Psychologists talk about the human propensity to gravitate towards evidence that supports existing biases. What that means, quite simply, is that in buoyant markets, investors are prone to believe outrageous claims by market bulls – think no further than “the world has changed forever” rhetoric and best selling books like “Dow Jones 36,000” and Harry Dent’s “The Great Boom Ahead” in the tech boom in 1999 and 2000.

In the same way, in negative markets such as we’re experiencing right now, investors tend to believe even the most gloomy assertions from “media gurus” and self appointed experts – a recent New York Times article headlined “Forecasters race to call the bottom to the market” discussed the competition among market pundits to come up with the most dire possible predictions. (It’s noteworthy that the same Harry Dent who wrote “The Great Boom Ahead” has just published “The Great Depression Ahead.”)

Most members of the media strive for accuracy in their reporting and work very hard to get the facts right. The problem – many of the assertions that get the highest profile are based on flawed analysis of past stock market performance by pundits who distort history to get media coverage for their alarmist claims or by well meaning commentators who quite simply get the facts wrong.

Among the common cautionary claims about investing in the stock market:

1. Investors made no money in the market from the mid 60s to early 80s.
2. It took 25 years for the market to recover to the level reached in 1929.
3. When inflation is taken into account, investors have lost money for long periods of time.

Stocks made no money from 1965 to1982

As just one example, a cover story in a recent Newsweek article featured the statement that the stock market was no higher in 1982 (the Dow ended 1981 at 875) than in 1965 (when it ended at 969). This is the most often quoted fact when people make the case that stocks can go sideways for long periods – and on the face of it, it’s hard to argue with this… unless we remember two critical points.

First, despite its prominence, the Dow Jones is only vaguely representative of the stock market as a whole. Because it only contains 30 stocks and is price weighted rather than market weighted (in other words a stock trading at $50 has five times the weight of a stock trading at $10), it doesn’t truly represent how the overall market performs. In the 70’s in particular, the Dow Jones was laden with large household names referred to as “the nifty 50” that were chronic underperformers of the market as a whole.

Second – and more important – looking at the overall price performance of any index ignores dividends, something that historically accounted for 40% of returns. Focusing on price performance of an index and excluding dividends isn’t just something that the media does – it’s a trap that many financial analysts and advisors fall into as well.

Here are the results from 1965 to 1982, using the Standard and Poors Composite Index, containing the 500 largest stocks by market value and if we include dividends.

Gain from Dec 31 1965 to Dec 31 1981:

Capital appreciation: 33%
Total return with dividends: 152%

The result is an annual return of 6% – well below the long run return on large U.S. stocks of 10% but still a very different proposition than being down over this period.

As an aside, people who use the period from the end of 1965 to 1981 are cherry picking one of the worst possible periods to make their case; here’s the total return for 16 year periods starting one year earlier and one year later:

Dec 31 1964 to Dec 31 1980: 198%
Dec 31 1966 to Dec 31 1982: 240%

Note that excluding dividends in calculating long term returns isn’t just a trap that the media falls into – many investment analysts who should know better make the same mistake.

Stocks took 25 years to recover to 1929 levels

A second common myth relates to how long it took for stocks to recover after the great crash. And if we look at just the price index, this is true – looking at year end price levels, it took until 1952 to match the high hit by the S & P index at the end of 1928 … appearing to be a disastrous experience for investors who held on after through the great crash. If we include dividends however, we see a different story – with dividends included, at the end of 1952 the S & P was four and a half times the level of 1928, for an annual return of over 6% and a real return of 4% per year.

Stocks lose money after inflation

Let’s look a final example of fun with numbers.

An article in the November 8 Globe and Mail featured an interview with Edward Kerschner, chief strategist with Citi Global Wealth Management, stating that in real terms the Dow fell 47% from 1960 to 1980. Kerschner’s point was that markets can be horrible places to be for long periods of time (especially with free spending presidents such as Kennedy, Johnson, Nixon – and perhaps Obama.)

Here are the year end numbers for the Dow, both before and after inflation:

Again, it’s tough to argue with the argument that this twenty period was disastrous for investors in real terms – until we look at a broader based measure of stock market performance and include dividends. S&P 500 from Dec 31 1959 to 1979

On a total return basis, the annual real return in this 20 year period was 2% – because of a combination of lower stock market returns and much higher inflation than the historical norms, this period did indeed substantially underperform the historical real return of 7% (a gain of 10% less 3% inflation). Still, underperforming with a real return of 2% is a very different story than losing almost half your money. And again, on the theme of cherry picking time periods, if we use the 20 year period starting one year later, from the end of 1960 to the end of 1980, real returns are more than 50% higher at 71%.

None of this is intended to say that stocks will always be a safe or pleasant haven for investors. And despite the overwhelmingly positive returns that long term investors in U.S. stocks have seen across virtually every time frame, there is always the possibility that it could be different going forward. Just remember, though, the only guide we have going forward is what happened in the past. And in looking at the past, we need to look at all the facts – not just those selected by people looking to grab newspaper headlines.

Special to the Globe and Mail

By Erik Heinrich

 Time Magazine

In the midst of the worst financial crisis since the Great Depression, Canada has joined the ranks of governments that in recent weeks stepped up to help banks cope with more fallout from bad U.S. subprime mortgages. In Canada’s case, however, the reason for the assistance is a little different from some of its G-7 partners. Unlike banks in the U.S., Britain and Germany, which needed to be bailed out with hundreds of billions of dollars in new capital, Canada’s major banks are solid and solvent. They don’t need any help to work through their subprime exposure. (Find out 10 things to do with your money.)

So why did Ottawa agree to insure the money they routinely borrow from other banks, a practice that keeps their credit operations liquid? Ironically, the troubled non-Canadian institutions that received capital injections and loan guarantees in other countries now carry a government seal of approval that tilts the playing field in their favor when it comes to borrowing. That leaves Canada’s big banks, including Scotiabank, TD Bank Financial Group, RBC Royal Bank and CIBC, at a competitive disadvantage. So the government acted to level the field, not to aid troubled banks. (See pictures of the global financial crisis.)

Why has Canada withstood the subprime tornado better than other countries, and should the Canadian banking system be a model for G-7 and G-20 leaders when they gather in Washington on Nov. 15? Consider that the Geneva-based World Economic Forum, an influential think tank whose annual conference attracts the likes of Bill Gates and Tony Blair, earlier this month ranked Canada’s banking system as the soundest in the world. The U.S. came in at No. 40, and Germany and Britain ranked 39 and 44, respectively. (Switzerland was No. 16, just ahead of Namibia.) “For Canadian banks, having higher capital ratios than anyone else in the world is a source of pride,” says analyst Mario Mendonca with Toronto-based investment bank Genuity Capital Markets. (Read “Four Steps to Ending the Foreclosure Crisis.”)

The average capital reserves for Canada’s Big Six banks — defined as Tier 1 capital (common shares, retained earnings and non-cumulative preferred shares) to risk-adjusted assets — is 9.8%, several percentage points above the 7% required by Canada’s federal bank regulator. That’s a little better than major U.S. commercial banks like Bank of America, but significantly higher than an average capital ratio of about 4% for U.S. investment banks and 3.3% for European commercial banks.

Another factor that helped make Canada the new gold standard in banking was Ottawa’s decision in the late 1980s to allow commercials banks to acquire investment dealers on Toronto’s Bay Street, the country’s financial hub. As a result, these institutions are subject to the same strict rules as commercial banks, while U.S. investment dealers are subject to only light supervision from the Securities and Exchange Commission. Morgan Stanley and Goldman Sachs, of course, will now be under the U.S. Federal Reserve’s supervision since they have been chartered as bank-holding companies.

Canada’s banks make bad investments on occasion. When Toronto-based CIBC, Canada’s most aggressive big bank, took $3.5 billion in charges against the U.S. subprime debacle, federal regulators quickly arrived on the scene. But here’s the difference: CIBC ended up selling $2.94 billion worth of its own shares in the first quarter of this year to shore up capital reserves. “The relationship between government and banks is a positive one,” says Minister of Finance Jim Flaherty. “We have a lot of discussions and regular meetings. The common goal is a sound financial system.”

There is, of course, a flip side to Canada’s regulatory system. When the global economy was flying high, Canadian banks complained about not being allowed to merge to become more significant international players. “In hindsight, that decision may have saved Canada from having a Royal Bank of Scotland on its hands,” says Lawrence Booth, a finance specialist at the University of Toronto’s Rotman School of Management, referring to the overly ambitious bank’s bailout earlier this month by the British government.

Says FFlaherty: “The credit crisis we’re facing is the result of unbridled greed. We need to bridle greed.” Perhaps when world leaders sit down in Washington to forge a 21st-century New Deal for the global financial system, it may have more than a smattering of Canadian banking know-how.

Record $8.45-billion pulled from mutual fund market; index up almost 20% from October low

SHIRLEY WON AND ROB CARRICK

Mutual fund investors embarked on their biggest selling binge on record in the month of October, when the spiralling global financial crisis drove stock markets to one of their most dramatic drops in history.

Panicked investors in Canada yanked a record $8.45-billion from the mutual fund market in a stampede for the exits. It was the worst month for net outflows since the Investment Funds Institute of Canada (IFIC) began collecting data in 1990, and nearly doubled the previous record posted in September, which saw net outflows of $4.5-billion.

“October was an absolutely brutal month,” independent fund analyst Peter Loach said yesterday. “People are still taking refuge in cash and money market funds.”

Even as the market continues to rally into November, the net outflows of about $13-billion over the past two months are expected to spur more layoffs and industry consolidation, observers say.

Norman Bambrick, a 72-year-old retiree in Port Perry, Ont., was part of the wave in mutual fund selling last month. He bailed out of his bank fund after seeing his $200,000 investment in two accounts take a $12,000 haircut in 10 months. “The funds didn’t work out for me and I cashed them,” Mr. Bambrick said.

He now has most of his savings in guaranteed investment certificates and bonds.

As he watched the unit price of the bank fund plunge, he also worried about the security of his investment.

“I had a feeling that they were headed for a disaster,” he said. “I had no confidence in them.”

Investors headed for the exits as the S&P/TSX composite index lost 17 per cent in October after bouncing back from a 27-per-cent slide. The index has posted a 29-per-cent decline for the first 10 months of the year. The S&P 500 composite index also plunged 17 per cent last month for a more depressing 10-month loss of 34 per cent.

“It was a record month of fear,” said Frank Hracs, chief economist with Toronto-based Credo Consulting Inc. “October was way worse in terms of market psychology than September.”

But investor psychology is improving in Canada as the S&P/TSX index is now up almost 20 per cent from its lowest point last month, Mr. Hracs suggested.

“It appears that a lot of the ingredients for more stable financial market conditions have been put in place with lower interest rates, bailout packages and a U.S. election [which creates uncertainty] out of the way.”

Besides retail investors, there were also institutional investors leaving money market funds for better yields in short-term investments elsewhere, said Dennis Yanchus, manager of statistics for IFIC.

Two bank-owned fund giants took the biggest hits.

RBC Asset Management Inc., which also owns Phillips Hager & North Investment Management, suffered from nearly $2-billion in net redemptions, including $902-million in higher-margin “long-term,” or non-money market funds.

CIBC Asset Management saw nearly $1.4-billion in net outflows, while TD Asset Management Inc. posted $1.1-billion in net redemptions. “Many investors opted for guaranteed term products during the month,” said Tim Pinnington, president of TD Mutual Funds.

Among large Canadian public fund companies, IGM Financial Inc., which includes Investors Group and Mackenzie Financial, suffered from $489-million in net redemptions; CI Financial Income Fund, $340-million; AGF Management Ltd., $232-million; and DundeeWealth Management Inc., which owns Dynamic Funds, $171-million.

Invesco Trimark Ltd., formerly AIM Funds Management Inc., had $537-million in net outflows and Franklin Templeton Investments Corp. posted $465-million.

Companies like AIC Ltd., Sentry Select Capital Corp. and Fidelity Investments Canada, meanwhile, were handing out pink slips to employees last month.

“There will likely be more layoffs,” Mr. Loach predicted in an interview. And there will be more pressure on fund companies with less than $10-billion in assets to consider options like strategic alliances, whether it be a merger or a outright sale, he said.

On Monday, DundeeWealth said it struck a deal to sell its Quebec mutual fund and insurance sales force – including 340 advisers with $2.6-billion in assets – to Industrial Alliance Insurance and Financial Services Inc.

When Mavrix Fund Management Inc. reported a third-quarter loss yesterday, it said that total assets under management tumbled 45 per cent at the end of Sept. 30 to $395.8-million from a year earlier.

That included assets in mutual funds and resource flow-through limited partnerships.

Mavrix chief executive officer Malvin Spooner said his firm, which is half controlled by its employees, has been approached by potential buyers, but described them as “not serious” proposals.

“Should something fall into our lap, we would certainly examine it,” Mr. Spooner said. “But our intention currently is get through this market, which has put a lot of pressure on our valuation.”

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