One of the biggest mistakes investors make is chasing performance, maintains William Sterling, chief investment officer at New York-based Trilogy Advisors LLC. The result, he says, is they generally end up in the wrong place at the wrong time, dramatically crimping their returns.

Certainly, a look at recent data on Canadian mutual fund flows supports this thesis. The most popular fund categories in 2000 — foreign and U.S. equities — actually experienced negative returns over the next five years. In contrast, the least popular fund categories in 2000 — income, balanced and Canadian equities — produced positive returns over the next five years. Instead of taking money away from the top-performing asset and adding money to the lagging asset, investors as a group tend to do the exact opposite. And this is not a new problem.

Using data from the Investment Funds Institute of Canada and Morningstar Canada, Sterling has documented how chasing performance has not benefited investors. Looking at the flows of money by fund category from 1998 to 2004 and corresponding performance on an annual basis, he has identified the following trends:

> The best-performing fund category in any given year has never followed a year when that fund category had the highest net inflow of new money.

> Investors who chose to invest each year in the least popular fund category from the previous year earned a cumulative positive return of 20%.

> Investors who chose to invest each year in the most popular fund category from the previous year would have experienced a cumulative loss of 11%.

Is this pattern sustainable over the longer term? Yes, more often than not, Sterling says. He went on to look at data on the total return of Canadian bonds, Canadian equities and foreign equities over the past 25 years to determine what the returns would have been like in a “performance-chasing” portfolio, in which investors put all their money each quarter into the asset class that had posted the best performance over the previous five years.

Ten thousand dollars invested using this strategy at the beginning of 1980 would have grown to $71,000 by the end of 2004 — assuming no taxes and no transaction costs. Not bad, but inferior to a simple buy-and-hold strategy. Simply hanging on would have seen $10,000 grow to $103,000 by the end of 2004, he reports. Canadian bonds and global equities would have done far better, with the initial $10,000 growing to $169,000 and $182,000, respectively, over the same period.

Looking at longer historical periods produced similar results, leading Sterling to conclude this type of event-driven strategy has frequently been a losing proposition that sees investors repeatedly buying high and selling low.

What to investors do? Well, rather than chase yesterday’s news, investors would be better off considering a systematic rebalancing approach, Sterling maintains, citing the work of William Bernstein, publisher of the outspoken journal Efficient Frontier.

Bernstein has published several papers studying the approach to portfolio rebalancing, including periodic monthly, quarterly and annual rebalancing. He has also examined what he calls “threshold rebalancing,” which is essentially rebalancing when performance differences cause major disparities within the portfolio.

While all types of periodic rebalancing seemed to add value across many markets and time periods, Bernstein has never really produced a definitive conclusion about whether monthly, quarterly or annual rebalancing worked the best. Furthermore, the evidence he has looked at suggests rebalancing after market movements put portfolios out of kilter was generally not as effective as simple periodic rebalancing, although it was better than not rebalancing at all.

In fact, given real-world costs, the answer to the rebalancing frequency problem would seem to be “not very often.” Monthly rebalancing is too frequent, Bernstein believes. And, while there are small rewards to increasing rebalancing frequency, this comes at the price of increased portfolio risk. The return differences among various rebalancing strategies are quite small in the long run, Bernstein says, so costs and ease of access become the determining factors.

As a result, Sterling concludes, Canadian investors would be better off avoiding the hassle of monthly or quarterly portfolio rebalancing, sticking to annual rebalancing instead. If nothing else, it forces them to do something they rarely have the discipline to pull off — selling high and buying low. IE

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