Practical goals keep a portfolio on track

On the Contrary

One of the toughest things for an investor to do is to set realistic return expectations. The most common mistake people make is to choose an investment or set a return target simply because of what has happened in the past one or two years on the premise that it will repeat. They do so in spite of all of the fine print warnings and empirical evidence that past performance does not guarantee future results.

Part of the problem is that the investment industry is dominated by professionals, from stock brokers to advisers to financial planners, who are paid to sell a particular mutual fund or investment product. Knowing full well of the behavioural flaw of return chasing, those funds with the best short-term track records and highest rating are marketed extensively.

As the old saying on Wall Street goes, “when the ducks are quacking, feed them.”

There have actually been some very interesting studies on this, such as the one by Vanguard in October 2013, showing on average only 30 per cent of funds with fivestar ratings outperformed their style benchmarks. Interestingly, this is almost identical to the 28 per cent of funds with a one-star rating that outperformed their style benchmarks.

In addition, the study showed that most funds had less than a 50 per cent chance of maintaining their rating just 12 months following the initial rating.

This isn’t to say that there are not managers out there who can add alpha, as there certainly are; one just needs to take a different approach when selecting them.

A great starting point is to decide what your investment goals are while recognizing the current state of the market for both equities and bonds. There are a couple of different approaches to this depending on whether it’s important for you to keep up with the market or not and your overall risk tolerance.

For those whose goal is to obtain a better return than the market, selecting the right manager is paramount. Look for those with a record of generating alpha or superior returns to their benchmark. For example, for your Canadian equity allocation identify those managers who have consistently been able to beat the S&P TSX on a relative basis with a lower standard deviation over at least a five-year or 10-year period.

For those who do not have the time or expertise in manager selection, then employing a passive approach is the safest way to keep up with the market. For example, there are all kinds of low-cost ETFs out there that track the S&P TSX or other larger markets such as the S&P 500 or MSCI EAFE.

An important consideration in both of these cases is that they are not mutually exclusive and it isn’t uncommon to apply a passive and active approach together such as utilizing those mutual fund managers in smaller and less-efficient markets such as Canada and ETFs in larger and more efficient markets such as the U.S.

Asset allocation between bonds, stocks and global markets should also be watched carefully with proper diversification deployed depending on your risk tolerance. For example, many investors are currently tempted to chase Canadian equity funds simply because of their high double-digit returns last year while selling some international equity and bond funds due to their weaker performance.

Instead, avoid this chasing altogether and make allocation changes based on forward outlooks that factor in risks versus rewards that are reflected in valuations. This is the true value of having someone oversee your portfolio.

Finally, there are those who want to set their investment goals independent of everyone else. This approach requires finding a manager that employs absolute-return investment strategies, meaning they give away some of the upside in rallying markets in order to protect some of the downside in correcting markets. Look for those who have delivered a stable return profile through a full market cycle.

For example, a goal for someone in retirement could be to identify the income needed from their portfolio to fund their near-term needs and balancing that off against their estate plan. In such a case and after considering today’s environment of low bond yields and equity markets near their highs we would target an annualized five per cent to six per cent return for a traditional balanced portfolio.