October 5, 2004

Dear Client:

The last six months have had little overall effect on investor portfolios, although daily volatility has been high. In the third quarter, equity markets were slightly down and fixed income markets were slightly up, putting a typical diversified investor up negligibly this quarter. To see your portfolio's performance, please see the "PORTFOLIO SUMMARY" and/or the "PERFORMANCE REPORT" on pages 2 and 3 of the enclosed statement.

Political news is unrelentingly bleak. The effect that our government's involvement in the Persian Gulf is having on the federal budget is detrimental to long-term economic stability. The current administration managed to turn a surplus in 2000 of 5% of the federal budget into a deficit of 25% of the 2003 budget.

A deficit of this scale becomes self-perpetuating, in that the cost of financing the debt takes up an increasing share of current revenues (taxes). The federal government will have to finance that debt, which sets off a reaction:

It is reasonable to wonder what the effect on stocks and bonds will be going forward, given the environment of low interest rates, ratcheting deficits and global war.

For investors, rising interest rates are harmful if you currently own a lot of long-term bonds paying fixed interest rates, but are not necessarily bad if you can (re)invest at increasingly higher yields.

For the bond issuers, however, rising interest rates are undesirable because they increase the cost of capital. For the federal government, which will need to finance the increasing deficit, rising rates are extremely detrimental.

Interest rates have been declining since the early 1980s, which has reduced the cost of financing the deficit, which in turn has helped to reduce the deficit. The deficit as a percentage of the budget peaked in 1983, at 26% of federal outlays. In 2003, the deficit percentage was back up to 25%, from a surplus in 2000.

Instead of trying to predict the impact on financial markets, let's look at effective risk reduction methods that work in any investment environment.

First, let's look at some sample portfolios: a "75/25" portfolio which contains a mix of securities that are U.S. and foreign, large company and small company, equities (stocks) and fixed income (bonds), dollar-denominated and non-dollar. Our sample 75/25 portfolio is invested in four mutual funds according to the following percentages:

This 75/25 portfolio was rebalanced each year back to the same starting allocation. In the graph below, the bar shows the investment return of the 75/25 portfolio each year since 1994. The orange line is the annualized return of the 75/25 portfolio. The other bars are the returns of the individual mutual funds, plus one more that follows the NASDAQ Composite Index.

Notice that investment risk has been reduced by time and diversification. Although the returns of every type of investment vary tremendously from year to year, the annualized returns range from 4% for international stocks to 10.6% for the S&P 500, with the 75/25 portfolio returning 8.5% per year over the past ten years.

Now let's look at the riskiness of different types of investments (asset classes). In the graph on the next page, the bars show the normal range of returns for each asset class. The bar shows the normal range of returns for the 75/25 portfolio. By "normal" we mean that over a long period of time the returns will fall into the gold range 2/3 of the years and outside of the gold range 1/3 of the years. The is the annualized return for each portfolio for the past ten years.

It is also important to look at the volatility of returns. If you have a theoretical portfolio that is left intact for ten years, increased volatility will not affect the annualized returns.

But investors have real portfolios, not theoretical ones. Real portfolios have contributions and withdrawals. If money is withdrawn during a down year, the annualized returns will be reduced. And real investors have emotions that affect their investment decisions. It can be difficult to hold a NASDAQ investment that gains 86% in one year and loses 29% the next. If you buy near the top or sell near the bottom, your annualized returns will be far below the theoretical portfolio.

Thus, it is more desirable to own an S&P investment that gains 10.6% over ten years with less than half of the volatility of the NASDAQ. And it may be desirable for you to reduce volatility even further with a 75/25 portfolio that trades 2% of its annual return in favor of reducing volatility by 25% below the S&P 500 portfolio.

So, in addition to long holding periods, portfolios are far more stable when invested across asset classes.

What else can we do to reduce investment risk? Rebalance regularly. Without making any other changes besides rebalancing back to the original mix once a year, the annual return increases from 8.2% to 8.5%. Rebalancing carries zero risk, yet increases your returns, which is one of the ways we are working to your benefit.

Finally, you can hedge against specific types of inflation by buying specific types of stocks. We are concerned about long-term price increases in medical products and services, and the effect that this type of inflation would have on retirees, so we include health care stocks and/or mutual funds in most portfolios. If health care costs continue to outpace the rest of the economy, the stock of the companies that are providing such products should outpace the rest of the market.

If you have questions or comments please don't hesitate to call or email.

Regards,

Audrey Grubman, CFP^®