The silver lining from a tough year in the markets is higher expected returns.

by James Parkyn

Anyone who is familiar with PWL Capital will know we don’t make predictions about the future direction of financial markets, the economy or anything else.

We accept the large volume of academic research confirming that no one can accurately forecast the future. Renowned economist John Kenneth Galbraith may have captured our attitude best when he said: “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.”

Nevertheless, we still need estimates of future investment returns to use in financial planning models for our clients. For this purpose, we use future expected returns, and they are quite different from predictions made by analysts, pundits and gurus.

In estimating future returns our research team at PWL doesn’t pretend to know what will happen in the markets or the economy in advance. Instead, they take the average of all possible return scenarios for a broadly diversified portfolio of publicly traded investments over a 30-year time horizon.

They generate these scenarios by combining observations of current market conditions and more than 120 years of historical returns for various asset classes.

Of course, we don’t know which scenario will come to pass in the markets in any year, which explains why our research team also estimates standard deviation – the percentage that an actual return could fall above or below our estimate in a given year.

This last point is important. In the short-term, returns will likely be substantially different from the expected return. Over the long-term, however, the dependability of the expected return estimate increases (although there remains a substantial margin of error). 

Last year was an example of short-term returns coming in far below long-term expectations for both the stock and bond markets. Both asset classes fell by double-digit percentages for one of the few times in history.

That was painful for investors, but the silver lining is that those market declines improved long-term expected returns, especially for bonds. We can see this in PWL’s recently published update of our Financial Planning Assumptions, authored by Ben Felix, Portfolio Manager and Head of Research, and Raymond Kerzérho, Senior Researcher and Head of Shared Services Research.

It shows that higher bond yields in 2022 produced a remarkable increase in our estimate for expected bond returns going forward. It climbed to 4.15% a year from 2.5% the previous year.

Gains in expected returns for stocks were less impressive because PWL’s equity estimates are based much more on historical returns than on current market conditions. Our estimated return for global stocks is 6.9% a year, compared to 6.6% a year earlier.

For a balanced portfolio composed of 60% stocks and 40% bonds, PWL estimates an expected return of 5.81% annually. Again, we can expect actual returns to deviate widely from this estimate in any given year.

Specifically, if we say the expected return is roughly 6% with a standard deviation of 9%, it means that two-thirds of the time, annual returns will be between -3% and +15%. The other third of the time the deviation will be even further from the mean. This is why investing often calls for patience and discipline.

PWL’s Financial Planning Assumptions makes a few other observations that may come as a surprise to you. Our research team estimates inflation at 2.4% annually over a 30-year-time horizon. That’s well below the current 5%+ inflation rate in the U.S. and Canada.

The report also estimates future returns for Canadian residential real estate market. Here, the recommended planning assumption is that an investment in a primary residence will return just 1% a year net of inflation, or 3.4% including inflation.

Return estimates are an important planning tool, but you should always keep in mind that we can’t know in advance what markets will return. Instead, you should seek to capture available returns as efficiently as possible while controlling risk through broad diversification and prudent asset allocation.

Then, it’s a matter of keeping the faith and patiently letting compounding do the work of building your wealth.

I encourage you to download a free copy of PWL’s Financial Planning Assumptions, and for more insights on investing and personal finance, listen to our Capital Topics podcast and subscribe to never miss an episode.

The experts’ crystal balls were as foggy as ever in 2022

by James Parkyn

To kick off the new year, our Capital Topics podcast looked at investing lessons from 2022. In this article, I want to focus on two of those lessons because they are so important for your financial health.

For our first lesson, we looked at last year’s events to see what they could teach us about what’s to come in 2023.

That’s just what’s done by the many financial experts who produce forecasts about the economy and the markets. We take a different approach. We look at those forecasts and wonder why anyone would pay attention to them.

To understand our attitude, let’s step back a year and consider some of the events you would have had to predict at the beginning of 2022 to have made winning bets.

• Russia’s invaded Ukraine to start the biggest land war in Europe since 1945.

• For the first time ever, both U.S. stocks and long-term bonds registered double-digit losses for the year. Value stocks outperformed growth by the largest margin since 2000, amid a tech stock crash.

• Runaway inflation took hold around the world, including rising to a 40-year high in the U.S. Major central banks hiked interest rates aggressively in response.

• China abandoned its zero-COVID policy as its economy stalled and widespread street protests emerged.

No one could have predicted these developments, but that’s not unusual. Every year, the markets are buffeted by unforeseen events that make a mockery of expert forecasts. If you want another example, look no further than early 2020 and the start of the global pandemic.

Yet, economists, analysts and money managers continue to confidently predict what’s going to happen at the beginning of each year. Why? It’s precisely because the future is unknowable that people crave the illusion of certainty that comes from predictions.

“The inability to forecast the past has no impact on our desire to forecast the future,” financial author Morgan Housel writes. “Certainty is so valuable that we’ll never give up the quest for it…”

Despite this deep need for certainty, one of our most important lessons from 2022 is to ignore the forecasts and outlooks. Instead, we recommend you focus on maintaining a steadfast commitment to controlling risk through broad diversification and a long-term investor mindset for whatever may come in 2023.

The second lesson we take from 2022 is related to the first. It’s to watch out for hindsight bias in your thinking and decision-making. This is the tendency to look back and delude yourself into believing you knew what was going to happen all along.

Writing in the Wall Street Journal, Jason Zweig explained it this way: “Countless hunches and gut feelings flicker through our consciousness over the course of a year. We naturally remember the ones that turn out to be right. The multitude of other hunches that turn out to be wrong go into our mental garbage can.”

Zweig writes that that hindsight bias translates into “what if” thinking. What if I’d only acted on this or that hunch last year, I would be so much richer today. However, our memory of past predictions is often faulty.

To prove the point, Zweig surveyed readers of his newsletter in late 2021 and asked them to forecast where a series of market indicators would be in a year’s time. Then, a year later he asked them to recall those predictions with the knowledge of how the year had actually turned out.

On average, the readers’ recollection of their forecasts was closer to how the markets actually performed in 2022 than their predictions back in 2021, which turned out to be far too optimistic.

This points to the human tendency to reconstruct the past based on what we know now. As Zweig notes the danger is that mistakenly thinking you knew what was going to happen in the past may lead you to think you know what’s going to happen in the future.

For more insights on how to navigate the markets, please check our PWL team website. And if you’re not already a listener of our monthly Capital Topics podcast, I encourage you to download the latest episode and subscribe to receive future episodes. 

Our best investment advice of 2022

by James Parkyn

As 2022 draws to a close, we wanted to look back at the blog posts that drew the most positive reaction from our readers during the year.

As markets gyrated, the focus in 2022 was on how to deal with a protracted downturn and prepare for the next bull market. I looked at everything from how to keep a tight rein on your emotions to avoiding poor decisions when markets are falling to the importance of not falling prey to unhelpful predictions.

1. You can’t catch a market rebound if you’re not invested—U.S. stocks and bonds suffered through one of their worst ever six-month periods to start the year. The Canadian markets were also down, although by a smaller margin. Naturally, these declines made many investors nervous about just how bad the losses would get. Then, the markets rebounded powerfully over the summer. A similar pattern played out in the fall. A steep decline in September was followed by rebound in October and November. These episodes show just how fast the markets can move.

2.  4 ways to prepare for the next bear market—I wrote this piece before the U.S. stock market had fallen into bear market territory by dropping more than 20% during the spring. It contains timeless advice on how to prepare for serious market downturns and ride them out when they inevitably come.

3. Ask yourself this simple question before changing your portfolio—From the field of behavioural finance we know that people tend to feel the pain of losses much more intensely than the joy of gains. That’s why falling markets can provoke so much anxiety and lead investors to make wealth-destroying decisions. One way to deal with the temptation to overhaul your portfolio in the heat of the moment is to ask this simple question: Once I make this move, then what?

4. Will higher interest rates push the economy into recession? —Predictions come in many shapes and sizes. This year the media has been focused on how high interest rates will have to go to bring down inflation and whether these hikes will push the economy into recession. In this article, I discuss an interview with former Bank of England Governor Mervyn King who offers some sage advice about the value of predictions. (Spoiler: He’s not a big fan.)

5. Does diversification still make sense? —With stocks and bonds falling around the world this year, there seemed to be no safe harbour. Since the financial crisis of 2008-09, global markets have appeared to move in lockstep during times of trouble. This has led some investors to question the value of portfolio diversification. I take a closer look at this question with the help of the Credit Suisse Global Investment Yearbook, which is a guide to historical returns for all major asset classes in 35 countries, stretching back in most cases to 1900.

To get more advice on investing and personal finance, please subscribe to our Capital Topics podcast and download our popular eBook, Seven Deadly Sins of Investing.

We hope you are enjoying a restful and joyous holiday season and the whole team joins in wishing you a healthy and prosperous 2023.

Our Best Bear Market Advice from the First Half of 2022

by James Parkyn

The first six months of 2022 were brutal for investors around the world.

Runaway inflation prompted central banks to hike interest rates and that led to worries the economy would be thrown into recession. At the same time, China’s harsh response to COVID outbreaks and the war in Ukraine compounded supply chain disruptions and economic uncertainty.

Markets around the world dropped in response. And it wasn’t just stocks. The bond market, which is supposed to be a safe harbour when the stock market turns stormy, also fell sharply in response to rapidly rising rates. 

Personal finance author Ben Carlson described the first half of 2022 as one of the worst six-month periods ever for stocks and bonds. According to Carlson, returns from a portfolio composed of 60% U.S. stocks and 40% bonds were in the bottom 2% of rolling six-months returns going back to 1926.

And those losses were mild compared to the crash in formerly high-flying speculative assets such as cryptocurrencies, non-fungible tokens and special purpose acquisition companies (SPACs). 

Over the last six months, I’ve written a series of blogs that brings together our best advice for coping with a bear market. Before we recap the highlights of those articles, let’s take a quick look at some key numbers from the fist half.

To June 30, Canadian short-term bonds were down 4.35% and the total bond market, which is the most widely followed benchmark for bonds in Canada, was down by a shocking 12.19%. It’s rare to see such negative numbers in the bond market. The last time a drop of this magnitude happened was in 1994.

Earlier in the year, Canadian stocks outperformed other international markets, thanks to the rocketing price of crude oil and other commodities. However, the Canadian market has been losing ground in recent months and ended the first half down 9.87%.  

One bright spot was large and mid-cap value stocks, which we tilt portfolios towards. In Canada, they had a year-to-date performance of 0.78% versus -20.38% for growth stocks. Small cap stocks have, however, followed the trend downward, they were -13.2%.

In the U.S., we are in bear market territory with the total market is down to June 30 by 21.1% in U.S. dollar terms and 19.4% in Canadian dollars. Here again, large and mid-cap value stocks outperformed growth at -11.01% year to date versus -26.55% for growth stocks.

It’s at times like these that it’s crucial to go back to the fundamental principles of good investing. Here are some of the core concepts I discussed in blogs in recent months that are especially relevant in the midst of a bear market.  

1. Don’t let anxiety drive your investment decisions—The illusion you can time the ups and downs of the market leads many investors to commit wealth-destroying errors. Consider what happens if you sell to avoid more losses. First, you will have to grapple with the notoriously difficult challenge of deciding when it’s safe to get back into the market and second you will risk missing out on strong returns while you’re sitting on the sidelines. Tune out the short-term noise from the media and accept that no one can forecast when the market will go up or down.

• Cultivate a long-term investor mindset—Bear markets are when investors learn their true tolerance for risk. The emotional pressure to decide and act can feel overwhelming at times. But panic almost always leads to a permanent loss of capital. That’s why it’s crucial to be mentally prepared and stick to a plan based on scientific principles. It should include broad diversification across assets and geographies and periodic rebalancing back to target allocations to position yourself to reap future returns. Louis Simpson, who managed the investment portfolio for Berkshire Hathaway’s insurance company GEICO, once said: “We do a lot of thinking and not a lot of acting. A lot of investors do a lot of acting and not a lot of thinking.” 

• Short-term pain in the bond market will lead to long-term gain—Losing money in what supposed to be your portfolio’s safe bucket is unpleasant. However, higher interest rates will lead to better bond returns in the long run. Investors, who have suffered through years of rock bottom bond returns, should want rates to rise, even if it means some capital losses in the short-term.

• Diversification is still your best strategy–It has often seemed in recent years that when trouble strikes, the markets tend to move down together. This raises the question: Does diversification still do the job it’s supposed to do: increase expected returns while reducing risk? The Credit Suisse Global Investment Returns Yearbook is a guide to historical returns for all major asset classes in 35 countries, dating back in most cases to 1900. The 2022 edition includes an examination of diversification across stocks, countries and asset classes. Among the authors conclusions is that “globalization has increased the extent to which markets move together, but the potential risk reduction benefits from international diversification remain meaningful.” They also note that international diversification is particularly important in small markets like Canada and highlight studies showing that most investors are woefully under-diversified.

A wise man once said: Expect the unexpected and you won’t be disappointed. It hasn’t been an easy time, but market history shows that the best way to ride it out is to tune out the noise, develop a long-term investor mindset and keep your focus on the fundamentals.

Be sure to check out our Capital Topics website where you will find all our podcasts and blogs to help you become a better investor.

The Bear Market in Bonds: Short-Term Pain, Long-Term Gain

By James Parkyn

Most readers will be aware that Canada and the rest of the world have an inflation problem. You’ve no doubt noticed on your trips to the grocery store, your local restaurant, or Canadian Tire that prices are up for all sorts of things.

You also probably know that central banks are fighting inflation by increasing interest rates to cool down the economy. The other day, the Bank of Canada increased its benchmark rate by 0.5%, the largest one-time increase in over 20 years. It’s a safe bet the U.S. Federal Reserve will raise its rate at its next meeting in May. And both banks are expected to announce several more hikes in the months ahead.

What you may be less aware of is the extraordinary effect rising interest rates are having in the bond market. They’ve created a bear market like nothing we’ve seen since the mid-1990s.

You can be forgiven if you don’t follow twists and turns in the bond market. It’s usually quite staid compared to its flamboyant cousin, the stock market.

The stock market’s ups and downs are driven by investor emotions and that naturally draws the attention of the media and the public. By contrast, movements in bond prices are much more driven by boring, old math.

Bond yields—the current interest rate paid by bonds—move in the opposite direction to bond prices, meaning rising interest rates cause falling bond prices. This is because investors who wish to sell bonds have to accept lower prices since the purchasers of those bonds now expect to earn the new higher interest rates.

This effect has meant a steep decline in bond prices this year in response to higher rates. The FTSE Canada Universe Bond Index—the benchmark for bond ETFs held by many Canadians—is down 8.5% (excluding interest payments) year to date and 10.8% since hitting its high mark of the last 12 months in August 2021.

A decline of that size would be bad enough in the stock market; in the normally less volatile bond market it’s an epic debacle. In fact, there have only been two other bear markets on this scale in the Canadian bond market since 1980 – in 1980-81 and in 1994. The one in 1994, which also occurred in the U.S. was dubbed by our southern neighbors the Great Bond Massacre!

This year’s decline will be unsettling for investors, especially because the bond portion of their portfolios is supposed to be the “safe” bucket. However, there a couple of mitigating factors to keep in mind when thinking about this bear market.

The first point is that the decline in bond prices is more pronounced when you hold bonds with longer maturities. The longer a bond’s duration, measured in years, the more sensitive its price is to changes in interest rates.

Short-term bonds, as measured by FTSE Canada Short Term Bond Index, have lost 3.3% (again excluding interest payments) this year and 5.8% since hitting its high of the last twelve months in April 2021. This is still a significant drop, but a lot less severe than the one for longer dated bonds.

In our client portfolios, we prefer short-term bonds with maturities ranging from one to five years. The ETFs we use have a duration of roughly 2.7 years which compares to 7.9 years for the FTSE Canada Universe Bond Index.

Besides being less sensitive to interest rate increases, short-term bonds also provide better protection against rising interest rates in response to higher inflation and are less volatile than longer maturity bonds.

They offer better protection against rising interest rates because with shorter maturities, the portfolio turns over more rapidly, and the bonds can be reinvested at higher rates more quickly. In this context, it’s important to keep in mind that high inflation is a greater risk than rising interest rates because it eats into the value of your savings.

The second point to remember is that higher interest rates lead to better bond returns in the long run. Long-term investors, who have suffered through years of rock bottom interest rates, should want rates to rise, even if it means some capital losses in the short-term.

This is one clear case where short-term pain will produce long-term gain.