Welcome to the third edition of the Wealth Manager e-LETTER.

We hope you enjoyed the first two e-LETTERS in January and February and look forward to continually providing you with the stories, strategies, tools, and tips needed to reach your personal financial goals.

Please enjoy this month's edition of the Wealth Manager e-LETTER, where you will see the 3 Most Timeless Investment Principles, theWMN.com - Revised and Rejuvenated, the 2007 Q4 Market Commentary, the Federal Reserve's Fight Against Recession, as well as a Flashback to items of interest from the Wealth Manager e-LETTERS.

In This Issue of: Wealth Manager...

Warren Buffett is widely considered to be one of the greatest investors of all time, but if you were to ask him who he thinks is the greatest investor he would probably mention one man: his teacher, Benjamin Graham. Graham was an investor and investing mentor who is generally considered to be the father of security analysis and value investing.

His ideas and methods on investing are well documented in his books, "Security Analysis" (1934), and "The Intelligent Investor" (1949), which are two of the most famous investing texts. These texts are often considered to be requisite reading material for any investor, but they aren't easy reads. Here, we'll condense Graham's main investing principles and give you a head start on understanding his winning philosophy. (For more insight, read Ten Books Every Investor Should Read and The Intelligent Investor: Benjamin Graham.)

Principle No.1: Always Invest with a Margin of Safety
Margin of safety is the principle of buying a security at a significant discount to its intrinsic value, which is thought to not only provide high-return opportunities, but also to minimize the downside risk of an investment. In simple terms, Graham's goal was to buy assets worth $1 for $0.50. He did this very, very well.

To Graham, these business assets may have been valuable because of their stable earning power or simply because of their liquid cash value. It wasn't uncommon, for example, for Graham to invest in stocks where the liquid assets on the balance sheet (net of all debt) were worth more than the total market cap of the company (also known as "net nets" to Graham followers). This means that Graham was effectively buying businesses for nothing. While he had a number of other strategies, this was the typical investment strategy for Graham. (For more on this strategy, read What Is Warren Buffett's Investing Style?)

This concept is very important for investors to note, as value investing can provide substantial profits once the market inevitably re-evaluates the stock and ups its price to fair value. It also provides protection on the downside if things don't work out as planned and the business falters. The safety net of buying an underlying business for much less than it is worth was the central theme of Graham's success. When chosen carefully, Graham found that a further decline in these undervalued stocks occurred infrequently.

While many of Graham's students succeeded using their own strategies, they all shared the main idea of the "margin of safety".

Principle No.2: Expect Volatility and Profit from It
Investing in stocks means dealing with volatility. Instead of running for the exits during times of market stress, the smart investor greets downturns as chances to find great investments. Graham illustrated this with the analogy of "Mr. Market", the imaginary business partner of each and every investor. Mr. Market offers investors a daily price quote at which he would either buy an investor out or sell his share of the business. Sometimes, he will be excited about the prospects for the business and quote a high price. At other times, he is depressed about the business's prospects and will quote a low price.

Because the stock market has these same emotions, the lesson here is that you shouldn't let Mr. Market's views dictate your own emotions, or worse, lead you in your investment decisions. Instead, you should form your own estimates of the business's value based on a sound and rational examination of the facts. Furthermore, you should only buy when the price offered makes sense and sell when the price becomes too high. Put another way, the market will fluctuate - sometimes wildly - but rather than fearing volatility, use it to your advantage to get bargains in the market or to sell out when your holdings become way overvalued.

Here are two strategies that Graham suggested to help mitigate the negative effects of market volatility:

1. Dollar-Cost Averaging
Dollar-cost averaging is achieved by buying equal dollar amounts of investments at regular intervals. It takes advantage of dips in the price and means that an investor doesn't have to be concerned about buying his or her entire position at the top of the market. Dollar-cost averaging is ideal for passive investors and alleviates them of the responsibility of choosing when and at what price to buy their positions. (For more, read DCA: It Gets You In At The Bottom and Dollar-Cost Averaging Pays.)

2. Investing in Stocks and Bonds
Graham recommended distributing one's portfolio evenly between stocks and bonds as a way to preserve capital in market downturns while still achieving growth of capital through bond income. Remember, Graham's philosophy was, first and foremost, to preserve capital, and then to try to make it grow. He suggested having 25-75% of your investments in bonds, and varying this based on market conditions. This strategy had the added advantage of keeping investors from boredom, which leads to the temptation to participate in unprofitable trading (i.e. speculating). (To learn more, read The Importance of Diversification.)

Principle No.3: Know What Kind of Investor You Are 
Graham advised that investors know their investment selves. To illustrate this, he made clear distinctions among various groups operating in the stock market.

Active Vs. Passive
Graham referred to active and passive investors as "enterprising investors" and "defensive investors". 

You only have two real choices: The first is to make a serious commitment in time and energy to become a good investor who equates the quality and amount of hands-on research with the expected return. If this isn't your cup of tea, then be content to get a passive, and possibly lower, return but with much less time and work. Graham turned the academic notion of "risk = return" on its head. For him, "Work = Return". The more work you put into your investments, the higher your return should be.   

If you have neither the time nor the inclination to do quality research on your investments, then investing in an index is a good alternative. Graham said that the defensive investor could get an average return by simply buying the 30 stocks of the Dow Jones Industrial Average in equal amounts. Both Graham and Buffett said that getting even an average return - for example, equaling the return of the S&P 500 - is more of an accomplishment than it might seem. The fallacy that many people buy into, according to Graham, is that if it's so easy to get an average return with little or no work (through indexing), then just a little more work should yield a slightly higher return. The reality is that most people who try this end up doing much worse than average.

In modern terms, the defensive investor would be an investor in index funds of both stocks and bonds. In essence, they own the entire market, benefiting from the areas that perform the best without trying to predict those areas ahead of time. In doing so, an investor is virtually guaranteed the market's return and avoids doing worse than average by just letting the stock market's overall results dictate long-term returns. According to Graham, beating the market is much easier said than done, and many investors still find they don't beat the market. (To learn more, read Index Investing.)

Speculator Vs. Investor
Not all people in the stock market are investors. Graham believed that it was critical for people to determine whether they were investors or speculators. The difference is simple: an investor looks at a stock as part of a business and the stockholder as the owner of the business, while the speculator views himself as playing with expensive pieces of paper, with no intrinsic value. For the speculator, value is only determined by what someone will pay for the asset. To paraphrase Graham, there is intelligent speculating as well as intelligent investing - just be sure you understand which you are good at.

Commentary
Graham's basic ideas are timeless and essential for long-term success. He bought into the notion of buying stocks based on the underlying value of a business and turned it into a science at a time when almost all investors viewed stocks as speculative. Graham served as the first great teacher of the investment discipline, as evidenced by those in his intellectual bloodline who developed their own. If you want to improve your investing skills, it doesn't hurt to learn from the best; Graham continues to prove his worth in his disciples, such as Warren Buffett, who have made a habit of beating the market.

by Daniel Myers, CFA

Daniel Myers has earned the CFA designation, and has managed money for investors since 1998.

NEW LOOK, NEW FEATURES, NEW FUNCTIONALITY, AND NEW FEEL...

Have you noticed? Wealth Management Network recently revamped and redesigned their website and went live in December of 2007. Learn about WMN and it's Team, the WMN Philosophy, the WMN Investment Protocol, how to get started and become a client and much more.

Visit our Website: theWMN.com

In spite of the many unpleasant surprises for economic policymakers and investors during 2007, few years historically have better shown the resiliency of the U.S. economy and equity markets.  Consider the following: Oil approached $100 per barrel while the U.S. dollar lost substantial value against most major currencies.  The housing market collapsed, accompanied by the sub-prime mortgage market meltdown.  Poor lending (and borrowing) practices and imprudent ratings on debt consolidation pools led to large write downs at several major U.S. banks and brokerage firms. Banks reacted by slowing lending activity to consumers and other banks.  Discontent with the war in Iraq and national political leadership continued.  In spite of these events, the U.S. economy continued to expand and the U.S. stock market (as measured by the all equity Wilshire 5000 Index) rose 5.6% for the year.

The official seal of the Federal Reserve System.

Throughout history, free market societies have gone through boom-and-bust cycles. While everyone enjoys good economic times, the downturns are often painful. The Federal Reserve was created to help reduce the injuries inflicted during the slumps and was given some powerful tools to affect the supply of money. Read on to learn how the Fed fights recession. (To find out more about recession, see Recession: What Does It Mean To Investors? and Recession-Proof Your Portfolio.)

The Evolution of the Fed
When the Federal Reserve System was established, its founders did not intend it to pursue an active monetary policy to stabilize the economy. The basic ideas of economic stabilization policy were foreign at the time, dating only from John Maynard Keynes' work in 1936. Instead, the founders viewed the Fed as a means of preventing the supplies of money and credit from drying up during economic contractions, as happened often in the pre-1914 period.

One of the principal ways in which the Fed was to provide such insurance against financial panics was to act as the "lender of last resort". That is, when risky business prospects made commercial banks hesitant to extend new loans, the Fed would step in by lending money to the banks, thus inducing banks to lend more money to their customers. (To learn more about the Fed, see The Federal Reserve.)

The function of the central bank has grown and today, the Fed primarily manages the growth of bank reserves and money supply in order to allow a stable expansion of the economy. To implement its primary task of controlling money supply, there are three main tools the Fed uses to change bank reserves:

1. A change in reserve requirements
2. A change in the discount rate
3. Open-market operations

The Tools
A change in reserve ratio is seldom used but potentially very powerful. The reserve ratio is the percentage of reserves a bank is required to hold against deposits. Joey0316A decrease in the ratio will allow the bank to lend more, thereby increasing the supply of money. An increase in the ratio will have the opposite effect. (Read more on this subject in Breaking Down The Fed Model.)

The discount rate is the interest rate that the central bank charges commercial banks that need to borrow additional reserves. It is an administered interest rate set by the Fed, not a market rate; therefore, much of its importance stems from the signal the Fed is sending to the financial markets (if it's low, the Fed wants to encourage spending and vice versa). As a result, short-term market interest rates tend to follow its movement. If the Fed wants to give banks more reserves, it can reduce the interest rate that it charges, thereby tempting banks to borrow more. Alternatively, it can soak up reserves by raising its rate and persuading the banks to reduce their borrowings.

Open-market operations consist of the buying and selling of government securities by the Fed. If the Fed buys back issued securities (such as Treasury bills) from large banks and securities dealers, it increases the money supply in the hands of the public. Conversely, the money supply decreases when the Fed sells a security. Note that the terms "purchase" and "sell" refer to actions of the Fed, not the public. For example, an open-market purchase means the Fed is buying but the public is selling. Actually, the Fed carries out open-market operations only with the nation's largest securities dealers and banks, and not with the general public. In the case of an open-market purchase of securities by the Fed, it is more realistic for the seller of the securities to receive a check drawn on the Fed itself. When the seller deposits it in his or her bank, the bank is automatically granted an increased reserve balance with the Fed. Thus, the new reserves can be used to support additional loans. Through this process, the money supply increases.

The process does not end there. The monetary expansion following an open-market operation involves adjustments by banks and the public. (To find out more, see Formulating Monetary Policy.) The bank in which the original check from the Fed is deposited now has a reserve ratio that may be too high. In other words, its reserves and deposits have gone up by the same amount; therefore, its ratio of reserves to deposits has risen. To reduce this ratio of reserves to deposits, it chooses to expand loans.

When the bank makes an additional loan, the person receiving the loan gets a bank deposit. At this stage, when the bank makes a loan, the money supply rises by more than the amount of the open-market operation. This multiple expansion of the money supply is called the money multiplier. Bank loans and purchases of securities are described as bank credit. It is the existence of bank credit that makes the money stock larger than the monetary base, also known as "high-powered money". High-powered money consists of currency and bank deposits at the Fed. 

Looking for a Hero
Today, the Fed uses its tools to control the supply of money to help stabilize the economy. When the economy is slumping, the Fed increases the supply of money to spur growth. Conversely, when inflation is threatening, the Fed reduces the risk by shrinking the supply. While the Fed's mission of "lender of last resort" is still important, the Fed's role in managing the economy has expanded since its origin.

To read more about busting markets, check out Guard Your Portfolio With Defensive Stocks and Has Your Fund Manager Been Through A Bear Market?

by Richard Cloutier

Richard Cloutier, Jr., CFA, is currently the director of research and a portfolio manager with Heritage Capital Management Inc

February 2008 Wealth Manager e-LETTER
Absolute Strategies pdf Article
Men Invest Differently Then Women pdf Article

January 2008 Wealth Manager e-LETTER
WMN 20th Anniversary Forum & Open House
WMN 20th Anniversary Forum & Open House Photo Gallery
2007 Q3 Market Commentary