Contents:

-Investor Beware: The Hidden Danger of Forecasts
-New Model Portfolios for July 2012
-Specific Model Portfolio Fund Selections from Jan. 2012 Doing Quite Well
-2nd Qtr Performance Update (added July 10): Click here
-The Glass Half Full. By Steve Shefler   (on separate page - to view, click here)

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Investor Beware: The Hidden Danger of Forecasts

Enter the phrase "investment forecasts" on Google and you will be bombarded with over 37 million hits. Merely append a single word to make your search "unsubstantiated investment forecasts" or similar phrases and not a single hit will likely be found! Yet it should be obvious that far too many investment forecasts prove to be less than helpful.

It is easy to locate investment forecasts whether they are actually labeled "forecasts" or not. As broadly defined, they can be found anywhere someone expresses a recommendation for (or against) one or more particular investments. Implicit would be the assumption that the forecast provider has some type of objective data, or at a bare minimum, a presumably knowledgeable opinion, reflecting favorably or unfavorably on what an investment's future performance is likely to be. If not explicitly stated, the target audience assumes a reasonable time frame for the prediction.

Sadly missing from the picture is that most of these forecasts will never be revisited to determine how accurate the forecast turned out to be. Predictions, obviously, are intended to cast some light on what the future will show. If a source issuing investment predictions has shown itself through follow-up data to have been relatively accurate, its forecasts might be said to show at least some degree of predictive validity. If the opposite, the forecasts would be said to show little or no validity. It stands to reason that it can be dangerous for investors to act upon predictions coming from sources that cannot document some sort of prior predictive validity regarding their forecasts.

In order to demonstrate the potential usefulness of a newly issued prediction coming from a given source, two requirements must be met: 1) in the past, the source must not only have stated a prediction, but the event predicted must have been revisited at some later date to assess its accuracy; 2) ideally, the source must be able to show at least several accurate predictions over a stretch of time to ensure that a single instance of predictive success was not merely the result of luck.

As investors, it behooves us to always be mentally "on guard" whenever we see an investment forecast. Is a particular investment forecast to be trusted, or do we take almost all investment forecasts with a grain of salt? If the former, have we based our judgment on the above two rules, or, perhaps the forecaster's expertise is merely assumed. If the latter, perhaps we may be giving short shrift to some forecasts that have indeed demonstrated relative accuracy in the past.

As you are likely aware, my investment newsletter, like most others, aims to help investors make sound choices. By making specific recommendations, I am really making predictions as to what will ultimately turn out to be good choices, or those that will be not so good.

I don't think it makes much sense for me to make recommendations as to what investments one should choose to achieve good future results without examining how my prior such choices have done. (If someone's past forecasts didn't pan out, why should you believe that their future ones will?)

While, granted, it is impossible for anyone to predict with anything near 100% accuracy, if positive and/or negative recommendations turn out to be closer to 50% correct, this means that there is really very little, or even no, value in considering them; merely guessing, or even flipping a coin, should yield a similar result. Of course, some forecasters' predictions are even less than 50% correct. This likely results from the often counterintuitive nature of investing: that is, just when things look about as bad as they can be for an investment, or vice versa, things can turn around, leaving even some who might seem the most expert with egg on their faces.

Along this line, if predictions fail to pan out, one could argue that something totally unexpected by nearly everyone occurred which caused the predictions to go awry. This might pass as an acceptable explanation on occasion. But too many near-chance predictive outcomes suggests that the predictions aren't working, and therefore, should not be given much credence. At best, it suggests that the kind of outcome being predicted is too complex and likely cannot be predicted by anyone, which is sometimes argued by some in the case of all investment forecasting.

Yet the great majority of investment recommendations we are exposed to in newspapers, magazines, other media, or even by financial advisors, do not give us a good idea of what the success rate was for these sources' prior predictions. Perhaps this is why some investors turn to investment newsletters, which, in my experience, do tend to show their prior forecasting track record. Of course, such a continuing source of predictions also allows longer-term readers to judge for themselves through time how accurate the recommendations previously given have proven to be.

Here is but one concrete example of the myriad of investment forecasts we all likely come across regularly. It was chosen not to single it out but only to illustrate our premise:

CNBC.com, among the most popular websites in the U.S., published an article entitled "10 Best Mutual Funds for 2012" near the close of 2011. Apparently, the list was derived from another popular financial website's rating of approximately 25,000 funds. The following table shows the 10 funds recommended and their current performance since the start of the year: (Note that neither CNBC, nor their associated website, are, as far as we know, providing you with this follow-up evidence regarding the predictive accuracy of their "10 best" list; I am. If a reader has knowledge of the source's own follow-up data regarding their predictions, we would appreciate hearing about it.)

This list of recommendations for 2012, which represents a forecast (although, as the author points out, not a guarantee) of good performance, is certainly not panning out as one might have hoped for thus far this year. As can be seen, the most highly recommended four funds are doing extremely poorly vs. their category peers. Out of the 10 funds, exactly half might be said to be doing satisfactorily while the other half certainly aren't. This represents at best a 50% success rate.

If one had invested equally in each of the 10 recommended funds, one's 6 month total return would currently be 2.91%. This compares with the YTD return of 9.41% on the unmanaged Vanguard 500 Index and 2.37% for the Vanguard Total Bond Market Index. With 2012 half over, it appears unlikely that the forecasted recommendations will wind up living up to their billing as the "10 best" for 2012.

See below for how our own fund choices made at the start of 2012 did during the first 6 months of the year.

New Model Portfolios for July 2012

In a nutshell, how would I describe my current investment stance regarding stocks?

• still positive on stocks in general
• a strong preference for Large Caps
• a somewhat mildly negative take on the Small and Mid-Cap categories
• our gut tells us that while many International funds are highly undervalued, this is still not the time to jump in with both feet.

We feel that many of the various categories of bond funds do not offer particularly good prospects for long-term investors. (Remember that all bonds should not be thought of monolithically; do not paint the bond market with one broad brush.)

And staying in cash does not make much sense to us in that accepting a guaranteed zero return overstates the risks we feel currently exist.

Looking forward, certainly bonds, and likely stocks, offer at least decent prospects of doing better than any idle cash. At a minimum, we feel that most "no brainer" bond funds, as represented for example by the Vanguard Total Bond Market Index (VBMFX), should be able to continue to generate small positive returns, easily surpassing cash.

Where stocks might be headed given all the global uncertainties is certainly anyone's guess. But we feel that this is nearly always the case. During periods when global growth is already recognized as strong and crises are relatively minimal such as during the last decade, investors tend to have already bid prices up, creating less opportunity going forward. Now, on the contrary, many types of funds can be purchased at much cheaper levels than possible during recent years.

For example, the S&P 500 Index is close to 10% cheaper than it was at the start of the previous decade. Are the large companies in the U.S. really worth 10% less than at the start of 2000? Unlikely, but investor psychology has certainly been diminished significantly since then, and it is more than likely to gradually move away from the negativity that now prevails to return to at least a neutral stance.

So, on balance then, we perceive that stocks, or at least Large Cap domestic ones, present a far better opportunity for investors than bonds or cash.

Overall Allocations

For Moderate Risk Investors

For Aggressive Risk Investors

For Conservative Investors

Model Stock Fund Portfolio

In line with our above comments regarding keeping international exposure somewhat limited, we recommend not only watching your exposure to International funds per se, but checking how much your domestic funds may also be committed abroad. Our recommended portfolio choices do this by not currently favoring funds with much invested abroad, such as is the case with, for example, Fidelity Low Priced Stock (FLPSX). This fund's latest breakdown shows that of its equity position, about 36% of it is invested in abroad. This may somewhat limit the fund's performance if turmoil continues in the international markets. You can check a fund's international exposure at sites such as morningstar.com.

Also, we continue to recommend less exposure to traditional international funds that subject you to deteriorated performance when global investors gravitate toward US dollar investments, as they tend to be doing now; instead, you may want to favor a fund that while still primarily investing internationally, "hedges" possible losses due to a strengthening dollar. Tweedy Brown Global Value (TBGVX) is such a fund; it has been an outstanding relative performer during the last year outperforming similar non-hedged funds typically by as much as 10 to 15%.

Model Bond Fund Portfolio

Comments: Continue to keep investments in U.S. Treasuries and even GNMA funds quite limited. We think that corporate bonds, including high yield funds, offer significantly more return potential without a huge amount of risk. PIMCO Total Return Instit (PTTRX) or, if not available to you, Harbor Bond Fund (HABDX) should continue to offer good bond fund returns with relatively little risk of losses.

Specific Model Portfolio Fund Selections from Jan. 2012 Doing Quite Well

Thus far in 2012, our beginning of the year Stock and Bond Model Portfolios have shown both good absolute performance and good performance when compared to their category peers. The table below shows the 6 month results. Readers can compare how our choices have done to those mentioned above in our lead article.

The average return for all 12 stock funds over the 6 month period is 9.03%. The average return for all 12 bond funds over the 6 month period is 3.96%. The average return for all 24 funds combined over the 6 month period is 6.49%.

We have now updated how our Model Portfolios have been doing over longer periods (added July 10): Click here

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Continue on to The Glass Half Full by Steve Shefler

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