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.

Here’s a better way to think about risk

by James Parkyn

Our job as investment advisors and portfolio managers is to capture returns from global capital markets while controlling portfolio risk. We do this by maximizing diversification, minimizing costs and seeking to make portfolios as tax efficient as possible.

A critical element in this work is matching portfolio risk to our clients’ risk tolerance. Your tolerance for risk depends not only on how comfortable you are with uncertainty, but also your capacity to take risk given your age, financial situation and life goals.

Last spring, Ken French, in association with Dimensional Fund Advisors, published an essay entitled Five Things I Know About Investing. French, a professor at Dartmouth College, is a giant in the world of finance who is best known for his work with Nobel Prize winner Eugene Fama.

The first part of his essay deals with risk. French proposes a definition of risk that steers clear of such technical concepts as volatility, standard deviation and beta. Instead, he defines risk as “uncertainty about lifetime consumption.”

He explains that people invest because they want to use their wealth in the future to achieve important goals like enjoying financial security, supporting the people and causes they care about and retiring comfortably. Risk is uncertainty about how much wealth it will take to achieve those lifetime goals.

“Some might plan to spend all the money on themselves for things like food, shelter, travel, recreation and medical care,” French says. “Others may plan to spend some of their wealth on political contributions, charitable donations, or gifts and bequests to their children…Investors like a high expected return because it increases the expected wealth that will be available to spend or give away. And everything else the same, risk averse investors prefer less uncertainty about their future wealth.”

In this light, the financial author Morgan Housel makes some important observations in his book The Psychology of Money about how risk and unforeseen events can jeopardize your future wealth.

“A plan is only useful if it can survive reality,” Housel writes in this excerpt from his book. “And a future filled with unknowns is everyone’s reality.”

According to Housel, surviving future unknowns to build wealth for lifetime consumption comes down to three things.

• First, more than big returns, you want to be financially unbreakable. In other words, you don’t want to take the kind of risks that will deplete your wealth and prevent you from benefitting from the power of compounding over the long term.

• Second, the most important part of your financial plan is to be prepared for things not to go as planned. You only have to think about the pandemic, the war in Ukraine or rising interest rates to know you should expect the unexpected. “Room for error – often called margin of safety – is one of the most underappreciated forces in finance. It comes in many forms: A frugal budget, flexible thinking and a loose timeline – anything that lets you live happily with a range of outcomes.”

• Third, Housel writes it’s vital to have a “barbelled personality” – optimistic about the future, but paranoid about what will prevent you from getting there. According to Housel, sensible optimism is a belief that odds are in your favour for things to work out over time even if you know there will be difficulties along the way. To make it to that optimistic future, you have to make prudent decisions and stay the course when things are looking bleak.

I encourage you to read Ken French’s essay to benefit from his other observations about investing. I also invite you to download the latest episode of our Capital Topics podcast where we discuss French’s essay in more detail.  

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.

Focus on tax optimization, not tax minimization

by James Parkyn

For many years, Canadians have been conditioned by investment industry marketing to focus on maxing out their RRSP contributions to realize as much income-tax deferral as possible.

While reducing taxes is always enticing, a tax minimization mindset may not be the best approach in the short term, especially for high-net-worth individuals. Instead, you should cultivate a tax optimization mindset.

What is a tax optimization mindset? It’s thinking not just about the current tax year, but how your assets will evolve over the long-term and planning to fund your retirement in a tax efficient way.

We like to discuss this issue with our clients by getting them to imagine three buckets. In the first bucket is assets in registered accounts – RRSPs, Registered Retirement Income Funds (RRIFs) and other similar accounts. When you withdraw money from them, you pay income tax on it.

The second bucket is for non-registered investment accounts and Tax-Free Savings Accounts (TFSAs). Here, income tax has already been paid on the money that went into the account, so you don’t have to pay when you withdraw funds from these accounts. Obviously, if you realize capital gains in these non-registered accounts, 50% of these gains will be taxed at your marginal tax rate.

The third bucket is for business owners who have moved earnings from their operating company into an investment holding company to defer paying personal income tax. Many entrepreneurs accumulate large amounts of money in their holding company and eventually have to pay tax on it, just like on their RRSP savings.

As they head to retirement, people are often focused on the year they will turn 71, knowing they must convert their RRSP into a RRIF by the end of that year. However, they fail to plan for the tax implications of having huge amounts of money in buckets one and three – accounts where they will have to pay income tax on withdrawals.

They work on the assumption they’ll have a large pool of savings to draw on during their retirement but, in reality, they could have only half the amount in after-tax dollars. What’s more, their mandatory RRIF withdrawals might trigger clawbacks on their old age security pension.

That’s why it’s so important to plan early for how you will fund your retirement tax efficiently.

Your plan should include maxing out your TFSA contributions. As I explain in this article, there are no taxes to pay on capital gains, interest or dividends in a TFSA and you withdraw your money from it free of income tax. That makes your TFSA a highly attractive investment vehicle that gives you tremendous flexibility in retirement income planning and in distributing assets to your children upon your passing.

Besides taking full advantage of your TFSA, your retirement income planning may also involve withdrawing money from your RRSP and holding company in the years before you reach age 71 to reduce your tax bill after that age.

While the right mix of assets in different accounts will depend on your individual circumstances, it’s never too early to take a long-term view and start planning.

With the end of the year fast approaching, it’s also time to make sure you’ve made all the moves you need to for your 2022 income taxes. These may include crystallizing capital losses to offset capital gains, making charitable donations and several other possible actions we discuss in detail in the latest episode of our Capital Topics podcast.

While tax planning keeps us busy at this time of year, please remember that optimizing your taxes should be a year-round process and that we’re always here to help.

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