Business COVER

Caution: rough road ahead

Three pros give frank advice on protecting your money

January 26 1998
Business COVER

Caution: rough road ahead

Three pros give frank advice on protecting your money

January 26 1998

Caution: rough road ahead

Three pros give frank advice on protecting your money

After three years of impressive gains for stock-based mutual funds, the investment outlook has suddenly turned cloudy. Maclean’s asked three seasoned professionals—Eric Kirzner, professor of finance at the University of Toronto; Wendy Brodkin, manager of asset consulting at Towers Perrin; and Dan Richards, president of the Toronto-based financial services consulting firm Marketing Solutions—to discuss the current state of the market and the best strategies for individual investors. Highlights:


Maclean’s: In 1997, the average equity mutual fund in Canada gained 13.6 per cent. Should investors he celebrating?

Kirzner: I consider 13 per cent a great year. The average return over the past 40 or 50 years is somewhere around 10 or 10.5 per cent. The problem, I think, is that investors have been mesmerized by the 18or 19-per-cent average in the previous five years.

Brodkin: The first thought I have is that Canadian equities have been outperformed over the past 10 years by the U.S. market and by bonds, so in that sense we haven’t done well at all. Unfortunately, people don’t realize they’ve been investing in a utopian environment, and with the Asian crisis they’ve got to consider the implications of a doomsday environment. We’ve also got to remember that we’re investing in a currency that’s always going to be volatile in relation to the U.S. dollar, in a market dominated by cyclical industries. So our money is being held hostage in quite a dangerous environment. Maclean’s: Do you believe a disaster is looming?

Brodkin: Well, doomsday starts with a D and so does deflation, so that’s the link. Frankly, I think a lot of investors don’t even know what kind of return they earned in 1997. They’ve invested in mutual funds, which is better than trying to run their own portfolios for the most part, but beyond that they’re simply choosing the fund companies with the largest advertising budgets and thinking, This must be a high quality company.’ They may not realize that their supposedly high-quality mutual fund actually earned three per cent.

Richards: I think it’s a gross overstatement to talk about a doomsday environment. Sure, we’re not in all likelihood going to see dramatic improvement over the 10or 10.5-per-cent average. We could be looking at single-digit returns, and there will at some point be a year or two or three of flat or negative returns. The big problem isn’t the upside expectation, it’s the readiness for a prolonged downturn. And the one absolutely consistent trap that Canadian investors fall into is the all-or-nothing mind-set. They put everything into GICs or everything into bond funds or everything into equity, and so they become vulnerable to a roller-coaster ride.

Maclean’s: Looking back over 1997, we saw two significant market dips in March and August, followed by the Asian crisis in October Yet despite the wild swings, investors were in no hurry to sell their holdings. Brodkin: Yes, it’s interesting that mutual fund contributions in November were higher than in October—we saw more money going in than going out. Most people seemed to be feeling that the worst had already happened, so there was no point in selling. Richards: Here’s our take on what’s happened: a year ago we asked investors what they would do if there was a 15-per-cent decline in the market, and only 12 per cent said they would sell compared with a quarter who said they would buy. When you look at what happened in March and August, there was a very similar pattern: new contributions dried up, but there was virtually nothing in terms of redemptions. And investors were rewarded for that, because four weeks later the market was back up. After Grey Monday in October, you had a lot of people saying not, ‘Should I sell?’ but ‘Should I buy?’ The real issue is that investors are conditioned for the market to go down but not for it to stay down. And what’s different this time is that rather than an immediate bounce-back, the market is experiencing £ significant volatility. So while November was a good month for 6 mutual fund sales, December was very slow because there is a drall matic increase in the level of investor nervousness.

2 Maclean’s: Is it time for investors to change strategy? d Kirzner: This is my biggest concern. In my opinion, the majority of E investors should have done nothing in October and nothing in November. Assuming they had a proper portfolio balance—something like 20 per cent in treasury bills, 30 per cent in bonds and 50 per cent in equities—they shouldn’t keep changing their portfolio mix. Brodkin: That’s assuming it’s right in the first place, and I think you’ve got to do a little bit of soul-searching about what’s right. We can’t keep relying on conventional wisdom.

Maclean’s: What about sophisticated investors? Should they be changing gears?

Kirzner: Studies indicate that there are very few people who can successfully time the market. If they think they can do it, be my guest. Brodkin: I’ve got a big beef here with Eric and Dan. Instead of talking about market timing, what about risk management? How many people actually know what their exposure is in these highrisk areas? How many know what their exposure is to the Canadian dollar when they know darn well they’re going to be spending six months a year in Florida?

Kirzner: That’s different. That’s part of getting your asset mix right.

Brodkin: I’m saying the U.S. dollar is a benchmark for the ordinary investor. And the Canadian dollar will always be volatile relative to the U.S. dollar.

Richards: You’re right—a lot of Canadians don’t understand the extent to which they’re exposed. But maybe that’s not such a bad thing. If you take a look at where the average investor is today in terms of his readiness for retirement, he’s nowhere close to where he needs to be. And the only way people are going to come close to their expectations is to accept a greater degree of volatility and the higher returns that go with that. Otherwise, people are going to end up working until they’re 72 and not enjoying the kind of retirement that they want. Brodkin: I think it’s important to talk about this, because the implication is that you take the higher risk to get the higher returns. Well, one of the reasons people invested in the Asian markets was for higher returns. If Asia is now going to have lower growth rates, you’re obviously not going to invest there for the returns. On top of that, one of the big myths of diversification is that you invest in the Asian markets because they’re out of sync with other markets, so it’s a way of balancing risks. Well, we’ve looked at correlations over different time frames going back to the 1970s, and there was a very high correlation between the smaller Asian markets and Canada. In other words, it doesn’t lower your risk. So if you’re not there for higher returns and you’re not there for lower risk, why invest there in the first place? Kirzner: Wendy, if your numbers are correct, that would imply the Far East is not a good diversification target. But that doesn’t negate the value of global diversification.

Brodkin: The problem is the advice investors are getting. Financial planners try to put it all on one page and keep it snappy—“Invest here for higher returns.” And someone has to address those myths. Kirzner: It may be that people haven’t done enough research into the returns in various countries, but the principle of global diversification to me is still valid. Even taking the Far East case, if an investor had five per cent of his portfolio in Far Eastern securities, and the total portfolio was $100,000, he might have lost a couple thousand dollars in October and November, which is sad but may well have been balanced out by something else. If someone had 20or 30-per-cent exposure to the Far East, they were given very bad advice. Richards: Wendy is saying that given globalization and the growing interconnectedness of markets, it’s going to be tougher to escape the ups and downs, which is probably right. But as an investor, I have a choice. Do I say, OK, I don’t want to face the prospect of losing 10 per cent in a given year, so I’m going to invest in a GIC at five per cent? For most people, that is not an alternative. Brodkin: Maybe it’s not losing 10 per cent in one year. Maybe we’re going into an environment where investors will only be making five per cent a year, or less, over the longer term, as happened in the 1930s and is happening in Japan now. I’m not saying people should plan for a deflationary environment, but they should recognize the implications. And maybe they can’t afford the implications.

Maclean’s: It sounds as though you think people should be tailoring their investment strategies to a very bleak economic outlook.

Brodkin: That raises another issue, which is what you believe. Everyone has to rely on experts these days—there’s just so much complex information. And in 1997, we were duped by the experts in two cases: Bre-X and the Asian markets. I’m talking about a scam. People knew what was happening in the Far East, they knew what kind of accounting practices they had, and they knew what kind of

bad loans they had. And where was the International Monetary Fund? What about the investment managers and the brokers? This sustained duping is going on even now, because 3M is the only large company that I know that has actually come out with a currency write-down as a result of the Far East crisis, and the day it was announced 3M’s stock fell 15 per cent. Well, if the brokers are reacting in that kind of manner to information they already had, I don’t see how individual investors can form their own beliefs.

Kirzner: I don’t mean to be cavalier about Bre-X, which has major implications for index funds and pension funds, but for individual investors the risk associated with individual positions should be minimal. A properly advised investor should not have been significantly hurt by the Bre-X scandal because he or she shouldn’t have had more than a half of one per cent of their portfolio in Bre-X, and the same goes for the Far East.

Maclean’s: If Wendy is right about a doomsday scenario, why not pull out of the market altogether?

Richards: Because the classic problem with market timing is that no one has done it on a consistent basis. When you ask investment experts to name a great stock-picker, no problem: John Templeton, Warren Buffett, Peter Lynch. In Canada, perhaps Bob Krembell and Frank Mersch, until recently. But name one person who has consistently been able to call the market. On Wall Street, Joe Granville did it once and he rode on that for a number of years. Elaine Garzarelli did it once and she’s still riding on it.

Kirzner: Here’s how I would respond to Wendy’s scenario, which I have some respect for. For long-term armchair investors, I’m not going to change my balanced portfolio. However, in talking to active investors, and in particular people who are reaching a stage in their life where short-term volatility is a threat, I’m going to change my tune. I do have concerns. I think the Asian flu is much more serious than some people are letting on. We may in fact be looking at negative returns in 1998 and 1999.

Brodkin: The past three years in Japan have been negative. Kirzner: The point is that the short-term investor, the investor who is approaching retirement or some major expenditure, can’t afford the volatility. But for people who still have 15 or 20 years to retirement, I have no particular reason to change my strategy.

Brodkin: Your scenario is for investors who are not leveraged, but I think there’s a lot of individuals out there who are leveraged. If this crisis plays out, they’re going to have to pay back money that they won’t have. When I talk about risk management, I mean people should figure out what their ‘ouch factor’ is and whether they can afford it. Our banks are still advertising loans for people who want to invest, which might not be a very good strategy if their returns from the market are lower than their interest payments.

Richards: Let me come back to Eric’s point. I think in principle he’s right because everyone has to know their own ability to withstand short-term declines. But I would perhaps disagree with him about the cutoff. Historically, the mind-set has been that you can afford to take risks until you’re 60 or 65, but when you hit that magic age you become conservative. That was true when lifespans were shorter, but today if you’ve got a couple who are both age 65, half the time one of them is going to live to age 90. That has huge implications. Kirzner: It’s a matter of degree. Recently I’ve seen some truly irresponsible recommendations from people who have suggested aggressive portfolios for elderly people. Richards: Wendy, you talk about investors in Asia being duped. I’m not sure I agree that an overheated market in Asia can be put in the category as a fraud like Bre-X.

Brodkin: The similarities are that in both cases there was a re| fiance on experts who should have known, d Richards: You could have said the same thing about the I housing market in Ontario in the late 1980s. I just don’t think 1 it’s fair to put that in the same category.

I Brodkin: The issue here is what are the investment standards and what is being done to explain the risks? One bit of good news that comes out of this crisis is that we will see the death of some of the more shaky Asian standards as they adopt Western standards. Richards: The irony is that for all the focus on Asia, it’s still a small percentage of the portfolio for the average Canadian. The real problem is the impact of a declining economy in Southeast Asia on the ability of North American companies to meet profit expectations. Maclean’s: Another issue that takes on added significance in a downturn is management fees. Is the fund industry facing more pressure? Richards: You’re starting to see it. Of course, when you're making 15 or 20 per cent a year you can’t get too excited about half a per cent here or one per cent there. But when you get into a flat or declining market, you’re going to find much focus on management fees. Mutual funds are virtually the only investment product out there where there are fees that are not fairly transparent. I think that’s going to change as investors get more educated and as you see more competition. Inevitably, fund providers are going to start competing on price. Maclean’s: What’s your hunch of where the market is going in 1998? Kirzner: I believe we’re going to have a poor year—low returns and possibly losses. But I qualify that by saying my short-term timing record is not particularly great.

Richards: I do think that for the foreseeable future we will be in for increasing volatility. One of the things that has to happen is a realignment of investor expectations, or people will be in for a rude shock. Brodkin: Dan’s talking about volatility, but I prefer to talk about the downside—how much could be lost. Remember, it took 10 years for the stocks that crashed in 1929 to regain their value. My timing may be off, but I think we’re in for a period of lower profits and lower equity returns. If I had to put a number on it for 1998, I’d say we may be looking at an overall return of five per cent in a diversified portfolio. □