Coffeehouse Newsletter

Spring 2005 Newsletter

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Welcome to the 2005 Spring Edition of The Coffeehouse Investor.

First, I would like to thank everyone who has taken a moment to share our investment philosophy with someone else. It has been seven years since The Coffeehouse Investor was published, and each year I have noticed a significant increase in the number of people who are tuning in to our investment philosophy and embracing the three Coffeehouse principles. This has almost nothing to do with me and everything to do with YOU, and the fact that you continue to take the time to introduce our three simple principles to friends or neighbors who have a desire to build wealth, ignore Wall Street and get on with their lives.

Many of you have recently inquired about the availability of the book, The Coffeehouse Investor. The bad news is that the previous publisher is not printing any new books due to financial constraints. The good news is we have secured a new publisher, and the second edition should be available by the end of April, with an extended preface and updates throughout. I think you will enjoy this updated edition, and I will inform you when it is available. Again, thank you for your patience. It’s hard to believe that it has been eleven years since I first tried to get the book published. I guess time flies when you are on a mission to get something done.

From 1982 to 1999, with the stock market returning almost 80 percent more per year than its long-term average, it was fun to invest in stocks and mutual funds.

You know the rest of the story. A grueling, three year bear market finally caused many investors to wake up to the daunting task facing them; that of saving enough money and investing it wisely to sustain them for what could quite easily be a 10 to 30 year period of unemployment (called retirement).

As you know, corporations as well as the government are starting to place more responsibility on our own shoulders for financing our retirements. That means that you can’t afford to make the same investing mistakes you’ve made in the past in the stock and bond markets and still come out ahead.

Speaking of markets, in 2004, a seven-index fund Coffeehouse portfolio, consisting of a 60/40 stock-bond split, with the bond portion reflecting an intermediate-term bond index and the equity portion equally divided between large, value, small, small value, international and REITS asset classes, generated a return of 14.18 percent (represented by appropriate Vanguard funds).

More impressively, in what has been a most difficult investment climate over the past six years, the seven-index fund portfolio generated an annualized return of 7.88 percent.

I share the returns with you for one reason; to show you that you don’t need the high- priced handholding of Wall Street brokerage firms to be a successful investor. With that in mind, I would like to share a few reflections, (dare I say certainties?), regarding Wall Street and the future of investing.

1. Because of current valuations in both the stock and bond market, it is highly unlikely that portfolio returns over the next ten years will match the returns generated by a Coffeehouse portfolio over the past six years.

2. Based on the above assumption, you can be sure that the financial industry will do everything in its power to lure you into playing its game of "let’s beat the market." As I have said many times in the past, if there is anything more destructive to building wealth in the stock market than trying to "beat" the market, I have yet to discover it. Make no mistake; Wall Street’s primary objective is to grow its own bottom line, even at the expense of yours. In fact my acquaintances in the financial industry tell me there is more pressure from upper management than ever before for stockbrokers to generate commissions and fees. Unfortunately, this type of environment causes lots of competent and honest stockbrokers to be less than competent and honest when making investment decisions that are right for you. Chances are you will never notice the impact these fees and commissions have on your financial well being. The impact will only gradually occur over time as you begin to shrink your lifestyle in your retirement years to meet your reduced financial resources.

The obvious benefit of the Coffeehouse philosophy is that in this new investing climate, you maximize your return potential in each asset class for a given level of risk.

However, I have always felt that the primary benefit of our philosophy is that it allows you the freedom to ignore things that are out of your control (like the stock market) and focus on the one aspect of investing that matters most of all – your ability to save more than you spend.

Tuning in to a monthly burn rate (expenses) is important for a recent college graduate who is just starting to invest; it is even more important for someone who is getting close to retirement or in their retirement years. The amount you spend and save today will have a dramatic impact on your portfolio value fifteen years from now. You will never know this if you don’t first create a long-term financial plan, which happens to be the third coffeehouse principle.

Speaking of principles, the three Coffeehouse principles are straightforward and easy to understand.

1. Don’t put all your eggs in one basket.

The key to building a successful portfolio is to diversify your assets in such a way that you maximize your chances of reaching your financial goals with a minimum amount of risk.

2. There is no such thing as a free lunch.

Because markets are efficient, any attempt to beat the market is likely to prove disastrous to your long term financial health; thus, it is essential that you capture the entire return of each asset class, and leave it at that.

3. Save for a rainy day.

Developing a long term financial plan, with a keen eye on your saving and spending levels, is critical for you to reach your long-term goals.

Don’t let the simplicity of these principles fool you. They are based on practical application far more sophisticated than anything Wall Street will throw your way.

You might have come across The Coffeehouse Investor which has been featured in several national publications of late, including The Wall Street Journal and Physician's Money Digest. I wanted to take a moment and clear up a few misconceptions that seem to have arisen about our approach to building long-term wealth…

Misconception #1. The Coffeehouse philosophy consists of Vanguard funds.

The Coffeehouse philosophy is just that – a philosophy – based on three principles – it has nothing to do with Vanguard Index funds, even though for the sake of articulating the philosophy in my weekly column, I have presented a seven-index fund portfolio represented by appropriate Vanguard funds only as an example of what a portfolio might look like.

In my opinion The Vanguard Group does offer the best lineup of index funds for do-it-yourself investors, but they certainly aren’t your only option.

You can build a Coffeehouse portfolio using index funds from other mutual fund companies as well, and many investors build a portfolio using only exchange traded funds (ETF’s); that is, index funds that trade like stocks on major stock market exchanges.

Misconception #2. The Coffeehouse philosophy consists solely of "index" funds.

Although the concept of "indexing" is the backbone of our investment philosophy, you can build a Coffeehouse portfolio using actively managed funds, and in many cases you have no choice, especially in 401(k) accounts where selections are limited. The biggest challenge is to identify characteristics of these managed funds that closely mimic the index funds you want represented in your portfolio.

Once you have chosen the appropriate managed funds for your portfolio, our second principle (capturing each asset class’s entire return) still adheres, and is accomplished by never trading these funds, except for rebalancing purposes.

Misconception #3. The Coffeehouse philosophy requires an investment in the stock market.

The first step in becoming a successful investor is to create a long term financial plan. If, in doing so, you discover that you can reach your financial goals by limiting your portfolio to a ten year Treasury bond ladder, then you are a successful Coffeehouse Investor.

If you are like me, Treasury bonds won’t get the job done. In pursuit of higher returns, you might be faced with the task of diversifying your portfolio across four different accounts or more, including your IRA, 401(k), Roth IRA, and taxable account. Applying the Coffeehouse philosophy to this jigsaw puzzle so that your accounts grow in a tax-efficient manner is a great way to put together a portfolio.

I continue to receive countless e-mails and phone calls from investors who are seeking assistance to integrate this philosophy into their lives. Here are a few suggestions….

1. There are several books available that offer a more detailed explanation of the Coffeehouse philosophy, and can be found under the bookshelf at our web site.

2. Check out the Vanguard Diehard forum at Morningstar.com. This forum consists of a wonderful and knowledgeable group of investors who call themselves the Vanguard Diehards. I am continually impressed with the wisdom and insights they share with everyone

3. Many investors who visit the Coffeehouse and embrace our simple investment philosophy come to the conclusion that they are better off working with a professional asset management company. I work with a great crew at Pacific Asset Management LLC (PAM), a fee-only registered investment advisor headquartered in Kirkland, WA that adheres to the Coffeehouse approach. As you know, several studies have shown that the biggest drain on taxable accounts is the tax liability; as such we have on staff Certified Financial Planners as well as CPAs, and working together we provide our clients with investment management services and financial guidance to last a lifetime. Please e-mail me with any inquiries, and include your state of residence and telephone number, as we cannot conduct business in any state unless we are registered or qualify for an exemption to registration.

Best wishes for a prosperous 2005. When we look around the world, we have so much good work to do, and what a tragedy that so much energy goes in to predicting the daily ticks of the stock market. Working together, we can have a profound impact on the lives of millions of investors who want to make the right decisions with their investments. You can make a difference, as you already do.

Bill Schultheis

The Coffeehouse Investor