How to avoid being tricked by hindsight bias

How to avoid being tricked by hindsight bias

By James Parkyn

In late 2021, Wall Street Journal personal finance columnist Jason Zweig asked readers to guess how several financial markets would perform in the year to come as well as where interest rates would at the end of the year.

The following December, Zweig surveyed the same readers again. This time, he asked them to try to recall what they’d predicted the previous year. Then, he compared their recollections to what actually happened in 2022.

He called this little quiz the Hindsight Bias Buster, so it should come as no surprise that readers were way off when they tried to remember what they’d predicted a year earlier.

You will recall that 2022 was a terrible year for investors, marked by soaring interest rates and double-digit losses in both the U.S. stock and bond markets. When Zweig’s readers thought back to their predictions, they remembered being far less bullish at the start the year than they actually had been in real time.

The reason for the discrepancy can be attributed to what behavioural psychologists call hindsight bias. It’s when your knowledge of what actually happened shapes your beliefs about what you’d predicted would happen. As Zweig explains: “It makes us all think we had a better idea of how the past year would unfold than we really did—which, in turn, makes us more confident in our hunches about this year than we probably should be.”

Let’s see how this might play out with regard to the year just past and this year. After a strong 2023 in the markets, it may be difficult to remember that many observers were making gloomy predictions at the beginning of the year. Back then, they forecast that high interest rates would cause a recession that would, in turn, hurt the markets. In fact, the economy proved highly resilient and the prospect of falling interest rates sparked a massive stock market rally at year-end.

Today, it would be natural to fool yourself into thinking you knew all along that the markets would bounce back in 2023. And this distorted hindsight could cause you to become overconfident in guessing how 2024 will unfold. However, the bottom line, as we often remind readers, is that we have no way of predicting what the future holds.

A closely related psychological pitfall to hindsight bias is recency bias. It’s the tendency to give more weight to occurrences in the recent past. For example, a soaring U.S. stock market in the last year might lead you to want to bail out of other global markets and put all your chips into equities south of the border.

If we look further back in the history, we will see the danger of this kind of thinking. For example, following the exceptional run-up in the U.S. market during the dot.com era of the 90s, investors suffered through 2000-2009, a period that came to be known as “the lost decade” for U.S. stocks. In those years, the S&P 500 Index recorded one of its worst 10-year performances with an annualized compound return of minus 0.95%, according to Dimensional Fund Advisors.

What can we say about 2024 without making predictions? Higher interest rates have brightened the long-term picture for investors. Of course, that doesn’t necessarily mean 2024 will be a positive year for stocks or bonds, but as Vanguard noted in its 2024 outlook: “For well-diversified investors, the permanence of higher real interest rates is a welcome development. It provides a solid foundation for long-term risk-adjusted returns.”

The antidote to both hindsight bias and recency bias is a sound financial plan built upon a broadly diversified portfolio that reflects your risk tolerance. Then, your job is to remain invested through good times and bad, patiently allowing the markets to do their work over time.

For more commentary and insights on investing and personal finance, be sure to listen to our latest Capital Topics podcast and subscribe to never miss an episode. And download your free copy of our popular eBook Investing Life Skills for Early Savers. It’s designed for young people starting out on their investing journey but its tips apply to investors of every age.

Our best investment advice of 2023

Our best investment advice of 2023

By James Parkyn

This year has been one of recovery in the markets. But to benefit, you had to once again remain patient and keep a long-term perspective, especially through a sharp pullback in the markets this fall.

Through much of the year interest rates continued to rise as central banks kept up their battle against inflation. Then, with progress being made on inflation and the North American economy remaining surprisingly resilient, investor hopes for a soft economic landing and lower rates in 2024 began to rise. That sparked an impressive rally in the stock market in the final months of the year.

As 2023 comes to a close, we wanted to look back at some of our most popular blog posts.

1. The silver lining of a tough year in the markets is higher expected returns—2022 was an especially painful one for investors with both the stock and bond markets falling by double-digit percentages. The good news is that those declines led to a substantial improvement in future long-term expected returns. Higher bond yields were especially welcome for investors who have experienced nearly 15 years of ultra-low yields, including periods when they didn’t even keep pace with inflation.

   In PWL Capital’s latest Financial Planning Assumptions, our estimate for expected annual bond returns jumped to 4.19% from 2.48% at the end of 2021. Our expected return for a broadly diversified 60/40 stock/bond portfolio rose to 5.75% from 4.97%. The improvement could allow investors to reduce the riskiness of their portfolio while still achieving their financial goals, as I discuss in this post.

2. Here’s a better way to think about risk—When academics and professional investors talk about risk, they usually refer to technical concepts like volatility and standard deviation. But in an essay entitled Five Things I Know About Investing, famed finance professor Kenneth French proposes a simpler definition – risk is uncertainty about how much wealth it will take to achieve your lifetime goals. In light of this definition, I turned to one of our favourite authors, Morgan Housel. In his book, The Psychology of Money, Housel says risk is unavoidable because the future is unknowable, but you can take steps to put the odds on your side.

   • Don’t take risks that will deplete your wealth and prevent you from benefitting from the power of compounding over the long term.

   • 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. According to Housel, preparation can be in many forms: “A frugal budget, flexible thinking and a loose timeline – anything that lets you live happily with a range of outcomes.

   • Cultivate a “barbell personality”—be optimistic about the future, but paranoid about what will prevent you from getting there. 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.

3. Why too much exposure to Canadian stocks hurts your portfolio—According to a report from Vanguard, Canadian stocks represent just 3.4% of the global equities market, but Canadian investors allocate 52.2% of the equity portion of their portfolio to Canadian stocks, a 15-to-1 mismatch.

    That kind of home bias can be found in other countries and is a serious impediment to portfolio diversification, which is the key to reducing risk. In Canada, the problem is made worse by the concentration of our market. The top 10 stocks represent nearly 37% of the Canadian index and the market is heavily overweighted in financial services (+16.4%), energy (+12.1%) and materials (+7.2%) as compared to the global market, and underweighted in information technology (-13.0%), health care (-11.7%) and consumer discretionary (-7.3%). As a result, the Canadian market has historically been more volatile than the global market without a proportionate increase in return. That’s a bad deal for investors and the obvious reason why you need a substantial quantity of global stocks to your portfolio mix.

4. Young people need to grow both their financial and human capital—This year we launched a new eBook, Investing Life Skills for Early Savers, that covers key investing concepts in a format that’s accessible and relevant for young people.

   One of the seven concepts included in the book is the importance of managing your human capital. While it gets very little attention in the media, this is of critical importance, especially for young people. Human capital is your potential to generate income over your lifetime. It can be defined as the present value of all future income from working and, for most people, it’s their most valuable asset. For young people, it represents a huge number and is even more valuable because it’s hedged against inflation because wages tend to rise over time.

   You can increase your human capital through education, training and cultivating interpersonal skills. You also need to protect it with tools like disability insurance. As you move through your career, your goal should be to convert your human capital into financial capital by earning, saving and making good investment decisions.

   If you haven’t already done so be sure to download your free copy of Investing Life Skills for Early Savers.

For more advice on investing and personal finance, subscribe to our Capital Topics podcast and download another of our popular eBooks, 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 2024.

Is it time to dial back risk in your portfolio?

Is it time to dial back risk in your portfolio?

By James Parkyn

Earlier this year, I discussed how a painful 2022 in the markets created a much brighter picture for long-term investors going forward.

Double-digit losses in both the stock and bond markets last year led to an important gain in future expected investment returns.

The improvement in bond yields has been especially impressive for investors who lived through close to 15 years of ultra-low yields, including periods when they didn’t even keep pace with inflation. During that time, many investors increased the equity allocation in their portfolio to make up for anemic bond returns—accepting more risk in search of higher returns from the stock market.

The strategy worked for those who could stomach periods of volatility and stay invested. Despite some setbacks, including the sharp but mercifully short pandemic bear market in 2020, stocks produced excellent returns from the financial crisis of 2008-09 through 2021.

Now, the picture has changed. Fixed-income securities are yielding nearly 5% and the question becomes: Is it time to move money from stocks to fixed income to take advantage of the higher yields and reduce risk?

Yields in the 5% range weren’t unusual before the financial crisis and, without predicting the future direction of interest rates, current action in the bond market suggests they will remain higher for longer than many economists had predicted.

In PWL Capital’s latest Financial Planning Assumptions, our estimate for expected annual bond returns jumped to 4.19% from 2.48% at the end of 2021. Our expected return for a broadly diversified 60/40 stock/bond portfolio rose to 5.75% from 4.97%.

As I noted earlier this year, in estimating returns, our research team doesn’t pretend to know what will happen in the markets 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. Of course, returns in any given year can vary widely from the estimates.

This article argues that investors tempted by high yields should be careful not to short-circuit their long-term investment plan by forgoing higher expected returns offered by stocks.

“Stocks, which carry a risk premium to compensate for added volatility, will beat bonds over time, and bonds, which earn extra yield from taking term and credit risk, will beat secure, short-term vehicles such as GICs,” writes investment manager Tom Bradley.

Nevertheless, the emergence of higher interest rates marks an important shift. Changing your asset mix should never be done lightly or based on temporary economic, geopolitical or market developments. Instead, it should be executed as part of a comprehensive financial plan that considers your financial and personal situation, your investment knowledge, objectives and needs, your time horizon and your risk tolerance and capacity.

However, if the evolution of fixed-income yields allows you to achieve your goals while reducing the riskiness of your portfolio, it’s an option you should seriously consider with your investment advisor.  

For more commentary and insights on investing and personal finance, be sure to listen to our latest Capital Topics podcast and subscribe to never miss an episode.

How equity premiums improve your expected investment returns

How equity premiums improve your expected investment returns

By James Parkyn

At PWL Capital, we take an evidence-based approach to investing that relies on peer-reviewed research by leading academics who have drawn insights from decades of market data.

At the core of our approach is a large body of research that shows a broadly diversified portfolio of passively managed investments is the best way to capture market returns with the lowest possible risk.

To achieve this, we construct globally diversified portfolios using low-cost index funds that reflect the risk tolerance of our individual clients. We then rebalance them periodically to bring asset weightings back to agreed targets.

Another aspect of our approach is to tilt equity portfolios toward factors that have been shown to produce greater expected returns.

Factors expected to produce premium returns over time are as follows:

• Market premium: Stocks tend to outperform risk-free government bonds (short-term U.S. Treasury bills).

• Size premium: Small stocks tend to outperform large stocks.

• Value premium: Value stocks tend to outperform growth stocks.

• Profitability premium: Stocks of highly profitable companies tend to outperform those of companies with low profits.

A recent paper from Dimensional Fund Advisors looked at how these equity premiums have performed over 10 years to the end of 2022. (Dimensional is a fund manager that uses financial science to add value to fund performance, including by emphasizing the factors listed above. We use select Dimensional funds in our portfolios.)

The Dimensional paper found that in the 10-year period to the end of 2022, high-profitability stocks generally outperformed low profitability stocks and small cap stocks outperformed large caps outside the U.S.

The group of stocks that underperformed globally during the decade was value, a fact that’s attracted a lot of attention from market observers. Despite a strong rebound from late 2020 through 2022, the MSCI world value index delivered a 7.25% annualized return versus 8.49% for MSCI’s total market world index.

The paper observes that it’s not uncommon for one premium factor to underperform over a 10-year period. However, in looking at data back to 1963, it’s much rarer for two of them to underperform over that length of time and there are no instances when three or four underperformed the market.  

It notes that “while a positive premium is never guaranteed, the odds of realizing one are decidedly in your favour and improve the longer you stay invested…Furthermore, premiums can materialize quickly, so you want to be properly positioned to capture the returns when they show up.”

A recent article by our colleague Raymond Kerzérho reminded us of the importance of capturing returns from small cap stocks as part of a fully diversified equity portfolio.

Raymond, Senior Researcher and Head of Shared Services Research at PWL, looked at the performance of funds that track the total U.S. market index versus those that track the S&P 500. The key difference between the two is that the CRSP Total Market Index holds over 3,800 U.S. stocks, including small- and mid-cap equities, while the S&P 500 holds roughly 500 large-cap stocks.

Since the launch of the S&P 500 Index in March 1957 to June 2023, the total market index has outperformed the S&P 500 by a very small margin of 0.03%. The CRSP Index returned 10.48% while the S&P500 returned 10.45% on an annualized basis.

Despite this small difference in performance, we know that adding small-cap stocks to your portfolio not only adds diversification but increases its expected return going forward. This is a key reason why we use the Vanguard U.S. Total Market ETF in client portfolios.

What’s more, as Raymond writes in his article: “…at the margin, a small number of winning stocks explains the long-term market performance; thus, we prefer not to miss out on these stocks.” By including small-cap and mid-cap stocks, you increase the odds of holding the companies that grow into the next large-cap winners.

“The risk of missing out on the high return stocks was highlighted in 2020 when the S&P 500 Index committee failed to include Tesla’s shares in the index until December after the share’s price had increased by 400%,” Raymond writes.  

We tilt portfolios to capture equity premiums as part of our commitment to adding value to client portfolios. Over the long term, even small gains can make a significant difference to your wealth.

For more insights on passive investing and personal finance, download the latest episode of our Capital Topics podcast and subscribe to never miss an episode. Be sure to also download your free copy of our popular eBook The Seven Deadly Sins of Investing.

Raise taxes on high income earners? Let’s try another approach

Raise taxes on high income earners? Let’s try another approach

By James Parkyn

Canada’s social safety net is a great achievement by successive generations in this country. It provides health care, support for the poor and disabled, and pensions for senior citizens among other critically important benefits that citizens of other countries can’t count on.

Of course, someone has to pay for all those services and they’re a big part of the reason why Canadians—especially higher income earners—pay a lot of taxes.

Now, most people support the idea that underpins our progressive tax system – those who earn more should pay more. However, a thornier question is: At what point do high taxes become a disincentive to work and fuel for tax avoidance?

There’s a common perception that the better-off do not pay their fair share of taxes and that perception is used by politicians to pile tax increases on the upper end of the income spectrum. Finance Minister Chrystia Freelance was at it again last March when she raised taxes on wealthier Canadians so they would “pay their fair share.”

However, in a recent report, the Fraser Institute found that higher income Canadians are paying more than their fair share, much more. The report calculates that the top 20% of income earning families in Canada pay nearly two-thirds (61.9%) of the country’s personal income taxes and more than half (53.1%) of total taxes.

The report’s authors state that “raising taxes on high income earners ignores…the associated behavioural responses of taxpayers.” Those responses include tax avoidance and evasion and results in government collecting less revenue than expected.

In this light, it’s notable that one big reason that Freeland was pushed to raise taxes in her March budget was that the government collected $5.7 billion less revenue last fiscal year than it initially projected.

The top marginal income tax rate in Quebec is 53.31% and kicks in at $235,675. In Ontario it’s 53.53% starting at $235,675 and for B.C. it’s 53.50% starting at $240,716. While $236,000 may not strike you as particularly wealthy, you only have to look a few tax brackets lower to see how much earners who are solidly in the middle class have to pay.

For example, income between $106,717 and $119,910, the marginal rate in Quebec is 45.71%, meaning for every extra dollar people earn above $106,717, they pay 46 cents in income tax. And, of course, that doesn’t include the sales taxes, fees and other levies.

Even taxpayers with far lower incomes end up paying “marginal effective tax rates” of around 50% when the complex interaction between transfer programs, tax credits and taxation of income is taken into account, according to another Fraser Institute study.

Is it any wonder then that many Canadians prefer to avoid working extra hours even as businesses struggle with serious labour shortages? Or that under-the-table work is rampant, as is undeclared income? It’s basic psychology that when marginal tax rates hit 50%, people ask why bother working extra hours, or they start looking for ways to hide income. The social compact between taxpayer and governments starts to break down and that’s what we’re seeing today.

Last year, the Canadian Revenue Agency estimated the federal “tax gap” at $23.4 billion a year. That’s the difference between how much the federal government collects each year and how much it could have collected if every individual and corporation paid all the tax they legally owed. The CRA’s number seems low to me, but it does signal that governments need to devote more resources and hire more skilled people to crack down on tax evasion.

We support the progressive tax system and full compliance with it. The real debate we need to have is: How can we both increase compliance and lower marginal tax rates? Because when people can legally keep more of the money they’ve earned in their pockets, governments will find they are bringing in more revenue, not less.

For insights on passive investing and personal finance, listen to our Capital Topics podcast and subscribe to never miss an episode.