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The five lessons of the correction

Thursday, July 16, 2010


We can all learn from our mistakes. We also learn from adversity. This is true of the 2008 financial crisis and consequent recession. Sometimes we have to learn them the hard way. At other times, we are lucky enough to heed the voice of experience. I was fortunate indeed, then, to hear some pointed words of wisdom from a market veteran at a recent seminar in Vancouver, sponsored by Mackenzie Financial. The keynote speaker was Nick Murray, a 40-year veteran of the financial advisory profession. Here’s what I learned.

Lesson # 1 –You will never, ever be able to anticipate what the economy will do in the next year or two.

Lesson # 2 –You will never be able to anticipate what markets will do over the next 30 months, and there is no shame in this. Nobody else can anticipate it either.

Lesson # 3 –The more dramatic the events in the economy or markets (good or bad), the less likely you will be able to anticipate them. Think 911 or the credit crisis.

Lesson # 4a – There is no statistical evidence for the persistence of performance. Future mathematical performance is unknowable.

Lesson # 4b – At critical turning points in a person’s lifetime, no one has been saved by selection. That means, for example, you weren’t saved because you held, say, AGF Canadian Stock fund instead of, say, Ivy Canadian. The differences in each category weren’t great enough to make a large difference over time.

Lesson # 5 –The world didn’t end, because it doesn’t end. This means a correction is just that, and they are a normal occurrence in a health stock market.

Yes, it sounds like common sense – and it is. But in investing, common sense is rarely the order of the day. If we can learn, and apply, these lessons, we will be far better off the next time things go bad. Many advisors (including me) sometimes get caught up in following too much economic data and fund performance/volatility information. I think what Mr. Murray is telling us is to get beyond the noise of the markets and media, decide on your asset allocation (percent of assets in fixed-income, equity, cash, and other categories), buy some investment funds, and stick with the plan.

I personally believe in having a few sectors that don’t normally correlate with the stock market too closely. Precious metals and real estate are a few examples.

Interestingly, Mr. Murray also showed that the best fund in the U.S. made about 18% over the last decade, yet the average unitholder lost 11%. How is this possible? Simple: It boils down to clients and their advisors chasing returns, which is a surefire method to losing money. Essentially, they get in after a 60% gain and bail out after a 30% loss, when they should be doing the opposite.

Clients sometimes switch advisors because they made 9% and a friend made 25%.They switch and promptly lose 30%. Anything that can make 30% can also lose 30% (or more). Buy on the lows.

I agree with Mr. Murray that we can’t predict anything, but I do have a contrarian preference, and I believe my clients will be better off in the long run if they buy more during corrections. When markets are near record highs, ease up on the equity and buy more fixed income with less downside risk. Downside risk is at the highest near market highs, or after a good run of a few years.

Any advisor who tells you he or she can make you 8% to 10% per year is misguided, misinformed, or outright lying. You can purchase funds that are more volatile and invest 100% in equities, which might give you the “opportunity” to earn 8% to 10% in the long term. But if you purchase a balanced portfolio or diversify with funds weighted more heavily to fixed income, achieving performance of 8% to 10% is very unlikely, if not impossible.

Your advisor’s role is to guide you through the years of market ups and downs and help you achieve your financial goals. Most people have very similar goals: buy a home, pay off the mortgage, retire early, and comfortably, put some money aside to help educate your children, pay less income tax, and perhaps buy a second home or cottage. There are, of course many others, but those cover many clients’ basic goals. If you don’t meet with your advisor once a year (or more), if you stop your contributions when markets correct, or worse yet sell investments consistently while in a correction, it will be more difficult if not impossible to meet your goals.

If you do meet your advisor annually, buy more when markets correct, stick with the plan (although it’s your right to question strategies), invest 10% of your salary for savings/retirement, have sufficient life/disability insurance, and get more conservative as you approach retirement, you should be in good shape.

Your advisor should show you how markets have corrected in the past and how they have come back every time to hit record highs (usually sooner than later). That provides you with some perspective. That is why we need to stay the course when things look bleak. Stocks are a different animal. When you have a big loser (like the infamous Nortel Networks Corp.) and the stock has dropped 50% but the company’s prospects look even worse, it makes sense to get out. Individual stocks have more risk, which is why I stay away from them. I did buy some once in my RRSP, but found it took too much time to stay abreast of the market in addition to work, family, and other activities.

My advice is to commit these lessons to memory, discuss them with your advisor, and apply them to your financial planning and investing strategies. Next time the markets “correct” (and they will!), you’ll emerge well ahead of the game.

 

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Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated.

Personal Opinions & Recommendations Disclaimer

The foregoing is for general information purposes only and is the opinion of the writer. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. However, please call the author to discuss your particular circumstances.


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