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Predicting this years winner.

Who could have predicted that BOTH Stanley Cup finalists from last year, the Edmonton Oilers AND the Carolina Hurricanes, would miss the playoffs this year?

(Hint: Not me).

Predicting this year’s winner based on last year’s performance doesn’t always work in the investment world either.

Studies (by SEI securities and others) have shown that more than half of top performing fund managers over a five year period end up being the poorest performers in the subsequent five year period. Hero to zero.

Investment companies publish ‘periodic tables’ that rank top to bottom performance of asset classes, geographies, sectors and the like. They too show the difficulty in making predictions. With no discernible pattern and seemingly random performance from year to year, we can safely say that recent performance is not a reliable guide to future performance.

Rather than make ‘bets’, investors can put themselves in a position to win by following a process that focuses on what is known, what can be predicted and manages what is controllable.

What is known? Investors know something about asset class returns, their volatilities and their correlations – on average, over time. Investors can, therefore, make a reasonable forecast as to how asset classes will perform – within a range – long-term. Without making bets.

What is controllable? The investors plan, investment policy, asset allocation and portfolio construction.

Investors benefit from comprehensive planning work. Planning produces long-term objectives that form the basis for an Investment Policy. Focusing on the long-term helps investors avoid making emotional or arbitrary decisions based on market ups and downs – never good.

Investment policy establishes risk guidelines, return expectations and time horizons that are appropriate to the realities of the investor (and the markets). It also produces an asset allocation plan.

At its core, asset allocation is the balance between stocks, bonds and cash. It is the single most important (and controllable) decision any investor can make. It determines the risk characteristics and return pattern of an investment portfolio – more so than any other factor. (The evidence is compelling). Client requirements drive any strategy and any strategy must revolve around asset allocation (regardless of the advisor).

Portfolio construction, then, is the implementation of asset allocation. It is the mix of asset classes, regions, currencies and sectors – in what proportions and at what times. A globally diversified mix ensures participation in broad market opportunities while helping to offset portfolio volatility. In a word, balance – which has proven to reduce risk and increase returns over time.

Too many risk-averse investors underestimate risk. This, unfortunately, becomes apparent during a market correction or prolonged downturn. Recall 2000-2002. For those who lack the resilience required to wait it out, it is a big mistake to underestimate the importance of diversification.

If an investor does correctly and consistently guess what will perform next, the rewards can be astronomical. Wrong guesses are penalized with brutal performance. For the average investor the penalty outweighs the reward. By far. Following a well defined process helps investors avoid making bets. Instead, decisions are based on long-term requirements, objectives and goals.

Bet on your favorite NHL team, not with your investments.

Originally published in the Business Thompson Okanagan news, June 2007.

Doug Cronk CFA is Manager, Investments for a Canadian Pension Fund.

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