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Dont Be Spoiled for Choice March 2013

Being broadminded but selective about investments and advice isvital because so many choices exist, says David Darst of MorganStanley Wealth Management

Conditions in the financial markets have changed immenselybetween 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 atMorgan 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.

TaraKalwarski: Whats the best investment advice you

ever received?

DavidDarst: 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 anyMicrosoft 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 andwho 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


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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, inflation-

protected securities and managed futures. Many people

thought they were diversified because they had differentkinds 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 thetremendous 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, J eff 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 inManhattan, 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 good-

quality 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

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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 westin 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 richinvestors 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, the10-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, dividend-

paying multinationals with fortress balance sheets; cross-

border flows of ideas, products, marketing, and talent; and

worldwide management mentalities.


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Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment. Companiespaying dividends can reduce or cut payouts at any time.

International investing involves certain risks, such as currency fluctuations, economic instability and political developments.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.

Indices are unmanaged and are not available for direct investment.

Alternative Investments often engage in speculative investment techniques involving a high degree of risk and are only suitable for long-term,qualified investors. They are generally illiquid, often engage in speculative investment techniques, and may be highly leveraged, thus magnifying thepotential for loss or gain. Investors can lose all or a substantial amount of their investment.

Managed futures investments are speculative, involve a high degree of risk, use significant leverage, are generally illiquid, have substantial charges,are subject to conflicts of interest, and are suitable only for the risk capital portion of an investors portfolio. Before investing in a managed futuresfund and in order to make an informed decision, qualified investors should read the funds private placement offering memorandum or prospectuscarefully for additional information with respect to charges, expenses, and risks.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to thisrisk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduledmaturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amountoriginally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to thecredit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are alsosubject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interestrate.

Many floating rate securities specify rate minimums (floors) and maximums (caps). Floaters are not protected against interest rate risk. In a declininginterest rate environment, floaters will not appreciate as much as fixed-rate bonds. A decline in the applicable benchmark rate will result in a lowerinterest payment, negatively affecting the regular income stream from the floater.

Asset Allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Because the return of TIPS is linked to inflation, TIPS may significantly underperform vs. fixed return treasuries in times of low inflation.

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This material is not a product of Morgan Stanley & Co. LLC or CitiGroup Global Markets Inc.'s Research Departments or a research report, but it

may refer to material from a research analyst or a research report. Thematerial may also refer to the opinions of independent third party sources whoare neither employees nor affiliated with Morgan Stanley. Opinions expressed by a third party source are solely his/her own and do not necessarilyreflect those of Morgan Stanley. Furthermore, this material contains forward-looking statements and there can be no guarantee that they will come topass. They are current as of the date of content and are subject to change without notice.

Any historical data discussed represents past performance and does not guarantee comparable future results.

Tracking No. 2013-PS-154 3/2013

2013 Morgan Stanley Smith Barney LLC. Member SIPC

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