Lessons from the past

Every year the Morningstar organization publishes a chart of the best-performing asset categories. Not only does it offer a graphic depiction of how investment fashions constantly change but it also serves as a reminder of that old financial maxim: “Past results are no guarantee of future returns”. But that does not mean we should pay no attention to the past. In fact, there is a lot to learn from the Morningstar chart.

As we all know, 2011 was not a great year for investors. The European sovereign debt crisis, the Japanese earthquake, tsunami, and nuclear accident, and the debt ceiling cliff-hanger in Washington all combined to knock the stuffing out of the stock markets. Only one equity category, U.S. large caps, posted a gain and that was only a modest 4.2 per cent. In this country, our large-cap stocks fell 8.7 per cent on average while the small-caps were off 14.4 per cent.

The gold medal for the top performing asset group in 2011 went to U.S. bonds, with a gain of 10.5 per cent. The reason wasn’t hard to figure out. Bad as things were in Washington, they were worse in Europe when for a time it appeared the eurozone might implode (and it still could). The result was a classic flight to safety. Investors poured money into U.S. Treasuries even though the yields on 10-year bonds fell below 2 per cent. Security, not profit, was top of mind.

(It should be noted that the Morningstar chart does not include gold and precious metals, a rather strange and glaring omission.)

A look back at the best performers over the past 20 years shows that the same pattern occurs every time there is a major financial crisis. In 2008, when the worldwide credit crunch hit, U.S. bonds soared almost 32 per cent while global bonds did almost as well. (Canadian bonds, by contrast, gained only 6.4 per cent despite the fact our financial markets were in better shape than anyone else’s.)

Going back even farther, the same thing happened during the tech crash of 2000 and 2001 with U.S. bonds scoring gains of over 15 per cent both years to lead all categories.

The lesson for investors is obvious. If a financial crisis looms, stock up on U.S. Treasuries or the funds that invest in them. Even if they appear to be overpriced, panic buying will drive them higher. Once the crisis eases, sell.

What else does the chart tell us? Buying the worst-performing asset class in the previous year often produces a profit within the next two years, sometimes a big one. For example, BRIC equities fell 49.1 per cent in 2008. If you’d bought at the start of 2009, you would have earned 64.3 per cent that year and an additional 4.1 per cent in 2010.

U.S. bonds were the worst performers in 2009, dropping 10 per cent. Buying at the start of 2010 would have produced a modest 1 per cent gain that year but a 10.5 per cent profit in 2011.

The worst-performing category in 2011 was BRIC equities which fell 20.8 per cent. The sector is up almost 9 per cent year-to-date, despite all the gloomy stories you read about the BRIC countries in the media.

It’s interesting to note that at no time over the past 20 years did Canadian equities finish at the top of the Morningstar list. Even during the boom years of 2003 to 2007, the best our large-cap equities could do was third place while the small-caps finished second once (2003). The BRIC countries and emerging markets headed the list during those years.

Those results reinforce the importance of diversification. Keeping all your money in Canada is simply not good strategy, especially now with commodities under pressure and financial stocks in the doldrums. Your portfolio needs to have good international balance, with special emphasis on the U.S. market at this time.

History does have some lessons for us. We should heed them.

Visit Gordon Pape’s website for information on his newsletters.

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Photo ©iStockphoto.com/ TIM MCCAIG