Past results not only thing investors should check
There’s a commercial currently running on local radio stations encouraging people to invest in a real estate project. The announcer talks about the high returns the company has achieved and stresses that investors have never lost a penny. At the very end, in a disclaimer, you’ll hear the words: “Past results are no guarantee of future performance.”
In fact, every ad for an investment product is required to say the same thing in one form or another. A security may have a terrific history, as this real estate deal apparently has. But that doesn’t mean it will produce the same results going forward. Things change.
People who focus too much on historical results when making their decisions are what I call “rear-view mirror investors.” They look for what has done well in the past — perhaps because it’s easier than trying to predict what will happen in the future. That may explain why so many people still have most of their equity investments in Canada. Through most of the first decade of this century, the TSX was the place to be. Commodity prices were high, driving up the value of the mining and energy stocks which, along with financials, form the backbone of our stock market. The loonie was steadily rising, boosting the value of Canadian investments in international terms. The TSX hit an all-time high in June 2008, riding the crest of these waves. That’s all changed.
The Canadian stock market has been one of the world’s weakest performers in the past couple of years. As of Sept. 24, it was showing a gain of only 3.3 per cent for 2013, while all the major U.S. indexes had posted double-digit advances with the Dow up 17 per cent, the S&P 500 by 19 per cent, and Nasdaq a whopping 24.8 per cent. Investors who based their decisions on history were hurting.
I see the same kind of attitude when it comes to choosing mutual funds. Too much emphasis is put on past performance, which is easy because the numbers are available on many websites. This is not to say that a fund’s history should be ignored, but it should form part of a larger picture.
I’ve been rating mutual funds for more than 25 years, with a pretty good success record (no one gets it right all the time). Here are the main criteria I use: Economic conditions. This is the No. 1 determinant in how a specific class of funds will perform over the short to medium term. Rising interest rates will depress the value of bond funds. GDP expansion will boost stock markets and equity funds. An international crisis will prompt investors to seek the safety of U.S. Treasuries, pulling money out of emerging markets in the process. You need to know what’s going on and understand the implications for your money. Risk. We are always being told to invest for the long term. That’s true up to a point. But no one should place their money in a position where there’s an elevated risk of a quick loss. It can take years to recover from something like that.
The degree of risk with which an investor is comfortable is highly personal. Some people cannot tolerate the thought of losing any money. They should be content with GICs, money market funds, mortgage funds and the like, understanding their returns will be low. Certain types of funds are inherently more risky than others. They include small-cap funds (those that invest in small businesses), emerging markets funds, natural resource funds, and junk bond funds. In good years, such funds can produce spectacular returns — occasionally more than 100 per cent. But when things go wrong you could lose more than half your money in less than 12 months. I generally avoid high-risk funds. When I occasionally recommend them it is always with a caveat — don’t touch this one if you can’t deal with the risk factor. Consistency. This is where history comes into play. Funds that have a long record of outperforming their peers will usually (but not always) continue to do so. I look at the annual quartile rankings of funds compared to those of their peer group over several years to determine that. A fund which is consistently in the first or second quartile (top 25 or 50 per cent of its category) merits serious consideration. That doesn’t mean it will never lose money — all equity funds fell in value in the crash of 2008-09. But the top quartile performers lost less than their peers, in some cases much less. Above all, never invest in a fund, or any security, that you don’t understand. That often turns out badly. There are always other options. Gordon Pape is editor and publisher of the Internet Wealth Builder newsletter. His website is www.BuildingWealth.ca Stay up-to-date and share your thoughts. Subscribe to Gordon Pape’s Facebook page at facebook.com/GordonPapeMoney