Don't Fall Victim to Anxiety about Where the Market is Headed

By James Parkyn

When it comes to the stock market, some investors seem to believe in the old adage “what goes up must come down.” They worry that after such an outstanding year in the markets, we must be headed for a fall. This month’s downturn is no doubt feeding those fears.

One way this kind of thinking manifests itself is in a reluctance to invest new money in equities because the market is “too high.” Other investors take it a step further and actually sell stock with the intention of buying back in “after the correction, when prices are more reasonable.”

Before the recent bout of turbulence, the stock market had provided exceptional returns dating back to pandemic crash in February and March 2020. In 2021, the Canadian market was ahead 25.1%, its best year since 2009, while the U.S. market produced a Canadian dollar return of 24.6%.

The 2021 gains put equity valuations at relatively high levels, according to such metrics as the Shiller CAPE 10. However, the same observation was made at the beginning of 2021. Then, the S&P 500 went on to make 70 all-time highs during the year.

As author Larry Swedroe notes in this article, valuation metrics shouldn’t be used to try to time markets. “While higher valuations do forecast lower future expected returns, that doesn’t mean you can use that information to time markets,” Swedroe writes. “And you should not try to do so, as the evidence shows such efforts are likely to fail.”

The advice is equally true for market pullbacks and the days when markets hit an all-time high. These periods are often the trigger for the media and individual investors to start speculating about how portfolios should be readjusted on the fly. That’s when people make wealth-destroying errors.

The danger of succumbing to anxiety by selling equities or holding off on new investments is two-fold. First, you will have to make the thorny decision of when it’s safe to get back into the market. Second, you risk missing out on strong returns while you’re sitting on the sidelines. If you want to know how that feels, just ask anyone who sat out 2021.

When it comes to investing, the antidote for unhealthy emotions is a long-term financial plan with asset allocation targets that reflect your objectives and risk tolerance. As the markets move up or down, you periodically rebalance your portfolio back to your target asset allocations and keep your faith that the process works over time.

Your goal should be to cultivate a long-term investor mindset. Long-term investors ignore the day-to-day noise that comes with volatility and stick to their plan with discipline.

High Hopes for Future Returns Can Cloud an Investor’s Judgment

by James Parkyn

It’s been another outstanding year in the stock market. We will have the final performance numbers for you in the new year, but equities have continued a remarkable run that started in March 2020 when the COVID crash hit bottom.

While the strong results are certainly welcome, they appear to have conditioned many investors to hold unrealistic expectations about their future investment returns.

That’s the key conclusion from a survey of 8,500 individual investors in 24 countries and 2,700 financial professionals in 16 countries conducted by Natixis Investment Managers, a French financial services firm with US$1.4 trillion under management.

The survey found a huge gap between the returns individual investors expect to earn over the long term and what financial professionals say is realistic. Globally, investors anticipate annual returns of 14.5% over inflation while the financial professionals said 5.3% over inflation is realistic—that’s a whopping 174% difference.

Canadian investors were somewhat more conservative than their global peers, according to the survey. Individual investors in Canada expected annual long-term gains of 11.2% over inflation while financial professionals believed realistic returns for their clients were 5.1% a year.

By contrast, U.S. investors were even more aggressive in their return expectations than the global average. American investors anticipated 17.5% annual returns above inflation compared with the 6.7% financial professional said is realistic.

The research team at PWL uses an evidence-based approach for setting expectations for future returns for various asset classes and inflation. In our Financial Planning Assumptions paper, published in October, we estimated expected annual returns from a 60/40 equity/bond portfolio to be 4.86% above inflation.

Why are investors so optimistic about future returns? We can attribute it to what’s known as recency bias—a common error in thinking that leads people to give greater importance to recent events.

Clearly, many investors have grown accustomed to excellent portfolio performance. Even before the powerful rally that began in the early weeks of the pandemic, returns had been strong ever since the 2008-09 financial crisis. This has led them to expect it to continue and get even better in the future.

In the Natixis survey, investors identified market volatility as their No. 1 concern, yet their elevated return expectations suggest they’ve become desensitized to risk. We see this in a growing appetite for risky investments such as tech stocks, cryptocurrencies and special purpose acquisition companies (SPACs).

However, capital market history, valuation metrics and common sense suggest we should be tempering our return expectations after such a long period of exceptional performance, not ratcheting them up.

We are careful to control risk for our clients through broad diversification and periodic portfolio rebalancing. No one can predict what the future holds, but a patient, realistic view is the best way to build wealth over the long term.

As the year comes to a close, Francois and the whole PWL team join me in wishing you a happy holiday season and a healthy and prosperous 2022. We look forward to reviewing your portfolio with you in the new year.

Acting in the best interests of clients

by James Parkyn

Some of Canada’s big banks took quite a lot of criticism recently for their decision to stop selling mutual funds from outside companies through their financial planning arms.

CIBC, RBC and TD claim the decision to allow financial planners to sell only inhouse funds is in response to new regulations that come into effect at the end of this year. Those regulations are known as know your product (KYP) and are part of a larger package of client-focused reforms (CFRs) being brought in by the country’s securities regulators.

The KYP rules are designed to ensure investment firms and their advisors have a deep knowledge of the products they recommend to clients.

For firms, this means having policies, procedures and controls in place to monitor investments offered to clients and providing training to advisors on them. For advisors, it means recommending only firm-approved investments and demonstrating they understand what they are recommending and ensuring they are suitable for a client’s portfolio.

The overall goal of the client-focused reforms is to create a higher standard of advisor conduct that will put clients’ interests first. Essentially, it could be viewed as a codification and enhancement of industry best practices that many firms and advisors are already incorporating—from gathering detailed client information to demonstrating product knowledge to revealing potential conflicts and putting clients’ interests first.

The decision by the three big banks to stop selling third-party mutual funds sparked an outcry from critics in the media and the financial industry who say the banks are not acting in the best interests of their clients. They argue the banks are using the new rules as an excuse to sell only their own funds, which are more profitable for them, through financial planners in branches. (Third-party funds will still be sold by the banks’ full-service brokers and their online discount brokerages.)

Globe and Mail columnist Rob Carrick noted the banks are depriving investors of the opportunity to choose better alternatives available from third-party fund companies and said the three big banks are “effectively turning their planners into sellers of bank products.”

For my part, I hope the actions of these three big banks will lead clients to reflect on what they want and should expect from their investment advisor.

The country’s securities regulators introduced the new client-focused reforms after resisting calls to bring in the more rigorous fiduciary standard for investment firms in the face of stiff opposition from the industry.

At PWL Capital, we have long adhered to a fiduciary standard in our client dealings and have argued it should be applied throughout our industry. Under a fiduciary standard, a firm must put its client’s interests above its own and act strictly in a client’s best interest.

For many years, our firm has been accredited by the Centre for Fiduciary Excellence (CEFEX), a global organization that audits and certifies the processes of investment advisory firms.

CEFEX-accredited firms adhere to the Global Fiduciary Standard of Excellence. To obtain this accreditation, PWL was required to undergo an extensive “best interest” review—and, to maintain this status, we must undergo annual audits by CEFEX.

At PWL, we don’t have any in-house products. We have a list of approved securities that includes only investments that have been researched by the firm and approved by our investment committee.

These investments are all low fee and tax efficient. They offer no compensation to PWL, or the firm’s advisors, and they reflect our philosophy that passive portfolios and broad diversification are the keys to long-term investing success.

In all these ways, we demonstrate our steadfast belief that investment advisors must always act in the best interests of their clients. It is the bedrock upon which our firm is built.

The bonds in your portfolio are doing their job

by James Parkyn

It’s been another very good year for stocks and another lacklustre one for bonds. That’s led many investors to wonder whether they should be allocating more money to stocks and less to bonds.

To the end of September, Canadian stocks were up 17.5% this year while bonds were down 4% (including interest and dividend income). Despite this performance, our advice is to proceed cautiously when considering increasing the equity weighting in your portfolio at the expense of bonds.

Yes, stocks have had strong returns since the markets bottomed out from the COVID crash in March 2020 while rock bottom interest rates have meant paltry bond yields of little more than 1%.

However, bonds do more work than just contribute to your overall returns. They play a critical role in diversifying your portfolio by acting as a shock absorber when corrections hit the stock market.

This is because bonds—especially the short-term, high-quality ones we favour—are much less volatile than stocks.

That’s important to remember at a time when equity markets have been so strong for so long. Even before the rapid recovery from the pandemic shock, stocks had a great run dating back to the rebound from the 2008-09 financial crisis. The good times have desensitized many investors to risk as we see in the surge of speculative trading in hot stocks, cryptocurrencies and special purpose acquisition companies. But risk hasn’t gone away.

We can see the shock-absorbing effect of bonds through a metric known as the Sharpe ratio. Named for its inventor, Nobel laureate William Sharpe, it measures the performance of an investment compared to a risk-free asset, after adjusting for risk. When comparing two portfolios, the one with a higher Sharpe ratio provides a better return for the same amount of risk.

As economist and market strategist David Rosenberg demonstrates in this article the addition of a meaningful portion of bonds to a portfolio dramatically improves risk-adjusted returns.

Rosenberg calculates that an all-stock portfolio over the last five years had a Sharpe ratio of 1.08 compared to 1.2 for a portfolio composed of 60% equities and 40% bonds and 1.25 for a 50/50 mix. So, despite the low returns of bonds over the last five years, the Sharpe ratio increases because the bonds substantially reduce the volatility of the portfolio. The same pattern can be seen over 10-, 20- and 30-year periods.

Besides being a buffer against volatility in the stock market, there’s another reason why bonds are useful in a portfolio. When the stock market suffers losses, you can use your bond allocation to raise cash to cover your spending needs, while you wait for equities to recover. You can also use it to buy stocks when they are down.

Of course, a 100% stock portfolio will have higher expected returns, but it is also riskier. Good portfolio management involves finding the right balance between risk and reward given your goals and tolerance for risk.

The bottom line is we believe a bond allocation should viewed as a portfolio stabilizer, not an impediment to maximizing your returns. Experience has taught us that a lower volatility portfolio is going to produce better, more tax efficient performance over the long run than a highly volatile one.

So, don’t worry about your bonds, they’re doing their job.

4 essential investing lessons from the last two decades

by James Parkyn

At PWL Capital, we believe it’s crucial to take a long-term view of investing. That’s why I sat down recently with my colleagues François Doyon La Rochelle and Raymond Kerzérho to talk about our investing lessons since 2000 for an upcoming episode of our Capital Topics podcast.

The common denominator in our discussion was the importance of patience for successfully building your wealth over the long term.

You only have to consider the many momentous events that have occurred during the last two decades to understand why patience is so important. The list includes the bursting of the tech bubble in 2000, 9/11, the Afghanistan and Iraq wars, an extended bear market in 2001-03, the financial crisis of 2007-09 and, most recently, the COVID-19 pandemic.

Through it all, the stock market has kept going up. Since September 2001, the S&P 500 has gained an annualized 8.2% per year in Canadian dollars, while the S&P/TSX Composite in Canada is up an annualized 8.1%, and the combined MSCI EAFE and Emerging Markets index is up 6.6%.

If you had let your emotions get the better of you and bailed out of the markets in response to any of the events listed above (or the many others of lesser importance), you would have deprived yourself of those gains.

With that in mind, here are the four most important lessons to take away since 2000.

1. You don’t know what you don’t know

This phrase encapsulates the deceptively simple observation that no one knows what the future holds or what impact events will have on the markets. For example, no one could have predicted the terrorist attacks of September 11, 2001, or the devastation of the global pandemic.

Howard Marks, co-chairman of Oaktree Capital Management, summed up the importance of intellectual humility when investing this way: “No amount of sophistication is going to allay the fact that all of your knowledge is about the past and all your decisions are about the future.”

2. You can’t forecast the future, but neither can anyone else

This lesson is a corollary to the last. Despite the impossibility of predicting the future, many economists, analysts and active investment managers earn their money trying to do just that.

All the noise they create can lead you astray from your investment plan with dire consequences for your wealth.

3. Investor behaviour and discipline are crucial

To avoid pitfalls, it’s essential to develop a disciplined investing mindset. This means filtering out the noise of the moment and sticking resolutely to a long-term view that’s guided by your investment plan.

A well-designed investment plan is a roadmap you can return to when times are tough and you are tempted to stray off-course. Your portfolio should be aligned with your risk tolerance and risk capacity. It should also be tax efficient and broadly diversified. These are the factors you can control.

4. Evidence-based investing works

I recall in 2003 when as a firm we made the decision to implement fully passive portfolios. My experience in the years that followed has confirmed my belief that adhering to scientifically verified principles of sound investing is the best way for our clients to have a successful investing experience.

It has produced solid investment results for them and remarkable growth for PWL Capital as more and more people have embraced the power of low-cost passive investing and the other best practices we follow. It’s an approach to investing that gives clients the confidence to stick with their investment plan through good times and bad.

Be sure to download our podcast to hear more investment lessons from the past two decades. You can also learn more about the fundamentals of evidence-based investing by downloading your free copy of our eBook, 7 Deadly Sins of Investing.