Resist the
urge to buy past returns
I am struck
by the number of GIC ads of late by banks and other deposit-taking
institutions. They’re spinning their ads to play on the emotional pain of stock
market losses. History indicates that giving into these ads by forking over
some dough could be your worst long-term move.
One ad in
my local paper by a credit union shows a frowning man below the caption, “Are
you frustrated with your RRSP invested in the stock market?”. GIC rates were
shown, but only those applicable to investments of $500,000 and up. Sure, it’s
aggressive marketing but it’s really no different than what the mutual fund
industry has done throughout the bull market of the 1990s.
It’s a well-known
phenomenon that investors follow returns. So, it’s no surprise that fund
companies rushed their top performing funds to prominent ad spots in print
media across the country after a hot run. The problem: by the time you see a print ad for an investment
that has just posted a year of 30, 50, or 100 per cent returns, it’s often the
worst time to buy.
At my
former job, we studied ads featuring performance through most of the 1990s. The
performance quoted in the ad for each fund was compared against the performance
of those same funds for the subsequent year.
In all
cases, performance dropped off by a full 10 percentage points or more. About ¼
of the funds studied subsequently underperformed their advertised returns by
more than 25 percentage points.
The
lesson: financial markets are cyclical
by nature. Just when the status quo looks poised to continue forever, that’s
when a shift begins to occur. And before you know it – and likely before you’ve
made any changes – you’ll “see” the shift in trends.
To read
more about the study of performance ads, check out this 1998 Globe and Mail
article by Duff Young.
During
calendar 2000, mutual fund investors ploughed more than $34 billion into pure
stock funds. Interestingly, the sum of net money invested in all other
categories was negative to the tune of nearly $1 billion. Of course, it was the
spring of 2000 that tech stocks began showing their vulnerabilities; peaking in
late summer.
The
negative stock returns that began in the latter part of 2000 accelerated in
2001. It became apparent that fund investors were getting nervous, though not
panicky since more than $16 billion flowed into funds during the year. Money
market funds picked up its largest share of net investments ever while stocks
continued to weaken.
So, let’s
recap quickly. By the time big returns had been posted by the beginning of
2000, investors were piling more and more money into the industry’s hottest
funds. Maintaining an overly optimistic outlook, the weakness in 2001 caused a
slowdown in net investments, but didn’t deter new investment.
To that
point, certain areas had remained unscathed – i.e. value stock pickers and other
defensive funds. But by late spring, May to be exact, the bottom began falling
out. As it happens, June was the first of what is now a seven-month streak of
net outflows for pure stock funds.
If history
is any indicator – and I believe it is where human behaviour is concerned –
fund investors will continue to pull money out of stock funds until most of the
recovery in stock prices has already occurred. By that time, investors will
have seen the attractive returns advertised and want to jump back in.
But I’m
afraid that, by doing so, investors will simply be making the same mistakes
they’ve been making for years.
The
challenge for investors and their advisors is to base today’s investment
decisions without the undue influence of the recent past. Last
week, I walked through the reasoning of one of the industry’s most
insightful analysts, and extended his conclusions to a basic, long-term return
projection for U.S. stocks.
The greater
challenge will be to continue to have a forward-looking focus and realistic
expectations – admittedly difficult both in good times and bad.
Recognizing
the behavioural patterns that hurt investor returns is the first step to being
able to correct that behaviour. It would be a massive understatement to say
that such discipline is easier said than done. And it’s fair to say that many
people (even many industry professionals) simply don’t have the personalities
to consistently implement such a discipline.
But
sticking to the basics of diversification and having a plan (i.e. investment
policy statement) to use as a reference when considering changes will go a long
way toward helping you stay on track.
Dan Hallett, B.Comm., CFP, CFA is the Senior
Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, Alberta, and Manitoba.