July 31, 2006

Dear Client:

Small-cap stocks performed the worst, losing 5% in the second quarter, although still up 8% since January 1, 2006.

The conflict between Israel and Lebanon has caused oil prices to spike in anticipation of reduced supply and the possibility of a more widespread disruption in economic growth.

The escalation of conflicts in the Middle East is a concern for investments (the financial implications pale in comparison to the concern for people's suffering, but we're talking about your money here).

Although professional and lay investors might feel that markets are headed down, we should not base our investment decisions on feelings. Research has shown that people react irrationally when faced with the potential for loss. Daniel Kahneman, who won the Nobel prize in economics in 2002 for his research into behavioral finance, describes his main insight into investor behavior as the realization that people's decisions are based upon the utility* of gains and losses, and not overall wealth.

Dr. Kahneman gives an example of two investors with identical income, expenses and financial goals, but different net worth. Both investors suffer a decline in investments, although of different magnitude. Investor A begins with $4,000,000 and loses 20%, ending with $3,200,000. Investor B begins with $2,000,000, but endures only a 10% loss, reducing net worth to $1,800,000.

Rationally, Investor A ($3,200,000) should be more satisfied than Investor B ($1,800,000): Investor A is more likely to achieve his financial goals than B. But research shows that Investor A would be more dissatisfied than Investor B, despite the fact that Investor A is more likely to achieve his goals, and less disadvantaged by the loss.

Taking this insight a step farther, Dr. Kahneman and other researchers have shown time and again that investors are not risk averse, they are loss averse. It is that aversion to loss that leads us to make bad investment decisions.

Passive managers like Grubman Financial, by definition, assume that investors are best served by earning market returns. But if investors are irrational, then wouldn't pricing anomalies exist? And if pricing anomalies exist, then isn't active management, i.e. stockpicking, a better investment approach?

Let's look at some real data. Twenty years ago the financial services research firm Dalbar Inc. produced a study of investor decisions using data from mutual fund inflows and outflows. Each year since, the data has been updated. The most recent 2005 study yields the stunning conclusion that the average equity investor earned a 3.9% average annual return since 1986, while the S&P 500 index return was 11.9% per year.

If markets have returned 12% each year and individual investors averaged 4%, then what happened to the other 8%? Management fees, transaction fees and taxes could eat up 4% of an annual return. Some outstanding individuals and firms might earn some better-than-market returns (think: Warren Buffett and Goldman Sachs); perhaps an excess 2% overall, although I doubt the premium is even that high. The other 2% might go to some lucky or talented managers.

The problem is that luck and talent are largely indistinguishable. How many years of outperformance are needed to prove talent? Is the talented manager going to be available to you after several years of outperformance? Jonathan Berk of UC Berkeley has shown that managers of closed-end mutual funds who consistently earn higher returns eventually demand the excess return in the form of compensation; the period of time that an investor gets the excess return is limited.

We have noticed an increase in attention paid by the media to the daily gyrations of the markets, as "evidence" that markets are headed for losses. But one would expect that high volatility would presage above average performance and low volatility expectations would presage low performance (high volatility is risky and investors will only endure the risk if rewarded with higher returns).

Wall Street Journal columnist Mark Hulbert recently examined the relationship between market volatility and market performance. He examined the relationship between the VIX index and subsequent market performance. The VIX index is the S&P 500 Volatility Index, which measures professional traders' expectations of market volatility. Hulbert found that an unlikely relationship exists: higher performance follows both very low and very high volatility. Low performance follows normal expected volatility.

One section of the volatility index chart on the next page jumps out: the stellar returns from April 2003 through April 2006 correspond to a period of very low volatility. One could reasonably conclude that even professional traders lack the ability to predict the markets. Or perhaps a more complex relationship exists that has not yet been identified. In any event, the prediction of impending losses because of excess volatility is baseless.

I spoke with a client this morning. She said she had a chunk of money to invest, but is worried about the markets dropping over the next year. She said she knows my official position is that I am unable to predict market direction, but then asked me for my "unofficial opinion".

On and off the record, I do not have any insight or opinion about where markets are headed in the short-term. It is in my best interest for your portfolio to perform well. My reputation and compensation depend on it. I truly believe that the preponderance of data and research overwhelmingly supports the passive investment methodology and that attempts to avoid market declines will reduce your investment return.

As always, I appreciate your business and hope you will contact us at any time.

Regards,

Audrey Grubman