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Let's say you think the Green Bay Packers will win next year's Super Bowl. You go to Las Vegas tomorrow and put your cash on the line. In early 2004, the Packers romp to victory. You return to Vegas to collect your winnings -- but there are none to be had. Turns out that instead of a direct, straightforward bet on a Packers victory, you had placed a complex wager in which a number of other things also had to come true for the bet to pay off. Some didn't. So you go home with nothing -- even though your forecast had been right on target.
Betting and investing differ in many ways. But this hypothetical Super Bowl scenario could be your fate should you try to invest based on your intuition about market trends or global political events. If you're one of the few who have had success predicting such trends, you might be tempted to act on those instincts when making your fund selections. But be wary of trying to capitalize on such forecasts.
One reason is that it is exceedingly difficult to make such predictions accurately with any consistency. But you already knew that. What's worse is that you can lose even when your predictions pan out. A number of macroeconomic, market, and stock-specific forces are always exerting influences a fund's performance, and even if you guess right on a few of them, others could still spoil the party. Here are a few examples from 2002.
Growth stinks?
At the end of 2001, you might have concluded that the slide in growth stocks was going to continue. Let's say you decided to switch out of American Century International Discovery (TWEGX) into a fund with less of a growth bent. Fair enough. The American Century fund, though perhaps less momentum-oriented than the firm's domestic-stock offerings, certainly plays the growth game; that's how it posted stunning returns during the growth-crazed late 1990s, culminating with an 88% gain in 1999 that doubled the foreign-stock category average. So you shifted your money to a big, respected middle-of-the-road fund, such as Fidelity Overseas (FOSFX) or Vanguard Developed Markets Index (VDMIX).
Your prediction hit the bulls eye: Growth stocks around the world continued to languish in 2002. But your fund switch didn't pay off. In fact, it has cost you. Small caps in many countries outperformed their bigger brethren, and the American Century fund made some astute selections; so it held its loss to 12.8% in a terrible 2002 and is down only 2.6% for the year to date through March 6, 2003. By contrast, Fidelity Overseas has fallen much harder. It lost 19.5% last year and is down 7.8% so far this year. The Vanguard fund lagged the American Century offering by 3 percentage points in 2002, and has dropped nearly as far as Fidelity Overseas this year.
Of course, you would've done better had you taken more drastic steps, such as switching to a deep-value player or leaving your money in a cash account. But the point stands. What appeared to be a reasonable fund switch, reflecting a forecast that turned out to be accurate, nonetheless backfired.
Getting defensive
It also would have been reasonable in late 2001 to decide that the federal government's defense spending would increase sharply, given the concerns about terrorism and other international threats. Based on that forecast, you might have moved into a fund with a strong record that was emphasizing defense companies. Mainstay MAP (MUBFX) would have fit that description. Its managers were keen on defense, an area they had followed closely for years.
So what happened? The fund suffered one of the few bottom-half showings in its history in 2002, losing 19.8%. Your prediction wasn't at fault: Though defense stocks didn't continue their rally as long as many thought they would, two of this fund's top defense holdings held up well. Northrop Grumman (NOC, news, msgs) lost only 2.4% in 2002, much better than most stocks, and Raytheon (RTN, news, msgs) lost just 3%. Other, non-defense holdings bear the blame for the sub par performance.
What if you had taken a more direct approach, investing in Fidelity Select Defense & Aerospace (FSDAX, news, msgs)? That would've worked out better -- but only if you sold at the end of 2002. The fund posted a fairly mild 6.8% loss that landed in the mid-blend category's top decile. So far this year, however, it is one of the worst funds in that group, losing 10.9%. With Northrop Grumman and other defense stocks plunging recently, this fund's trailing 12-month return is now a painful 26.7% loss.
Go euro, go
A final example comes from the complex currency arena. With the dollar having been strong for years and the U.S. economy slowing, you could have forecast that the dollar would sink in 2002. To prepare, a logical move would have been to shift out of two international funds that typically hedge all of their foreign-currency exposure into the dollar (and thus don't get any kick when the dollar weakens and foreign currencies rise, as most of their unhedged peers do).
This prediction, too, was on the mark. The dollar declined sharply against all major currencies. But what happened to those hedged funds? Two such offerings rode out the currency turbulence in fine form. Tweedy, Browne Global Value (TBGVX) landed in the top quartile of the foreign-stock category, helped by the relatively sound performance of the small-value stocks it tends to favor. A similar bent helped {Franklin Mutual European {TEMIX} finish in the top quartile of the Europe-stock category.
Best advice: be cautious
The point is not to ignore developments in the world or to avoid making shifts in your portfolio. Rather, just be cautious when making such changes, especially if they are based on your expectations of broader trends. As these examples show, even if your market forecasts or current-events predictions come true, the rewards are by no means guaranteed.
If you want to make such a move, consider shifting just part of your stake out of a fund rather than selling the whole thing. Another smart way to play a market trend is to choose two funds that you think will benefit from the trend, rather than just one. Finally, always make sure that whatever you do, your overall portfolio still reflects a diversified plan that's designed with your long-term goals in mind.
Copyright 2003 Morningstar, Inc.
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