APPROPRIATE BALANCE FINANCIAL SERVICES, INC.
Market Recap & Outlook
After fluctuating in a frustratingly narrow trading range for the first 9½ months of 2004,
stocks finally broke out to higher levels the
last ten weeks of the year, and most indexes
finished the year with gains. The Dow was up
5.3%, the NASDAQ gained 8.6%, and the
S&P 500 rose 10.9%.
Volume 10 Issue 1
| January 24, 2005
ABFS Celebrates
20-Year Anniversary
By Bruce Yates, ABFS Founder and President
I am proud to announce that ABFS has
reached a major milestone: late last year we
reached our 20th anniversary as a company.
When I started ABFS in late 1984, I had no
idea it would become the firm it is today. With
Because most of 2004 was marked by repeated sixteen employees—including six advisors—
rallies and declines, it was a particularly diffi- we now serve clients in 26 states and manage
more than $365 million in client assets. This
Short-term gains can be fleeting.
exceeds anything I imagined when I left ShearThe first three weeks of 2005 have
son 20 years ago to set off on my own (living
on my wife’s teaching salary for the first few
already erased more than 2/3 of the
years while ABFS got established).
Dow’s 2004 total return—and
more than 3/4 of the NASDAQ’s.
Tsunami Tragedy
2004 ended with a sobering display of
Mother Nature’s awesome power. The South
Asia tsunami has filled
TV screens and newspapers in recent weeks
with images of devastation, as more than
225,000 are now confirmed dead and millions more homeless.
The outpouring of aid
from around the world
has been heartwarming,
but it will surely take
years for the millions of
survivors to rebuild
their lives. In a small
effort to help, ABFS has
matched employee donations for tsunami relief, and altogether our
donations now total
more than $4,500. ♦
cult year for active managers (like ABFS) who
use sell disciplines to limit risk. Many got
“whipsawed,” as each successive rally quickly
reversed direction and triggered sale of recently purchased holdings.
In that environment, it is no surprise that,
while all of ABFS’ mutual fund strategies advanced for the year (see graphs at the back of
this newsletter), our least active strategy—
Index Plus—did the best. Its 14.4% return beat
not only our other strategies, but the S&P,
Dow and NASDAQ as well.
The fact that stocks made gains in 2004 is encouraging, but it is important to remember that
short-term gains can be fleeting. The first three
weeks of 2005 have already erased more than
2/3 of the Dow’s 2004 total return—and more
than 3/4 of the NASDAQ’s. Clearly, limiting
losses remains important. In fact, much of this
On Balance is devoted to comparing our active
investment style to the less active “buy and
hold” approach to investing.
Economy and Interest Rates
Amid flagging but still positive economic
(See Market Recap on page 2)
Much of ABFS’ success is attributable to the
contributions of my partner, Bob Pennell. We
joined forces (ultimately merging his firm,
Harvard Financial Advisors, into ABFS) more
than ten years ago. Bob’s insights and “market
sense” have been invaluable in shaping ABFS’
investment strategies and services.
But it is more than Bob—or me—that has enabled ABFS to consistently grow and improve
(See 20-Year Anniversary on page 6)
Seminar and Open House
Join us on March 22nd for a seminar and
open house to celebrate our first twenty
years! First, at 3:30PM, we will host a
seminar on the 2nd floor of our building to
discuss the current economic and market
outlook. That will be followed by an open
house here in our offices on the 9th floor
from 5:00PM to 7:00PM. Hors d’oeuvres
will be served, and parking validated, so
we hope many of you will come. (Maps
and directions are available by phone or
e-mail.) Feel free to bring friends or other
guests, but please RSVP, since space is
limited and we need to know how many
people to expect. ♦
Indicators or Tea Leaves? Predicting 2005 Stock Market Results
•
•
•
•
•
•
Santa Claus Rally: The 7-day period ending on the second trading day of January,
since 1969, has produced an average stock return of +1.7%. When negative, it usually precedes bear markets or corrections. Result this year: -1%
Mid-decade years: There has never been a down market in a year number ending in
5. Undoubtedly a statistical coincidence, but interesting nonetheless.
First 5 trading days: Since 1950, the year has been profitable 29 of the 34 times it
rose the first week. When down the first week, half of the years were up and half
down. Result this year: -2%.
Post-election years: The first year of a presidential term has tended to be negative for
stocks. When the first 5 days were also down, 6 of the last 8 post-election years had
full-year losses of more than 11%.
Three unlikely: Only twice in the past 50 years has the S&P 500 produced doubledigit returns (which it did in 2003 and 2004) three years in a row.
The January Effect (as January goes, so goes the year): Has only failed 5 times in 50
years, and only once in a post-election year. One week still remains in January... ♦
(Market Recap—cont. from page 1)
growth, the Federal Reserve is proceeding with its policy of “measured” interest rate hikes (five since June). The
overnight Fed Funds rate rose from 1%
in June to 2¼% at year-end, and the Fed
appears poised to continue raising rates
until they reach a “neutral” level
(neither stimulative nor restrictive).
That likely equates to a Fed Funds rate
between 3.5% and 4%, which will entail
multiple additional rate hikes in 2005
and 2006.
Much to the consternation of most experts, longer-term bond yields (which
are controlled by market forces, not the
Fed) did not rise over the past six
months. A survey of 55 economists in
mid-2004 revealed that all but one of
them expected the yield on 10-year Tnotes to rise by year-end. Instead, de-
Recent Fixed Income Results
Annual total returns
as of Dec. 31, 2004*
Last 12
3 Yrs
Months (per yr)
ABFS Income
Securities Accounts
5.9%
10.9%
Short-Term
High Yield Bonds
4.5%
4.5%
1-5 Year Corporate/
Treasury Bonds
1.7%
3.9%
* Pre-tax returns for ABFS Income Securities strategy are for
accounts invested for the entire period, after all fees and expenses. Individual results vary, and past performance should not
be construed as indicative of future results. Returns include all
discretionary assets in all discretionary accounts, but exclude
accounts with tax-exempt (municipal) securities in order to
make comparison with taxable alternatives meaningful. Comparative figures are for the Strong Short-term High Yield Fund
(STHBX) and Vanguard Short-Term Bond Index (VBISX),
which mimics the Lehman 1-5 year Corporate/Treasury Index.
Although these funds share some characteristics with the ABFS
Income Securities strategy, the ABFS strategy may utilize
substantially different types of securities, including mutual
funds, convertible securities, and/or income-oriented stocks,
making it substantially different from these and any other funds,
indexes or benchmarks. Minimum account size for this strategy:
$100,000 (but requires a total of $300,000 managed by ABFS).
spite rising inflation and Fed (shortterm) rate hikes, bond yields actually
fell slightly—a phenomenon known as
“flattening” of the yield curve.
There are several possible explanations.
One is that bond investors are worried
about waning economic growth, and
fear further weakness ahead.
Another possible explanation is related
to the burgeoning U.S. trade deficit.
Foreign governments (especially Chinese and Japanese central banks)
have—due to huge trade surpluses with
the U.S.—had so much excess cash that
they have been major purchasers of
U.S. treasury securities. This demand
has helped keep U.S. interest rates
down. Unfortunately, it is a phenomenon that may not last, since the declining dollar is making many foreigners
disenchanted with U.S. securities.
As the Fed continues hiking short-term
rates in 2005, bond yields are likely to
rise, not necessarily in lock step with
the Fed Funds rate, but certainly moving in the same direction. If the Fed
Funds rate ends up at 3.5% to 4%
(from 2%), we expect the yield on 10year T-notes—which is currently
around 4¼%—to rise to at least 5%.
Record low interest rates have made
fixed income investing difficult the past
few years. We are pleased with the returns that our Income Securities accounts have produced in this environment (see table at left). However, just as
the prospect of rising inflation and interest rates caused us to predict lower
fixed income returns in 2004
(confirmed by the actual results in the
table), fixed income investors—
2
including ABFS clients—should continue to expect only mid-single-digit
total returns for the next few years.
Non-ABFS fixed income investors
seeking higher yields should resist the
urge to load up on real estate investment trusts (REITs), junk bonds and
other high-yielding securities. Although
those vehicles have performed well the
past few years, they are increasingly
risky, since their values could drop dramatically if the real estate bubble and/or
economic recovery seriously falter.
Speaking of real estate, the real estate
boom accelerated in 2004, as low interest rates and a “can’t lose” mentality
fueled prices. This is especially true in
growing metropolitan areas, where
home buyer expectations have reached
“irrational exuberance” levels. A Los
Angeles survey revealed that home buyers there expect their homes to appreciate an average of 22% per year over the
next decade, and two-thirds fear being
left out if they don’t buy now. San
Francisco and Boston surveys revealed
similar attitudes, reflecting a growing
“bubble” mentality.
The pin that pricks the real estate bubble may very well be rising interest
rates—both short-term (by the Fed) and
long-term (as foreigners reduce U.S.
treasury purchases). Just as tech stock
speculators had a rude awakening in
2000-2002, people expecting everincreasing real estate prices are likely to
be shocked when prices start to weaken
in coming years. ♦
What is the “Best”
Growth Approach?
Buy-and-Hold vs.
Active Management
2004’s choppy stock market has made
some people wonder if active management (like that offered by ABFS) is
really the best investment approach.
Some experts—after falling silent
when the bear market caused massive
losses in many portfolios that were not
managed—are again touting the “buy
and hold” approach to investing. Even
“indexing”—simply holding funds
that mimic broad stock indexes like
the S&P 500—is gaining popularity
again. We therefore thought it would
be a good time to compare these dif-
ferent approaches, and point out some
of the strengths/weaknesses of each.
The Importance
of Independent Thinking
At ABFS, we generally avoid the common Wall Street approach of simply
buying stocks and hoping their prices
rise. Many investors, mutual funds and
money managers tend to buy a diversified portfolio of stocks (or index fund),
and then—with minimal changes—wait
for rising stock prices to increase the
value of their holdings. We believe this
is a dangerous approach, and we will
explain why.
order to meet their goals. What people
really need are two things: to avoid depleting their assets (through loss or
overspending), and to achieve positive
long-term returns that exceed inflation
sufficiently to provide for their (and/or
their heirs’) long-range needs and objectives. While it is reasonable to measure portfolio returns relative to some
index or benchmark (and we do so), one
should never lose sight of the importance of those other, more personal
goals.
stocks are rising, the natural urge is to
be more aggressive, and be frustrated
that you aren’t getting all the gains you
hear about on TV or from neighbors.
Unfortunately, both of these emotions—fear of loss and fear of missing
out—are usually based on short-term
market direction, and they are not necessarily conducive to achieving your
long-term financial goals. Fear of loss
keeps investors out of the market too
long, and fear of missing out encourages people to take too much risk and to
At ABFS, because we often tend to err
“stay the course” far longer than they
on the side of caution (to limit risk), we should. You probably know people who
don’t necessarily get the full benefit of
got caught up in the speculative internet
every stock rally. When the market rises stock fervor a few years ago, and were
in any given month, quarter or even
forced by the ensuing bear market to
postpone retirement, go back to work,
Fear and greed might more aptly
sell vacation properties or otherwise
be called fear of loss and fear of
drastically alter their lifestyles. People
missing out (we don’t believe most whose stock investments were managed
by ABFS were spared that upheaval.
people are actually greedy).
Three fundamental characteristics of
our “active” management style set us
apart, and have been key to our success.
For one thing, our growth strategies
place great emphasis on limiting risk
(using stop-loss and other disciplines to
eliminate large losses). As a result,
ABFS growth strategies are consistently
year, our strategies can just as easily
less volatile than most stock market
indexes, as the graphs at the back of this underperform as outperform. Sometimes we do better and sometimes
newsletter show.
worse, but we almost never “mimic” the
market. That means you will almost
Another defining characteristic of our
approach is our willingness to raise and always be able to find at least one index
that is “doing better” than an ABFS
hold “cash” (money markets) during
market declines. Although we prefer to growth account.
be in the market, at times we use cash to
protect principal while we seek pockets Despite—or actually, because of—that
lack of correlation between our strateof strength in which to invest.
gies and the market’s short-term performance, we are confident that our
Lastly, in deciding what to buy, we go
approach will enable our clients to
to considerable effort identifying specome out ahead over any full market
cific areas of opportunity (whether in
the U.S. or overseas markets). We try to cycle (bull and bear market). We’d love
avoid sectors that are weak, even if eve- to beat the market every month, quarter
and year, but that’s not realistic if we
ryone else seems to be holding them.
consistently think independently. Our
Indeed, our ability to think independreal objective is to significantly beat the
ently—to be different—may be what
market over time, since that is how we
attracted you to us in the first place.
can best achieve your long-term goals.
Our actively managed mutual fund
strategies have dramatically outperShort-term Emotions
formed all major indexes over time (see vs. Long-term Goals
Investors naturally feel one of two emopage 7). However, our independent
tions as the stock market moves up and
approach makes short-term “apples to
down. The two emotions are often reapples” comparisons with indexes—
ferred to as “fear and greed.” But they
such as the Dow, S&P 500 or
might more aptly be called fear of loss
NASDAQ—problematic. For proper
perspective, our results must not only
and fear of missing out (we don’t bebe viewed in the context of return and
lieve most people are actually greedy).
relative risk, but also in terms of your
own long-term goals and needs.
When prices are plummeting, it is natural to fear that they will continue falInvestors don’t need to match a certain
ling, and to wish you didn’t have any
market index every quarter or year in
money in the market. Conversely, when
3
If your long-term goal is to increase the
value of your portfolio, while limiting
the likelihood that your life plans will
be disrupted by unforeseen market
events, you must think “beyond” shortterm market gyrations (and emotions).
Your objective should be to utilize the
investment approach most likely to
achieve your goals. For most people,
that includes limiting exposure to declines that could derail their life plans.
Different Markets/
Different Strategies
Every investment approach entails
trade-offs. Not every strategy works
equally well in all circumstances. To
illustrate that point, let’s take a look at
three different approaches in three common market environments.
Three environments occur repeatedly in
the stock market: extended uptrends
(bull markets); extended downtrends
(bear markets); and choppy periods
(sideways or “trading range” markets).
For purposes of this discussion, we will
consider in each environment three investment approaches: active management (such as that ABFS employs); a
“buy-and-hold” approach (which might
include individual stocks, index funds
and/or other mutual funds); and staying
out of the market altogether. Which of
these approaches performs best in the
short run depends very much on which
of the three market environments exists.
Which approach is best in the long run
depends on how each one handles combinations of those environments.
• Bull Markets
In a roaring bull market, it’s pretty easy
to make money. A buy-and-hold approach works very well. In fact, the
more aggressive the stocks or funds a
person buys and holds, the more money
they make during extended uptrends.
An actively managed approach should
also do well in a bull market, since it
should stay pretty fully invested, ideally
in relatively strong market sectors. In
fact, both active management and a
buy-and-hold approach should do far
better than staying out of the market
altogether. Which of the two will do
best, however, depends on the nature
and duration of a given bull market, and
the relative skill of the active manager.
• Choppy (Sideways) Markets
During a prolonged period of choppiness (as we saw for most of 2004), none
of the three approaches is likely to produce much of a return. Staying out of
the market (e.g., in money markets) will
produce a positive, but low, return.
A buy-and-hold approach may be able
to “ride through” choppy periods. It
may, therefore (especially if the choppiness ends on an up-note, as 2004 did),
produce better returns than staying out
of stocks altogether.
Active management, on the other hand,
which does best (relatively speaking)
when stocks move in one direction or
the other for awhile, struggles during
choppy periods. When there are no extended trends in either direction, shortlived rallies and corrections tend to
cause “whipsaws” (purchases quickly
followed by market reversals that trigger sales). And repeated whipsaws can
produce numerous small losses. As a
result, active management often underperforms one or both of the other approaches during such times.
ter rally made both of them look better
by year-end.
• Bear Markets
In the third market environment—an
extended market decline—staying out
of the market altogether will at least
produce a small positive (i.e., money
market) return. The worst returns (i.e.,
biggest losses) are likely to result from
remaining fully invested.
Active management may or may not be
better than staying out altogether, but
should do significantly better than the
buy-and-hold approach. Active disciplines can reduce losses, and may
even—if they use a “tactical”
(opportunistic) approach to security
selection—make money during a bear
market. That’s because even in bear
markets, a few opportunities may arise
in sectors that buck the trend and do
relatively well. An actively managed
approach that can identify those pockets
of strength may be able to produce positive returns (as the ABFS mutual fund
strategies did during the bear market of
2000-2002), while most investors are
losing money. (Of course, there is no
assurance that ABFS or any active manager will do so in every bear market.)
Which Trade-offs Do You Choose?
Clearly, no single approach provides
optimal results in all three market environments, and each approach involves
trade-offs. Since we as investors don’t
know what investment environments lie
immediately ahead, we must simply try
Whether either the buy-and-hold or
active approach is better than simply
staying out of the market depends on
whether the choppiness ultimately turns
into an uptrend or downtrend. For 9½
months of 2004, for example, staying
out of the market was better than the
other two approaches, but a fourth quar4
to understand the impact of those different trade-offs, and decide which ones
we are willing to live with.
Many investors are so concerned about
missing out when stocks are rising that
they endure large bear market losses by
staying fully invested. Other investors
are so conservative (and afraid of losing
money) that they aren’t willing to invest
in stocks at all.
Neither extreme is really necessary, and
generally neither is in your best interest.
Staying out of stocks altogether denies
you the opportunity to benefit from
stocks’ high historical returns (relative
to bonds and many other assets). Holding stocks “through thick and thin,” on
the other hand, lets you participate in
the market’s gains, but you may give
those gains back during bear periods.
And therein lies the real fundamental
problem with the buy-and-hold approach; it provides little or no protection against major market declines. During the recent bear market (early 2000
to late 2002), the S&P 500 dropped
47.5% and the NASDAQ dropped
77.9%. By simply “hanging on,” many
buy-and-hold stock investors ended up
losing half to three-quarters of their
capital.
Although stocks may not experience a
bear market as severe as that of 20002002 again any time soon, it is foolhardy to assume that stocks are immune
to steep and/or extended declines. In-
dexing or otherwise remaining fully
invested may assure that you don’t underperform “the market,” but it could
also create losses that take many years
to recoup. Thus, lack of downside protection is arguably the biggest risk of a
buy-and-hold approach.
Rather than staying entirely out of
stocks or staying fully invested, we
believe it is more prudent to use active
management in order to (a) participate
in much/most of the stock market’s
gains, and (b) limit exposure to major
declines. Limiting portfolio declines/
losses is more important than you think.
More Risk = Less(!) Return?
Everyone knows that risk and return go
hand in hand. But many investors misinterpret that concept. They assume that
paper losses in risky stocks or funds
will be “worth it” in the long run because those losses will be more than
offset by spectacular returns in bull
markets. This leads to the misconception that the best long-term returns simply require willingness to endure more
volatility (and paper losses) along the
way.
While it is true that investments with
unusually high return potential generally entail higher risk, you cannot assume that just because something en-
There is a misconception that the
best long-term returns simply require willingness to endure more
volatility (and paper losses)...longterm returns are not necessarily
proportionate to the risk you take.
tails high risk, it will produce high returns, either in the short or long run.
Many high risk investments end up disastrously (e.g., defunct internet stocks
and numerous hedge fund collapses).
But even “good” ones don’t necessarily
pay off in the end. Let’s examine why.
High returns only result from high-risk
investments when those investments are
successful far in excess of negative
setbacks they suffer. When problems
(with an individual company or stock,
its sector or the entire market) cause
stocks to lose large portions of their
value, there may be no reward for having taken that extra risk. In fact, one of
the most surprising facts for most people is that—even after many years and
multiple bull and bear markets—
taking extra risk may leave them
with lower cumulative returns (i.e.,
less money) than a more conservative approach.
To illustrate this fact, consider aggressive growth stocks, which tend
to produce very high returns during
bull markets and rallies. Do such
stocks (or funds containing them)
also produce the best bottom line in
the long run? Not necessarily.
As of last month, according to mutual
fund tracker Lipper, most aggressive
growth mutual funds were still down
50% or more from where they were five
years ago. Even over the last ten years,
which included the roaring bull market
of the late 1990s, their average annual
return was only 6.1%. That’s less than
government bonds, which averaged
6.6% per year over the same period.
gains. We discussed this principle at
length in our January, 2004 article, Investing Like Animals: Lessons on Risk
and Return (give us a call if you would
like a reprint). For example, losing 50%
in an investment doesn’t just require a
50% gain to make that money back;
your remaining capital has to earn
100% to be “even” again.
Because of this principle, the S&P 500,
which declined 47.5% during the recent
And bear in mind that even getting
bear market, will need a gain of 90%
6.1% required being in (and staying in) (from its 2002 low) to get back to its
those funds the entire ten years. Many
March, 2000 peak. And the larger the
investors only get drawn into aggressive loss, the more dramatic the gain reinvestments after seeing big gains (they quired to recoup it. For the NASDAQ
buy near the top, driven by fear of miss- (which declined 77.9%), the gain reing out), and later—after those investquired will be 352% from its low! It
ments experience steep declines—get
could literally take a decade or more for
scared and sell them. For investors who many investors to fully recoup the
did either of those things, the average
losses from that one bear market.
10-year return would be significantly
less than 6.1%.
Here and Now
You may think none of the above is
relevant because it is all ancient history.
In other words, long-term returns are
But human nature doesn’t change and
not necessarily proportionate to the
amount of risk you take, and buying and we are all subject to human emotions,
holding stocks or funds does not assure so history often repeats itself. These
concepts are important to consider now
you of high returns (even in the long
because they pertain to your future. You
run). In fact, taking lots of risk in the
already may be feeling an urge to bestock market (or even just holding
“average-risk” stocks without somehow come more aggressive in order to avoid
“missing out” if the late-2004 stock
limiting your losses) may leave you
rally continues in 2005. We want to
with less money than a more actively
make sure you don’t put yourself in a
managed approach that produces more
situation where unexpected market
modest gains during rallies, but limits
events could deplete so much of your
downside risk.
capital that it takes you years to recover.
Pain Trumps Gain
Why are losses such a big deal? It’s not Perhaps the most basic question you
must ask yourself is whether there exthat we think stocks will lose money
ists a real possibility that another major
more years than they make it, or that
stocks will experience larger losses than market decline will occur in the years
ahead. As dramatic as the 2000-2002
they do gains. The real issue is how
bear market was, many experts believe
badly large losses “hurt” your capital.
that it was only the first stage of a much
Large losses impact capital much more larger secular decline necessary to correct excesses of the late Nineties.
dramatically than the same percentage
5
Consider the Japanese Nikkei 225 index
(sort of a Japanese version of the U.S.
Dow Industrial Average). Following its
speculative peak of 38,915 in December
of 1989, the Nikkei suffered multiple
declines (albeit with intermittent rallies
that drew investors back in) over the
following 13 years. It finally bottomed
out in 2003 at less than 8,000, a total
decline of roughly 80%. In fact, a “buyand-hold” Nikkei investor who has remained fully (planning to ride out its
declines) is still down more than
70%...after fifteen years!
We’re not saying that will happen to
U.S. markets, but neither are we sanguine about the outlook. Economists
point to troubling trends as cause for
Rising inflation, huge budget and
trade deficits, record consumer
debt, a weak U.S. dollar, waning
earnings growth...it isn’t hard to
envision scenarios that could
trigger another bear market.
concern: rising inflation; huge budget
and trade deficits; a rapidly developing
real estate bubble; record consumer
debt; a weak U.S. dollar; still-high (by
historical standards) stock valuations
and waning earnings growth; and a
tenuous geopolitical environment. It
isn’t hard to envision scenarios that
could trigger another bear market.
Conclusions
We believe that ABFS’ active management offers substantially better tradeoffs than simply “indexing” or taking a
buy-and-hold approach to the stock
market. Using ABFS may mean that
you occasionally experience lower
short-term returns, but that is a small
price to pay for knowing you are less
vulnerable to potentially debilitating
losses. We are confident that our approach offers a higher likelihood of
achieving your long-term financial
goals than any alternative we’ve seen.
It is important, however, to remember
that each ABFS growth strategy is designed to accommodate certain risk/
return comfort levels and expectations.
You should periodically ask yourself
(and discuss with your ABFS advisor)
whether a particular strategy you are
utilizing still meet your needs.
If your goals or comfort level change
(e.g., if you want to be a little more
aggressive), don’t throw caution to the
wind. Just ask your advisor about the
advisability of shifting some money to
a different strategy. On the other hand,
if your needs and objectives have not
changed, simply remind yourself that
occasional fear of “missing out” is
perfectly natural, and refocus on your
long-term goals. That is what we do. ♦
(20-Year Anniversary—cont. from pg. 1)
the services we offer. ABFS owes much
of its success to our exceptional group
of dedicated associates/employees, half
of whom have been with ABFS for
more than a decade.
Over the past few years, we have gone
to considerable effort and expense to
increase the “depth” of talent here at
ABFS. It wasn’t long ago that I personally managed all of the firm’s fixed
income portfolios and Bob managed all
of our growth strategies. Today, I am
assisted in the fixed income area by
Mary Ann Ferreira, who has over 15
years of experience in the bond industry. And Bob has been working closely
with Eddie Woo for more than eight
years now, managing and constantly
improving the ABFS growth strategies.
office on a given day.
Building a strong team also has important long-term implications for ABFS—
and you. Because ABFS is no longer
dependent on me—or indeed any one
person—for its existence, there is much
less chance that our ability to carry on
as a firm will be disrupted in the future.
While Bob and I expect to remain involved in ABFS for many years to
come, we are also developing a longterm succession plan that will enable
ABFS to continue serving your needs—
and those of your children—far into the
future.
Which brings me to one final point as I
reflect upon ABFS’ 20-year history. I
want to thank all of you—our clients—
for your loyalty and trust, without
which ABFS could never have come
this far. You have stuck with us through
both bull and bear markets, as we
worked to refine and improve our investment techniques and disciplines.
We are both honored and humbled by
the faith you exhibit in us by trusting us
to manage your investments.
As I look forward to ABFS’ next twenty
years, I am proud to say that ABFS has
never been stronger—or in a better position to help you reach your goals—
Last year, we also hired a Chief Operatthan we are right now. With virtually no
ing Officer/General Manager—Phil
corporate debt, steady growth, and the
Platt. Phil oversees many of the day-tomost talented group of employees ever,
day operations of the business (staffing,
we are deeply committed to providing
administration, regulatory compliance,
the best investment management availetc.). Not only has that freed up time for
able anywhere. As we continue to grow
Bob, me and others, but having Phil
in orderly fashion, we plan to continue
running the business full time (rather
improving existing services and investthan Bob and me squeezing it in while
ment processes, while remaining true to
managing investments) has significantly
our basic approach. Rather than blindly
improved the overall quality and effiseeking the most thrilling returns, we
ciency of our operations.
will continue paying special attention to
risk. And as we strive to be worthy of
This increasingly robust “team” apyour continued trust and confidence, we
proach, combined with constant adwill make every effort to produce revances in technology, have enabled
sults that provide you with both finanABFS to keep growing, while simultacial security and peace of mind. ♦
neously improving the services we alOn Balance is published quarterly by Appropriate Balance
ready provide. It is also allowing Bob
Financial Services, Inc. (ABFS), a Washington corporation,
which is registered with the U.S. Securities and Exchange
and me to get our work/personal lives
Commission as a Registered Investment Advisor. Information
into better balance, taking some long
herein is from sources believed to be reliable, but whose
accuracy we do not guarantee. Subscriptions are free to clients
overdue vacation time while still reof ABFS and others at the sole discretion of ABFS. Reproduction without express permission of ABFS is prohibited. On
maining involved in important ABFS
Balance is not reviewed, endorsed, or approved by any regulamatters, such as strategic investment
tory agency. Employees of ABFS may buy and sell the same
securities owned by or purchased for clients, but manipulative
decisions. It is nice to know that ABFS'
trading or placing employee orders ahead of client orders is
strictly prohibited. Certain employees of ABFS (Bruce Yates,
strong, experienced team of investment
Marhe Youch, Mary Ann Ferreira and Phil Platt) are concurmanagers, advisors and staff can assure
rently registered representatives of Pacific West Securities, Inc.,
a registered broker/dealer. The latest version of our disclosure
that your investments needs are being
document, SEC Form ADV-Part II, is available at any time
upon request.
met, even if any one of us is not in the
6
PERFORMANCE OF ABFS GROWTH STRATEGIES
Inception through December 31, 2004 1
Graph shows model portfolio performance
RETURN & RISK DATA
Cumulative (graph period)
$210,113
SD
MDD
2.5% -12.2%
Value Plus
$198,574
2.2%
-9.1%
+26.4%
+16.8% +9.5% +0.7% +14.0%
+7.0%
-5.7% (31%)
Managed Risk
$195,470
1.6%
-6.2%
+22.9%
+15.7% +14.2% +4.0% +12.7%
+2.7%
-4.2% (22%)
+6.9% -0.4% +20.1% +14.4%
-6.6% (31%)
-9.1% -12.0% -22.2% +28.5% +10.7%
-39.3% -21.1% -31.5% +50.0% +8.6%
-18.6% (100%)
-32.4% (174%)
ABFS Strategies 1
Momentum Growth
Investment 2
Index Plus
$146,287
Indexes
S&P 500
NASDAQ
$107,320
$99,210
1
2
3
4
1
3
Avg Yearly Risk/
MDD (and as a
2004
% of S&P 500) 4
+7.3%
-7.0% (38%)
Component Returns for Each Year 2
1999
2000
2001
2002
2003
+50.4%
+5.5% +5.5% -1.7% +19.0%
Value of $100,000 Risk/Volatility
1.7% -12.4%
n/a
n/a
5.7% -47.5%
9.9% -77.9%
+21.1%
+85.6%
The first three ABFS strategies have existed under their current approach and trading disciplines since the beginning of 1999 (the entire
graph period). The Index Plus strategy began in early 2000, so its first full year of data is 2001. Accordingly, the Index Plus graph line
begins on 1/1/2001, originating at the same point as the S&P 500 stood on that date (since that is the index it attempts to outperform).
Yearly return figures are actual net returns to clients after all fees and expenses. “Cumulative” data are for all of the individual “component”
years (same as graph period, except for Index Plus, which only has data from 2001 on), compounded at the end of each year. “Value of
hypothetical $100,000 investment” includes all component year returns, compounded at the end of each year.
Risk/Volatility Measures (larger numbers = higher volatility/risk):
SD = monthly standard deviation of return.
MDD = maximum draw-down in account value from any high point to subsequent low point during the period. This is the worst
decline in account value an investor had to “endure” in order to achieve that strategy or index’s return.
Average yearly MDD (i.e., largest decline endured). Unlike “Cumulative” MDD, which is the worst decline over the entire graph period,
this is the average of the worst declines in each individual year. This provides an idea of the average declines in value investors had to
endure from year to year. The figures in parentheses show how each one compares to (as a percentage of) the S&P 500’s average MDD.
IMPORTANT: The above is not complete without “Notes Regarding ABFS Growth Strategy Performance” on reverse side.
7
Notes Regarding ABFS Growth Strategy Performance
GENERAL
The data in the graph and table on the reverse side are for informational purposes only. Proper interpretation requires some knowledge of market risks,
returns and portfolio theory. This information is best used by professionals, and the general public should not act based on it without substantial explanation,
qualification, and discussion. We believe – but do not guarantee – that these data are accurate. Of course, there is no assurance that future returns, declines, or
volatility will in any way resemble the past, or that results will even be profitable. Some of these results were achieved during unusually positive periods for
U.S. equity markets. We do not intend to imply that high relative returns will be produced on an ongoing basis, and periods of negative returns should be
expected. Investors should be prepared to endure such periods, and should be sure money invested in growth portfolios is of a long-term nature (not needed
for at least 5-10 years).
The first three ABFS growth strategies shown (or their predecessors, which were also managed by Robert Pennell, the current primary growth manager) have
existed since late 1986. However, their methodology has evolved and changed significantly over the years, and a major modification occurred in late 1998.
This modification included the implementation of much stricter sell disciplines, which are intended to help optimize risk-adjusted returns and reducing
absolute downside exposure. Because of the significance of the change in late 1998, we believe only the performance since then is representative of these
strategies’ current management style, and hence only that period is shown. The fourth ABFS strategy shown—the Index Plus (NonTimed) mutual fund
strategy—has only existed since early 2000; its first full year of client data is 2001. Due to these limited track records, investment decisions should not be
based solely on these results. Investors should make sure they fully understand and agree with each management style utilized. Due to our emphasis on stoploss disciplines, much of the return in the ABFS growth strategies is expected to be in the form of short-term capital gains, making these strategies most
attractive for tax-sheltered accounts and/or clients wishing to reduce exposure to large declines, rather than for taxable investors who are concerned with
minimizing taxes.
RETURNS
Returns for ABFS strategies in the table are “iterative internal rate of return” figures for actual client portfolios. The figures for each “component” year
include all client portfolios (even new and terminated accounts) that were invested in that strategy for the entirety of that year (or other period as noted), but
exclude any non-managed securities (which were occasionally held at clients’ request) in those accounts. The Cumulative “Value of $100,000 Investment” is
calculated by simply compounding the actual returns for the component periods at the end of each year. Note that for Index Plus, all data are for a period two
years less than for the other three strategies, due to its later introduction. Returns are calculated on a dollar-weighted basis; that is, they include the actual
beginning values, all expenses (including management fees), and deposits and withdrawals for all accounts, calculated as one large “portfolio” for each
strategy. Returns are therefore net of all fees and transaction charges, and include reinvestment of all dividends and earnings. Returns ignore tax implications,
which may be a significant consideration for taxable accounts. Actual individual client returns usually differ somewhat, depending on such factors as each
client’s beginning date, transaction costs (which vary by account size), additions and withdrawals during the period, etc. “S&P 500” data are for the
Vanguard Index 500 Fund (VFINX) total return, including all dividends. “Nasdaq” data are for the Nasdaq Composite index price only.
GRAPH
Unlike the return figures in the data table, which are for actual client accounts, the graph lines for ABFS strategies are not drawn from actual account values,
but rather are plotted using a model portfolio with the same mix and proportions of mutual funds held for clients, adjusted daily for purchases and sales made
in actual client accounts. The model performance of the graph takes into account a model performance fee; however, model trading does not involve financial
risk and cannot completely account for the impact of financial risk involved with actual trading. Model trading or model performance may not reflect the
impact that material economic and market factors might have had on the management of actual client accounts. The performance results of a model portfolio
do not reflect actual investors’ ability to withstand losses or to adhere to a particular trading strategy in spite of trading losses, which can adversely affect
actual trading performance (results). Therefore, although we believe the graph is a rough visual approximation of account fluctuations, it is not meant to
precisely represent or take the place of the actual account returns that are reflected in the figures below the graph. Note that the Managed Risk strategy often
contains individual convertible bonds as well as funds. Since the graph reflects only mutual funds, a short-term bond fund was used to represent the allocation
to convertibles. This substitution is not intended to imply that convertibles and short-term bond funds are equivalent (convertible bonds are in fact riskier),
but rather to somehow attempt to account for them in the graph. Since the return figures in the table reflect actual clients’ managed holdings, including
convertibles, they do incorporate the actual impact of the convertibles on returns.
RISK/VOLATILITY
Generally, investment analysts measure portfolio risk using some type of volatility measure that includes both realized and unrealized (paper) gains and
losses. Two such volatility figures are shown in the accompanying table:
SD = monthly standard deviation of return for the period. SD reflects the range of variation in return, both up and down.
MDD = maximum draw-down (decline) in account value from any high point to subsequent low point during the period. Unlike SD, MDD focuses only on
downside fluctuation (which some people consider more useful as a measure of risk than fluctuation up and down). In essence, it shows the worst
decline in value “endured” during the period in order to achieve the resulting return.
Note that SD and MDD figures for the ABFS strategies are not calculated from actual client account values, but rather using the same model portfolio data
used to create the graph (as described in the “Graph” section above). MDD and SD figures should therefore only be considered a rough approximation of, not
an exact measure of, the actual fluctuation experienced by client accounts.
Although SD and MDD figures indicate each strategy’s volatility and declines during the periods shown, they cannot indicate all types or amounts of risk
taken in each strategy, and how those risks differ from the S&P 500 or Nasdaq indexes. For example, the S&P 500 is an index of U.S. large company stocks.
ABFS growth strategies, while primarily utilizing mutual funds containing stocks, often employ funds containing types of securities different than the S&P
500, such as small company stocks, foreign stocks, domestic or foreign bonds, convertible securities, and/or cash equivalents. The Managed Risk strategy may
also contain individual convertible securities in addition to mutual funds. We believe the flexibility to use a wide variety of securities and market sectors
facilitates enhanced risk-adjusted performance, but investors should be aware that some individual holdings purchased in these strategies may have
substantially different (and greater) risks than the S&P 500 and/or Nasdaq, and that direct comparison with these or any other indexes is not possible. The
comparisons in the table and graph are only meant to provide a general idea of relative return and volatility, and should not be taken to imply that ABFS
strategies are actually similar to the S&P 500, Nasdaq, or any other index or investment.
ABFSDGPDisc012005
8
ABFS Growth Strategies - Comparative Performance
through December 31, 2004
20.0%
14.4%
Last 12 Months
10.7%
10.0%
2004 was a difficult year
for active managers, as
repeated market reversals
caused “whipsaws” for
those employing buy and
sell disciplines. As a
result, ABFS’ least active
strategy (Index Plus) and
the indexes themselves
were the best performers.
7.0%
-10.0%
-7.5%
-5.7%
-20.0%
-6.2%
-7.2%
-6.2%
-18.6%
-30.0%
S&P 500
NASDAQ
ABFS
INDEX PLUS
ABFS
M OM ENTUM
GROWTH
Total Return
ABFS
VALUE PLUS
ABFS
M ANAGED
RISK
Risk (MDD)
36.8%
10.8%
25.5%
11.5%
20.4%
22.8%
Last 3 Years
The latest 3 years include
the final year of the bear
market, followed by two
up years. All four ABFS
strategies significantly
beat the market over this
period, while substantially
limiting risk.
0.0%
-20.0%
-40.0%
2.7%
0.0%
40.0%
20.0%
7.3%
8.6%
-12.4%
-6.9%
-7.2%
-6.2%
-33.0%
-45.9%
-60.0%
S&P 500
NASDAQ
ABFS
INDEX PLUS
Total Return
Last 5 Years
The S&P 500 and Nasdaq
have yet to recoup their bear
market losses; both still have
negative returns for the past
five years. Lower risk—plus
careful fund selection—
provided investors in ABFS’
strategies not only solid
positive returns, but the
luxury of sleeping soundly as
well.
80.0%
60.0%
40.0%
20.0%
0.0%
-20.0%
-40.0%
-60.0%
-80.0%
-100.0%
ABFS
M OM ENTUM
GROWTH
ABFS
VALUE PLUS
ABFS
M ANAGED
RISK
Risk (MDD)
57.1%
59.0%
39.7%
-11.4%
-46.5%
-12.2%
-9.1%
-6.2%
-47.5%
-77.9%
S&P 500
NASDAQ
ABFS
M OM ENTUM
GROWTH
Total Return
ABFS
VALUE PLUS
ABFS
M ANAGED RISK
Risk (MDD)
NOTES
Total Return for ABFS strategies is actual net total return for client portfolios after all fees and expenses. 3-year and 5-year figures are actual yearly
returns, compounded at the end of each year. Indexes are the Vanguard Index 500 (VFINX), including dividends, and NASDAQ Composite (index only).
MDD = maximum draw-down in account value from any high point to subsequent low point during the period. It is the worst decline in account value an
investor had to “endure” in order to achieve that strategy or index’s return. Unlike Total Return figures, which are for actual client accounts, the MDDs
for ABFS strategies are based on a model portfolio with the same mix and proportions of mutual funds held for clients in these strategies, adjusted daily
for purchases and sales made in actual client accounts. Thus, while MDDs are believed to be representative of actual relative declines in client
accounts, they are only approximations thereof. Past MDDs should not be taken to guarantee similarly low MDDs – or “sleeping soundly” – in the future.
For additional details and information, including data since inception and year-by-year returns, see “Performance of ABFS Growth Strategies” sheet.
IMPORTANT: The above is not complete without notes and disclosures on reverse side.
Appropriate Balance Financial Services 425-451-0499
Notes Regarding ABFS Growth Strategy – Comparative Performance
GENERAL
The data in the bar graphs on the reverse side are for informational purposes only. Proper interpretation requires some knowledge of market risks,
returns and portfolio theory. This information is best used by professionals, and the general public should not act based on it without substantial
explanation, qualification, and discussion. We believe – but do not guarantee – that these data are accurate. Of course, there is no assurance that
future returns, declines, or volatility will in any way resemble the past, or that results will even be profitable. Some of these results were achieved
during unusually positive periods for U.S. equity markets. We do not intend to imply that high relative returns will be produced on an ongoing basis,
and periods of negative returns – with declines larger than those experienced during these periods – should be expected. Investors should be prepared
to endure such periods, and should be sure money invested in growth portfolios is of a long-term nature (not needed for at least 5-10 years).
Three of the ABFS growth strategies shown (Momentum Growth, Value Plus, and Managed Risk—or their predecessors, which were also managed by
Robert Pennell, the current primary growth manager) have existed since late 1986. However, their methodology has evolved and changed
significantly over the years, and a major modification occurred in late 1998. This modification included the implementation of much stricter sell
disciplines, which are intended to help optimize risk-adjusted returns and reducing absolute downside exposure. Because of the significance of the
change in late 1998, we believe only the performance since then (which includes all of the periods shown in these bar graphs) is representative of
these strategies’ current management style. The fourth ABFS strategy shown—the Index Plus (NonTimed) mutual fund strategy—has only existed
since early 2000; its first full year of client data is 2001. Due to these limited track records, investment decisions should not be based solely on these
results. Investors should make sure they fully understand and agree with each management style utilized. For additional detail and information,
including results since inception and year-by-year return data, see sheet entitled “Performance of ABFS Growth Strategies.” Due to our emphasis on
stop-loss disciplines, much of the return in the ABFS growth strategies is expected to be in the form of short-term capital gains, making these
strategies most attractive for tax-sheltered accounts and/or clients wishing to reduce exposure to large declines, rather than for taxable investors who
are concerned with minimizing taxes.
RETURNS
Returns for ABFS strategies in the bar graphs are “iterative internal rate of return” figures for actual client portfolios. The figures for each individual
year include all client portfolios (even new and terminated accounts) that were invested in that strategy for the entirety of that year, but exclude any
non-managed securities (which were occasionally held at clients’ request) in those accounts. The returns for the 3-Year and 5-Year periods are
calculated by simply compounding the actual returns for the component periods at the end of each year. Returns are calculated on a dollar-weighted
basis; that is, they include the actual beginning values, all expenses (including management fees), and deposits and withdrawals for all accounts,
calculated as one large “portfolio” for each strategy. Returns are therefore net of all fees and transaction charges, and include reinvestment of all
dividends and earnings. Returns ignore tax implications, which may be a significant consideration for taxable accounts. Actual individual client
returns usually differ somewhat, depending on such factors as each client’s beginning date, transaction costs (which vary by account size), additions
and withdrawals during the period, etc. “S&P 500” data are for the Vanguard Index 500 Fund (VFINX) total return, including all dividends.
“Nasdaq” data are for the Nasdaq Composite index price only.
RISK/VOLATILITY
Generally, investment analysts measure portfolio risk using some type of volatility measure that includes both realized and unrealized (paper) gains
and losses. The volatility figure used on this sheet is MDD. MDD stands for maximum draw-down, and represents the largest decline in account
value from any high point to subsequent low point during the period. Unlike some other volatility measures, such as standard deviation, MDD focuses
only on downside fluctuation (which some people consider more useful as a measure of risk than fluctuation up and down). In essence, it shows the
worst decline in value “endured” during the period in order to achieve the resulting return.
Note that, unlike the return figures, which are for actual client accounts, MDD figures and bars for ABFS strategies are not drawn from actual account
values, but rather are plotted using a model portfolio with the same mix and proportions of mutual funds held for clients, adjusted daily for purchases
and sales made in actual client accounts. The model performance of the graph takes into account a model performance fee; however, model trading
does not involve financial risk and cannot completely account for the impact of financial risk involved with actual trading. Model trading or model
performance may not reflect the impact that material economic and market factors might have had on the management of actual client accounts. The
performance results of a model portfolio do not reflect actual investors’ ability to withstand losses or to adhere to a particular trading strategy in spite
of trading losses, which can adversely affect actual trading performance (results). Therefore, although we believe the MDD bars are a rough visual
approximation of account MDDs, they are not meant to precisely represent exact account declines. Note that the Managed Risk strategy often contains
individual convertible bonds as well as funds. Since the charts reflect only mutual funds, a short-term bond fund was used to represent the allocation
to convertibles. This substitution is not intended to imply that convertibles and short-term bond funds are equivalent (convertible bonds are in fact
riskier), but rather to somehow attempt to account for them in the charts. Since the return figures in the charts reflect actual clients’ managed
holdings, including convertibles, they do incorporate the actual impact of the convertibles on returns.
Although MDD figures indicate each strategy’s worst declines during the periods shown, they cannot indicate all types or amounts of risk taken in
each strategy, and how those risks differ from the S&P 500 or Nasdaq indexes. For example, the S&P 500 is an index of U.S. large company stocks.
ABFS growth strategies, while primarily utilizing mutual funds containing stocks, often employ funds containing types of securities different than the
S&P 500, such as small company stocks, foreign stocks, domestic or foreign bonds, convertible securities, and/or cash equivalents. The Managed
Risk strategy may also contain individual convertible securities in addition to mutual funds. We believe the flexibility to use a wide variety of
securities and market sectors facilitates enhanced risk-adjusted performance, but investors should be aware that some individual holdings purchased
in these strategies may have substantially different (and greater) risks than the S&P 500 and/or Nasdaq, and that direct comparison with these or any
other indexes is not possible. The comparisons in the bar graphs are only meant to provide a general idea of relative return and downside volatility,
and should not be taken to imply that ABFS strategies are actually similar to the S&P 500, Nasdaq, or any other index or investment.
ABFSBARGDisc010705