• AAII Model Portfolios
  • Good-Bye and Good Riddance: 2008 Enters Stock Market History

    by James B. Cloonan

    Good Bye And Good Riddance: 2008 Enters Stock Market History Splash image

    I am not sorry to see 2008 become history.

    Like most everyone else, I am hoping for a significant market upturn in 2009, but I would settle for some firmness and reduced volatility.

    Historically, the stock market is a leading indicator, and thus it should recover before the economy. But when that will occur is unknown, even though experts are making lots of predictions. Since the market tends to defy analysis, the turnaround will probably come earlier or later than generally expected.

    In 2008 AAII’s Model Mutual Fund Portfolio was down 36.5%, as compared to –37.0% for the benchmark Vanguard Total Stock Market Index fund (VTSMX). While the Model Mutual Fund Portfolio came out only slightly ahead in 2008, you can see in Figures 1 and 2 and Table 1 that it continues to outperform its benchmark significantly over the long term.

    I continue to believe our allocation across the objectives of our current funds is appropriate and will continue to outperform the general market over time.

    2008: The Outlier

    I have always believed that mathematical measures of risk derived from modern portfolio theory understate real-world risk by overlooking outliers—unusual and rare occurrences of stock market behavior. However, I do not believe it is wise to let these unusual occurrences influence your long-term investment approach, except in the determination of what fraction of your wealth to commit to common stocks and stock funds.

    My own general rule has been that you should not invest capital in stocks that you will need in the next three years, and that is why one of our criteria for selecting the mutual funds is to require that they have not (in the last 15 years) had a three-year period with negative returns. Thanks to 2008, the vast majority of common stock mutual funds have a negative return for the three-year period of 2006 through 2008. However, since I believe that 2008 was truly unusual, I am not selling any of the portfolio’s holdings based on the past three years’ results.

    No Changes

    Currently there are no changes in the portfolio. If I need to replace any funds in the near future, I will modify the three-year rule somewhat because I don’t want to select funds that only outperform in down markets.

    There have been changes in data calculation for capitalization and style measures due to industry consolidations, as well as a significant shift in price-to-book-value ratios over the entire stock market. We will continue to provide the same size and style categories as before, but will have to adjust cut-off points in the future.

    Assessing Your Own Tolerance


    Fund (Ticker) Style Market-
    Annual Return (%) Fund
    ($ Mil)
    1- 5- 10- Ret
    Yr Yr Yr (%)
    CGM Realty (CGMRX) Very Low Value Large-Cap –46.8 –46.8 9.7 15.9 1,032.70 0.86 175 –0.1
    Stratton Multi-Cap (STRGX) Moderate Value Giant-Cap –38.3 –38.3 0.9 3.6 75 1.06 116 3.6
    CGM Focus (CGMFX) Very Low Value Giant-Cap –48.2 –48.2 8.6 17.7 4,160.70 1.27 160 2.9
    Manning & Napier Pro-Blend Ext A (MNBAX) Moderate Value Giant-Cap –25.3 –25.3 2.6 5.1 415 1.11 80 –4.4
    Meridian Value (MVALX) Moderate Value Mid-Cap –32.0 –32.0 0.6 9.8 935.1 1.09 98 –5.4
    Madison Mosaic Mid-Cap (GTSGX) Low Value Mid-Cap –36.3 –36.3 –0.9 4.8 88.3 1.25 104 –7.6
    Northern Small Cap Value (NOSGX) Very High Value Small-Cap –23.4 –23.4 2.2 6.7 1,106.00 1 117 –4.9
    Royce PA Mutual/Inv (PENNX) High Value Small-Cap –34.8 –34.8 0.8 7 2,302.60 0.88 115 –7.6
    Tamarack Microcap Value “S” (TMVSX)* Very High Value Nano-Cap –39.4 –39.4 –2.3 5.3 153.2 1.07 124 –10.4
    FMI Common Stock (FMIMX) High Value Small-Cap –20.4 –20.4 3.5 7.7 429.5 1.22 114 –2.6
    Avg of Funds in Model Fund Portfolio**

    –34.5 –34.5 2.6 8.3 1,069.80 1.08 120 –3.2
    Actual Fund Portfolio Performance***

    –36.5 –36.5 0.1 na 1,069.80 1.08 107 –6.8
    Vanguard Tot Stock Mkt Idx (VTSMX) Low Value Giant-Cap –37.0 –37.0 –1.8 –0.7 39,440.40 0.15 108 –8.5

    While most investors say they are long-term investors and can weather short-term negative returns, a severe downturn provides a test of how much risk we can endure and still sleep at night. If the current downturn is causing you too much anxiety, or you gave up and sold near the bottom (the bottom so far), you may want to reassess your asset allocation because this kind of downturn will likely happen again in your lifetime.

    This past year also provided an example of the inexact nature of market movement: Although sometimes the stock and bond markets go in opposite directions, sometimes—including this time—they move together. To reduce your portfolio risk, it is more effective to use short-term bonds rather than long-term bonds to diversify your stock market risk, since short-term bonds tend to be less volatile than long-term bonds.

    When our next Mutual Fund Portfolio column appears in the August AAII Journal, I hope there will be more stability in the stock market.

    In the meantime, you can follow the portfolio at AAII.com.

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    Model Mutual Fund Portfolio: Selection Rules

    To make it into the Model Mutual Fund Portfolio, a fund must meet the following criteria:

    1. It must be a pure no-load fund. While it may charge a penalty for short-term redemptions, the penalty must be paid to the fund and benefit the shareholders. I feel this type of penalty is desirable particularly for small-cap and mid-cap funds to offset the transaction costs caused by short-term traders.
    2. It must have been in existence for at least 10 years. However, it makes sense to consider exceptions to this rule in certain circumstances. The major exception is if the results to date almost guarantee qualification at the 10-year mark.
    3. It must have had higher returns than the S&P 500 index on both an absolute and risk-adjusted basis for the most recent five-year and 10-year periods. I am interested in future performance, and the funds with the highest returns in the past are not necessarily those that will perform best in the future. But I feel that better funds always outperform the market (S&P 500 index) in the long and intermediate run, and risk-adjusted return is an essential risk control.
    4. It must never have had a three-year period with negative returns. This requirement seeks consistency. In addition, I feel an investment horizon of three years is the minimum for equity investing. This rule emphasizes the importance of never having to sell your portfolio holdings at a loss. We only go back 15 years for this criterion.
    5. Net assets must be less than $9 billion for giant- and large-cap funds, $4 billion for mid- and small-cap funds, and $1 billion for micro- and nano-cap funds. I believe it is too difficult to invest in areas that offer unusual opportunities with a cumbersome amount of assets.
    6. It must have an expense ratio no greater than 1.25% if assets are less than $3.5 billion and 1% or less if assets are over $3.5 billion. Many of the selected funds will be smaller in size, and I can therefore justify the 1.25% level, which is somewhat above the average for no-load stock funds. However, I believe that a higher expense ratio not only will cost in the future (past expenses are reflected in past returns), but says something about management’s attitude. However, there may be justifiable exceptions.
    7. It must currently be open to individuals, with a minimum investment of less than $25,000 and available to residents of larger states. However, I will follow openings and closings of otherwise qualified funds.
    8. If more funds qualify than are needed, new qualifiers are listed in terms of preference based on a number of quantitative and qualitative factors. These may include: stability of risk, turnover ratio, manager tenure, and shareholder services, in addition to basic criteria.
    9. Funds can be sold for violation of the above rules or if we feel that because of other changes there are better funds available. However, we do not anticipate much turnover.

    How many funds should you hold?

    • If you buy mutual funds through a discount broker, having 10 funds is easy enough. If you want fewer funds, you can apply your own criteria to reduce the group.
    • It is not necessary to have a portfolio of 10 funds. All of these funds are so effectively diversified that their average risk is reduced only slightly when combined with others in the portfolio.
    • On the other hand, you do not want to winnow your selection down to just one fund. While these funds in the past have had similar diversification benefits, changes specific to each fund may alter its level of diversification—for instance, a fund may get a new manager who changes direction, or there may be a change in philosophy. For that reason, you should hold at least four different funds.
    • No matter how many funds you buy, equal dollar amounts are invested in each fund initially.
    • Well-diversified mutual funds do not have to be changed very often, so the screen will only be performed twice a year.


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