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Overwhelmed By Data? Keeping Investment Decisions Relatively Simple

The purpose of my free web publication, Mutual Fund Research Newsletter, which this month marks 10 years since we started publishing, has always been to help investors decide when is an appropriate time to be invested in certain types of mutual funds, whether stock, bond, money market, or any other type of specialized fund, including ETFs.

Given the sheer amount of information investors are exposed to, it's no wonder that the average person cannot decide what if anything to do at any given time, and thus frequently chooses to take no action at all regarding their portfolio. So, any method that cuts through all the information overload and helps reduce choices to a very simple clear-cut test, yet still seems to work a majority of the time, should be seriously considered.

Yet, if you are mainly convinced that buying and holding a stationary set of investments is better than making occasional adjustments to your choices, or, you feel you have too little time in your already hectic life to easily revisit your investment decisions anyway, then you will perhaps remain cool to the whole idea of making changes.

But if you do accept our basic premise that better results can be achieved by those who are watchful and know what to look for, any time can be a good time to reassess your portfolio. At a minimum, we recommend at least yearly, or even quarterly, looking at all the major categories of fund investments available to see which, if any, of your current investments you might feel confident in increasing or decreasing, or which unowned ones you might now start a position in. Note that we do not usually focus on which particular fund you should buy or sell, but rather on favorable fund categories. However, there are some particular funds that are nearly "one of a kind" that we do sometimes recommend.

We base our overall portfolio recommendations on a variety of factors too numerous to elaborate. But we tend to focus on a small number of tests discussed below which we have found, in over 25 years of studying investment results, to do the best job in determining when is a good time, or a bad time, to be invested in certain types of fund investments. As you will see, though, the tests do not always lead to the same conclusions so one must decide which test is the most prudent one to follow, given your own particular investment preferences and situation.

Using Relatively Recent Performance as a Guidepost

Let's start with our simplest test to implement: whether the investment category has produced adequate returns over the last 12 months.

Our premise in adopting this test is that different investments usually perform well or below par in multi-year cycles. If an investment has been performing adequately over the last year, it is a far safer bet than an investment that has been performing below par over the same period.

Obviously, this rule will not usually work when there is a major turnaround in market direction. So, back at the start of Oct. 2007, every category of stock fund would have appeared promising based on past one year performance. But by one year later, each of these same categories of funds had performed extremely poorly. But since investment category performance tends to run in multi-year cycles, such true turnarounds occur without a high degree of frequency. For example, in considering the overall market as measured over yearly periods, stocks were basically going up without much pause between 1991 and 2000 and 2003 and late 2007. And they were going down without much pause between 2001 and 2002 and late 2007 and now.

Thus, while you have most likely heard the phrase "past performance is no guarantee of future results," which is completely true, there is more than ample data to show that past performance, especially recent past performance of broad investment categories, is a good guide to what to expect going forward. But, as you will see shortly, the relationship between past performance and future performance is not always positive. That is, eventually, an investment category that is becomes overvalued will, with a high degree of probability, falter.

To implement our simple test, merely see whether the total return over the last year from the stock, bond, or cash investment is what you would consider at or near normal for a year's time for that type of asset. For us, these returns should approximate at least 7% in all types of pure stock funds, 5% in quality taxable bonds, 3.5% in municipal bond funds, and 3% in cash.

You can always get these return figures (except for cash) by going to the morningstar.com web site, clicking on the Funds tab, and then dropping down to find the "Category Returns" under "Performance". For cash, you will need to check elsewhere to see what your investment has returned, or most likely would return if held for a year. Note that since we are not trying to evaluate how a particular stock or bond fund is doing, we use the average return of all funds within an overall fund category such as Large Blend stocks or Long Government Bonds. However, if you choose, you can merely use the return from your particular fund, such as for example, from the Vanguard International Growth Fund or the PIMCO Total Return Institutional Fund.

Returns lower than the above suggested figures would indicate the category is in at least a one year subpar trend as compared to historical expectations. If so, we consider the category to be likely, at a minimum, to underperform your goals, or even worse, potentially dangerous to buy or hold. Any fund you hold within this category is therefore a possible candidate to sell, until the 1 year performance returns to the guideline figure above. Only if this figure is equalled or exceeded do we usually consider a fund a relatively good prospect. (Note: When most or all available categories fail the above test, such as is true for stocks right now, an investor may still choose to hold, or emphasize in a portfolio, the categories with the best relative 12 month returns.)

More Stocks Anyone?

Since all stock prices have been trending down over the last year or more, 1 year returns now are deeply in negative territory. And it will take a considerable uptrend to return the 1 year trailing returns back to positive ground. By waiting to make sure the 1 year trend of a stock category has returned to near normal, you may be spared the need to take any action for a considerable period of time. However, you will certainly miss out on the early gains of any sustained bull market in that asset, which could be considerable.

But look at one of the best virtues of using this test aside from its simplicity: Given that there may be considerable volatility over the course of a year's time, and possible false promising starts within an otherwise continuing underperforming market, this strategy is geared for lessening the probability of jumping back into an investment with only relatively limited evidence of a true turnaround to a satisfactory trend. In that sense, this is a strategy that could best serve the needs of relatively conservative-minded or currently gun-shy investors.

Note: Instead of using a criterion of 1 year returns, you could opt for the less strict criterion of returns over the last 6 months. This way, you would accept a shorter period of normal returns to indicate an investment's likely future trend. There are two problems associated with this approach: 1) It is hard to find an always available source showing 6 mo. total returns, possibly requiring you to calculate them yourself. 2) Six month performance (or using an even lesser period of time), while it may appear to be a sufficent period to judge an investment trend, may be too short to reliably judge an investment category's likely trajectory. Therefore, we recommend using 12 month data unless you want to be more of an aggressive investor, or to trade over short periods of time.

More (or Less) Bonds?

The situation right now for bond fund categories is somewhat more varied. That is, there are a few categories that pass (or nearly so) this simple test while most others do not. (Performance as of 4-30-09.)

In spite of US Treasuries currently being written off by many investing experts, Long and Intermediate Govt. bonds would be regarded at the top of the bond fund pack, with positive returns over the last year of 8% and 4.8% respectively (The Intermediate Govt. category includes GNMA funds.) And the Muni Single State Short category passes as well with a 3.8% return.

No other bond fund category currently passes our simple test with all other category returns showing negative 1 yr. returns. (This includes Inflation bonds, as well as non-government (corporate) bonds, in spite of receiving a lot of positive press lately.)

Note: While the category averages may not come close to passing our simple test, specific funds within a given category may have significantly better prospects. For example, a bond fund we have repeatedly recommended, PIMCO Total Return or one of its variants, has returned about 4% over the last year vs. a much poorer -3.3% for its category (Intermediate-Term Non-Govt) average.

Using Significant Changes from Longer-Term Performance as a Guidepost

The above performance test is based solely on the absolute value of the past 12 month's total return. A single year's trailing return, while a good test of a category's current trend, still only provides information based on a relatively limited amount of data. Our research suggests that a discrepancy in the magnitude (and possibly the direction) of returns over the last year vs. the return from the entire preceding 5 years is a more sophisticated, and therefore, a more accurate test of where the performance of a fund category is likely headed.

To understand this, look at the following examples and the explanations that follow:

Annualized Stock Fund Returns (Hypothetical)
Example 1 Yr
Tot Return
5 Yr
Tot Return
Best Decision
a) + 8% +16% Sell
b) + 3 + 9 Hold
c) -30 - 6 Buy
d) +13 - 1 Buy !!!

In a), while the fund category has a near normal 1 yr. return of 8%, notice that the 1 yr. return is considerably less than the average 5 yr return. In fact, since the trailing 5 yr. return includes the 1 yr. return within it, the investment category was doing more than twice as well on average during the first 4 yrs. of the 5 yr. period than during the most recent year of the period. Since such a fund category has therefore lost a considerable amount of momentum, we would suggest that such returns show a strong possibility of characterizing an investment that is "only a shadow of its former self." We would recommend avoiding adding to such an investment or even selling all or some of one's position for now.

In b), it might appear that the fund category's 1 yr. performance is quite sufficently below what we might consider normal using the simpler test described above to justify a similar conclusion as in a). But, unless you are very risk averse, my research suggests that such a deviation from otherwise previous average performance is not enough to reliably suggest an outright sell if you own such a fund. Rather, it may be more advantegeous for most investors to continue to hold a fund in a category showing such a result.

The difference between example a) and b) comes down to this: The 5 yr. fund results for a) are basically unsustainable; diversified mutual funds rarely can average performance very much above normal performance for periods much longer than 5 years because they will likely have become overvalued. The category performance shown in a) has already started to drop in the last 12 mos., but even without such a drop this category is unlikely to continue to do well too much longer. In the case of b), there is no such problem; the fund has performed pretty much as expected over the last 5 yrs. so the drop over the last year is not highly worrisome.

In c), it might appear that this category has been doing so poorly both long and relatively short-term that it should be sold if owned, or otherwise avoided at all costs. However, my research shows that in such extreme situations, there is a very compelling, although totally counter-intuitive, reason to be on board. The 5 yr. result is now so poor that it is now highly likely that the category will return to favor among astute, forward-looking investors.

Why would any investor take on an investment that appeared to be such a risk? Because it is likely quite undervalued in the sense that history suggests stocks will show a return averaging 10% per year. Since in this example, the actual cumulative (non-annualized) 5 yr. total return is - 30% (that is, 5 years times - 6%), and the 5 yr. expected return + 50% (5 times + 10%), the discrepancy between the two is so great (i.e., 80%), it is highly improbable the shortfall will continue too much longer. But highly risk averse investors may still choose to stay away since the underperformance may continue for a while longer, perhaps, I would suggest, up to another year.

In d), unlike all the other examples, the category is now showing a highly favorable turnaround as reflected in an obvious constructive change of direction between the two figures. Thus in spite the relatively poor, and likely unsustainably so, 5 yr. performance, one can be reasonably confident that this category will deliver the goods going forward. Not only has there been significant underperformance over 5 years, but there is now strong positive momentum. This is an outcome which happens very rarely, and therefore, it would be quite frustrating if one were to just sit and wait for results such as shown in d) before feeling comfortable making investments. Typically, it would only happen after a long-running bear market in some or most stock categories followed by a strong, sustained recovery. But everyone, including conservative investors, should be watchful should such results appear.

Where Are We Now?

Here is a question: Which of the above examples most closely resembles where most categories of stocks are today?

Answer: c)! Nearly all U.S. stock fund categories are down 30 to 40% over the last year. And they are down around 1 to 2% annualized over the last 5 years. While I wouldn't go quite as far as to say that all stock categories are promising enough for everyone now to buy more, they are quite close to the figures that would justify such a conclusion similar to that shown in example c). Actually, around the first ten days in March of this year, they were even closer to the hypothetical data shown in c). Since then, stocks have had a huge rebound. Whether that March low will hold, no one, including me knows. But if many categories of stocks were to suffer further losses back to where they were in early March, or lower, I would become much more likely to raise my suggested allocations to these categories.

Note: In our Feb. '09 Newsletter, we did issue a buy signal for the Small Cap Growth category based on the 1 and 5 yr. performance test for category data as of Jan. 30th. Thus far, over the following 3 months, our recommended fund for that category, Vanguard Small Cap Growth Index (VISGX) has returned more than 15% (non-annualized). However, the true value of our buy signal will not be fully known until, at a minimum, a year has passed.

Back in the Fall of 2007, the typical stock fund was returning results similar to that in example a). As we now know, that would have been an ideal time to reduce or sell from most funds.

Hopefully, over the next year or so, if we're lucky, some or many stock fund categories might even resemble the data in d)! This could happen if stocks not only continue to stabilize over the next 6 months, as many categories have already done over the last 6, but show a nice positive comeback of about 15% from today's prices over the period based on our more sophisticated performance test (but perhaps a little less based on our earlier simple test). In either case, it would make sense for almost all investors to increase their stock allocations, based on the empirical data we have studied.

"It's The Economy, Stupid" (Or, Is It?)

This phrase originated during the U.S. Presidential campaign in 1992. It certainly seemed to have helped Bill Clinton get elected, but how useful is focusing on the economy when trying to make the best investments you can?

Notice we have not mentioned the economy or the current financial crisis one time thus far in helping to decide on an investment strategy, although we frequently do mention it in our Newsletter articles. That is not to say that these factors won't affect how one's funds will perform, or whether bonds, stocks, or cash will be better investments to hold over the next few years.

But we believe it is extremely difficult for anyone to accurately and consistently predict what the economy will do next. And even if one does correctly predict certain aspects of the economic outlook, it is nearly impossible to know in advance exactly how investors will react to these outcomes in terms of which fund categories will be positively affected and which will lose out.

Year after year, investors often seem to react to the economy in almost the exact opposite way that one might have predicted. For example, on Wednesday of this week, the government reported that GDP, the most basic measure of the economy, contracted by 6.1% on an annualized basis during the last 3 months.

In spite of one of the poorest domestic economies since 1958, and with the global, financial, housing, and automotive crises still raging, the stock market has rallied considerably lately. And given the poor economy and overall severe bear market for stocks, one would have expected most bonds, except for the riskiest, to have done pretty well. But as mentioned above, most categories of bonds have not done very well during the last year.

Such data appears to strongly confirm our belief that it's not the economy per se that needs to be monitored for successful fund investing. Rather, we believe that the best time to invest seems to be when a category's fund prices have severely underperformed for periods of 5 or more years. (Actually, right now, most stock fund categories have underperformed for more than 10 years - since the late 90's - making now an even more likely good entry point. It should be noted too that during the last 10 to 12 years, the U.S. as well as the world economy has enjoyed more ups than downs - yet the major thrust of most global stock prices has been down.)

And what shows up as the worst time to invest? That has consistently been when 5 or more year annualized returns have soared, creating unsustainable numbers as they did in most of the latter half of 2007, and in 1999-2000, regardless of what the economy appeared to be doing at the time.

So, rather than "it's the economy, stupid", you might say I believe in "keep it simple, stupid" or KISS; or, at least relatively simple. It becomes almost mind-bogling to try to keep up with all the twists and turns in the economy, especially during such a period as we are going through now. Learning to regularly apply the above two relatively straightforward performance tests (which actually do incorporate everything about the economy that investors have known and reacted to during the past) is one of the best pieces of advice I can give you on what it takes to successfully invest in funds.


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