Saturday, January 20, 2007

Chasing Returns

One reason international investments have been good performers for U.S. investors over the past few years is the weak U.S. dollar. Is U.S. dollar weakness a trend that will persist going forward? It likely is, but not against all foreign economies so selectivity will be an important aspect of ones returns from international investments.

Following is an excerpt from a recent Schwab Insight Report that highlights the comfort level of investing in yesterday's strong market performers.
Be the “Smart Money”
By Liz Ann Sonders, Chief Investment Strategist
Charles Schwab & Co., Inc.

You may have heard the terms “dumb money” and “smart money,” which typically refer to individual investors and professional investors, respectively. In reality, there is a lot of gray area, as there are many smart individual investors and quite a few dumb professional ones. But the “dumb money” term stems from the historic tendency for individual investors to act like lemmings, chasing past performance in the hopes of its repetition.

Take a look at the chart below, which shows the annual performance rankings of the broad asset classes, from best to worst, over the past 10 years. If there were ever a snapshot exemplifying why investors should be diversified, this quilt pattern is it. But there’s more: boxes bordered in black represent the year (specific quarter in box) during which an asset class saw peak mutual fund inflows. Conversely, boxes bordered in yellow represent the year (and quarter) during which an asset class saw peak outflows. It turns out that mutual fund investors have regularly poured money into asset classes after their peak, while bailing out closer to the bottom.

(click on chart for larger image)

Let’s take a few examples. In the first column, you’ll see emerging markets’ weak performance, followed by another brutal year in 1998. By the fourth quarter of 1998, investors threw in the towel and withdrew from emerging markets mutual funds at a record pace. This, of course, was just in time for 1999’s record-breaking return. Fast-forward to 2006, when in the first quarter, there were record inflows into emerging market funds, as investors were “chasing” the prior three years’ exceptional returns. This peak inflow was just in time for the big swoon between May and June of this year.

In 1998 and 1999, large-cap growth was a big winner, while smallcap value had terrible performance. Not surprisingly, investors left small-cap value in droves in 1999’s fourth quarter, just in time for it to top the performance rankings the next two years! On the other hand, the peak inflows into large-cap growth, in reaction to past performance, came in 2000’s first quarter, just in time for its abysmal three-year run. When investors finally decided to bail in 2002’s third quarter, large-cap growth went on to post big gains the next year.

I think you get the picture, and you can see the trend for the other asset classes. The bottom line: Don’t be a performance chaser. Stay diversified. Rebalance regularly. Be the “smart money!"

Be the "Smart Money"
Insights Report: Best Ideas For 2007 And Beyond
Charles Schwab & Co., Inc.
By: Liz Ann Sonders, Chief Investment Strategist
December 21, 2006

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