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November 1, 2006
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Perception and Reality
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Before buying or selling, understand what is driving your decision.
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Day after day I hear reports that the Dow Jones Industrial Average has made a new all time high. Coming from the depths of the longest bear market since the 1930s, investors should be pleased to know that they are back to where they were. And yet, Canadian investors are disappointed with the performance of their mutual funds, because many US equity funds have simply not come back from the highs that were set in 2000. Connecting the dots, Canadian investors are questioning whether actively managed mutual funds are good investments. I am not here to debate the pros and cons of mutual funds, but merely to point out that what we are witnessing, is an example of investor perception being at odds with market reality.
Canadians investors have seen the value of the Canadian dollar rise substantially, which has had a profoundly negative impact on the performance of assets outside Canadians. The problem, is that when the news media talks about record highs, they are looking at it from the perspective of a US investor. For Canadian investors, after converting the results back into loonies, the Dow is still 18% below its’ all time high. Unfortunately, for investors, the strong Canadian dollar has distorted investors view about performance in general.
This example is a classic case study about investors viewing performance data without understanding all the facts. It is worth talking about, because we know that investors are reference dependent – i.e. they look at historical returns on the basis of one, three and five year numbers – and given the data over that time period, there is a risk that investors will sell out of their US and international investments, solely on the basis of lackluster historical performance. When in reality, this is probably the time to hold onto, or even add to, foreign positions.
Think about that for a moment. The biggest problem for investors is that they make important decisions on the basis of past performance. Buying a hot mutual fund because of a solid one three and five year track record. Buying a stock because it has just moved up sharply. When you make decisions on that basis, you are by definition, making an assumption that what drove the past performance will continue to drive performance going forward.
In the case of a mutual fund, you might be lead to believe that the fund’s past performance is the result of a strong portfolio management team. In reality, the performance has more to do with the sectors or markets the portfolio manager is invested in, and the macro economic environment that existed during the measuring period.
Further, buying a particular fund on the basis of its past performance, means that you are, by definition, buying into the belief that the sector or market environment that existed during that measuring period will continue to drive values going forward.
That’s a tall order. One thing we know with certainty, is that capitalist economies are always in transition, and that history is not usually the best predictor of future performance. In fact, if you are buying into a fund with a stellar one, three or five year history (and if you are like most investors, strong performing funds are the only funds you would buy), you probably have less than a 10% chance of seeing those performance numbers repeated over the next one three and five year cycle.
Coming full circle, to sell foreign assets at this stage, you have to believe that what drove the less than stellar performance in the past will drive results going forward. In reality, the so-called poor performance was driven by higher oil prices which had a slowing affect on mature industrialized economies like the U.S. and Europe, and a strong Canadian dollar that negated all the post bear market returns.
To sell now means that you think oil prices and the Canadian dollar will continue to rise. In fact, oil would have to go to US $100 per barrel in order for it to have the same negative impact that it had in the past three years. And the Canadian dollar would have to trade at a premium to the US dollar, which equates to the kind of returns the Canadian dollar has had in the past three years. Is that the most likely scenario?
The point is, successful investors look through the front window, not the rear view mirror. So before you catapult your foreign equity assets, think about the environment you are in.
In that light, a lot of analysts – including myself - also believe that we are nearing the end of the commodity cycle. If so, that would be a positive for the industrialized economies of the world. And with a stable, or possibly, weaker Canadian dollar, foreign assets should perform above expectations. So maybe, this is not the time to sell… it is the time to buy.
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