The New Rules of Investing for Retirement

1. The New Rules of Investing for Retirement Bob Carlson Editor, Retirement Watch AAII February 2006 800-552-1152 www.RetirementWatch.com

2. The Investment Battle The Windshield vs. The Bug

3. The 7% Club • Individual investors earn lower • returns than they should. • Most losses are due to key • mistakes. • Mistakes are both macro and • micro.

4. Micro Investing Mistakes • Asking the wrong question • Investing with a rearview • mirror • Following the ratings • Not building a portfolio

5. Traditional Investment Strategies • Investing for Income (being • conservative) • Holding stocks for the long run • Using the “policy portfolio”

6. The Policy Portfolio Determine return goal  Determine level of risk (volatility)  Pick diversified, efficient portfolio — index funds  Hold portfolio for the long term

8. Problems with CAPM • Volatility is not risk • Real risk is goals are not achieved • Few investors can ignore the short and intermediate term • Bear markets can last 10 years or longer

9. Problems with CAPM • Markets not always efficient • Past patterns don’t always continue — Remember LTCM • “Diversified” portfolios usually are correlated to stocks • “Utterly naïve” “utterly unrealistic” — Martin Whitman

10. Problems with CAPM Source: T. Rowe Price

11. Rational Investing: Risk Management • Markets are not always efficient and rational • Investors are rational but not necessarily right or in agreement • Results in valuation cycles for all assets

12. Rational Investing: Risk Management • Optimists vs. pessimists determine the markets — expectations of returns • Consensus views tend to persist for a long time • Consensus at the extremes usually is wrong •  Cycles are the biggest risk to investors

14. Rational Investing • The very long-term is not the way to manage money • Risk is uncertainty. It must be managed. • Managing the valuation cycle is key to managing risk •  A margin of safety is essential

15. Rational Investing in Action • The Core Portfolio • Always have a fixed, diversified, balanced portfolio • Always in the markets. Avoids overtrading, trend following • Value-oriented funds in the Core Portfolio

16. Rational Investing in Action • The Managed Portfolio • Manage the investment cycles and their risk • Not short-term trading; one- to three-year outlook • Primary goal is to reduce risk; eliminate high risk assets • Combine valuations with market and economic trends

17. Micro Investing Mistakes • Using the economy and earnings • to adjust portfolios • Taking big risks to earn high • returns • Using automatic investment • signals; being fooled by • randomness • Confusing beta and alpha

19. Meandering Markets

20. Where Are We Now? Source: Ned Davis Research

21. Falling Valuations 2/1/991/26/06Change S&P 500 1273 1273 0% S&P 500 EPS$44.49 $74.02 66% S&P 500 P/E28.4 17.2 -39%

22. Where Are We Now?

23. Where Are We Now?

24. Where Are We Now?

25. Where Are We Now?

26. Where Are We Now? • Few values and opportunities worldwide • Likely in an era of below-average returns • U.S. stocks neither undervalued nor overvalued • Pockets of opportunity in U.S. stocks

27. Where Are We Now? • International and emerging market stocks better values than U.S. stocks • U.S. real estate is fairly valued to modestly overvalued • Commodities probably still a good opportunity • Few opportunities in bond markets

28. The Hedge Fund Phenomenon • Trillions of dollars of flowed into hedge funds since 2000 • Believed to be over 6,000 hedge funds • Investment talent flowing into hedge funds • Initially for wealthy, institutions

29. The Hedge Fund Phenomenon • Investors seek:  Absolute returns, more • predictable returns •  Reduced risk, volatility •  Low correlation with major • market indexes

30. Disadvantages of Hedge Funds • Difficult to evaluate • Little transparency, low regulation/accountability • Low liquidity •  High fees

31. Disadvantages of Hedge Funds • Potential volatility • Low capacity, most of the best funds closed • Too many funds chasing the same strategies • Great variability; not a real asset class

32. The Mutual Fund Solution • A number of mutual funds use “hedge fund” or alternative strategies • Open to all investors • Lower cost •  Daily liquidity

33. The Mutual Fund Solution • Transparent investments, easier to evaluate • Low correlation with major markets • High long-term returns • Best funds have limited capacity, closed to new investors

34. The “Hedge Fund” Portfolio • A portfolio of no-load, low expense mutual funds • Funds have low correlation to major market indexes • Funds have low correlation with each other • Use traditional “hedge fund” strategies

35. The “Hedge Fund” Portfolio • Portfolio achieves long-term returns similar to stock indexes with less volatility • Buy-and-hold portfolio • Will lag in bull markets

36. Mutual Fund “Hedge Funds” • Core “hedge funds”: • Hussman Strategic Growth • Pimco All Asset • Leuthold Core Investment • Long/Short Equity • Laudus Rosenberg Global • Long/Short Equity

37. Mutual Fund “Hedge Funds” • Opportunity Funds • Third Avenue Value • Berwyn Income • FPA Crescent • Other funds: • High yield bonds • Cohen & Steers Realty Shares • American Century • International Bond • Oakmark Equity & Income

38. Hedge Fund Portfolio Returns Back-Tested Results (Last 10 Years) Alpha 5.60 Beta 0.27 Std. Deviation 6.46 Worst Quarter -9.54% Best Quarter 10.84%