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A trader works on the floor during afternoon trading at the New York Stock Exchange. (Spencer Platt/Getty Images/Spencer Platt/Getty Images)
A trader works on the floor during afternoon trading at the New York Stock Exchange. (Spencer Platt/Getty Images/Spencer Platt/Getty Images)

Strategy

Looking in the rear-view mirror may crash your portfolio Add to ...

Investors are reminded all the time that past performance is not indicative of future returns. But it's a lesson that apparently hasn't sunk in yet, much to the detriment of investors who are shunning stocks and piling into bonds.

That's the conclusion Murray Leith, vice-president and director of research with Odlum Brown Ltd. in Vancouver, came to after analyzing mutual fund investment flows over more than a decade.

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"The majority of investors make their mutual fund investments based on the belief that history will repeat," he said in a recent note to clients.

As a result, they load up on stocks after prices have already soared, and sell when prices have tanked, which is a surefire recipe for subpar returns.

The tendency of small investors to buy at the top and sell at the bottom is well known, but Mr. Leith's analysis illustrates how dangerous rear-view-mirror investing can be.

As the chart shows, the largest inflows into foreign equity funds were in 1999 and 2000, as Canadians chased the high returns of U.S. stocks.

But their timing was disastrous, as the S&P 500 delivered an annualized total return - including dividends - of negative 0.9 per cent from Jan. 1, 2000, to July 30, 2010, according to Bloomberg.

Taking into account the rising Canadian dollar, the returns were even worse. A Canadian who invested in the S&P 500 would have suffered an annualized loss of about 4 per cent, or a total loss of 35.5 per cent.

Now, the situation is reversed. With the average Canadian bond fund having delivered a 5-per-cent annual gain over the past decade, investors have plowed $10.8-billion into fixed-income funds in the past year, while withdrawing $2.1-billion from Canadian equity funds and $4.7-billion from foreign stock funds.

The shift to fixed income is even more dramatic in the United States, where investors have shovelled $480-billion into bond-oriented mutual funds in the two years that ended in June - just shy of the $497-billion invested in equity mutual funds in 1999 and 2000.

Will bonds continue generating such high returns? Not likely, Mr. Leith said.



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"We are confident that we will look back in 10 years and see, once again, that the herd was doing the wrong thing and setting the stage for a reversal of asset-class fortunes," he says.

"With Canadian 10-year government bonds and high-quality corporate bonds currently yielding less than 3 per cent and 4 per cent respectively, it's a mathematical certainty that the average Canadian bond fund will not achieve a compound annual return of 5 per cent over the next 10 years."

The returns for stocks, on the other hand, should be much higher in the next decade than they were over the previous 10 years, he predicted.

After two nasty bear markets, U.S. stocks in particular are trading at attractive price-to-earnings multiples, making this a good time for Canadians to invest in blue-chip U.S. companies such as Procter & Gamble, Johnson & Johnson, Kraft and Wal-Mart, he said.

"What you have today with equities in general and American blue chips in particular is that they've had poor performance, so people believe that there's something fundamentally wrong with them," he said in an interview.

"But the underlying businesses have continued to grow and the valuation multiples have continued to ratchet down."

Follow on Twitter: @johnheinzl

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