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This recent volatility has been the most extreme we have experienced since the 2008 meltdown. I don’t remember a time there has been so many huge, back-to-back, up-and-down market moves in a row. On a regular basis, the Dow Industrials has been losing or gaining 400, 500 and 600 points at a time.

This type of volatility can make the most seasoned investor a little queasy. The volatility, accompanied by the endless negative news — real and imagined — is enough to make investors question if there is anywhere safe to put their money.

Studies have shown most investors consistently underperform the market indexes. The reason they underperform is because they sell out of their investments when they get scared and then go back into them once they feel safe. Investing based on feelings is a recipe for buying high and selling low.

So what should an investor do in these difficult times? How do you avoid selling low and buying high? Here are three basic rules I recommend.

Rule #1: Never sell out during panic.
Wait for sanity to return before you make any changes to your portfolio. When the markets are moving 500 to 600 points a day, it represents extreme panic. The stock market is essentially a high-tech auction. If you try to sell at the same time as everyone else, there are very few buyers. Those few buyers can essentially name the price they are willing to pay you. That price will be well under fair value.

Rule #2: Establish your risk tolerance BEFORE you invest.
You need to define in advance how much risk you are comfortable with. Investors often ignore this step. Then, when markets become volatile, they become painfully aware their risk tolerance is not set properly. Making the effort to set your risk tolerance initially — and reassessing it annually — is critical to your long-term success.

Rule #3: Keep your focus on the long term.
Mistakes are often made when investors make emotional decisions based on short-term market action. Unfortunately, decisions based on short-term market movement can have long-term negative consequences. Your investment strategy should be based on your long-term goals and objectives. While your plan should be reviewed and adjusted annually, it should not be drastically changed, especially when markets are volatile. Define your long-term investment plan when markets are stable.

What can investors expect going into the end of the year? Usually markets will do whatever the majority doesn’t expect, and right now most investors are scared and expecting the worst. We don’t expect another recession soon based on the current economic numbers we track. That may change, though, if Europe doesn’t deal with its debt problems or U.S. consumers scare themselves silly and pull back on consumer spending. Unfortunately, recessions can be self-induced.

On a positive note, historically, the third year of every president’s term since 1939 has been positive for the markets — even during Jimmy Carter’s presidency. In addition, surprisingly, the S&P 500 has produced a positive return for the final four months of the year during seven of the last eight years.

To learn more about how to implement these strategies, go to paragonwealth.com. Or for regular strategy updates, follow us on moneymanagerslive.com.

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Whether it’s a tsunami, a drilling rig disaster, a financial meltdown or unrest in the Middle East, the world is a scary place. Something is always going wrong somewhere. So how do you invest and still sleep at night?

Set Your Risk Tolerance
The way to deal with uncertainty and manage the impact of unforeseen events is to build strict risk controls into your investment portfolio. While the risk of one-time incidents can’t be eliminated, through diversification and risk management we hope to limit the damage when negative events occur.

Considering this, it might be useful to provide an overview of our approach to risk management and portfolio construction. The first step toward controlling risk is to make sure your individual risk tolerance is set properly.

Your risk tolerance can depend on many factors, such as how close you are to retirement, your goals or your lifestyle needs. It is determined by the returns you need to generate in order to meet your objectives and by identifying how much risk you are comfortable with. If your risk tolerance is set too low, you won’t generate the returns you should. If it is set too high, should market conditions become difficult, you will feel pressure to sell your investments, which could cause you to miss out on superior long-term returns.

Once your risk level is set, it helps to identify the mix of stocks, bonds and cash that you should hold in your portfolio. It determines how conservative or how aggressive your portfolio should be. The allocation put together based on your risk tolerance strongly determines how much volatility you will have to endure when unexpected events occur.

Use Models to Reduce Risk
The second step to reduce risk is the actual process we follow to manage the portfolios. We seek to manage risk by using two unique groups of quantitative models. The first group of models is proactive in nature and determines which areas to invest in. The second group of models is protective in nature and determines how aggressively the portfolio will be invested at any point in time.

The proactive set of Paragon models are designed to identify trends and measure velocity within the universe of available market styles, sectors and industries. When trends are identified, the portfolio stays invested in those market areas until certain exit criteria is met. When that occurs, the funds are rotated into other areas that currently meet the model’s recommendations. This rotation is ongoing, and the models are constantly adapting to current market conditions.

The protective set of models is designed to reduce risk when possible. These models determine how aggressively the portfolio will be invested at any point in time. The models adjust market exposure up or down depending on how much risk is in the market.

Expect the unexpected
We’ve always had unexpected events and always will. And despite these unforeseen events, economies have grown, companies have prospered and stock markets have generated positive returns. The key to benefiting from this long-term growth is to structure your portfolio so that no single event can create permanent damage to your portfolio.

If you would like to determine your personal risk tolerance, go to www.paragonwealth.com and take the complimentary risk tolerance survey.

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Time to get back in shape. Time to set new goals. Time for your annual portfolio review!

I know for some that sounds about as much fun as an annual physical. But in terms of importance, it ranks at the top of your list. If you don’t know where you’re going, it’s difficult to get there. And if you don’t measure your progress, you may never get there.

It’s time to clarify why you’re investing in the first place. Is it to provide retirement income? Is it to supplement it? Is it to provide an education for your kids? Is it so you can travel? Is it so you can be financially free?

Whatever the reason, clearly define it. And once you’re clear on the why, look at how you’re going to make it happen.

How much money do you need to save each year to meet your goals? What rate of return does your portfolio need to generate? What is the probability you will reach your objective — at different rates of return? Is your portfolio properly positioned for the market cycle? Are you taking too little risk? Are you taking too much?

If you can’t answer these questions, you’re leaving your financial future up to pure luck. “Luck” and “hope” are two words you never want to use when talking about your investments.

At Paragon, we offer free portfolio reviews each year through our website. Many are for local investors. Others are investors referred to us nationally from Morningstar, the well-known mutual fund rating organization. Most are experienced, retired investors with significant investible assets.

Below are five mistakes we repeatedly see in portfolios.

1. Risk levels: Investors often don’t know how much risk they need to take in order to reach their goals. They haven’t defined how much market volatility they can comfortably live with. What’s more, they have no idea how much risk they’re actually taking. As a result, next time the market goes down, they will likely endure sleepless nights as they hope the market recovers. Odds for success? Low.

2. Diversification: Investors own many mutual funds and think they are diversified. We regularly see accounts holding 40-plus funds. What they often don’t realize is many of their funds hold the same stocks. In reality, they’re not diversified at all. They’re usually taking much more risk than they realize.

3. Bonds: Investors hold bonds for safety and stability. Bonds provided safety over the past 30 years because interest rates declined from 18 percent down to 2.5 percent. Most bonds do not provide safety when interest rates move up. To the contrary, bondholders may see significant losses going forward as rates increase from all-time lows.

4. High expenses: Many portfolios are filled with expensive mutual funds. Investors are paying management fees, transaction costs and 12b1 fees. They can often achieve the same market exposure through ETFs at a fraction of the cost.

5. Knowing when to sell: Buying a stock or fund is the easy part. Knowing when to sell is the hard part. Investors should never own a position they wouldn’t be willing to buy today. We see portfolios full of investments that should have been sold long ago.

If you have at least $200,000 invested and would like a second opinion on your portfolio, go to www.paragonwealth.com and request a free portfolio review.

It’s that time again.

In October 2007, the Dow Industrials hit a high of 14,164. From that high we saw one of the worst bear markets in history with the Dow plunging to 6,547 in March 2009. Then, as many proclaimed the world was ending, we saw the Dow rally from that 6,547 low up to 11,205 by April 2010. Since April, we’ve spent the past six months going back and forth, only to recently hit a new high of 11,444 on Nov. 5.

So what’s next? If you follow what the media has said, you might think the markets will never recover. Actually, it’s amazing how many people don’t realize the Dow has already rallied 75 percent off of the March lows. But some still believe the world is ending.

While there are many reasons to be concerned about the future, there are more reasons to be optimistic:
1. The Fed wants the stock market up and interest rates low. It is taking its most aggressive action in history by buying $600 billion in Treasury bonds. A basic rule of investing is, “Don’t fight the Fed.”
2. Based on the results of the last election, politicians should be much more friendly to business than they have been. This should be good for the economy.
3. From a cyclical standpoint, the third year of a presidential term has almost always been the best year of the term for stocks. It’s known as the “sweet spot.”
4. Every time the market has lost ground over a 10-year period, like it has recently, performance the following decade has been positive.

Two Investment Rules
I often receive subscription invitations to various investment services. Usually I ignore them, but this one was from a highly regarded firm. Its pitch was compelling. They offered eight “exclusive” stock picking services priced at $3,000 per year, per service. I told them I wanted to “look under the hood” — to see if the performance matched the hype.

I was shocked to discover that the historical performance of six of the strategies was terrible, and the other two mediocre. Surprisingly, most of the services were sold out.

What did I learn from this? Why would anyone pay $3,000 a year for a stock picking system that doesn’t add value? Apparently, many investors act on the “hype” but don’t investigate the numbers.

Rule No. 1: Always thoroughly evaluate the numbers. Don’t rely on what sounds good. You would think a big, national firm with unlimited resources could put together a successful trading strategy. You could very well be wrong.

Rule No. 2: Investing is very difficult, whether the firm is big or small. Don’t assume that the big firms have the advantage when it comes to investing. Often the bigger the firm, the worse its investment strategies perform. Because of their bureaucratic structure, they are not usually nimble or creative.

Because investing is difficult, many investors become convinced that no one can beat the market. They give up trying and simply buy and hold some mutual funds hoping to at least match the performance of the broad market.

At Paragon, we believe there is a better way to invest. Our performance tells our story. From Jan. 1, 1998 through Oct. 31, 2010, our Top Flight growth portfolio has generated a net compound annual return of 13 percent versus 3.4 percent for the S&P 500 Index.

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Investing in the wrong place at the wrong time … again?

When people find out I’m in the investment business, they usually ask me where to invest. They ask if it’s better to be in stocks, bonds or real estate. They want hot tips like, are U.S. stocks better than international stocks? What about China and Brazil? Etcetera, etcetera.

Next, they tell me their horrible investment experiences. Typically, they’re convinced that anything they invest is destined for doom. This leads me to ask, “Why do the majority of investors have bad experiences?”
It doesn’t help that for the past 10 years, the stock and real estate markets haven’t gone anywhere. After mostly going up during the ’80s and ’90s, the markets went down hard between 2000 and 2002. From 2003 through 2007, they did great. But what came in 2008 to early 2009 was one of the worst bear markets in history, after which the markets rallied once again.

It’s understandable investors have had it tough. However, studies have shown that the average investor did poorly during the good times, too. Historically, retail investors have underperformed when markets are good and performed horribly when markets are bad. No wonder investors are frustrated and disillusioned.

So, are people hard wired to invest in the wrong place at the wrong time? Yes. And I’ll tell you why: emotions. Most investors invest based on emotions, driven by a constant tug-of-war between fear and greed.
Will Rogers said investing is simple: All you do is buy low and sell high. The problem is when prices are low, everyone is consumed with FEAR. And that is precisely when they should invest.

The other side of the cycle is when markets have gone up. Investors tell their friends about the 20 percent return they got last year, and all of a sudden the 1.5 percent they got in their CD doesn’t look so great. So then they, along with millions of other investors, come piling into the market consumed with GREED.
This cycle of fear and greed repeats itself over and over. Consider where the masses invested the past 10 years. Back in 2000, record numbers flooded the stock market right before a horrible three-year bear market hit. Investors in the NASDAQ watched their accounts lose 80 percent of their value.

Many of those investors said they would never invest in stocks again. So they piled into real estate to be safe. As we saw in 2008, it wasn’t safe after all. Depending on which part of the country they were in, they experienced losses anywhere between 30 and 80 percent. Some leveraged real estate investors lost everything.
For the past year, we’ve seen investors piling into bonds. Bonds have been pushed to the lowest yields I’ve seen — simply because everyone is buying them “to be safe.” The bond bubble looks a lot like the previous stock and real estate bubbles. Odds are that investors who buy bonds for safety are about to get crushed.
At Paragon Wealth Management, we avoid emotional investing by following our quantitative models. We do not care what the media is saying or what we hope or how we feel. Our models process the market data and we invest accordingly. We are constantly adjust our portfolios to what the market is actually doing.

Paragon cannot guarantee the accuracy of information from other sources. Opinions are as of the dates indicated only. This report is not a solicitation for any security. Past performance is not a guarantee of future results. Investment performance reflects time and size-weighted geometric composite returns of actual client accounts. Investment returns are net of all fees and costs. The S&P Index is a diversified, size weighted index of 500 stocks.

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They’re upset … but they don’t do anything about it. They seem to believe the situation will somehow fix itself. What they don’t realize is if you do what you’ve always done, you’ll get what you’ve always got. Insanity is repeating the same poor actions over and over — and expecting a different outcome.

There is a much better way to invest, but it requires you to take action and be proactive. It all starts with selecting a quality financial adviser. Interview a prospective financial adviser just like you would a prospective employee. While hiring the wrong employee can cause unnecessary grief, hiring the wrong financial adviser can wreak havoc with your entire future.

Often, because people don’t know how to evaluate an adviser, they simply invest with the first person that impresses them. This is a mistake. The best salespeople are not necessarily the best advisers.
We provide educational resources on our Web site, www.paragonwealth.com, that outline seven steps to selecting a financial adviser. Three of them are non-negotiable. First, the adviser must be a fiduciary. Second, he or she should have 10 years of investment experience. And third, the adviser needs to show you a 10-year investment track record.

These may seem like stiff requirements, but they will significantly increase your odds of success.

Why is it important to find a fiduciary adviser? Fiduciary advisers have a legal obligation to put your interests ahead of their own. They are held to a much higher standard. Most people do not realize that all financial advisers are not fiduciaries. Surprisingly, it’s been estimated that only about 15 percent of advisers are fiduciaries. Generally speaking, most sales reps who receive a commission for selling financial products such as annuities, insurance and mutual funds are not fiduciaries. On the other hand, Registered Investment Advisers and their reps usually are fiduciaries.

Why should they have 10 years of experience? Because markets are difficult to navigate and are constantly changing. Ideally, your adviser should have experience investing in both good and bad markets. Experience is critical.

Why should you require them to show you their 10-year track record? If they don’t, then how do you know what they’ve done for prior clients? Talk is cheap. Legitimate advisers can show what they’ve done for clients over the years. Showing you the track record of a mutual fund, a hypothetical model, or anything else they have recently started selling does not count. They need to show you their own track record, which would be a composite of the results of their previous clients’ investments. Any adviser who refuses to show you their track record should be crossed off your list.

Make sure your adviser meets these three requirements. If you are not happy with your investment performance or your current adviser, do something about it. Poor investments will not fix themselves. To improve your situation, you must be proactive.

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This stress-free picture describes what an ideal investment program would be like — a low-stress, methodical strategy that allows you to reach your long-term goals.

Is it possible to have this type of experience?

Over the past 10 years, many investors’ experiences have been more like riding a roller coaster in the dark with no brakes, which is the complete opposite of low stress.

While it is impossible to have a completely stress-free experience, it is possible to reduce stress significantly by building a portfolio that is aligned with your specific risk tolerance. Your risk tolerance determines how aggressive or conservative you are invested. Your particular mix might be 20 percent conservative and 80 percent growth, 50/50, 70/30 or some other combination. It is different for each person. It depends on your individual goals and objectives and what you can handle.

Every investor has an amount of risk he or she is comfortable with. If your risk level is set too high, you will most likely have a hard time every time your account value declines. If your risk level is set too low, your returns may be inadequate, and you will never reach your goals. Basically, when it is not set right, you will worry every time the market drops and become euphoric every time it goes up.

Why is this so important? Because many investors do not consider how much risk they are signing up for when they initially invest. It might be invested in a way that you will lose everything when something goes wrong. For long-term success, it is critical you have a clear idea of exactly how much risk you are exposed to. Otherwise, your chances of success are slim.

Paragon cannot guarantee the accuracy of information from other sources. Opinions are as of the dates indicated only. This report is not a solicitation for any security. Past performance is not a guarantee of future results. Investment performance reflects time and size-weighted geometric composite returns of actual client accounts. Investment returns are net of all fees and costs. The S&P Index is a diversified, size weighted index of 500 stocks.

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In an effort to stem the overwhelming tide of fear, we created a presentation called “Is The World Ending?” In short, we didn’t believe it was the end. We believed the entire situation had evolved into unwarranted panic and fear, and we advised clients to become fully invested.

As we expected, the March lows were the market bottom. Since then, the economy has moved back from the precipice. In mid-July, we wrote several articles stating we believed the recession actually ended around June 30. Since the March lows, the U.S. market has gained 50 percent, retracing a good portion of the losses since last fall. Many of the international markets have come back even stronger, with the emerging markets leading the way.

Buy and Hold?
So, after all of this market drama, what is the best way to invest? Wall Street, mutual funds, stock brokers and financial planners all pitch “buy and hold” as the best way. Buy and hold is the most “promoted” investment strategy there is. John Bogle, founder of Vanguard Funds, is the poster child of the buy-and-hold strategy. He endorses it with evangelical zeal. Buy and hold is an investment strategy where you simply buy an investment and then hold it indefinitely. In theory, as the markets move up and down, your investment moves up and down, but over time you are rewarded.

Active management is a strategy where you are constantly adjusting your portfolio to what the market is doing. Unlike day trading, most active strategies are trying to capture intermediate term (three to 18 months) moves.

There has always been a debate whether buy and hold or active management is better. Since this is such an emotional debate, let’s look at the numbers.

In mid-October, the Dow Industrials moved above 10,000. Everyone cheered. The last time it hit 10,000 was about a year ago, on its way down. Looking longer term, the Dow Industrials first hit 10,000 back on March 18, 1999. That was more than 10 years ago. During that 10-year period of time, faithful buy-and-hold investor’s returns have been almost non-existent. When you factor in inflation, the returns are actually negative.

The Dow paints a relatively positive picture. Let’s say you invested in the NASDAQ (which represents 6,000 stocks) more than nine years ago on March 10, 2000. Buying and holding the NASDAQ from March 10, 2000 through Oct. 16, 2009 would have given you a loss of 57 percent. Out of curiosity, just how much longer do the buy and holders recommend you keep holding the NASDAQ?

Active Management
At Paragon, we are proponents of active management. And the numbers back us up. Both of our actively managed portfolios are doing extremely well year-to-date. Stocks trounced bonds, small cap and mid cap stocks outperformed large caps, and emerging markets outperformed all asset classes. Fortunately, that is where our models positioned us, and it is why our portfolios once again outperformed their benchmarks. Our conservative portfolio, Managed Income, is up 11.93 percent year-to-date, through Sept. 30 — more than doubling the 5.72 percent for its benchmark, the Barclays Bond Index.

Our growth portfolio, Top Flight, is up 27.7 percent year-to-date, through Sept. 30 — versus 19.3 percent for its benchmark, the S&P 500. Since January 2007, Top Flight is down only one percent versus its benchmark, the S&P 500, which is down 21 percent during the same period. Since its inception in January 1998, Top Flight has gained 337 percent versus only 33 percent for the S&P 500 index.

Active management does work.

Paragon cannot guarantee the accuracy of information from other sources. Opinions are as of the dates indicated only. This report is not a solicitation for any security. Past performance is not a guarantee of future results. Investment performance reflects time and size-weighted geometric composite returns of actual client accounts. Investment returns are net of all fees and costs. The S&P Index is a diversified, size weighted index of 500 stocks.

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Since the March 9 low through July 31, the S&P 500 has gained 46 percent. It has made back its losses from January through mid-March and is now up 10.9 percent year-to-date through July 31.

During that same time, our growth portfolio, Top Flight, is up 17.2 percent year-to-date. The reason we are up substantially more than the market is because we invested in those areas that perform best after a severe market decline — just like we recommended.

If you followed our advice, you were rewarded. But going forward, the question is how should an investor be invested? In July, our indicators and the models we follow indicate there is a high probability the recession ended in June — although this hasn’t shown up in the press and is not yet mainstream knowledge.

The first and sharpest stage of market recovery usually occurs right after the initial market plunge and takes about three to four months. We believe stage one occurred between March 9 and June 30. The second stage of recovery occurs after the recession ends, which we believe was around the end of June.

If it is true the recession ended in June, then we now want to be invested in those areas of the market that do best during the second stage, or after a recession ends. The second stage lasts for about six months. Following the last 11 recessions, the data clearly shows that certain areas of the market consistently perform best during stage two.

Typically, bonds perform poorly after recessions and should be avoided. Interest rates get pushed down during the recession, and then, as the economy starts to expand, demand for money increases and interest rates go back up. When interest rates go up, most bonds get hammered and lose money. Bonds are one of the worst places to be as an economy emerges from a recession. Unfortunately, many misguided investors have been running to bonds for the past six months, hoping to find safety. If history repeats, they will find the opposite of what they seek.

From a big picture perspective, small cap, growth, commodities and emerging market stocks have performed the best for the six months following the end of the recession. On a sector basis, energy, materials, tech and consumer discretionary stocks performed the best.

On the other hand, in addition to bonds, other sectors that usually perform poorly after a recession ends — and should be avoided — include consumer staples, health care and telecommunication stocks.

This difficult market highlights why “active” investment management is so important. If market dynamics always stayed the same, then a simple buy-and-hold approach would most likely work well for investors. Because market dynamics are constantly changing and evolving, we believe the best investment approach is one that actively adjusts, moves and changes based on market conditions.

The views in this column are my opinions. They are not intended as a forecast or a guarantee of future results.

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