by Doug Cronk on February 1, 2008

Just in time for RRSP season, expect the mutual fund marketing machine to promote the past five-year average rates of return. A five-year average return means the most recent year is added on while the earliest year drops off. Add 2007. Drop 2002. This year, the five-year average returns for 2003 – 2007 are a marketers dream and a problem for investors.

As investors know, 2003 – 2007 saw some of the best investing times of a generation. Nearly all markets, everywhere, were up. So the most recent five-year performance is favourably skewed minus the abysmal returns of 2002 and worse, 2001 included.

How much of a difference does this make?

The 2003 – 2007 five-year average return was 18.4% for Canada’s S&P/TSX stock market. Include 2002 and the six-year average drops to 13.3%. Include 2001, and the seven-year average drops to 10.2%.

The US numbers are just as dramatic. The five-year average is 13.3%. But the six-year average is 7.4%.

Mutual fund marketers will advertise the last five-year period. Unfortunately, investors can’t buy past performance. By definition. And one of the biggest mistakes an investor can make is to assume the next five years will look like the previous five years. They won’t.

In fact, research by Dalbar and SEI show that more than one-half of the top performing funds over a five-year period end up being the bottom performers in the next five-year period. So if an investor selects funds based on past performance alone they risk buying at or after a peak just when a fund is about to regress to below average performance. (Like, right now). These investors will end up with a collection of recent top performers that all move in the same direction at the same time. (Like, right now). This is risk.

Past performance is not enough. Instead, think portfolio.

One of the mistakes often seen is adding new positions without regard to existing portfolio assets. With a focus on asset allocation and diversification, however, investors can instead augment existing holdings. Include all asset classes stocks, bonds, real estate, gold and lots of cash. Include Canadian, US, International and Emerging in all asset classes. Because all asset classes, geographies and currencies don’t move in tandem (low correlation) they tend to offset each other providing the investor with many sources of potential return and a smoother ride. This is one of the basic principles of portfolio construction the pieces must complement each other.

And that’s the key, it’s not about the past returns of the pieces it’s about the future performance of the asset allocation pie.

Originally published in the Business Thompson Okanagan news, February 2008.

Doug Cronk CFA is Manager, Investments for a Canadian Pension Fund.