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Reminder: get back to basics
Diversification is key to stability

A recent news story 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. 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.

Rates of return: investors vs. their funds

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 lustre 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 lustre (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.

Portfolio structure

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 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.

Core value

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, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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