Ask yourself this simple question before changing your portfolio

by James Parkyn

We know from the field of behavioural finance that people tend to feel the pain of losses much more deeply than the joy of gains. That’s why a bear market like the one we’ve experienced this year can be so hard to take.

When the markets become turbulent, most investors know they should keep a tight rein on their emotions. But in the heat of the action, when markets are sinking, it’s not easy.

There’s just so much uncertainty. You don’t know how bad the bear market will get or how long it will last. And don’t look to the media for help. Stock market commentators tend to focus on the negative and trot out clichés like “It’s a stock-pickers market” or “Buy and hold is dead.”

These bromides encourage people to trade their investments, but if you’re tempted to veer away from your long-term financial plan, ask yourself one simple question: Then what?

Once you make the decision to sell stocks to avoid further losses, what comes next? At some point, you will have to buy back into the market. But how will you know when it’s safe? In the meantime, you risk missing out on returns when the markets rebound.

Or you might be persuaded to purchase an actively managed mutual fund based on its past performance. However, we know that only 18% of actively managed Canadian equity funds outperformed their benchmark over the 10 years to December 2021, according to the S&P SPIVA Canada Scorecard. Actively managed U.S. and international funds have similarly dismal track records.

If the mutual fund you’ve chosen underperforms, then what? Do you go in search of yet another fund in hopes it will do better? Or perhaps you try your hand at picking individual stocks even though we know investors tend to fare even worse when they try this DIY approach.

In an insightful column, David Booth, Executive Chairman of Dimensional Fund Advisors, acknowledges that the uncertainty of the markets and life is highly challenging for people. However, he also observes that with uncertainty comes opportunity.

“Most of what happens in our lives is unpredictable, and it’s impossible to forecast the future,” Booth writes. “But you can live your life fully without knowing what’s going to happen. And you can have a good investment experience without forecasting what the market is going to do, because you’re not trying to guess which companies will succeed and when. You’re investing in the ingenuity of people to solve problems and make their companies run better.”

While the future course of the markets is impossible to predict, we can control how much risk we take; how broadly we diversify our investments; and who we turn to for financial advice.

When our emotions start to boil, we can remind ourselves that the key to investing success is to remain in markets long enough for compounding to work its magic. Blogger Ben Carlson put it this way: “The bedrock of my investment philosophy is based on the idea that it’s best to think and act for the long-term. But you have to survive the short-term to get to the long-term.”

Your goal should be to make decisions based on a well-structured financial plan and a tried-and-tested evidence-based approach to investing.

Then what? Then, you face the future with courage and optimism and let time do its work.

For more insights on how to navigate the markets, please download our eBook the Seven Deadly Sins of Investing. 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.

It’s a terrible time to be bailing out of bonds

by James Parkyn

Most readers of this column will be familiar with the unfortunate tendency of some investors to buy high and sell low. They rush into rising markets and flee when they come back to earth.

That’s a pattern we usually see in the stock market, although this year U.S. equity investors have shown patience in the face of falling markets. Where they’ve been running from is the usually staid world of bond funds.

Bond prices have been going through a downturn in 2022 like we haven’t seen in 40 years. Our latest market statistic report shows the total global bond market (hedged to Canadian dollars) was down 12.3% to the end of September, while the Canadian total bond market was down 11.8%.

Those are pretty horrible numbers for what’s supposed to be the safe bucket in your portfolio. Investors in the U.S. have responded by cashing out of bond funds in droves. Morningstar data shows that year-to-date to August 31, US$330 billion had flowed out of U.S. bond mutual funds and ETFs. Surprisingly, the opposite has occurred in Canada where bond mutual funds saw net inflows of $1.3 billion and bond ETFs saw net inflows of $4.5 billion.

The discrepancy in bond fund flows between the two countries is hard to explain; however, Canadian balanced funds—those that hold a mix of stocks and bonds—followed the U.S. pattern, experiencing a net outflow of $6.5 billion for the year.

Those investors who are fleeing bonds are focusing on the short-term pain they’ve experienced from falling fund prices but are missing out on the several reasons why bonds have actually become more attractive this year for long-term investors.

Before we look at those reasons, let’s recall why it’s been such a challenging year for bonds. Coming out of the pandemic, inflation has been surging around the world. That’s prompted central banks, including the Bank of Canada and the U.S. Federal Reserve, to raise interest rates aggressively to cool the economy and bring down inflation.

What’s more, central bankers, led by Fed Chairman Jerome Powell, have also been clear that they will do what it takes to bring price increases under control, meaning they will keep raising rates until the inflation rate comes down to around their target of 2%.

Bond prices are inversely related to interest rates so that when rates rise, bond prices fall. Therefore, rising rates have meant capital losses on bond investments. But when watching bond fund prices drop, it’s important to remember the other side of the equation – falling prices mean bonds are paying higher interest rates, or in industry parlance, they are yielding more.

In fact, rising interest rates are creating a whole new investment landscape from the one we’ve known since the financial crisis of 2008-09. The rock-bottom interest rates we’d become accustomed to are now in the rear-view mirror.

Bonds are generating more interest income than in years past and that increases expected portfolio returns – good news for long-term investors. That’s the first reason why it’s a better time to invest in bonds than it was a year ago.

The second reason is that bonds will continue to be an important diversifier for your portfolio and thus reduce its riskiness – even in periods of rising interest rates.

The stock and bond markets have been relatively well correlated this year – going down in tandem – but that’s a highly unusual occurrence. Bond prices usually have a lower correlation with stocks than most other major asset classes and are also less volatile.

Mark Haefele said in his weekly blog, published on September 26th that History suggests bonds will resume their traditional role as a diversifier. Periods when 12-month rolling total returns fall simultaneously for both stocks and bonds have been followed by periods of strong bond performance. In fact, since 1930, the 12-month bond performance following such periods has been positive 100% of the time.

No one can predict the course of interest rates, as former Bank of England governor Mervyn King has pointed out. However, the picture for bonds has brightened not worsened this year. If anything, investors who reduced their bond holdings in favour equity during the long period of low interest rates may want to revisit their asset allocation.

For more insights into investing and personal finance, please download our Capital Topics podcast.

Will higher interest rates push the economy into recession?

by James Parkyn

With so much global economic uncertainty, investors are more sensitive than ever to the comments of central bankers. They parse every word, trying to figure out how high interest rates will go and whether the hikes will push the world’s major economies into recession.

A couple of weeks back, we saw just how sensitive the markets can be to the words of Jerome Powell, Chairman of the U.S. Federal Reserve, the most powerful central bank in the world.

At the Annual Economic Symposium in Jackson Hole, Wyoming, Powell said the Fed’s “overarching focus right now is to bring inflation back down to our goal of 2%.” He went on to say that “restoring price stability would take some time and requires using our tools forcefully to bring demand and supply into better balance.”

The market interpreted the statement that there will be no quick respite from large interest rate increases, raising the odds of a severe recession. The S&P 500 dropped by over 4%.

Central bankers must be careful about every word they utter publicly because they can have that kind of outsized effect on the markets. That’s why I like to listen to what former central bankers have to say because they can speak more freely about the current situation and what’s led to it.

I recently came across an interview with the former Bank of England Governor, Mervyn King, that I found highly insightful and recommend to everyone interested in where interest rates might be headed in the coming months.

King, who was Governor from 2003 to 2013, calls inflation a sign of a sick economy because wages are constantly chasing after rising prices, creating instability and hardship for households and businesses. That’s why it’s so important to bring inflation under control as quickly as possible.

King believes the current bout of the inflation is the result of two errors committed by the major central banks and the economists who advise them.

When the pandemic hit, central banks printed money to stimulate spending and boost demand. At the same time, you had governments injecting massive stimulus into the economy through direct support programs for households and businesses.

However, the pandemic caused a shutdown of economies, constraining production and the supply of goods and services. “You [had] a classic case of too much money chasing too few goods and the result of that is inflation,” says King, speaking in May. He believes government stimulus should have been sufficient to support the economy without the need for central banks to print money.

The second mistake was to rely on economic models that failed to take into account what was actually happening in the economy and instead relied on inflation targets. King noted central bankers can’t make inflation return to a 2% simply by setting a target. Words have to be backed by aggressive interest rate hikes to bring demand back into balance with supply.

As we saw during the inflationary spiral of the 1970s and 1980s, the sooner tough action is taken the better to avoid the need for even more draconian action in the future, he says.

As if they’d listened to King’s advice, that’s exactly the approach that’s been taken in recent months by the Federal Reserve under the leadership of Powell and the Bank of Canada under Governor Tiff Macklem as well as by other central banks. They’ve hiked rates aggressively and clearly signalled more increases are to come until inflation is brought under control.

How high will interest rates go? King says there is no way to know in advance. But he does note the near-zero rates in recent years were historically unusual and unhealthy for the economy because they distorted investment decisions. Will the rate hikes cause a recession? Here again, he won’t make a prediction, except to say it’s likely but not inevitable.

In fact, this former central banker doesn’t have a high opinion of forecasts in general. Who predicted, for example, the pandemic in 2020 or the Russian invasion of Ukraine this year?

“The mistake is to believe you can make accurate forecasts,” he says. “The more important thing to do is not to pretend that we know inflation is going to be 3.2% in a particular year but try to identify the risks. What are the risks on the upside and the downside? What actions can we take to mitigate those risks?”

This is exactly the approach we take in managing investments. We don’t try to predict the future but instead construct portfolios that reap returns from markets while prudently managing risk.

No one knows how high interest rates will go or whether a recession is in the offing. But we can prepare ourselves for different scenarios and then meet challenges as they come with patience and optimism.

For more insights into investing and personal finance, please download our Capital Topics podcast.

You can’t catch a market rebound if you’re not invested

by James Parkyn

What a difference a month can make. At the end of June, I shared some pretty grim market numbers from the first half of 2022.

It was one of the worst ever six-month periods for U.S. stocks and bonds. South of the border, stocks dropped 20%, falling into bear market territory, while bonds were down 8.8%, the biggest decline in four decades. In Canada, stocks were down 9.9% while bonds were off 12.2%.

Then, the markets rebounded powerfully. As of August 18, the U.S. stock market had recovered 13.2% in U.S. dollars while Canadian stocks had gained back 7.4%. The Canadian bond market gained 2.6 % in that same period.

The turnaround may seem surprising but actually, it isn’t unusual, judging by the historical market data presented in a recent webinar from Dimensional Fund Advisors. The webinar highlighted the fact that stock market declines of 20% or more occur fairly regularly and so do bounce backs.

Between 1979 and 2021, intra-year declines in the U.S. stock market averaged 14% from peak to valley. In 10 of those years, the drop was 20% or more. However, when looking at the market history of annual returns, only 8 of the last 46 years were negative.

So, at some point in a year you’re going to have a decent correction if not a bear market, but it doesn’t necessarily mean the year will end in negative territory. That’s why it’s so important to prepare yourself for market declines and not give into fear during those episodes.

The last time we had a first half as bad as this year was in 1970 when the S&P 500 lost 21%. Today’s investors can imagine just how gut-wrenching that must have felt. But in the second half of that year the market rocketed 29% higher and the S&P 500 finished the year at +4%.

Investors who sold their stocks that year because they feared more losses would have ended up missing on a huge rally and gain for the full calendar year.

Indeed, trying to time the market by jumping out to avoid losses and then getting back in when things appear calmer is often a very costly mistake as Dimensional demonstrated in another chart presented during the webinar.

It shows that had you stayed invested in the U.S. market during the 25-year period from 1997 to 2021, $100,000 would grown to slightly more than $1 million, or 10 times your initial investment

Of course, it wasn’t all smooth sailing during those years. There were many times when you could have become spooked by a market decline and decided to go to cash.

If you had and missed out on the best month during this period, your returns would have melted to $865,000. Had you missed the best three months, you would have earned just $731,000.

And as the presenters remind us, you would have also given up a lot of peace of mind. It can be just as stressful to be out of the market when it’s rising as it is to be in it when it’s falling

Now, I’m not predicting that when the end of 2022 rolls around the stock market will show a positive return for the year. We don’t know what’s going to happen between now and then.

However, the reason we earn returns from stocks and bonds is because we are willing to accept a measure of uncertainty and risk in return for the expectation that returns will be positive over time.

And while positive returns don’t come every day, the longer you are in the markets, the more you should expect positive returns. Therefore, the antidote to volatility is to stick to your financial plan and keep focused on the long-term.

As we saw last month, the markets can turn quickly and rise substantially in a short period. To capture those returns, you must be invested.

I encourage you to watch the full Dimensional webinar where not only bear markets but also inflation and recessions are discussed. And be sure to listen to our Capital Topics podcast for more insights into evidence-based investing and personal finance.

Sources: Quotestream and Dimensional Fund Advisors

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.