Diversification
is key to stability
A recent
story (http://www2.mybc.com/bc/money/fs.cfm?source_id=CP&id=988092)
on this website highlighted investor behaviour during the emotionally draining
month of September. In summary, mutual fund investors actually pulled out more
money from their non-money-market funds than they invested for the first time
in years.
While
mutual funds are still attracting money from investors on a net basis, money
market funds continued to be the main draw. This ties into a column I wrote
recently on investor behaviour (http://www2.mybc.com/money/tidd_fs.cfm?source_id=&id=995649).
Among other things, it concluded what we’ve known for a long time: that investors take very recent events or
performance, and project them far into the future. The lesson this week is one
about which investors need to be constantly reminded: stick to the basics.
Investors
underperform the funds in which they invest. This has been frequently stated in
mutual fund articles but what does it really mean? Let’s use the category of
precious metals funds as an example. Precious metals funds usually hold stocks
in companies producing gold and, to a lesser extent, other precious metals like
silver, platinum, and palladium.
The last
time gold stocks had any luster was in 1996. Gold stocks took off during the
first half of 1996, did nothing the rest of that year, and have been dormant
ever since – until September 11. While the awesome returns of 1996 attracted
many investors, many had bailed by 1999, when gold was seen as “old news” and
technology was the “new paradigm”. By the time gold regained its luster (in
2001), most investors had bailed on this tarnished asset class. What impact did
this have on returns?
Think about
it. By the time gold funds run up to a peak, there just aren’t many investors
left that benefited from the big returns. Investors pile in just after a big
run, and just in time for the down side of the performance cycle. Since “the
fund” is invested during all cycles it picks up the performance from all points
of the cycle. However, investors’ bad timing results in fund investors catching
more of the down side and less of the upside, thereby resulting in awful
performance. Bottom line: they’re
better off either sticking with the fund for a long period of time, or avoiding
it altogether.
Now that
gold stocks have given up some of their post-attack gains, investors may be
getting frustrated again as broader stock markets have made up most of their
mid-September losses.
Do yourself
a favour and don’t repeat this vicious cycle of investor misbehaviour.
Investors
can avoid this recurring behaviour by picking their investments with a
disciplined, forward-looking approach. The first order of business: Write down what you want your portfolio to
do for you. If, for example, you have a retirement plan that says you need a
return of at least 8 per cent per year to reach your retirement goals, that’s
an excellent start. Target rate of return:
8 per cent per year.
Next, think
about how comfortable you are with declines in value, or downside risk. While
past experiences should be used to gauge your risk tolerance, don’t let one bad
investment with energy stocks, for example, drive you away from the sector
forever. Rather, reflect on the experience and place your discomfort in the
proper context. Most people with bad real estate or energy investments were
nailed on highly leveraged limited partnerships that they didn’t fully
understand. The lesson from such an experience shouldn’t be to avoid energy and
real estate. Instead, it should teach you that you’re uncomfortable with
leverage and instruments about which you don’t have much knowledge.
At this
point, you’ll want to make note of things like how long before you plan to
start using your investments for income, if that’s in your plans at all. You’ll
also want to make note of things like tax, legal, and other relevant
considerations as it affects your investments. These could include capital
losses of other years, the tax status of a corporation (if you hold some investments
in a company), or estate planning goals.
Only once
you’ve considered all of those things should you be deciding on how much to put
in domestic and foreign stocks and bonds – i.e. your asset mix. Now you’re
ready to start picking investments. If your main vehicle is the mutual fund, do
yourself a favour and stick to no more than six to eight funds, at most. Those
of you who are Sterling Mutuals Inc. clients with online access can view model
mutual fund portfolios in the October 2001 research report. That will give you
a good illustration of what I mean. If you’re not a client, check out an
article I wrote in June 2000 (http://www.sterlingmutuals.com/account_jun.htm)
on structuring fund portfolios. It’s an old article, but very relevant to this
topic.
Whatever
your approach, make sure it’s simple, logical, repeatable, and not based on the
list of last year’s, or last month’s, top performers.
Something
to keep in mind while you’re developing your strategy and picking specific
investments is to build the core or foundation of your portfolio with a value
discipline. Some would ask: Isn’t this
advice essentially chasing the more recent winners? No. While value funds have
shone brightly over the past eighteen months, it’s a bias I’ve always had – for
good reason. History illustrates a very strong statistical case for the
hypothesis that stock valuations today, have a very significant influence on
returns in the future. In other words, lower priced stocks, as a group, tend to
outperform their more expensive counterparts. By cheap and expensive, I’m not
simply talking about the stock price. Rather, my focus is on a company’s stock
price relative to its earnings (P/E), book value (P/B), sales (P/S), and cash
flow (P/C). If you’ve read my columns for any length of time, these terms will
be very familiar to you. Hence, the recommendation to build a value core is
truly one that looks forward, not back.
Round out
that core with a couple of funds that are a bit more aggressive and/or invest
in hard assets, depending on your circumstances. If you do it well (admittedly
not an easy task), you’ll have a mix that is well diversified by asset mix,
style, company size, sector, and geography.
Whether
you’re up to the task of doing this yourself, or if you require the help of an
advisor, it’s a process that must be done. And if you end up with a portfolio
boasting the fine qualities I just mentioned, you won’t have any worries the
next time a financial crisis is upon us.
Dan Hallett, B.Comm.,
CFP, CFA is 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, and Manitoba.