Client Letter – Q4 2007

Happy New Year!  The year 2007 was the most volatile year we have had since 2002. Our overall returns for the full year ranged from 4% to 7%, depending on the level of risk in your portfolio.  So, it turned out better than you probably thought!  As you can see from the chart below, the worst performing asset classes were U.S. small stocks, U.S. small value stocks, and real estate.  The best performing asset classes were international large stocks, international large value stocks, and emerging markets stocks.  Once again, our strong international exposure saved the day!  In addition, our bond funds provided a strong safety net.

The following chart shows the 1-year, 5-year, and 10-year performance of many DFA funds (representing different asset classes) compared to the S&P 500 Index:

Market Returns for the period ending December 31, 2007

 DFA Fund / Index 1 Year Return 5 Year Return* 10 Year Return*
S&P 500 Index5.4912.835.91
DFA U.S. Large Value-2.7615.418.87
DFA U.S. Small Cap-3.0616.459.01
DFA U.S. Small Cap Value-10.7518.5111.51
DFA Real Estate (REITs)-18.6717.3910.84
DFA Int’l Large12.4620.958.62
DFA Int’l Large Value10.2426.9113.03
DFA International Small5.6627.3214.29
DFA Int’l Small Value2.9529.5916.18
DFA Emerging Markets36.0236.5516.01
DFA 2-Year Global Bonds5.272.844.30
DFA 5-Year Global Bonds5.223.335.14

*Note: Returns for periods greater than 1 year are annualized.  Top 3 returns are in bold.

So far, 2008 is off to a rocky start.  How should a successful investor handle these difficult markets? More precisely, how should an investor handle his own feelings when markets are rocky? It is obvious to most investors that they can’t control the investment markets; they can only control their own reactions. If they let their negative emotions get the better of them they will not only feel bad, but they will be more prone to making mistakes with their portfolios.

Try approaching these fears and emotions as a behavioral therapist would: identify the irrational beliefs that underlie your fears. Often you will find that the beliefs don’t fully correspond to reality and your fears are not warranted. There is a toolbox of tricks and self-talk that even the most sophisticated investor can use to calm himself and use to stay on track.

First, when the market plummets and the headlines are bad, take a look at your own portfolio: has it really done that badly? Assuming you have maintained a balance of various types of stocks and bonds, both domestic and international, it is unlikely you are experiencing the same level of losses as the market. Bonds, for instance, are probably going up as stocks go down, so gains on part of your portfolio are offsetting stock market losses.

Next put your portfolio into its historical context. Yes, its value may have dropped over the last week, but where was it one, two, or three years ago? Chances are it is still ahead of those periods. How did you feel a year ago when your portfolio wasn’t as high as it is today? You probably were feeling good because it had gone up at that time. Why shouldn’t you feel even better today when it is higher than it was then?

Next, look at the stock market itself. What’s the worst it has done? Any brief study of stock market history shows that although some stock markets have disappeared when their countries were struck by war or revolution, the major markets have survived every crisis thrown at them. In fact, they have always recovered and eventually moved to higher ground. This quick look should convince you that you can’t lose everything. Again, market history shows that the more diversified a portfolio is, the better the chance that over longer periods of time—five, 10, or 15 years, say—you will not only have a positive return, but your gains will be respectable.

Finally, learn to accept temporary setbacks and uncertainty. We live in a probabilistic world; learning to take events as they come will help you survive the inevitable setbacks that come along. If all else fails, shut off the TV and ignore monthly account statements for a while; chances are things will look better down the road.

I have included several important tax-related documents in this quarterly mailing. First, for clients with taxable accounts, I have provided a Realized Gains and Losses report, which shows the net proceeds and cost basis for taxable securities that were sold during 2007. Second, for clients who do not deduct KFP fees from an IRA account, I have provided a report that shows the fees you paid during 2007. Make sure that you give these reports to your accountant or tax preparer, if you use one.

As we start the New Year, I am almost ready to “roll out” the changes that I discussed in my last quarterly letter.  Please mail in your “Client Satisfaction Survey” if you haven’t already done so.  I am relying heavily on the feedback from these surveys to improve my annual review process.  Once I’ve made these changes, I will be sending you out my updated ADV Part II and new investment and financial planning agreements (if applicable) to sign.  I am hoping to send these out within the next month or so (prior to your 2008 annual review).


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About Christopher Jones

Christopher Jones is the Founder and President of Sparrow Wealth Management, a fee-only financial planning and investment management firm. Before entering the investment field, Chris was a management consultant for Deloitte Monitor. He graduated summa cum laude from Brigham Young University with a B.S. in Economics and a minor in Business Management.