Market Equilibrium. I. What s Your Guess? Markets Integrate the Combined Knowledge of All Participants. People Trust Market Pricing Every Day

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1 Market Equilibrium I. What s Your Guess? II. III. IV. Markets Integrate the Combined Knowledge of All Participants People Trust Market Pricing Every Day What Affects a Share s Current Price? V. Markets React to Events VI. Share Prices Adjust Quickly VII. Picking the Fastest Lane is a Stressful Guessing Game VIII. Few Mutual Funds Survive and Beat Their Benchmarks IX. Let the Market Work for You

2 What s Your Guess? Participants were asked to estimate the number of jelly beans in a jar. The average estimate of all participants was very close to the actual count. Together, we know more than we do alone. Range: 409-5,365 Average: 1,653 Actual: 1,670 For illustrative purposes only. Illustration based on voluntary participation at adviser event in August Results audited by conference sponsor.

3 Markets Integrate the Combined Knowledge of All Participants The market effectively enables competition among many market participants who voluntarily agree to transact. World Equity Trading in 2014 Number of Trades GBP Volume This trading aggregates a vast amount of dispersed information and drives it into security prices. Daily Average 60 million 194 billion Global electronic order book (largest 50 exchanges) Source: World Federation of Exchanges. In GBP.

4 People Trust Market Pricing Every Day The daily price of fish may vary based on buyer and seller expectations of market forces. We accept the price as an accurate estimate of current value and make decisions accordingly. The same is true of a stock price, which reflects all known information about a company.

5 What Affects a Share s Current Price? All Available Information A company s equity, its prospects for future earnings, and perceived risk Price Given all information, a stock s current price offers the best approximation of actual value.

6 Markets React to Events Orange juice futures surge to record on fungicide fears Reuters, January 10, 2012 Prices adjust when unexpected events alter the market s view of the future. Source: Dow Jones-UBS Orange Juice Subindex. Dow Jones data provided by Dow Jones Indexes.

7 Share Prices Adjust Quickly Heinz, 14/2/2013 Heinz agrees to buyout by Berkshire Hathaway, 3G USA Today, February 14, 2013 News travels quickly, and prices can adjust in an instant. Source: Bloomberg. The security identified is shown for illustrative purposes only to demonstrate the investment philosophy described herein. These materials are not, and should not be construed as, a recommendation to purchase or sell the security identified or any other securities. Actual holdings will vary for each client, and there is no guarantee that any client will hold the security identified.

8 Picking the Fastest Lane is a Stressful Guessing Game Likewise, trying to anticipate the movement of the market adds anxiety and undue risk.

9 Outsmarting Other Investors is Tough Few mutual funds survive and beat their benchmarks, 15-yr period ending December 31, 2014 EQUITY FUNDS FIXED INCOME FUNDS 42% Survive 19% Outperform 41% Survive 8% Outperform 2,711 funds at the beginning 733 funds at the beginning Past performance is no guarantee of future results. In US dollars. Mutual fund data is from the CRSP Mutual Fund Database, provided by the Centre for Research in Security Prices, University of Chicago. Beginning sample includes funds as of the beginning of the 15-year period ending in The number of funds as of the beginning is indicated below the exhibit. Survivors are funds that are still in existence as of December Winners are funds that survive and beat their respective benchmarks over the period. Funds are identified using Lipper fund classification codes and are matched to their respective benchmarks at the beginning of the sample period. Loser funds are funds that did not survive the period or whose cumulative return did not exceed their respective benchmark.

10 Let the Market Work for You When you try to outwit the market, you compete with the collective knowledge of all investors. By harnessing the market s power, you put their knowledge to work in your portfolio.

11 Diversification I. Diversification Helps You Capture What Global Markets Offer II. III. IV. Diversification Reduces Risks That Have No Expected Return Diversification May Prevent You from Missing Opportunity Diversification Smooths Out Some of the Bumps V. Diversification Helps Take the Guesswork out of Investing Diversification does not eliminate the risk of market loss.

12 Diversification Helps You Capture What Global Markets Offer Percent of world market capitalisation as of December 31, countries Approximately 12,000 publicly traded stocks 30.0 trillion market value The global equity market is large and represents a world of investment opportunity. In GBP. Diversification does not eliminate the risk of market loss. Market cap data is free-float adjusted from Bloomberg securities data. Many nations not displayed. Total may not equal 100% due to rounding. For educational purposes; should not be used as investment advice. China market capitalization excludes A-shares, which are generally only available to mainland China investors. For educational purposes; should not be used as investment advice.

13 Diversification Reduces Risks That Have No Expected Return Concentrating in one share exposes you to unnecessary risks. Diversification reduces the impact of any one company s performance on your wealth. Diversification does not eliminate the risk of market loss.

14 Diversification May Prevent You from Missing Opportunity Compound average annual returns: Attempting to identify that group of future winners is a guessing game. All Stocks Diversification improves the odds of holding the best performers. 7.5% Excluding the Top 10% of performers each year 3.2% Excluding the Top 25% of Performers Each Year -6.0% Source: Bloomberg, London Share Price Database, and Centre for Research in Finance. Compound average annual returns are in US dollars. The returns are from the following developed and emerging markets: Australia, Austria, Belgium, Brazil, Canada, Chile, China, Colombia, Czech Republic, Denmark, Egypt, Finland, France, Germany, Greece, Hong Kong, Hungary, India, Indonesia, Ireland, Israel, Italy, Japan, Republic of Korea, Malaysia, Mexico, Netherlands, New Zealand, Norway, Peru, Philippines, Poland, Portugal, Russia, Singapore, South Africa, Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey, United Kingdom, and the United States. Diversification does not eliminate the risk of market loss. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results. Investing involves risks, including fluctuating values and potential loss of principal.

15 Diversification Smooths Out Some of the Bumps A well-diversified portfolio can provide the opportunity for a more stable outcome than a single security. Illustrative examples. Diversification does not eliminate the risk of market loss.

16 Diversification Helps Take the Guesswork out of Investing Annual returns (%): You never know which markets will outperform from year to year. By holding a globally diversified portfolio, investors are positioned to capture returns wherever they occur. HIGHER RETURN LOWER RETURN FTSE All-Share Index MSCI World ex UK Index (net div., GBP) MSCI Emerging Markets Index (gross div.) S&P Global REIT Index (gross div.) UK One-Month Treasury Bills Citigroup World Government Bond Index UK (hedged to GBP) Citigroup World Government Bond Index 1-5 Years (hedged to GBP) Barclays Global Aggregate Bond Index (hedged to GBP) Diversification does not eliminate the risk of market loss. In British pounds. Chart is for illustrative purposes only. MSCI World Index, MSCI Europe Index, MSCI World Ex Europe Index and MSCI Emerging Markets Index (gross dividends) copyright MSCI 2015, all rights reserved. FTSE All-Share Index published with the permission of FTSE. Includes 98%-99% of the UK market capitalisation and is an aggregation of the FTSE 100, FTSE 250 and FTSE Small Cap indices. FTSE is a trademark of the London Stock Exchange plc and the Financial Times Limited, and is used by the FTSE International Limited under licence. S&P Global REIT Index (gross dividends) provided by Standard & Poor s Index Services Group. UK One-Month Treasury Bills from January 1975-present: UK One-Month Treasury Bills provided by the Financial Times Limited. Citigroup World Government Bond Index UK is the Citigroup World Government Bond Index UK Years (Hedged), copyright by Citigroup. Citigroup World Government Bond Index 1-5 Years is the Citigroup World Government Bond Index 1-5 Years (Hedged to GBP), copyright by Citigroup. Barclays Global Aggregate Bond Index is the Barclays Global Aggregate Credit Index 1-5 Years (Hedged to GBP) provided by Barclays Bank PLC.

17 Dimensions of Returns I. Financial Capital Plays a Vital Role in Wealth Creation II. III. IV. Stocks and Bonds Are Conduits for Capital The Capital Markets Have Rewarded Long-Term Investors Markets Compensate Non-Diversifiable Risk V. Dimensions Point to Differences in Expected Returns VI. Portfolios Can Be Structured to Pursue Dimensions

18 Financial Capital Plays a Vital Role in Wealth Creation Using financial capital and other resources, a business produces goods or services that can be sold for a profit. As providers of financial capital, investors expect a return on their money. FINANCIAL CAPITAL RESOURCES: Labour, tools, knowledge, materials

19 Stocks and Bonds Are Conduits for Capital Bondholders are lenders to a company. Stockholders are equity owners in the business. Both expect an adequate return for the terms and risk of their investment.

20 The Capital Markets Have Rewarded Long-Term Investors Monthly growth of wealth ( 1), ,000 1, ,837 UK Small Cap Index 4,219 UK Value Index 716 FTSE All-Share Index 54 UK One-Month Treasury Bills 23 UK Retail Price Index Past performance is no guarantee of future results. In pound sterling. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. For the 58 years from 1956 to 2014, the compound annual growth rate of return was 15.20% for the Value Index, 15.83% for the Small Cap Index, 11.79% for the Broad Market Index, 6.98% for T-bills, and 5.44% for Inflation (RPI). Value Index,1955 December 1993: data provided by the London Business School; 1994 present from Bloomberg securities data. Small Cap Index,1970 June 1981: Hoare Govett Smaller Companies Index; July 1981 December 1993 from StyleResearch securities data; 1994 present from Bloomberg securities data. FTSE All-Share Index published with the permission of FTSE. T-bills, : UK Three-Month T-bills provided by the London Share Price Database; 1975 present: UK One-Month T-bills provided by the Financial Times. Inflation is the UK Retail Price Index provided by the Office for National Statistics.

21 Markets Compensate Non-Diversifiable Risk Risk is a complex concept it is always present, even if it has not been realised, and it cannot be directly observed until it occurs. The sources of return are directly observable, and decades of academic research have advanced our understanding of them. Investors balance risk and return by incorporating their expectations and preferences into securities prices.

22 Dimensions Point to Differences in Expected Returns DIMENSIONS POINT TO SYSTEMATIC DIFFERENCES IN EXPECTED RETURNS Academic research has identified these dimensions, which are well documented in markets around the world and across different time periods. EQUITIES Market Equity premium stocks vsbonds Company Size Small cap premium small vs large companies Relative Price 1 Value premium value vs growth companies Profitability 2 Profitability premium high vs low profitability companies FIXED INCOME Term Term premium longer vs shorter maturity bonds Credit Credit premium lower vs higher credit quality bonds Diversification does not eliminate the risk of market loss. 1. Relative price as measured by the price-to-book ratio; value stocks are those with lower price-to-book ratios. 2.Profitability is a measure of current profitability, based on information from individual companies income statements.

23 Portfolios Can Be Structured to Pursue Dimensions Investors can pursue higher expected returns through a low-cost, well-diversified portfolio that targets these dimensions. 1. Beta: A quantitative measure of the co-movement of a given stock, mutual fund, or portfolio with the overall market. 2. Price-to-Book Ratio: A company's capitalisation divided by its book value. It compares the market's valuation of a company to the value of that company as indicated on its financial statements. 3. Direct Profitability: A measure of a company s current profits. We define this as operating income before depreciation and amortisation minus interest expense, scaled by book equity.

24 Investor Discipline I. Humans Are Not Wired for Disciplined Investing II. III. IV. Many Investors Follow Their Emotions Reacting Can Hurt Performance Markets Have Rewarded Discipline V. Focus on What You Can Control

25 Humans Are Not Wired for Disciplined Investing When people follow their natural instincts, they tend to apply faulty reasoning to investing.

26 Many Investors Follow Their Emotions People may struggle to separate their emotions from their investment decisions. Following a reactive cycle of excessive optimism and fear may lead to poor decisions at the worst times.

27 Reacting Can Hurt Performance Performance of the FTSE All-Share Index, Missing only a few days of strong returns can 14,948 13,688 drastically impact overall performance. 10,284 10,523 Growth of 1,000 6,340 4,223 5,224 Total Period Missed 1 Best Day Missed 5 Best Days Missed 15 Best Days Missed 25 Best Days One- Month T-Bills Long-Term Govt. Bonds Annualised Compound Return 9.77% 9.44% 8.37% 6.58% 5.09% 5.87% 8.45% Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. FTSE data published with the permission of FTSE. Long-Term Govt. Bonds are the Citigroup World Government Bond Index UK Years, copyright 2015 by Citigroup.

28 Markets Have Rewarded Discipline Growth of a pound MSCI World Index (net dividends), $ $10 1 $1 Arab oil embargo UK s winter of Oil discontent prices quadruple Oil prices quadruple S&P 500 down 43% BusinessWeek: The Death of of Equities Gold hits Gold hits record high record high US UK inflation interest peak at 13.5% at 17% Dow Dow drops drops 23% 23% on Black on Black Monday Monday UK leaves Savings the ERM and loan crisis 1 Iraq Iraq invades Kuwait Income tax rates rate Russian financial crisis Asian currency crisis Dotcom Dotcom stock stock crash crash 9/11 Y2K Y2K terrorist 9/11 Scare Scare attacks terrorist attack Iraq war Iraq begins war begins Subprime mortgage Hurricanes Katrina and Rita crisis S&P 500 down 46% Subprime mortgage crisis Eurozone debt crisis UK s AAA US home rating prices hit downgrade bottom Fiscal Fiscal cliff cliff worries worries 70 $ $0 A disciplined investor looks beyond the concerns of today to the long-term growth potential of markets. In British pounds. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results. MSCI data MSCI 2015, all rights reserved.

29 Focus on What You Can Control No one can reliably forecast the market s direction or predict which share or investment manager will outperform. A financial adviser can help you create a plan and focus on actions that add value. Diversification neither ensures a profit nor guarantees against loss in a declining market.