January 13, 2012

Dear Client:

Your statement is now posted to Your Online Access. Please call or email us if you require assistance logging in. As a security measure we urge you to compare the information in your statement with the statements you receive directly from your custodian, including account balances, withdrawals from, and deposits to your accounts.

2011 Q4 Market Results

In our third quarter letter I wrote that "markets are unpredictable and do not always react the way experts predict... Quitting the equity market at a time like this is like running away from a sale." The fourth quarter provided another reminder of how quickly and unexpectedly results can turn around.

The last four years have been tumultuous and disappointing for equity investors. Most equity classes have not recovered to the highs they reached in October 2007. Foreign equities and emerging markets have lost more than 26% in the last four years. U.S. equities have performed better than foreign equities, but still are down more than 6% in the same period. Bonds have gained 32% in this period.

Investors expect that what has happened in the recent past will continue into the future. This is what causes investors to "chase returns", which can be measured by money added to or withdrawn from mutual funds. Stock market losses and bond market gains in Q3 caused mutual fund investors to pour a net $10 billion into bond funds and withdraw a net $13.4 billion from equity funds in September^[1].

The normal investment relationship is one in which return is a direct function of risk. Historically, bond returns have been lower than equity returns with less volatility, but the last four years have been anything but normal. Although bonds have had higher returns and lower volatility than equities in the recent past, we expect stocks and bonds to revert to their normal risk/return relationship as investors assess the relative attractiveness of each.

Let's consider a real example, in which you are offered an opportunity to invest $10,000 in either Investment A or Investment B.

Investment A will pay a guaranteed $197 each year for ten years. At the end of ten years, you will get back your original investment of $10,000. If inflation remains at its current rate of 3.4%, the buying power of your initial $10,000 will be $7,200 ten years from now.

Investment B will pay $203 a year. It is not guaranteed but has a long track record of making the annual payments AND increasing the annual payment faster than inflation AND returning more than your initial investment at the end of ten years. Based on historical averages the initial investment of $10,000 would be worth over $14,000 in buying power ten years from now^[2]. The price of this investment now costs less than it did four years ago, and to top it off, Investment B's earnings are taxed at a lower rate than Investment A.

The investment choices? Investment A is a 10-year U.S. Treasury bond. Investment B is the S&P 100 Index Fund, a pool of one hundred of the largest U.S. companies.

Passive Management Principles

This weekend I reread The Investment Answer, Learn to Manage Your Money & Protect Your Financial Future. This is a short book co-authored by Gordon S. Murray and Dan Goldie. Mr. Murray was an institutional bond salesman and managing director at Goldman Sachs, Lehman Brothers and Credit Suisse First Boston. When he retired at age 50 and needed to decide how to manage his own (large) portfolio, he turned away from Wall Street, to Dimensional Fund Advisors, a mutual fund company whose funds Grubman uses extensively. Mr. Murray said at that time "I learned more .. through Dimensional in a year than I did in 25 years on Wall Street".

The Investment Answer is a terrific primer: simple to understand and packed with pictures. Grubman's financial management philosophies are aligned with the authors'. If you would like a copy for yourself or someone you know, send us an email and we'll send you the book.

Following are excerpts from The Investment Answer.

How Investors' Performance Measures Up

Most investors are best served by working with a professional advisor. Behavioral inclinations work against individuals as long-term investors.

Wall Street and the financial press would like you to believe that your investment performance will be determined by picking the right stocks, timing when to get in and out of the market or sectors, finding the next top-performing manager, mutual fund or hedge fund, but research shows that these activities reduce your total return.

Investors often chase returns, investing with managers who have had a "hot hand". Investors' returns are quite different from the manager's returns, as investors often buy near market highs and sell near market lows.

How Much of an Impact Does Volatility Have?

Reducing volatility will have a significant effect on your bottom line. A lower volatility portfolio that achieves the same average return will create more wealth than a higher volatility portfolio. Standard Deviation (at the end of the table) is a measure of the volatility of the returns.

Diversification reduces volatility in your portfolio. The broad classes of equities and fixed income are divided into more narrowly-defined categories such as U.S. Large company stocks, U.S. Small company stocks, International Large company stocks, Emerging Markets stocks, Municipal bonds, and Corporate bonds. These categories have certain risk factors and relationships to other asset types. The objective is to smooth the overall return of the portfolio, not to avoid losses in individual components of the portfolio.

The Asset Allocation Decision

The primary determinant of investment return is risk, which is driven by the mix of equities (stocks) and fixed income investments (bonds) that you use in your portfolio.

Your asset allocation decision is really a risk decision. That decision will be influenced by your goals, by how much you want/need the portfolio to grow, your emotional ability to "stomach" volatility, and your age.

Active vs. Passive Management

Passive management is a more sensible approach to investing than active management.

Active managers try to "beat the market" by stock picking or market timing. Passive managers work to deliver market returns, avoid subjective forecasting and take a longer-term view.

Active managers often believe they know how markets will perform in the near future, or at least, have their clients think they know. But markets move quickly, often in large bursts over a short number of trading days. Missing these short bursts can be harmful to your financial health.

Costs Matter

Most active managers fail to beat the market, providing their clients with lower-than-market investment returns. Active management typically increases costs. Investors focus on management fees, but other less transparent costs also reduce investor wealth: operating expenses of mutual funds, transaction costs and taxes. Reducing costs is a no-risk way to increase your investment return.

The Investment Answer was published in January 2011. Recent market events reinforce its message: investors win by maintaining a disciplined approach that supports long-term goals and avoids reactions based on headlines and emotions.

There is no free lunch for investors. Fortunately, there is the ability to take your fair share of the profits owed to you as an investor. Grubman strives to deliver your fair share.

As always, please do contact us with any questions.

Regards,

Audrey Grubman
Portfolio Manager and President
GRUBMAN FINANCIAL
www.grubmanfinancial.com
ph. 510.883.1350
fax 510.548.3148

[1] Lipper FundFlows Insight Report September 30, 2011.

[2] Assumes 9% annual return of the S&P 500 minus 2% dividend yield minus 3.4% inflation.

[3] Results of a study in March 2010 from DALBAR, a financial services market research fund.

[4] Omitted Global Equity because Grubman does not consider it a distinct asset class. Omitted International small cap equity because most active managers include emerging markets, making benchmark comparison difficult.