As we finish 2014 and begin 2015, we cannot help but feel that we have just finished a tough time in the markets. The stock market in general took several volatile turns throughout the year – and as recently as October 15, was almost exactly where it had started at the beginning of 2014. It was only by a last-minute “rush to the end” that the S&P 500 was able to log a 13.7% return for 2014 – which, by the way, it promptly and sharply reduced as soon as 2015 was under way.

Unfortunately, 2014 was one of those years that definitely did NOT reward diversification. Small and midsized stocks generated middling returns, International stocks (both large and small) took losses, and fixed income (bonds) were generally flat for the most part – unless you happened to be in municipals or governments. The health sciences sector delivered strong returns – but unfortunately, that gain was offset by the losses in the energy sector at the end of the year. It seemed that the mantra for 2014 was “Three steps forward, two steps back.” Virtually every attempt to squeeze extra return out of the markets (alternative investments, international small cap value, energy, and international bonds) – strategies which have successfully worked in the past – were frustrated this year by topsy-turvy markets and global events. As strong advocates of being fully diversified, this type of year can be frustrating. Many hedge fund managers reported negative returns for 2014, while over 80% of investment managers appear to have underperformed benchmarks – many of them significantly.

It can be helpful to understand that our own challenges within the portfolios focused mostly around sectors versus individual holdings. At present, we are confident in the quality of each holding in the portfolio. Every single holding has been carefully selected (and is continually monitored) for low internal costs, low trading costs, above-average tax efficiency, and superior historical performance compared to its peers (if applicable). For example – our international holding continues to be rated as “Gold” and “5-Star” by Morningstar and other ranking firms – but it was one of the worst performers in the portfolio because the international sector struggled all year. Our international bond holding ranks in the top 10% of all international bond funds for the most recent 3 and 5 year period, however, it too struggled, delivering less than one percent of return for 2014.

Going forward for 2015, we are confident to say that we have solid, simple, low-cost portfolios that we believe are designed to position us well for the remainder of the economic cycle. Our stock portion of the portfolio is a low-cost blend of large, medium, small, international, and health sciences holdings. Our fixed income portion of the portfolio is a blend of all major bond segments, but mostly intermediate-term, high quality bond funds that should be a nice balance between returns and protecting us from price drops if the Fed raises interest rates later this year, as is generally expected.

There are some who do not believe the Fed will raise interest rates, and that being concerned about this possibility is a waste of return opportunity. Generally, the Fed lowers interest rates to boost the economy – and raises it to fight inflation or to cool the economy down when it “overheats.” While, at present, we do not have inflation to fight, and the economy is not necessarily overheating – it is important to remember that if the Fed does not begin to raise rates at some point in the reasonably near future – then they will have no hand to play when the next recession strikes. Recessions occur, on average, every 7 to 13 years, and 2007 is already 8 years distant. Sooner or later, we will have another recession – and if interest rates are not back up to their historical averages, then the impact of any future monetary policy will be sharply muted.

We know that when interest rates rise, bond prices (and thus the value of bond holdings in your account) will fall – thus the danger in holding bonds during rising interest rates. How MUCH prices fall depends upon the “duration” of the portfolio, which is a measure of interest rate sensitivity, determined mostly by the average time to maturity of the bonds being held. Historically, the “sweet spot” on the yield curve has been a duration of about 5-7 years – where, if interest rates do rise moderately, the yields that the bonds actually produce will offset the drop in price and still produce a profit. We have built the bond portfolios around that sweet spot, realizing that the most effective use of bonds within a portfolio is not really to generate returns, but to provide safety to the portfolio from all those stock holdings bouncing around as they tend to do.

It can be tempting to look at one’s portfolio and sell the assets that have underperformed and keep (or buy more of) the top performers. However, from an academic and historical perspective, this is probably not wise. It is virtually impossible to predict which sector will be the best performer all of the time – even though we do make occasional weighting adjustments in the attempt to capture additional return. Sometimes it works, and sometimes it does not – but each time, there is a logical and fundamental reason for doing so. So, fundamentally - while most analysts would agree that the US economy is certainly has more going for it than most other developed economies at this present time – it is also a fact that the dollar currently is at a 4-year high (meaning it is likely due for a correction) and that US stocks are currently the most expensive of all asset classes within the portfolio. Price-wise, at this particular moment in time, US Stocks are less attractive than either international stocks or high-yield bonds – both asset classes that are currently depressed below their average buy points.

Remember how, in 2007, real estate agents were selling houses by talking up how much the house had appreciated over the previous several years?? In retrospect, with the advantage of hindsight, we know that 2007 was the worst possible time to buy a house in most markets – but we also know that a lot of houses were sold in 2007 – with many buyers fully expecting to make money on the deal. This is a behavioral finance term known as “recency bias” – the expectation that what has occurred recently will continue to occur – and is one of the most dangerous of all investor behaviors – as it leads to the dreaded “buy high and sell low” habit that is the destroyer of many a portfolio and many a retirement.

So… our belief is that we are properly positioned to take advantage of the continuing strong economy in the US and the strengthening economies overseas, to manage risk effectively, and to deliver solid returns going forward. Historically, a low-cost, globally diversified portfolio has always delivered strong growth prospects for clients who are patient and remain long-term investors. We expect the future years to be no different. Happy New Year and best wishes for a profitable 2015.