The Globe and Mail, Report on Business
Published March 22, 2008

Between now and the time I publish my next column, you should receive a quarterly statement from your investment adviser or manager. Get prepared.

Your net worth will have felt the effect of recent turbulence in the capital markets.

Anything from outside Canada has been down, likely a lot. Other than government bonds, all other types of income securities, including corporate bonds and asset-backed paper, have taken a hit. And the hallowed Canadian banks - some people own nothing but the banks - have been pounded.

As a money manager, there is an interesting transition that happens at this time. Over the past month or so, we have been meeting with clients and discussing performance numbers for the period ending Dec. 31. The returns may not have been great, but the clients probably made a little money in 2007, and were just relieved they didn't own any ABCP.

But when we speak to clients in a couple of weeks, the experience will be quite different. We will have one more quarter to report...a lousy one. And the one that's dropping out of the one-year-return calculation - the first quarter of last year - was a pretty good one. Most of us will be showing clients that they paid us to lose them money over the past year. In a matter of days, we have gone from hero to zero.

I exaggerate a little bit - most clients know what's happening in the markets and appreciate that longer-term returns are what matter - but there's no doubt a negative one-year number affects how client reviews go. We don't sound as smart and the clients aren't as optimistic.

This is an environment where managers could have done well if they owned lots of energy and gold, avoided the financials and stayed in Canada. But most clients will be grumbling following a period when even value-oriented funds, which are expected to perform better in down markets, have done poorly. Established value managers, such as Brandes, Templeton and Trimark have struggled.

The purpose of this long lead in is not to have you feel sorry for investment professionals, but to point out that we're entering a perilous time. Not because uncertainty is at a fever pitch and recent returns have been poor, but because it's a time when investors are most likely to blow themselves up.

Consider the following facts. During the period from 1980 to 2005, the S&P 500 index returned an annual average of 12.3 per cent (in U.S. dollars). According to John Bogle of Vanguard, the average mutual fund investor achieved 7.3 per cent. A gap of five percentage points a year.

There are lots of reasons for the gap. A comparable mutual fund averaged 10.0 per cent, so some of the shortfall was due to fees, closet indexing, too much trading and portfolio manager turnover. But the largest contributor was investor error - sometimes self inflicted, sometimes adviser-aided.

Indeed, it is times like now when the gap between investor returns and the indexes/funds widens the most. It happens more with individuals, but institutional investors are not immune. After all, pension or endowment committee members are individual investors too. There were lots of examples of committees moving their funds toward growth and foreign content in the late nineties. Yikes.

The gap exists because our rear-view mirror has too big an influence on how we drive our portfolio. What's currently happening in the markets biases our view of what's going to happen in the future. How a manager has done in the recent past creates undue expectations and gives us comfort that we're in good hands. Too often we're sucked into the vicious circle of buying whatever has been good. I refer to it as the "Cycle of Hope."

Where would that lead you today? Government bonds, resource stocks and a little cash. All in Canada, eh?

There is also a gap because investors are fearful when they should be greedy and vice versa. They make poor decisions at critical points in the market cycle. This is not a surprise because at extremes it's hard to do the right thing. There is nothing in the investors' frame of reference that reinforces the correct actions. Nothing in the media. Nobody at the office or in the locker room.

I don't know if today will prove to be a good time to rebalance toward more corporate bonds, banks stocks and foreign equities. But I do know that it is a better time than it was a year ago. That we should be looking for things to buy, not sell. And that we are rapidly moving toward the fear end of the spectrum, which means we need to start showing the greedy side of our investment personalities.

But whatever you do, mind the gap.