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What the past two years should have taught investors about forecasting

Let's pretend it's two years ago and we're having coffee. I ask you to predict how your stock portfolio will do over the next two years, but there's a twist. I have divine insight and can tell you in advance what September, 2013, will look like.

As it happens, we're sipping our Starbucks at a particularly tough time for investors. The stock market is down almost 20 per cent from its April high, the news out of Washington and Europe is dismal, and the 2008 meltdown is still firmly planted in our psyche.

To add to the misery, I'm able to guarantee you that two years hence, the U.S. won't yet have resolved its budget issues, central banks will still be propping up their shaky economies, and the growth engine of the world, the emerging markets, will have stalled due to concerns about China's debt and India and Brazil's finances and infrastructure.

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On a more positive note, I can assure you that Canada's housing market and banks will still be at the top of the world rankings in September, 2013, and the stature of our financial system will be such that our central bank Governor will be recruited to run the Bank of England.

Knowing all this, it's unlikely you would have called for the MSCI World Index to be up 39.8 per cent over those two years with the U.S. market leading the way (up 48.6 per cent). If you were like most investors, you were expecting Canada to lead.

Unfortunately, Mr. Carney's magic wasn't enough – the S&P/TSX Composite Index lagged the U.S. by 38.6 percentage points and has been one of the poorer performing markets.

It's fair to say the market returns have surprised many investors. What can we learn from these wayward predictions, and what should we expect from the next two years?

With less-than-divine foresight, I would suggest the following.

Diversification is still a free lunch

As the last two years have demonstrated, it's impossible to get economic and market calls exactly right, and it's quite possible to get them dead wrong.

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Every portfolio should own different types of stocks and a variety of asset classes. In today's context, that means not giving up completely on bonds, resources and emerging market stocks.

Price rules

In the investment business, valuation is the closest thing we have to gravity.

Over time, security prices will reflect long-term fundamentals. It's not a precise trading tool, but it works.

Rising price to earnings multiples were a big reason why U.S. stocks, which were still under a cloud two years ago and trading below their long-term averages, beat Canada so badly. Similarly, it was depressed P/Es that led to the recent pickup in European markets, not a rosy economic outlook.

Time heals

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The strength and competitiveness of the U.S. economy has also surprised some people, but they forget that the recession started five years ago.

Consumers and companies adjust. Industries find a bottom and start recovering.

Two years from now, a good number of European and Asian countries will be growing again and other downtrends will have turned. The good news for investors is that stock markets don't demand perfection, they just need positive change.

Debt magnifies

It's a mathematical certainty – when financial leverage is added to operating leverage, the range of possible outcomes is much wider. So in areas of high leverage, such as housing, junior resources, China and Ontario's public finances, it's likely that in September, 2015, the situation will be good or bad, but not indifferent.

Mr. Market is unpredictable

On the way to September, 2015, you should expect to be surprised.

Market volatility, which is low currently, will be up, down and all around.

What's deemed a sure thing today will be labelled a laggard in two years. And conversely, a stock or fund that's polluting your portfolio right now will prove to be your best performer.

What's important in all this is how you react, and don't react, to the surprises.

Your behaviour will be considerably more important to your portfolio returns than the accuracy of your market predictions.

Tom Bradley is president of Steadyhand Investment Funds Inc.

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