I’m sure you’ve heard the old advice about the three most important things in real estate (location, location and location); well I think a similar principle applies to investing in stocks and bonds. What are the three most important things in investing? Expectations, expectations and expectations. What you expect to receive in investment returns has a lot to do with your disappointment in "only" getting an 8-10% return and often the resultant willingness to take excessive risk. Scores of investors in the late 90’s poured fresh money into tech stocks because they had built a set of expectations that made them believe that twenty plus percent returns were virtually guaranteed. Heaven forbid someone consider rebalancing by selling some of their highly appreciated stocks and buying a few bonds, their expectations told them rebalancing would only "dilute the returns." In much of the late 90s on into 2000 and 2002, most investors believed that you had to have a very heavy tech and growth exposure because that was the only way you could achieve the kinds of high returns they expected to get. Only those whose expectations were more grounded in historical reality could look at the market back then and say "this can’t last, let’s take some profits and rebalance."

So we all understand this concept now that the markets have erased much of their earlier gains, right? Unfortunately I’m not sure we do. Today we see substantial sums of money being invested in long treasury and mortgage bond funds. The rationale seems to be that since these have produced double digit returns over the last couple of years you can expect them to continue to produce those returns. Sadly these investors are letting their expectations, not their common sense, guide their decision making. Buying 30-year treasury bonds yielding less that 5.5% are not going to produce 10% returns in the long run, or even probably in the short run. At this point the only way treasury bonds will maintain the returns we’ve seen over the last couple of years is if the Federal Reserve takes rates down to 0% and that is extremely unlikely. You need to set your expectations lower. If you want the relative safety of treasury bonds then expect you’ll see low single digit returns, and maybe less, assuming you are willing to hold them through an up interest rate cycle.

It’s not just bonds that are triggering the trap of inflated expectations, it’s stocks too. Consider these return numbers, S&P 500 +15%, Russell 2000 +23%, and NASDAQ +21%. Sound like return numbers from 1999? Actually they are from the second quarter of 2003. Everywhere you turn you hear how nice it is the rally has returned and are offered advice that you’d better get in now before it’s too late. Investors are once again at risk of setting their expectations too high. If we learned nothing else from the market debacle of the past several years it should be that returns like those we saw last quarter are not sustainable long term. If your expectations are set at a realistic level, you will expect that we’ll see a correction at some point as stock prices settle out closer to their longer term rates of return. Your expectations will tell you that we had a great quarter and that we can now have a couple of weak quarters but still end the year with a nice gain. Your expectations will also tell you that trying to time the market swings is foolhardy, you should remain invested in a balanced portfolio and over time you will do well.

Manage your expectations well and it will help you manage your portfolio well.

As always, please feel free to call if you have any questions.

Randy Gridley

July, 2003