Dont Be Spoiled for Choice

March 2013

Being broadminded but selective about investments and advice is vital because so many choices exist, says David Darst of Morgan Stanley Wealth Management
Conditions in the financial markets have changed immensely between 2008when David Darsts The Little Book That Saves Your Assets: What the Rich Continue to Do to Stay Wealthy in Up and Down Markets, was first published and November 2012, when the second edition of the book came out. In this latest edition, entitled The Little Book That Still Saves Your Assets, the author, who is the chief investment strategist at Morgan Stanley Wealth Management, emphasizes staying afloat through financial crises, weathering volatile markets and using asset allocation to blunt the impact of steep declines. His overall advice to investors, however, remains constant: He believes investors should focus on diversification and managing risk. Darst discussed his approach toward investing and his outlook for the markets in a recent conversation with Morgan Stanleys Tara Kalwarski. The following is an edited version of their conversation. Tara Kalwarski: Whats the best investment advice you ever received? David Darst: The best investment advice I ever received is from Warren Buffett: Stay within your circle of competence. He tends not to get too heavily involved in biotechnology or software and things like that. He plays cards with Bill Gates several times a month, and he said, I dont own any Microsoft because I dont understand it totally. The second piece of advice is to find an Uncle Frank. This is a person who is wise, who has your best interests at heart, and who is an outside source you trust. Buffett has Charlie Munger [the vice-chairman of Berkshire Hathaway]. Many of the great investors of all time have had someone who is a Sancho Panza, or sidekick, to their Don Quixote. Its usually not your spouse because youre so caught up with many other things, like running a household. But it should be someone who likes you, who wants to see you succeed and who will advance the things that are good for you and throw cold water on some of your harebrained schemes. Ive had a couple of great Uncle Franks in my life who said, David, thats a very good idea, but its also the stupidest thing in the world that Ive ever heard. The third piece of advice is to get the facts and most importantly, to face the facts. We are deluged with facts. We need to face what kind of environment were really in, whats really happening. We need to get beyond the unemployment report, the industrial production report, currency moves, stock-price moves, sector moveswe need understand what is really happening. Kalwarski: Did the financial crisis change or prove wrong any conventional wisdom or rules of thumb? Darst: One element that was challenged and reconsidered concerns diversification. Many people thought they were diversified, but they really werent. Theres asset-price and

asset-class diversification, and theres systemic diversification. Very few things did well during 2008: cash, government bonds, managed futures, inflation-protected securities and precious metals. So, while many people said diversification didnt work, it didbut you had to really spread out to include Treasury bonds, cash, inflationprotected securities and managed futures. Many people thought they were diversified because they had different kinds of stocksU.S., Canadian, European, Japanese and emerging-market stocks. In reality, many things got hurt and hammered. Commodities, too, were not a place to hide. As for risk management, I think most people dont want to pay for it. But you need to build some defensiveness into your portfolio. One thing I learned is that if you cant do it actively, do it in a more subtle, DNA way. Construct the portfolio in a fashion that automatically has some defensiveness in it. So you might have some high-quality bonds or some U.S. or non-U.S. inflation-protected securities. You might have some industry groups that do well in deflationary or turbulent times or an asset class like managed futures. Kalwarski: The new edition of your book lists key events from the past five years, including the Lehman Brothers bankruptcy, the TARP bailout and the Federal Reserves quantitative easing. Were there key events at or near the stock market peak in 2007 that you think, in retrospect, foretold the financial crisis and bear market? Darst: The key event that warned of these things was the tremendous bullishness in the housing area in 2005 through 2007. I was on a Morgan Stanley business trip in Florida and my waiter said, Excuse me, Ill be right back, and he took off his apron. I said, Where are you going? He said, Im going out to buy another house. Ive been doing this several times. I put no money down. Im flipping houses. I thought to myself, This is reminding me of the dot-com thing. So there was an excessive enthusiasm and bullishness toward that asset class and very few voices crying in the wilderness saying its overdone. Even the Federal Reserve Chairman said that things looked reasonably solid in 2006 and 2007. So youve got the Fed chairman saying this, and the waiter is buying houses. That was one of the things. Another one that was amazing was the [discovery of a] rogue trader at [a well-known financial firm] in January 2008. When that happened, we should have said, Does everybody know what they have? He lost 5 billion euros, which was equal to $7 billion at the time, without his boss

noticing. That should have made us question whether managements in the systemically, important financial enterprises of the world had a handle on what was really going on. Kalwarski: Are there any developments today that recall that atmosphere and give you reason to worry? Darst: I think the scenarios and catalysts today that give me cause for concern are the tremendous exuberance over U.S. Treasuries yields. Theyre so low, and bond prices are so high. I wouldnt call it a bubble; we dont have people touting this on the radio. That said, bond prices have been going up for 32 years; another way of saying this is that interest rates have gone down since 1981. Another one is the tremendous 20-year-plus bearishness on Japan equities. I think thats one that we need to be constantly reevaluating. Widespread bullishness toward Treasuries and widespread bearishness toward Japanese equities would be two asset classes. Another potential area for worry is some of the contemporary art from artists such as Richard Prince, Gerhard Richter, Takashi Murakami, Jeff Koons and Damien Hirst, as well as some of the modern artists, such as Mark Rothko. These people are setting record after record, $30 million, $50 million. Whats really going on is not that the values of the paintings went up but that the value of money has been going down. I am also shocked at some of the numbers people are paying for trophy real estate in Manhattan, in Paris or even places like Miami. Miami is still down 40% or so from the peak, but for the trophy properties, prices are just incredible. Kalwarski: Where do you think individual investors are most underinvested and over-invested? Darst: I think individual investors are probably overinvested in bonds and underinvested in stocks, particularly in goodquality global growth franchises. Individual investors have been net sellers of stock while putting a lot of money into cash, certificates of deposit and bonds of various sorts. They own equities, but theyve pulled $500 billion out of stock funds in the last five years and put $1 trillion into bond funds. But even if there is underinvestment in stocks, if this is a multiyear period of essentially sideways movement in stock prices, theres no urgent reason to chase the market. I think

youve got to be very disciplined and organized, and youve got to pay attention and be nimble, opportunistic and tactical. On the Morgan Stanley Global Investment Committee, we think were in a more range-bound, up-and-down, sideways, risk-on, risk-off market environment that calls for paying attention a bit more. This is not like a straight road out west in Nevada or Utah, where you can put it on cruise control and hope that whoever is driving with you will not let you go to sleep. That was basically 1982 to 2000 in stocks; just stick with it and buy the dips. These times represent more of a choppy environment, where we think you need to have both hands on the steering wheel and be willing to make small adjustmentsor even larger adjustmentsfrom time to time. Some of them are going to be wrong, but hopefully the net effect will be that they will help you navigate this choppy, flat period. Kalwarski: What could make this bumpy environment give way to something more robust? Darst: You know, 13D Research has said theres the potential for a massive allocation shift in Japan, a great rotation from bonds into stocks, and that it may represent the leading edge of a worldwide wave. Central banks are buying government paper, banks are buying liquidity, corporations are buying cash. Foundations, pensions and endowments are buying alternative investments such as hedge funds and private equity. Mainstream investors, like most of our clients, have been buying bonds, and really rich investors have been buying art, jewelry, yachts and trophy real estate. Whats missing from all of these investors buying activity? Stocks. Its very intriguing. I havent bought into this thesis totally, and I think for it to occur, something meaningfully positive has to happen, like structural reform. Weve got to get people talking about the issuesnot even solving them but moving to try to work diligently and collaboratively on them. Then we could see, I believe, a massive asset allocation shift. It will happen when valuations are compelling, when there is societal dissatisfaction, disgust and distrust of the status quo, and [people] force the politicians to engage in structural reform. These are the things that I think have to happen.

Kalwarski: The last decade has featured low annualized stock returns. Do you think those sorts of changes could get us back to long-term averages? Darst: For the 10 years from 2002 to 2011, U.S. equities total return was 2.9% a year compounded, as measured by the S&P 500 index. When you take out 2002, which was a big decline, and put in 2012, which was a big increase, the 10-year compound total return number jumps to 7%. Thats exactly what were talking about as we roll past some of the bad years. The 2000s were the single-worst decade of all time, worse than the 1930s, when stock prices declined an average of 5.6% per year. In the 2000s, in price terms alone, they went down an average of only 2.7% per year. But in the 30s, you had a dividend yield of 5% instead of 1% to 2%, so the 1930s actually did better than the 2000s. The greatest post-war equities decade of all time was not the 1990s, with the Internet boom, lower taxes, falling interest rates, and rising stock prices and multiples. The greatest decade was the 1950sagain because dividend yields were 5%. I think we could be going back to long-term returns of 8%, 9%, 10% or more. Its going to take some time, but you may be able to achieve it in [what the Global Investment committee calls] global gorillas, highest-quality, dividendpaying multinationals with fortress balance sheets; crossborder flows of ideas, products, marketing, and talent; and worldwide management mentalities.

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