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    To Beat the Devil

    Advisors need to steel themselves to deal with market skeptics's claims.

    Don Phillips, 04/01/2009

    We value your feedback. Send comments, questions, and criticism to advisorquest@morningstar.com.

    The credit crisis and ensuing bear market have been bad enough, but now advisors face an even more insidious danger: financial cynics who call into question all the hard-won lessons advisors have accumulated about investing and the markets over the years. The threat comes from many corners: perennially bearish market commentators, government officials, gold bugs, and a host of other professional pessimists. The I-told-you-so crowd will argue that capitalism doesn't work and that risk-taking is unfair because risks sometimes don't pan out. They'll argue that the small investor can't win and that individuals should turn their backs to the market. In tough times like these, their siren song will tempt many. If advisors are to keep their clients on track to meet their long-term goals, they have to beat these devils.

    All of us in or around the asset-management industry face a basic moral question: Are we going to be a part of the magnification or the moderation of the fear-and-greed cycle that drives investment decision-making? Fund companies that tout short-term bull-market gains or that launch trendy, aggressive funds during a rising market have been rightly criticized for amplifying investor greed. Today's chorus of people saying that the system doesn't work and that investors should run and hide simply play to the other side of investor vulnerability. They are every bit as capable of undermining an investor's long-term prospects as are those who play to greed.

    Advisors have had ample practice tempering the inflated expectations created by fund marketers who prey on greed. Tempering the fearmongers, however, is largely a new challenge for advisors. Advisors need to steel themselves to deal with some of the claims their clients will hear in the coming months from market skeptics. Among the claims advisors need to refute are:

    Diversification Failed. This claim is based on the perception that because lots of stocks went down, holding a bunch of stocks didn't offset all potential losses. That may be true, but it doesn't mean that diversification didn't offer meaningful advantages. Excluding newfangled leveraged offerings, only one domestic-stock fund out of 15,272, and a tiny institutional offering at that, lost more than 75% last year. In contrast, 2,886 of the 10,691 stocks in Morningstar's U.S. stock database lost that much. Which odds would you prefer?

    Asset Allocation Doesn't Work. There haven't been many places to hide in this market, and many types of shading within asset classes, such as style and capitalization, haven't offered much performance differential. Still, there was a material difference between the returns of wide-moat stocks, which fell 28%, and no-moat stocks, which fell more than 48%. The Barclays U.S. Aggregate Bond Index rose 5.4%, while domestic stocks fell 37% and emerging-markets equities fell 54%. These asset classes performed as investment theory would predict in a rotten market: Higher volatility securities lost much more than their safer alternatives.

    401(k) Plans Fail Investors. In this heightened period of political reform, it's likely that 401(k) plans will get lumped in with other aspects of George Bush's ownership society, and many will call for changes. But did 401(k) plans really let investors down and was the asset-management industry irresponsible in its stewardship of retirement assets? I don't think so. Yes, many investors have suffered sharp losses, but losses are a part of investing in markets, not a flaw in the 401(k) system. Moreover, the asset-management industry has worked hard to discourage the use of company stock in 401(k) plans. It has also worked to automate enrollment and has created well-diversified target-date offerings to encourage better uses of these plans. Finally, while the losses in 401(k) plans are ugly, investors in these plans fared far better than did employees of recently bankrupted companies with underfunded defined-benefit plans.

    Mutual Funds Don't Work. Yes, some funds such as Schwab YieldPlus SWYPX and Oppenheimer Champion Income OPCHX had absolutely disgraceful performances in vehicles that masked their risk, but these examples were few, and nowhere near the scale of Bernie Madoff and some other hedge fund managers. While many mutual funds have offered poor relative performance during the bear market, outright fraud has not been an issue for investors. The Investment Company Act of 1940, independent directors, and transparent fund holdings all worked to protect investors. There remains no better-lit playing field in finance than the U.S. fund industry.