Thursday, February 2, 2012

The Devastation Wrought by Performance Chasing

As promised, I give you my third post on why using bank advisors, or really any commission-based or products-based advisor, is a bad idea for your retirement plans. The first was based on the historically higher expenses charged by this group of advisors. The second idea was what I've seen many people do which is hold all their money until February when they scramble to max out their RRSPs. Of course, my hypothesis that this would harm their long term returns was not upheld by the data, as I posted. But it is still a risky situation to put yourself in, if for no other reason than you may never get around to it and then you are leaving money uninvested that could be compounding its growth. This never was a great argument against advisors anyways since it is often the fault of the investor, not the advisor. Advisors would likely be just as happy to have those regular funds come in so they can collect regular trailer fees.

The common advisor practice of encouraging performance chasing is, however, the fault of the advisor and it most certainly is detrimental to the retirement goals set by the investor.

Performance chasing, in its most common form, goes like this. When you go for your yearly review with your advisor, he goes over a variety of funds that have done great over the past year and convinces you that, because they are on such a hot streak, you should move your money into them. This is often done with no regard to the stated goals of your portfolio or your desired asset allocation, which is incredibly reckless in itself because asset allocation alone accounts for 75-80% of portfolio returns.

Now, I was going to research the effects of this but turns out I already did. Here. On this very blog. Hmm. Go figure. In that post I studied the impact of switching all your investments to the top performing mutual funds reported in MoneySense magazine each year versus just keeping your money in a balanced portfolio of index funds and rebalancing yearly. The per year difference worked out to roughly 1%. What is the impact of a 1% performance difference over a 30-40 year investment horizon? Well, I'll take my own example. We put roughly $10 000 per year away for retirement. The difference in 1% performance would work out to about $250000. That's a lot of dough that I lost by chasing hot performers versus just buying and holding and sticking to my asset allocation.

But don't take my word for it. Here is some excellent data from various resources to prove my point.

S&P study: source here
-Over a five year study period, only 1.12% of funds maintained a top-quartile ranking by the end of the study period. Given the MASSIVE universe of funds you have to choose from, guessing which 1 of those funds will remain in the top quartile is a losing game.

Report by Jason Zweig here:
-over a 24 year period, the typical mutual fund underperformed the broad stock market by 0.55%
-but the average INVESTOR underperformed by 0.7%
-this spread is the COST of investors moving their money around too often by chasing performance
-perfect example provided in the article:
-Fund A earned 20.7% in 1996, but their average investor LOST 35%
-Fund B earned 26.9% but the average investor LOST 20%

Another great report here:
-only 16% of top 5 five funds make it to next years list
-top five funds average 15% LOWER returns the next year
-top five funds BARELY beat the market the next year (0.3%)
-average equity investor earned a measly 2.6% in the same time period that the S&P 500 gained 12.2% and inflation was 3.1%

So what is one to do instead of chasing performance? It's simple. Asset allocation and disciplined rebalancing.

First, you choose an asset allocation that suits your needs. For most this can be as simple as the stock to fixed income ratio. Many suggest that the portion of your portfolio in bonds/fixed income investments should roughly equal your age. I choose to change mine only every 5 years. So when I turn 30 in March I will realign my allocation from my current 25% bonds:75% stocks to 30% bonds:70% stocks. This ensures that as I draw closer to retirement, when I can ill afford significant volatility in my portfolio, less of it will be exposed to stocks, which are inherently more volatile.

The specific breakdown of your asset allocation is a matter for discussion, but can be as simple as 25% bonds, 25% Canadian stocks, 25% US stocks, and 25% international stocks. It's that simple. With that asset allocation, all you need is four index funds, and you are gold. Even the most widely diversified passive portfolio I've seen has only 10 funds in it and that is for very sophisticated investors. Most retail investors can do just fine with 4, even 3 funds and get very broad market diversification that will suit their needs.

Now that you've settled on an asset allocation, you setup pre-approved withdrawals from your bank into those funds EVERY month based on those percentages. Then, every year, if any of your funds is really out of whack on its percentage, you REBALANCE.

So, in my portfolio, I have 37.5% in CDN equity, 25% bonds, 25% international, and 12.5% US. At the end of a year, if any one of those composes 5% more or less than I set it to at the beginning of the year, I rebalance. The beauty of this is that it forces you to sell overpriced funds and purchase underpriced ones, a recipe for success. Look at it this way. If I've been putting exactly 37.5% of my funds each month into my Canadian equity fund but it is suddenly taking up 44% of the worth of my portfolio, the only explanation is a significant rise in the value of that fund. Or if the US fund is down to 8%, it means that US fund has totally tanked. So I sell the gains in my Canadian fund and buy more of the US fund, because the former is bound to come crashing down and the latter is bound to come racing back up. I just locked in my wins and bought some funds on sale. Plus, there was NO EMOTION involved. Just the numbers.

Is there any evidence that rebalancing based on asset allocation actually trumps performance chasing? You bet there is. In this study, the various portfolios that were rebalanced ALL trumped the performance chasing portfolio, until you got into portfolios with very low stock allocations, which only makes sense. The "average" portfolio construction many would use outperformed the performance chaser by 2%. I read a lot of other academic literature that showed similar results.

Now, what do you do if you are in the unenviable position of having a bank advisor for your main source of investment decisions and retirement planning? First of all, get out. But I recognize that some may not be able to do that. So, if you can't get away from your bank advisor or you don't want to, despite what you've read here, at least know thine enemy.

In the next post, I will give you questions to ask your advisor that are sure ways to find out if they are working for you or for themselves.

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