recency Bias.  Recent events shade our forecast of the future.  This bias causes investors to chase after last year’s hot investment and dump last year’s loser.  The wise investor regularly consults the periodic table of investment returns to remind himself that past performance is not a reliable indicator of future results.

Availability Bias.  The easier you can call something to mind, the more prevalent you judge it to be.  Investors who clearly remember a bad experience investing in a particular asset class will tend to avoid that class in the future.  Investors should comprehensively research and analyze potential investments to offset this bias.

Confirmation Bias.  Investors tend to pay attention to information that supports their current outlook and to ignore information that contradicts it.  To avoid this trap, make a concerted effort to read up on differing opinions.

These are just a few of the biases afflicting our fallen human condition.  The successful investor uses a rules based decision making process and keeps track of investment decisions for later evaluation. 

That seems to be the most common question we get asked this time of year and is on the minds of everyone.  The answer that garnishes a smile and lightens the mood is that my crystal ball is a little cloudy.

Let’s start with what we do know.  U.S. growth in the fourth quarter accelerated along with personal income growth.  Consumers were spending in the fourth quarter and the savings rate declined.  It appears the housing sector is bottoming and home prices seem to be stabilizing.  The labor market also appears to be improving.  The Federal Reserve has made a commitment to keep interest rates low possibly through 2014, based on economic developments.  The stock market picked up in January and the U.S. appears to have shrugged off the euro crisis and debt downgrade.

The headwinds are still apparent and will make it difficult for this momentum to continue.  The low savings rate is unsustainable and has already begun to increase as households devote part of their additional income to boosting savings.  The expectation is that home prices will not appreciate for some time as excess inventory needs to be absorbed by the market.  2012 will be a make or break year for the euro.  We don’t expect any major decisions to be made in the U.S. prior to the election.  With these headwinds in still in place, we expect volatility will extend into 2012.

There are so many factors we have to consider, but cannot control.  When the investment committee makes decisions, reversion to the mean plays an important role.  Here is where the story gets boring because we have been saying this for so long, but it is important.  U.S. high quality stocks, large company international stocks and emerging market stocks are priced to produce the best returns over the next seven years.

Bonds are over-valued, so we have therefore further diversified our portfolios into the alternative investment category.  We often get asked what makes up the alternative investment category.  Alternative investments provide a source of defense when the traditional sources—bonds and cash—are not attractively valued.  PIMCo All Asset All Authority actively selects from a wide variety of PIMCo mutual funds to meet its goal of CPI plus 6.5% over a full business cycle.  Absolute Investment advisors use a diverse group of strategies (i.e. long/short credit, long/short equity) normally associated with hedge funds to provide lower volatility and lower sensitivity to traditional market risks.

So while we can’t know exactly what 2012 will bring, we can tell you that we are already positioned in the areas priced at decent valuations and continue to look for additional opportunities based on valuation levels.  We are pleased that the balanced portfolio has returned over 3% so far, but as I mentioned earlier we expect 2012 to be a bumpy ride.

I came across a neat interview on CNN the other day.  Here’s the link:

http://money.cnn.com/video/news/2011/12/19/n_106_year_old_stockbroker_2.cnnmoney/

Irving Kahn, who began investing in 1928, is still at it, 84 years later, at the age of 106. 

My initial thoughts after viewing were:  1) If I am still going in to work 50 years from now my wife will kill me and; 2) Good for him.

His longevity is remarkable. 

The Founder and Chairman of Kahn Brothers for over 30 years, Mr. Kahn describes himself as a value investor, holding 20 or so stocks for clients over the (in his case really)long haul.   In his office a Bloomberg terminal gathers dust.   He owns a cell phone, “So I don’t forget my number.” I am sure he has outlived most of his clients, and many of their children.   Two of his own children who worked for him are retired. 

One of Mr. Kahn’s sons says what Dad values most is “an office, a job and responsibilities.”

I found that compelling.  It’s clear that much of Mr. Kahn’s identity is tied to his career, but it is his deal now.  As a middle aged father I look forward to the day that work is purely on my terms and that I go in because I want to, not because I have to. 

I am also struck by what the video doesn’t explicitly show.  For example, besides the clients he has helped reach their dreams, I can’t imagine how many people he has mentored in the business.

We all want to have a voice and a life with meaning, both personally and professionally.   I love my career for two reasons: 1) No two days are ever the same, with each day an opportunity to learn and meet new people; 2) Everything that goes on in our world relates in some way to the financial markets, from the toys my children use to the cars my neighbors buy. 

Everyone has a story.  Our business is about collecting stories in the hopes of being able to connect with clients and say, “I have been there, here’s how I can help.”

Guys like Irving Kahn have two lifetimes of stories.  I would love to hear more. 

And hopefully I am around to tell more. 

Recently, Cohen & Steers conducted a review of 2011 global real estate strategy results.   Results were mixed.  U.S. REITs gained 8% during 2011.  Credit was cheap and available in quantity for core properties.  Lack of supply countered slow demand.   In the rest of the world, real estate securities suffered with Europe down 13% and emerging markets down 29%.  Credit was tighter in Europe and the emerging markets than in the U.S.  

Among property groups in the U.S. self storage led the way gaining 35% as the least economically sensitive groups did best.  Hotels, with leases that usually last a day or so and very sensitive to the economy, lost 14%. 

Valuation at the end of 2011 seems to favor international REITs in 2012.  In the U.S. real estate securities are selling at about a 13% premium to net asset value (NAV).   In the rest of the world real estate securities sell at approximately a 20% discount to NAV.  In the U.S. cash flow multiplies are 17 while the rest of the world sells around 12 times.   In addition, banks in Asia and the emerging markets started easing in the fourth quarter of 2011 while central bank activity is on hold (at very low levels) in the U.S. 

TCI has owned REITs for the last 15 years.  In the late 1990’s REITs were considered a “fat pitch” with the best valuation of any equity group at the time. These stocks were truly out of favor with investors preferring “clicks” rather than “bricks”.   TCI asset allocation portfolios had a 10% position at the time.  Today, we own a 1% position because much better values exist elsewhere. 

Ron Paul’s perennial status as a presidential hopeful can be relied upon for at least one thing (beyond happy political cartoonists): Rally cries to bring back the gold standard. We have a friend who flashes 100 Trillion Zimbawean dollar bills at us as evidence of the malfeasance of governments, vis a vis their abuse of printed currency. We understand the limitations printed currency has as a store of value.

Buttonwood has a thoughtful post regarding the potential unintended consequences of readopting the gold standard. Combating inflation is a fine goal, but what about global growth and employment? 

Widely regarded as the world’s most influential living psychologist, Daniel Kahneman won the Nobel Prize in Economics for his pioneering work in behavioral economics — exploring the irrational ways we make decisions about risk.  In his book,  Thinking, Fast and Slow, Kahneman offers practical and enlightening insights into how choices are made in both our business and personal lives and how we can guard against the mental glitches that get us into trouble. 

Since investment management is all about making decisions about risk, I found many nuggets of wisdom in this book.   I’ll give two examples.  First, intuition cannot be trusted, even among experts, unless the expert has experienced or practiced his skill in many similar situations.  Second, there is no evidence that risk takers have an unusual appetite for high-stakes gambling, they are merely less aware of the risks than more timid people are.  

I recommend this book to anyone who would like to know more about how the brain works.  Let me know if you read it and what you think. 

We visited Disneyworld this past November, exposing our children to the omnipresent Disney branding that will have them imprinted like baby ducks. Perhaps from your own trips you remember Big Thunder Mountain at the Magic Kingdom? The ride begins with the guest sitting down inside a roller coaster car, one of a row pulled by an innocuous looking little blue train engine. Soon the train engine has accelerated to something like 195 mph; darting along curves and improbably defying centrifugal force, following the track up a hill and down just in time to prevent the riders from braining themselves on wooden beams framing fast-approaching tunnel entrances. And just like that, the ride jerks to a halt, right at the exact spot it started from. Which brings us to our wrap up of 2011 investment results.

The TCI Balanced Portfolio returned 0.1% (after fees) for the year, versus the Wall Street Index at 1.1% and the US OE Moderate Allocation at -0.1%. We consider this to be a very mixed result, a flat year in the face of extreme volatility. We had good performance from most of our active managers, with the notable exception of Bill Gross’ PIMCo Total Return Fund.

We trailed the Wall Street Index mainly due to asset allocation. The index owns 30% US Treasuries; our portfolio held only 20% bonds, most of which were managed by Gross who notoriously underweighted Treasuries. As volatility heightened throughout the year, investors fled to the perceived safety of Treasuries without regard to the price they were paying. Gross apologized for his decision, but we still think he made the right call. Treasuries are tremendously expensive and, as value investors, we avoid expensive assets.

The heightened volatility caused 2011 to be a mostly unpleasant year for investors, punishing the over-aggressive investor through September as the market did its best to imitate 2008 and then jilting those who fled to cash only to miss the largest October rally in history. To us, 2011 illustrates the foolishness of trying to time markets. The marketplace is made up of millions of irrational investors, moving asset prices far above and below fair value based on a variety of emotions, but mostly fear and greed. We try not to play the game of guessing where the herd will move to next.

We enter 2012 with a slightly larger than neutral weighting in equities, with a large portion of that weighting made up of high quality stocks. As we have noted for quite some time, high quality stocks offer the best value. We are overweight alternative investments, but not as much as we were. We sold a few funds and made an additional allocation to cash. Although money market yields are at 0%, we consider cash to be dry powder for use should valuation opportunities arise. We remain underweight in bonds.

As part of the retirement planning process, we are often asked, “Should I buy long-term care insurance?”  This question has become even more important with the Obama administration recently concluding that providing governmental long-term care coverage is cost prohibitive.  Unfortunately, there is not a “one size fits all” answer for long-term care insurance or hybrid insurance products that include long-term care coverage.

 In 2011, our financial planning committee decided to revisit this question and to do a thorough review of current academic research and other resources to determine what would be the best course of action for our clients.  Essentially, what we found is that buying long-term care insurance does make sense under certain circumstances.

 Here are some important things for you to know:

• 60% of individuals eventually need some type of long-term care
• For those who need long-term care, the average need is between 2 and 3 years
• Long-term care is not covered by health insurance or Medicare
• It currently costs approximately $75k to stay one year in a standard nursing home
• It costs approximately $19 per hour for basic (non-medically related) home care long-term care support
• It costs approximately $39 per hour for advanced (medically related) home care long-term care support
• In terms of cost, the ideal time to buy long-term care insurance for most people is in their 50’s
• If long-term care insurance is purchased, we generally recommend buying an inflation protection rider

Below is a link to a video produced by Morningstar on the topic on long-term care insurance.  Based on our own independent research, we agree with many of their conclusions.  They include:

• One rule of thumb is that long-term care insurance may be most appealing to individuals with a net worth between $250k and $2 million.
  • Those with less than $250k might want to look at Medicaid benefits
  • Those with more than $2 million may decide they want to self-insure
• It is recommended that those individuals who have a family history of dementia or Alzheimer’s seriously consider obtaining long-term care coverage
• As with any insurance, it is best to buy coverage from the highest rated insurance companies
• Obtaining long-term care in the home is becoming a popular option and this benefit should be considered if you decide to purchase long-term care coverage
• Hybrid insurance products that include some long-term care coverage can be considered, but the associated costs should be evaluated

 We are proactively addressing this issue on a case by case basis with all of our wealth management clients.  Please note, we are a fee only firm and do not sell long-term care insurance or any other type of insurance.  Consequently, our interests are aligned to help you make the right decision for you given your specific situation.

 Morningstar Long-Term Care Insurance video link:

 http://www.morningstar.com/Cover/videoCenter.aspx?id=448204#.TujKTZHgtu1.email

We are in the process of moving funds invested in the Goldman Sachs Financial Square Prime Obligation Money Market Fund to the Goldman Sachs Financial Square Treasury Instruments Money Market Fund.   The Prime Obligation Fund invests in a diversified portfolio of AAA domestic corporate and bank obligations.   The Treasury Instruments Fund invests solely in U.S. Treasury securities.  There are several reasons why we have made this very conservative move.

First, the cost is minimal.  The Prime Obligation Fund has current annual yield of 0.16%.  The Treasury Instruments Fund has an annual yield of 0.00%.  So the cost of unlimited insurance provided by the U.S. government is 0.16%.   The cost in lost interest for a $1 million portfolio with 8% invested in money market works out to $128 per year. 

Second, while we believe the odds of a credit crunch that might affect the liquidity of Prime Obligation Fund are minimal, the current issues in Europe are very serious and the European banking system is right in the middle of these problems.  Trying to dissect the interconnections of the global banking system is impossible.  Why worry when the cost to avoid these concerns is so low?

Last and perhaps most important, any credit crunch would likely create huge opportunities for the investors with the cash available to take advantage of them.  When the opportunity cost is so low why not pay it?

Our Investment Committee has made some year-end changes to the TCI Model Portfolios.  Gone will be Altegris Managed Futures Fund (MFTIX) and Absolute Opportunities Fund (AOFOX.)  The proceeds from the sale of those two funds will be allocated in part to our two remaining alternative investment funds, PIMCo All Asset All Authority Fund (PAUIX) and Absolute Strategies Fund (ASFIX.)  Additionally, a small portion of the proceeds will be allocated to cash.

Our goal has been to build out a robust alternative sector to limit risk in our portfolios without necessitating the purchase of (what we consider to be) expensive bonds.  The mutual fund world has introduced many new funds in the alternative space.  We’ve added a few of the newer offerings, but over time we became dissatisfied with relatively high expense ratios and performance that didn’t measure up to our longer-term managers.  Thus, the moves we are making.

We’ll continue to use the Altergris Winton LP as a managed futures vehicle for some of our accredited investors.  That fund has performed to expectations and well represents the strategy.  We may someday revisit managed futures in our model portfolios, but not until we have longer track records and more competitive pricing in the space.

As always, if you have questions about the changes, please contact your relationship manager.