I’m confused by a lot of things in investing, but the enduring influence of market forecasts is the one that stumps me the most. Year after year, expert predictions, estimates, forecasts and projections prove to be profoundly wrong. And yet next year we seek them out again. It’s like repeatedly pounding your thumb with a hammer and expecting that at some point it will stop hurting.

One of the reasons we still listen to forecasts is that the media love to celebrate the few that turn out to be right. Those that are wrong—which are the vast majority—are rarely held accountable.

With that in mind, I thought it would be interesting to look at the 2011 Fearless Forecast, the latest edition of a report published for 20 years by Mercer. The Fearless Forecast compiles the  consensus opinions of Canadian and global investment managers regarding the capital markets and the economy. The 2011 edition included input from 56 investment management firms, including some of the most prestigious asset managers in the world.

The last shall be first, and the first shall be last

The managers were asked to identify which asset classes they believed would be among the top and bottom performers in 2011. The most popular picks in each category are listed below, along with the percentage of managers who predicted that asset class would be among the best three and worst three performers. Where it was available, I’ve also included their average estimate for the returns of that asset class, followed by the actual index return for 2011.

It should be clear from the above table that the forecasts were not merely useless: they were spectacularly harmful to anyone who acted on them. An investor who followed these consensus opinions would have been slaughtered in 2011. They would have been helpful only to the strict contrarian: if you shorted all of the top picks and leveraged all of the bottom picks you would have made out like a bandit.

Dissecting the sectors

Let’s go one level deeper and see how the experts made out when forecasting the performance of  individual sectors of the Canadian economy. After all, active managers know when to get defensive during difficult markets, right?

Below is the percentage of managers who picked each sector as one of the best or worst performers, along with the actual 2011 return for that sector. (I was not able to find index data for the other four sectors—industrials, consumer discretionary, telecom and health care—but none of these make up more than 6% of the economy.)

The message here is not that these investment managers are fools. On the contrary, the participants in this survey are among the smartest folks around. They have a deep understanding of the markets, and access to more data than you and I will ever have. The point is that their superior knowledge and skill give them absolutely zero ability to predict what’s ahead. Their predictions were far worse than you would expect from random chance.

Human beings take comfort in forecasts because we detest uncertainty. But if you’re going to be a long term investor, you need accept that uncertainty is part of the deal. Since we can never be sure of what lies ahead, the most prudent strategy is to diversify.

All of the asset classes in the table above have positive long-term expected returns, but all of them will behave unpredictably over the short term. Rather than engaging in the futile attempt to guess next year’s winners and losers, hold all of them in your portfolio all the time. Rebalance once or twice a year. And make a pact never to listen to market forecasts again.

H&R Block tax software winners

Thanks to everyone who entered the draw for the H&R Block tax software. The five lucky winners are Michel, Mike, CCP Fan, Aziz and Rick. I will contact the winners by email to make arrangements.

Deciding on the right asset allocation can cause investors a lot of grief—far too much, in fact, since there is no such thing as a perfect mix of stocks and bonds.

In his excellent book Your Money and Your Brain, Jason Zweig reveals that even Nobel laureates are not immune. Zweig tells the story of Harry Markowitz, the creator of Modern Portfolio Theory, who struggled to put his own idea into practice. “I should have computed the historical covariances of the asset classes and drawn an efficient frontier,” Markowitz once said. “But I visualized my grief if the stock market went way up and I wasn’t in it—or if it went way down and I was completely in it. So I split my contributions 50/50 between stocks and bonds.”

There’s something elegantly simple about a 50/50 portfolio. Indeed, when finance writer Scott Burns created the original Couch Potato portfolio way back in 1991, that’s what he recommended: half your money in a bond index fund, and a half in an equity fund.

Of course, investors often equate simplicity with a lack of sophistication. In the last couple of decades, asset allocation experts have strived to create more efficient portfolios designed to squeeze out every last basis point without adding additional risk. And yet, as recent white paper from Vanguard shows, that simple 50/50 portfolio would have served investors extremely well—not just over the last 20 years, but during nine tumultuous decades.

In good times and bad

The Vanguard paper, called Recessions and Balanced Portfolio Returns, looks at the hypothetical returns of a blend of 50% high-quality US bonds and 50% US stocks, going all the way back to 1926. It shouldn’t be surprising that the overall performance would have been excellent: the average nominal return was 8.3%. What was far more interesting was that the real returns—that is, the nominal returns minus inflation—were essentially the same during recessions and periods of prosperity.

The authors classified every period since 1926 as either a recession or expansion, based on the criteria used by the National Bureau of Economic Research. During recessions, the average annual return of the 50/50 portfolio was 7.75%, versus 9.90% during expansions. However, once you adjust for inflation, the real returns were 5.26% and 5.59%, respectively. The small difference is statistically insignificant.

There are a couple observations that explain this result. The first is that inflation tends to be higher during periods of expansion and lower during recessions. But more interesting is the relationship between the two asset classes in the 50/50 portfolio: “First, when a recession is imminent, there is a tendency for bonds to outperform stocks during the initial period of economic weakness (a ‘flight-to-safety’ effect). Second … stock prices tend to decline before a recession officially begins and to rise before it officially ends (a ‘leading indicator’ effect).”

The Vanguard paper is quick to point out that no one is guaranteeing 5% real returns from a balanced portfolio going forward. But there is good reason to believe that the interaction between high-quality bonds and stocks will continue: it is, after all, the very heart of portfolio diversification. Like the yin and yang, stocks and bonds are not opposing forces, but “complementary opposites.”

Quicken giveaway and more

• Intuit Canada, makers of Quicken money management software, have offered to give away a copy of Quicken Home & Business 2012 to one lucky reader. This program, which retails for $110, allows you to track your cash flow and monitor your investments. To enter the draw, Tweet this post (include @cdncouchpotato so I can track you) or leave a comment below. Contest ends at midnight on Sunday, December 18, and I will announce the winner on Monday.

• I would like to welcome the first Vancouver-based firm to my Find an Advisor directory. Macdonald, Shymko and Company pioneered the concept of fee-only financial planning 30 years ago. Their team can help index investors set up passive portfolio with ETFs and Dimensional Fund Advisors mutual funds, and they also offer planning services to clients who manage their own portfolios.

• A huge thank you to readers who responded to the charitable initiative of Justin Bender and PWL Capital in Toronto. About half a dozen DIY investors contacted Justin to get advice in exchange for a donation to the Centre for Addiction and Mental Health (CAMH). Thanks to you, Justin has raised close to $10,000 for this worthy cause. Nice work, everyone!

Earlier this month, Mackenzie Investments produced this advertisement for the Mackenzie Sentinel Corporate Bond Fund. The banner headline reads “Think high yield means high risk?” The rest of the ad reads, “Think again. High-yield corporate bonds have produced equity-like returns with less risk.”

Two graphs then compare the performance of the fund with the S&P/TSX Composite Index from November 2000 (the fund’s inception date) through October 31 of this year. During that period, the Mackenzie fund delivered annualized returns of 5.7% with a standard deviation of just 5.8%. The Canadian stock market, by comparison, delivered just 4.5% with much more volatility: a standard deviation of 15.5%.

Those are compelling numbers: high returns with lower volatility is what every investor wants. But it’s always important to scrutinize comparisons like this. There’s nothing incorrect in the data here, per se, but one needs to ask whether the fund really did deliver superior risk-adjusted returns, and whether it is likely to do so in the future.

To begin with, the start and end dates examined here are crucial. If you look at the table under the two graphs, you’ll see that the S&P/TSX Composite returned 8.5% annualized during the 10 years beginning in October 2001, outperforming the Mackenzie fund by 2.8% a year. So by moving the start date by just one year, you get a completely different result. It may be true that “high-yield corporate bonds have delivered equity-like returns,” but only during specific periods when equities dramatically underperformed their historical averages.

Were you rewarded for taking more risk?

The ad also argues that “it takes rigorous company and credit analysis to find bonds with long-term growth and income potential. When you do, it adds up to superior returns and a smoother market ride.” In the case of the Mackenzie fund, it also adds up to an MER of 1.7% a year.

There are only two ways that a bond manager can deliver superior returns than a broad-market index. The first is by adjusting maturities—that is, by selecting a portfolio of bonds with shorter or longer terms than the benchmark. The second is by varying credit quality: by selecting bonds of lower quality, and therefore higher yields. With that in mind, did the Mackenzie Sentinel Corporate Bond Fund add value?

Justin Bender, a CFA and portfolio manager at PWL Capital in Toronto, supplied the following analysis. He compared the Mackenzie fund’s performance to a blended benchmark consisting of two indexes of federal government bonds: 60% DEX Mid Term Federal Bond and 40% DEX Short Term Federal Bond. This 60-40 mix creates a benchmark with an average term to maturity of about 5.7 years, which is identical to that of the Mackenzie fund’s portfolio. In this way, we’ve taken maturity out of the equation so we can focus only on credit quality.

Since high-yield bonds have far more credit risk than government bonds of the same maturity, investors should naturally expect higher returns. Would they have achieved them with the Mackenzie fund? Here are the numbers:

Sources:  PC-Bond, BMO Financial Group, Mackenzie Investments, Dimensional Returns 2.0. Returns as of October 31, 2011.

As you can see, since its inception, the Mackenzie fund has not even outperformed government bonds of similar maturities. Over the last 10 years, it managed a mere 10 basis points of outperformance. Over shorter periods, the results are mixed. This hardly a compelling argument for the fund’s “rigorous company and credit analysis.”

And what about volatility? The Mackenzie fund’s standard deviation of 5.8% does indeed look low when compared with the S&P/TSX Composite. Yet our 60-40 benchmark of government bonds not only achieved higher returns since November 2000, but it did so with a much lower standard deviation of just 3.5%, according to Bender’s analysis.

“Finding equity-like returns with less volatility is something many market weary investors are looking for,” the Mackenzie ad says. No argument there. But the data suggest they need to keep looking.

This post is the second of three that will look at the potential risks that ETFs may pose to the stability of financial markets. Last week I discussed synthetic ETFs, which use derivatives called swaps to get exposure to their underlying indexes. Now we’ll examine leveraged ETFs.

Leveraged ETFs are designed to provide double or triple the daily return of their underlying index. The Horizons BetaPro S&P/TSX 60 Bull+ ETF (HXU), for example, promises twice the daily return of the popular large-cap Canadian equity index. If the index goes up 2% during the day, HBP will return 4%, and if the index loses 2%, the ETF’s return will be –4%. In the US, some providers even offer triple-leveraged ETFs, such as the Direxion Daily Large Cap Bull 3x Shares (BGU), which delivers three times the daily return of the Russell 1000 index.

A related family of products, called inverse ETFs, move in an opposite direction to the market. If Canadian large caps lose 2% in one day, the Horizons BetaPro S&P/TSX 60 Inverse ETF (HIX) will gain 2%, and vice versa. Many inverse ETFs also use leverage: they may rise 4% when the their index declines 2%, for example.

The problem

Since leveraged and inverse ETFs appeared in 2006, critics (myself included) have argued that these products are potentially harmful for individual investors who may not understand their risks. For an even-handed discussion of these risks, see Dan Hallett’s comprehensive report.

But the recent concerns about leveraged ETFs do not centre around poorly informed individuals. Rather, the US Securities and Exchange Commission is investigating whether these products have played a role in creating extreme market volatility, especially the huge swings we saw in early August.

Although these concerns have been around for a while, they got a boost from an influential October 10 article by New York Times writer Andrew Ross Sorkin. The piece included an interview with hedge fund manager Douglas Kass, who argued that “at the end of every day, leveraged ETFs have to rebalance themselves by buying and selling millions of shares within minutes to remain properly weighted.” This flurry of trading, the article suggests, causes huge swings in the market during the final minutes of each trading day.

What Canadians need to know

Leveraged and inverse ETFs are primarily speculative products that have no place in a long-term investor’s portfolio. But there is simply no compelling evidence that these products pose a systemic risk—that is, that they cause market instability that affects all investors. Sorkin’s article offers nothing but vague suspicions: “Ask any hedge fund manager what their gut says,” is all we get. Let’s consider the other side of the argument:

They’re a tiny blip in the markets. Leveraged ETFs account for a mere 3% of total ETF assets in the US, while inverse ETFs make up another 2%, a market share that a Morningstar analyst called “a grain of sand on the beach.” It is hard to imagine that their rebalancing trades could be a primary cause of daily price movements. “Rather than focusing on leveraged ETFs’ supposed role in boosting market volatility, a more relevant examination would include options, futures and other financial products that increase leverage in the system, the analyst added,” says ETF Trends. “The size and scope of these markets dwarf leveraged ETFs.”

The tail doesn’t wag the dog. At the US Senate subcommittee hearing on October 19, Eric Noll of the NASDAQ presented an analysis showing that “trading in ETFs varies roughly in proportion with overall trading in the market. When news breaks and market prices move, trading volume increases in both the ETFs and the underlying stocks.” In other words, ETFs are responding to market volatility, not causing it. A Credit Suisse report echoed this argument: “We believe it’s a case of confusing correlation with causation.”

The world economy has a few other issues. Those who blame a tiny segment of the securities market for the recent market volatility seem to have forgotten that there are some serious macro issues in the world. As Eric Noll argued in his testimony: “Restricting or eliminating the [ETF] business will not solve the sovereign debt crisis in Europe, will not balance the US budget, will not restore bank balance sheets, will not add jobs, and will not repay consumer debt and get them spending again. There are very large, very real uncertainties that are driving global financial market volatility.”

If ETFs—leveraged or otherwise—are found to be contributing to market instability after a thorough investigation, I will be the first to support increased regulation. Until then, I’m inclined to echo the words of Dave Nadig of IndexUniverse. “There’s a big difference between being a niche, complex and sometimes misused product and being a threat to modern capitalism,” he writes. “Leveraged and inverse funds aren’t for everyone. In fact, they’re not for most people. They’re expensive, complex and require constant monitoring if held for more than a day…. But these funds aren’t the progenitors of some sort of global collapse.”

ETFs are on the hot seat these days. On Wednesday, a US Senate subcommittee held a hearing to consider the idea that ETFs are contributing to volatility and instability in the financial markets. This is pretty serious stuff. How did the humble ETF, once hailed as the most investor-friendly innovation in decades, become the target of such suspicion?

The brouhaha can be traced back to September 2010, when a little-known investment firm called Bogan Associates wrote a white paper called Can An ETF Collapse?, which got enormous media attention. One CNBC stock-picking guru reviewed the report and referred to ETFs as “a monster that will wreak havoc.” But almost immediately, the Bogan report was criticized as “wildly off the mark and highly irresponsible.” Credit Suisse exposed the report as specious.

Two months later came another alarmist report from the Kauffman Foundation, which argued that ETFs are distorting financial markets and presenting dire systemic risks. Within a day of its release the report was called out for its conflicts of interest and its “serious misunderstanding of how ETFs work.” Media outlets such as IndexUniverse and Forbes wrote scathing rebuttals, and a couple of weeks later the foundation released a revised version with most of the inflammatory claims watered down.

Yet despite their shoddy arguments, both the Bogan and Kauffman reports were highly influential. I received several emails from readers who wondered if they should be worried. Earlier this year, iShares Canada told me they were still getting phone calls every day from investors who were concerned that ETFs were going to trigger the next financial crisis.

Should you be concerned?

Although these two reports were thoroughly debunked, some of the concerns about the growing ETF industry do have merit. Several other reports released this year have raised the possibility that certain complex ETFs might potentially contribute to instability in the financial markets. Unlike the sloppy Bogan and Kauffman documents, these were prepared by people who actually understand how ETFs work:

• Global Financial Stability Report: April 2011, International Monetary Fund (see page 68)

• Market structures and systemic risks of ETFs, Bank for International Settlements

• Potential financial stability issues arising from recent trends in ETFs, Financial Stability Board

• ESMA’s policy orientations on guidelines for UCITS Exchange-Traded Funds and Structured UCITS, European Securities and Markets Authority

The concerns raised in these reports—and in the heated discussions that have followed them—can be boiled down to three important issues:

• the growing complexity of synthetic ETFs (which use derivatives called swaps rather than holding assets directly) and the risk that the swap counterparty could default

• increased volatility and market instability caused by ETFs that use leverage

• the potential dangers of excessive securities lending, whereby ETF providers earn additional revenue by lending the portfolio’s stocks to investors who sell them short

Next week, I’ll look at each of these concerns one by one, and I’ll do my best to explain how relevant they are for Canadian ETF investors.

I can’t seem to get my kids interested in index investing, but they do share my love of baseball. So last week I took my daughter to see Moneyball, based on Michael Lewis’s book of the same name. She was mostly interested in Brad Pitt, but that didn’t stop me from lecturing her about the lessons the film holds for investors. Bear with me while I explain.

If you’re not familiar with Moneyball, it’s the story of the Oakland Athletics and their maverick general manager, Billy Beane. In the early 2000s, the Athletics had a budget of just $40 million, compared with $126 million for the New York Yankees. The A’s would draft good players and turn them into successful major leaguers, but as soon those players became free agents they would leave for big-market teams. When the film begins, Oakland has just been knocked out of 2001 playoffs and lost three of its top players to clubs with deeper pockets.

Before the 2002 season, Beane decides to shake things up. He realizes he can’t beat the Yankees and other big-budget teams at their own game. So he uses a system of statistical analysis (known as sabermetics) to identify undervalued players. Instead of filling his team with expensive, high-profile stars—who may not be as valuable as they seem—he fills the roster with cheap, little-known players who have underappreciated skills. The A’s go on to win a remarkable 103 games, including a record 20 in a row.

What you know that isn’t so

Sabermetrics revolutionized baseball by debunking a lot of conventional wisdom. It revealed that many traditional statistics (batting average, runs batted in, fielding percentage, a pitcher’s win-loss record) actually tell you little about a player’s value. It found that that time-honoured strategies like the sacrifice bunt and the stolen base, despite their intuitive appeal, turn out to have a low probability of success. Even the idea of the clutch hitter—a player who consistently comes up with big hits in key situations—was revealed as a myth.

Not that everyone agrees with this assessment, of course. There’s a wonderful scene in the film where a veteran scout angrily tells Beane that he’s relying too much on stats and not enough on intangibles. “You’ve got a guy in there with an economics degree from Yale, and a guy out here with 29 years of baseball experience,” the scout fumes. “And you’re listening to the wrong one.”

What does this have to do with investing?

Moneyball reminded me that investing, like baseball, is dominated by old-school thinking that doesn’t hold up to rigorous scrutiny. Traditional statistics that tell you nothing useful? I’d put pretty much all technical analysis in that category. Strategies that sound compelling but rarely succeed? That’s the definition of active management. The financial equivalent of baseball’s mythical clutch hitter is the mutual fund manager with the hot hand.

Then there are the money managers who overvalue their knowledge and experience, like the old scout who criticized Billy Beane. Stock pickers continue to believe they can consistently identify market-beating stocks with methods Benjamin Graham pioneered in the 1930s. The irony is that Graham himself recognized this is futile in an efficient market. “I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities,” he said in a 1976 interview. “This was a rewarding activity, say, 40 years ago, when our textbook Graham and Dodd was first published; but the situation has changed a great deal since then.”

There’s one more parallel here. Statistics can tell you a lot about both baseball and financial markets, but in both cases the outcomes are never certain. Sometimes an ill-conceived, highly risky play will succeed and make you look like a genius—whether that’s stealing home or making a big bet on a single stock. Other times you’ll  do the right thing and suffer short-term failure. But overall, in sports and investing, long-term success comes from putting the odds in your favour. As Michael Lewis writes, that is “the art of winning an unfair game.”

The Canadian stock market officially crossed into bear market territory this week, falling to more than 20% below its April high. We’ve already endured five consecutive months of negative returns and October is so far showing no sign of improvement. It’s times like these that test the mettle of an investor. Do you have the discipline to stick to your long-term plan?

Whenever the markets tank, the very idea of a long-term plan gets called into question. The financial media are filled with stories about “repositioning your portfolio” and “how to invest in times like these.” The implication is that smart investors should react to what has already happened, and then try to predict what’s coming next. Investors who preach “stay the course” are ridiculed as naive fools.

The problem with the whole idea of trying to reposition your portfolio is that it you never know whom to listen to. Nothing illustrates this better than a report today from a UK site called Citywire Money. (Hat tip to De Thomas Financial for sending this along.) Last week, it says, Morgan Stanley polled 200 of its institutional investors and asked them, “What best describes your attitude to global stocks right now?” Here are the results:

•  20% agreed with the statement: “I am buying now because equities are very cheap and the macro issues are well known.”

• 30% said: “I expect policymakers to announce credible solutions before year-end and I am waiting for an entry point.”

• 25% said: “I continue to sell equities as the macro outlook will deteriorate further and policymakers have little or no options left.”

• 25% said: “I am confused and am doing nothing.”

What conclusion can investors draw from this poll? No matter what course of action you choose, 70% to 80% of institutional money managers will think you’re dead wrong.

Let’s end the week with one final post about the Permanent Portfolio. Many readers expressed interest in this strategy, introduced by Harry Browne in the early 1980s. I’ve spent so much time on the Permanent Portfolio because I find it fascinating, and I enjoyed discussing its subtleties with Craig Rowland, who has studied it extensively. I’d like to thank Craig for taking so much time to answer readers’ comments so thoroughly over the last couple of weeks.

There are many things I like about the Permanent Portfolio, especially that it’s a passive strategy based on asset allocation and diversification, rather than forecasting or security selection. I also think it’s extremely low volatility is perhaps the best example of Modern Portfolio Theory in action. But I can’t encourage investors in Canada to adopt the strategy. Here’s why:

• With just one quarter of the portfolio allocated to stocks, I don’t feel there is enough potential for long-term growth. Stocks have delivered—by far—the highest real returns over the 85-plus years for which we have good market data. Yes, they are volatile, but they have historically rewarded long-term investors with excellent growth in a way that cash, gold and government bonds have not.

• Long-term bonds may be a hedge against deflation, but we have not seen significant deflation in Canada since the Great Depression. That’s not to say it can’t happen, of course, but the probability of it occurring does not justify such a large place in a portfolio. A 40% allocation to an index fund tracking the broad Canadian bond market would give you about 10% long bonds, 10% intermediate, and 20% short, with about a third of these in corporate bonds. This kind of diversified fixed-income portfolio offers a better risk-reward trade-off.

• Gold can be a stellar performer during times of crisis, and I would never argue with an investor who kept a small holding (no more than 10%). But the idea that it is a hedge against inflation in the traditional sense—that is, in the sense of rising prices, as opposed to catastrophic hyperinflation—just isn’t borne out by the data. If our currency ever collapses I’ll regret not holding gold, and I can’t argue that will never happen. But in my opinion, the probability does not justify a 25% allocation.

• Cash is not an investment: it’s savings. It’s perfectly prudent to keep cash on hand as an emergency fund, especially if you feel that a job loss, illness or other unexpected event would put your lifestyle in jeopardy. Perhaps that’s three to six months’ worth of expenses for a working family, or maybe as much as a two-year cushion for a retiree. But should someone with a $400,000 portfolio keep $100,000 in cash, where its real return is unlikely to be much more than 0%? The opportunity cost would be enormous.

Another look at the returns

One of the reasons that the Permanent Portfolio has gained popularity recently is that its returns have been impressive over the last dozen years or so, a period when stocks have performed poorly. And it’s not just the medium-term results that look impressive: according to the historical performance data on the Crawling Road website, the annualized return on the portfolio was 9.7% from 1972 through 2008. The page doesn’t include the data for 2009 and 2010, but the returns in both of those years was higher still.

How would the Permanent Portfolio’s returns have stacked up against a traditional index portfolio? Justin Bender, a CFA and adviser with PWL Capital in Toronto, was kind enough to run these numbers, and he’s allowed me to pass on the results to readers. You can download the Excel spreadsheet here.

Justin analyzed the Permanent Portfolio using Canadian data for T-bills (cash), gold and long-term bonds. For the stock allocation he used an even split of Canadian stocks and the MSCI World Index. Then he compared it against the Global Couch Potato’s allocation of 20% Canadian stocks, 40%  U.S. and international stocks (also using the MSCI World Index), and 40% Canadian bonds (all maturities). He was able to get data going back to late 1979.

The Excel file includes three worksheets:

• The first indicates the volatility of the two portfolios. Justin measured the portfolios’ standard deviation over rolling three-year periods. You’ll notice that the Permanent Portfolio’s volatility is extremely low: it averages about 5.6%, compared with 8.5% for the Global Couch Potato.

• The second worksheet gives the annual returns for the two portfolios. From 1980 through 2010, the Permanent Portfolio’s compound annual growth rate was 8.42%, compared with 10.32% for the Global Couch Potato.

• How much difference did that added 1.9% a year make, compounded over more than 31 years? The final worksheet graphs the growth of $1 invested in each portfolio from December 1979 through June 2011. Each dollar invested in the Permanent Portfolio would have grown to $13.77. One dollar invested in the Global Couch Potato would have become $21.92.

I receive a lot of press releases, but few are as useful as the one that hit my inbox on Friday. It arrived after the markets closed, so I wasn’t able to act on it, but I’m sharing it with you today in the hope that you’ll benefit, too. According to a Toronto investment firm, gold may be overvalued based on the gold-to-decent-suit ratio.

This breaking news, which was picked up in Friday’s Financial Post, revealed that “the cost for an ounce of gold in 1967 was $35, exactly the same price as a decent suit from Eaton’s,” while in 1975, “gold weighed in at $100 an ounce, a 1:1 ratio with a decent suit from Eaton’s during the same year.”

However, with the shiny metal now at well over $1,800 an ounce, the gold-to-decent-suit ratio—let’s call it the GDSR—is way off. Today, says the investment firm, “a Burberry London men’s black wool two-button suit” costs a mere $1,150 at Holt Renfrew. “Although no one knows for sure, we believe that the price of a decent men’s suit and gold will converge to the same level.” Personally, I’m just grateful I didn’t invest in Eaton’s.

In any case, you can take advantage of insights like this by investing in the firm’s Canadian equity fund (MER 2.53%), which has underperformed the S&P/TSX Composite by 2.6% annually since its launch, or its balanced fund (MER 2.31%), which has lagged its own custom benchmark by 3.3% annually since 2002.

Taking comfort in good ideas

In turbulent times like these, it’s good to know that active managers are handling your money using robust ideas. Now that buy-and-hold is dead, “stay the course” is for chumps, and asset allocation has been exposed as a lie, investors need strategies like the GDSR when deciding where to put their hard-earned cash.

The notion that an ounce of gold is correlated with the price of dapper duds is one of the most revered in the academic literature. Even as far back as Roman times, an ounce of gold was enough to get you an Armani toga—although you could have saved XXV% to L% if you’d looked for after-Saturnalia sales. In Shakespeare’s day, a fine doublet and matching breeches would also have set you back one shiny gold piece. (However, interest rates were unusually high: borrowing  3,000 ducats cost you a pound of flesh.)

We know all of this from the centuries of data collected by the Centre for Research in Sartorial Prices, which tracks several well-known financial benchmarks, such as the “stocks-to-nice-hat ratio,” and the “real-estate-to-fancy-shoes ratio.” The CRSP’s research also tracks the price of large caps, small caps, and baseball caps.

Admittedly, sometimes the GDSR is just a wee bit off. From 1981 through 2004, the inflation-adjusted price of gold declined more than 67% in Canadian dollars. This information was omitted from the press release for space reasons. According to CRSP data, a decent suit actually did cost more in 2004 than it did in 1981. However, the ratio would have held up if you went smart casual for 24 years.

The other side of the gold coin

Friday’s Financial Post article on the GDSR included some healthy skepticism. That came in the form of a comment from a prominent gold bug who says the ratio is no longer relevant, because “suits are being made in Third World countries and distorting the price. Had that not happened, better tailors in London, U.K., would be charging two or three grand.” That means gold is actually undervalued.

The gold bug (who coincidentally manages precious metals funds with MERs over 3%) is about to publish a book called  Gold $10,000: Will it happen sooner than you think? He has said recently that the yellow nuggets could hit that price within five years. To get from $1,800 to $10,000 over that period would require a 41% annualized return, but because hyperinflation is a certainty and the world is on the verge of economic Armageddon, this is entirely reasonable.

Whatever suits you

With so much good advice out there, it’s hard to know just what to do. But one thing is certain: this is no time for a long-term investment plan.

How are you implementing your own panic strategy? What long-held principles are you abandoning because the TSX is up just 2.4% over the last 12 months? Have you identified a key asset ratio in a department store flyer? Or have you just loaded the minivan with bullets and butter and headed for the hills?

Please share your ideas below: I’ll choose the best one and send the winner a copy of the classic 1999 book Dow 36,000. This popular volume argued that stock prices would quadruple in three to five years because the old ideas don’t work anymore. It should prove to be a beacon of wisdom in these challenging times.

Monday’s post comparing one of my model ETF portfolios to one created by Dimensional Fund Advisors attracted a lot of interest from readers—and from some DFA advisors, too.

Shortly after that post went live, I was contacted by a DFA advisor whom I’ll call John (his compliance department keeps him on a short leash). John ran some numbers to compare how the original Über-Tuber might have performed alongside a DFA portfolio over the last 15 years.

Of course, none of the ETFs in my suggested portfolio were around in 1996. So John used index data to estimate the returns of the Über-Tuber, subtracting the MERs of the funds to account for costs. For the DFA portfolio, he subtracted a 1% advisory fee from the fund returns. Here’s the breakdown he used:

Here are the results from July 1996 through April 2011:

And here’s how the path of those returns would have looked during the period:

As you’ll see, the returns of the two portfolios over the 15 years were almost identical. The Über-Tuber trailed the DFA portfolio by just half a dozen basis points annually, and it accomplished that result with a lower standard deviation—which means lower volatility.

What’s it all mean?

So what conclusions can we draw from these data? First, it seems the ETF portfolio would have done a respectable job of mirroring DFA’s small-cap and value strategies. However, the simulation assumed that trading costs were zero, that the investor rebalanced religiously, and that the ETFs all tracked their indexes very closely. It’s safe to say that a real-world investor would have been hard-pressed to accomplish all of that.

What’s more, assuming our ETF investor did manage to do everything right for 15 years, the DFA portfolio still delivered slightly better results, even after deducting a 1% fee for the advisor. An experienced advisor would certainly have added value if he or she handled all of the heavy lifting during this turbulent period, which included three roaring bull markets (1996–2000, 2003–06 and 2009–10) and two swift kicks in the groin (2001–02 and 2008–09).

There’s one more interesting thing to add. John also ran the same simulation with the trusty old Global Couch Potato—which includes just three or four funds—and the results fell right in the middle: an annualized return of 6.40%. There was a bit of divergence between the three portfolios during some periods, but after 15 years it was essentially a wash, no matter which one you used.

Maybe it does pay to keep things simple after all: diversify widely, keep your costs low, rebalance and stick to your plan. If you can do that, you’re at least 90% of the way to the perfect portfolio.