The sorry history of bandwagon investing

Since 2000, the S&P/TSX composite index has more than doubled, while the benchmark U.S. S&P 500 has only recently nudged back into positive territory. On top of that, the U.S. housing market – hurt much worse than Canada's in the recent recession – continues to struggle. The U.S. unemployment rate remains nearly two percentage points higher than that of Canada, and its $1.5-trillion (U.S.) budget deficit is more than three times Canada's on a per-capita basis.

Based on that, it's a no-brainer that now's the right time to scrap U.S. stocks and international stocks (which also collectively have lagged far behind Canadian equities over the past decade), and go all-in on Canadian stocks, right?

Not so fast.

Putting all your chips on the home-favourite Canadian horse that's currently in the lead may seem logical, but in the stock market, history has shown that chasing past performance – whether it's with countries, regions, industries, or style-box distinction – and having a home bias can result in underperformance.

Consider the numbers: In the 1980s, the S&P/TSX composite gained 217.1 per cent, or 12.2 per cent per year – not bad at all, but well behind the S&P 500 (17.6 per cent per year), and even further behind the MSCI EAFE international stock benchmark (22.8 per cent per year).

Suppose, at the end of the '80s, you decided to ride the international stock wave, and ditch U.S. and Canadian equities. You'd have been in for some disappointing results. In the 1990s, the MSCI EAFE returned 7.3 per cent per year, lagging well behind the TSX (10.6 per cent per year), and returning less than half of what the S&P returned (18.2 per cent) on an annual basis. Chasing performance would have left your portfolio in bad shape.

And, of course, at the end of the 1990s if you started loading up on red-hot U.S. stocks after their incredible 10-year run, you'd have been even more disappointed. Through late 2010, the U.S. market had produced a negative return since the start of the millennium, while the Canadian market put up returns of 99.5 per cent (6.5 per cent annualized).

Here's another factor to consider: In the past 30 years, the index from among the S&P 500, S&P/TSX composite, and MSCI EAFE that has posted the best returns one year has managed to take the top spot again the next year less than half of the time. What's more, in 10 of those years, the index that had the best returns one year had the worst returns the next.

What does it all mean?

Why does chasing the best performing markets end so badly for most? The answer lies largely in our brains. Studies have shown that one of the behavioural biases that dogs investors is "recency bias," the tendency to believe that recent events will repeat themselves in the future. So, by the time an area of the market is hot enough for you to take notice, the odds are that thousands of others have probably noticed, too. And by the time you get on the bandwagon, whatever country or sector or size/style of stock you're buying may well be overheated, and positioned to underperform going forward.

So, how about taking a completely contrarian approach, then, and targeting areas that have been putting up the weakest recent performance?

Well, history shows that's a risky bet, too. In fact, if from among the S&P/TSX composite, S&P 500, and MSCI EAFE you'd picked the worst performer one year and went 100 per cent into it for the following year, you'd have significantly hurt your returns over the past three decades. From 1978 through November 2010, you'd have earned a bit more than 7 per cent per year; the S&P, TSX, and MSCI EAFE all individually posted double-digit average annual gains over that same period.

Rather than trying to make all or nothing bets on where to invest, I believe a better option is to use a diversified approach. By setting aside dedicated portions of your portfolio for particular areas and sticking to that allocation, you can smooth out your returns from year to year. When one region is out of favour, your entire portfolio doesn't have to suffer. And, while you might not get all the upside gains that you would if you were invested in one particular region that got hot, history shows that you actually wouldn't have to sacrifice long-term returns.

For example, consider a portfolio composed of 60 per cent Canadian stocks, 25 per cent U.S. stocks, and 15 per cent international equities. Over that same 1978-2010 period, it would have produced annual returns of 11.4 per cent, slightly better than the S&P 500 and S&P/TSX composite, both of which returned about 11.2 per cent, and almost a full percentage point better than the MSCI EAFE (10.4 per cent). And it would have done so with less volatility. The standard deviation of the blended portfolio's returns was 16.6 per cent, versus 17.1 per cent for the S&P 500, 17.7 per cent for the S&P/TSX, and 22.9 per cent for the MSCI.

Economic forecasting: forever cloudy

But wait – what about the economy? Given the mountain of U.S. debt, languishing housing market, and lingering unemployment problems, why bother with it at all? Shouldn't you invest in areas that look to have the best economic growth going forward?

It's an idea that makes sense on the surface, but in reality that notion has some major problems. In my next column, I'll delve into just what those problems are.