When life throws you a lemon, make lemonade.

In this case, the lemon happens to be the miserable returns the stock market has generated for your portfolio, not only during the past twelve months, but over the previous decade.

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The election is over and our country moves forward with president-elect Barack Obama, who has his work cut out for him. Unemployment numbers are up and retail sales are down sharply; proof enough that we are staring into the teeth of a fairly severe recession.

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Last week’s OP-ED piece in The New York Times, “Buy American. I Am.”, by Warren Buffett was interesting on several fronts.

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The stock market, after dropping over 800 points today, closed down 370 points, reacting largely to the growing credit problems in Europe and weakening economies in Asia. I want to share my thoughts with you in regards to the current situation.

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I saw last week where the volatility index for the stock market was running near an all time high, which comes as no surprise to me, given the 200 and 300 point swings the market seems to be experiencing on almost a daily basis. This is driven by an uncertainty over how the financial/banking crisis will shake out, fueled by the growing reliance on programmed computer trading by institutional traders.

Amid these wild short-term price swings, I received an email asking my opinion on the impact this short-term volatility will have on the longer-term performance of the stock market, and my response was, “likely no impact at all.”

In the short-run, the stock market is driven almost completely by the emotions of investors. In the long-run it is impacted by the growth and fundamentals of the underlying businesses that make up the stock market.

To that end, despite the crisis in the financial sector, the economy isn’t in a free-fall in terms of growth and productivity. Yes, unemployment is rising, and yes, the housing sector, a driving force in the economy, is in a tailspin. But we need to remember that our country is coming off a period of red-hot growth in the economy, and a certain amount of contraction is to be expected.

It is no fun to watch portfolios decline day after day and week after week, but one way to get through this period with your emotions intact is to avoid watching the fluctuations of your accounts every day. If you have created an asset allocation that is right for you based on your long term financial planning, a sell-off in the stock market of this magnitude won’t affect you long-term because your fixed income (bond, CD) holdings will cushion the downside during these months.

Longer-term, there is a strong chance that the stock market will be significantly higher two to five years out, and your stock market allocation will be positioned to take advantage of that.

If you haven’t created a financial plan that brings clarity to your longer-term financial picture, now is the time to establish one.

The stock market is having a rough year, but it is time to turn away from the 300 point swings for a moment and put things in perspective.

Through the first eight months of 2008, the broad stock market, as indicated by Vanguard’s total stock market fund (symbol VTSMX) is down 10.2%. Pundits and prognosticators alike are telling us how tough it is out there in the world of investing.

Sure, our economy is going through a rough stretch, caused in part by an increase in energy prices and the mortgage/housing debacle, just to name a few.

But, in light of the current market’s decline there is one topic that is rarely discussed by the pundits – it was due for a correction! From January, 2003 through October 2007, the stock market generated an annualized return of 15.54 percent. To put it bluntly, it would have been impossible for the market to have continued its torrid pace. Quite frankly, when you combine our current economic weakness along with its impressive performance during the recent years, I am somewhat surprised that the stock market hasn’t declined more.

It is never fun to have portfolios decline in value, but this recent sell-off is to be expected, if not welcomed. It is this very volatility and uncertainty that allows for the potential for higher long-term returns and why we invest in the stock market in the first place.

Even so, when the stock market languishes for an extended period of time, I have noticed that many investors tend to get a little antsy with their investments. It is not surprising that the Wall Street crowd starts creating newfangled products to assuage the fears and frustrations of investors. For instance, I have had many inquiries from folks across the nation wanting to know my thoughts about variable annuity investments that promise them participation in the stock market upside with limited downside risk. These annuities are usually pushed on to investors by aggressive salesmen who are looking for a hefty commission sale.

I found it interesting that not one person who inquired about these annuities fully understood the fees that were attached to the product, nor could they explain the investment parameters of the annuity involved. That doesn’t surprise me though, because the financial industry specializes in bringing to market extremely complex products with exorbitant fees attached, all pretending to help the investor through this rough stretch of investing.

Many are looking for an easy way to make money and get rich. A friend of mine, Rick Van Ness, whom I am collaborating with to bring The Coffeehouse Investor principles to college seniors, recently attended one of those mega-motivational seminars.

You have probably seen these seminars advertised in your local paper, consisting of six to ten fairly famous figures talking about different life-topics. I received an email back from Rick, and this was his report:

“One of their speakers talked about investing: how index funds would only earn 8% but their online newsletter would virtually assure 15% with its simple buy low sell high guidance, even when the stock is tanking. He got the Key Arena in a frenzy until it seemed like he had 10,000 believers that they could pick stocks and time the market better than institutional investors — because they were “nimble”. I was incredulous, but my heart sank when about 90% appeared to sign-up on the spot for his highly discounted training. It redoubles my belief that all of these people would be better off if they knew the facts. We have a purpose! There is a better way.”

In reflecting on his comments, I realize that we have a long way to go in highlighting The Coffeehouse message to investors across the nation, especially during market stretches like the current one. Our three principles are simple and straightforward. Take it upon yourself to introduce these principles to friends and family members who can benefit from them.

The past few months I have been putting a lot of work into gearing up for the “second chapter” of The Coffeehouse Investor. Truth is, it is more like the “second decade” as it will soon be ten years since the book was first published in January of 1999.

What a difference a decade makes. Ten years ago the domestic stock market was red – hot, and everyone seemed to be caught up in the easy money of daytrading.

Looking back though, I guess fate was smiling down on the Coffeehouse, because it wasn’t but a year later when the stock market began its nasty, three year bear market decline, and investors of all sizes started searching out a little common sense with their investing portfolios.

Now, ten years later, the market is languishing again, albeit not to the extent of 2000-2002. Even so, more investors than ever before are searching for a meaningful way to build long term wealth amid the frustrating volatility inherent in common stocks.

I am part owner of the Registered Investment Advisory firm at which I work, Sagemark Wealth Management (www.sagemarkwealth.com), and find it interesting that when the stock market languishes, our phones start ringing, not from our current clients, but from investors across the nation who are in search of a better investment approach toward building wealth (more on this phenomenon in future blogs).

You will notice a fantastic new web site design here at the Coffeehouse, created and produced by Rhaya Shilts. You can see more of her work at www.rhaya.com. I will be updating this blog at least weekly, if not more often. And the big news is that last January, Jeffrey Krames, (www.jeffreykrames.com), the editorial director of Portfolio/Penguin Books invited me to work with him to publish the 3rd edition of The “New” Coffeehouse Investor, with an expected release date of January, 2009.

So for the past six months I have been hard at work writing three additional chapters and updating the original manuscript. At times I felt like I should be writing an entirely new book, there was so much more I wanted to share with the readers. In light of the increasingly difficult investing climate and progressively more challenging task of building long term wealth, I feel a sense of urgency to disseminate the Coffeehouse philosophy to investors across the nation, and am excited with all the things we are putting in to motion to make that happen.

After a long, cold, dreary spring that extended into the early months of summer, the sun is finally shining in the Pacific Northwest. These days the temperatures creep up into the mid – 80’s and the sunshine seems to last forever, so I best get outside today.

Check back next week, because I am going to write a little about an experience I encountered with a stockbroker who is trying to win the investment account of a foundation on which I serve as a board member.

Is the stock market efficient, and does it matter?

Most investors buy and sell stocks (or invest in actively managed mutual funds), under the premise that markets are not efficient, and that securities are mispriced. They attempt to either buy companies that are worth more than today’s price, or sell companies that are worth less than today’s price.

To carry this question to its logical conclusion, those who feel markets are not efficient invest with the ultimate goal of outperforming, or “beating” the returns generated by the stock market average, which is simply a collective valuation of all the publicly traded companies.

Is the stock market efficient? This long-simmering debate between academicians and Wall Street stockpicker-types will never be resolved, and in the end, it doesn’t really matter.

A more relevant question investors should address in regards to this debate is whether or not one can, with any confidence, embrace a strategy that takes advantage of market inefficiencies and security mispricing, to outperform the stock market average over an extended period of time.

Let’s take a closer look at the data surrounding market efficiencies, and investors’ results from trying to exploit the mispricing of securities. According to Standard & Poor’s, for the five-year period ending March 31, 2007, the following percentage of actively managed equity funds underperformed their respective benchmarks

Large Cap Funds 72.22 percent
Mid Cap Funds 77.38 percent
Small Cap funds 77.67 percent

The above data suggests that, while markets might not be completely efficient, the fact that such a small percentage of professional stock pickers outperform a benchmark indicate the difficulty of consistently identifying mispriced securities.

Unfortunately, the above statistics reveal only part of the investment story for investors who try to “beat the market,” with actively managed mutual funds.

Dalbar, a Boston based company that compares investor behavior with investment results, recently completed their 2008 research paper titled, “Qauntatative Analysis of Investor Behavior.” In its annual report, the study found that for the twenty year period ending December 31, 2007 where the S&P 500 index generated an annualized return of 11.82 percent, the average equity mutual fund investor’s return was a paltry 4.48 percent, resulting largely from a fund holding period of only 3.14 years.

Dalbar’s study confirms that selling underperforming funds in search of top performing funds wreaks havoc on long term returns, and is a dilemma faced by many investors who hang their hopes on a star stockpicker.

A good example of this quandary has surfaced recently in the performance of Legg Mason’s Value Trust fund (LMVRX), managed by Wall Street’s widely worshipped stockpicker, Bill Miller. For the 15 year period ending 2005, this actively managed mutual fund handily outperformed the S&P 500 Index each year, by an impressive average margin of 4 percentage points a year.

Since then however, the returns haven’t been so rosy, with the Legg Mason Value Trust lagging its benchmark over the past 28 months by a 30 percent total return. Investors are now faced with the decision whether to stay invested in Miller’s underperforming fund, or switch allegiance to another professional stockpicker.

For portfolio dollars that are allocated to common stocks, investing in the stock market is all about maximizing one’s return potential over an extended period of time that includes both up and down markets. A simple and successful way to achieve this investment objective, that also puts the pursuit of performance in its proper perspective, is through globally diversified, low-cost, portfolio of index funds.

One way to invest in the stock market is through a “total stock market” index fund. However, there are potential benefits of taking this concept to another level by identifying and investing in different components of the market that include value and small dimensions. This is a topic that will be covered in a future blog post, so stay tuned.