How to juice your returns, crush the market and grow your net worth without breaking a sweat
Ready to take a serious look at your portfolio? We're here to help
by Max Fawcett
Maybe you’ve finally paid off those student loans and are ready to put some money to work in the market.
Maybe you’re thinking more seriously about your retirement, and trying to figure out how to grow your net worth as quickly – and safely – as possible. Or maybe you’re just unhappy with the returns you’re getting from your investments. Whichever it is, you’re ready to take a serious look at your portfolio.
Well, we’re here to help – and really, aren’t we every February? After all, two years ago we talked about the rise of passive investing and why it might be right for you. Last year, we pointed out that the biggest risk to your investment returns could be your own habits and biases (you dealt with those, right?). And this year, we’re going to tie it all together by helping you build a portfolio that can withstand volatility, minimize risk and meet your investment objectives. Buckle up.
At its core, investing is about balancing risk against reward. But it’s not nearly as simple as determining how much of your money should be invested in stocks and how much in bonds. Risk comes in a variety of forms, and many of those are either invisible to most investors or obscured by more immediate concerns about day-to-day movements in the markets and month-to-month trends in the global economy. And while there are people writing their dissertations at MIT on the various nuances of risk management, asset allocation and portfolio optimization, it doesn’t have to be that difficult. Avoid making the following four mistakes and you’ll be well ahead of the game – and better positioned to make the most of your investments.
Risk: Trying to time the market
Remedy: Set it and forget it
You can’t time a market. And in case you still thought you could, 2013 offered up a textbook lesson in why it’s foolish to try. Investors who heeded the “sell in May and go away” thesis, for example, and cashed out in the spring watched as U.S. markets tacked on an additional 14 per cent to an already impressive rally. It’s yet another reminder that, when it comes to investing, it pays to stick around.
Indeed, between 2002 and 2012, those who tried to time the market may have done grievous harm to their returns. By missing out on the 10 best days over that period, investors turned a nearly 70 per cent aggregate gain into a four per cent loss. And if they missed the best 20, they were down 32 per cent. Oh, and the kicker? Those best days tended to come on the heels of big sell-offs – precisely the kinds of things that push people out of the market in the first place.
Risk: Backwards thinking
Remedy: Forget the past
It’s a widely known truism among investors that past performance is no guarantee of future results. And yet Robert Armstrong, the vice-president and head of managed solutions at BMO Global Asset Management, says investors continue to make the mistake of looking back to predict what lies ahead. “The number one mistake I see is investing in yesterday’s winners,” Armstrong says. “That’s the wrong approach to investing, and it’s a mistake I’ve seen investors make over and over again.” The data bears that out, too. While a strategy built around picking the 25 best-performing stocks on the MSCI World Index in 2010 earned investors a 27.8 per cent return versus an overall market return of 11.8 per cent in 2011, the same strategy a year earlier actually yielded a 3.8 per cent loss versus a return for the broader market of 30.8 per cent. For what it’s worth, picking the previous year’s biggest dogs doesn’t work any better.
Risk: Too much Canada
Remedy: Diversify, diversify, diversify
Most investors understand that a diversified portfolio is important. But what they often miss is the fact that diversifying between bonds and stocks and across sectors doesn’t do you much good if the majority of said assets are from a single country. And when they’re from a country that makes up less than three per cent of the global economy (as do Canadians)? Well, that’s just asking for trouble.
Over the last three years, the TSX has underperformed the S&P 500 by nearly 60 per cent. “That’s pretty brutal,” says Franklin Templeton’s Stephen Lingard. “And I don’t think we will recover that underperformance any time soon.” And he would know, given that many of his client portfolios were tilted more heavily towards Canadian assets than he would have liked in retrospect. “We wish it were zero over the last few years,” he says of that exposure. “Even 30 per cent gave us a return that didn’t track anywhere close to the S&P 500 or global stocks. That home bias definitely hurt us.”
His advice? Find a different way to express your national pride, and limit your portfolio’s exposure to Canadian assets. “Most people still have the majority of their investments in Canadian assets,” Lingard says. “We think it should be closer to where we run, which is 20 to 25 per cent. At the very least, make sure it’s a minority, not a majority.”
Risk: Mistreating an asset
Remedy: Give it shelter
What’s in a name? A lot, apparently, judging by the way Canadians are treating their Tax-Free Savings Accounts (TFSAs). Canadians, to be blunt, aren’t using them properly, and it could be costing us tens – and eventually, hundreds – of thousands of dollars. Despite the fact that they cost nothing and have been around now for six years, less than half of those eligible to open one have actually done so – and only half of those have put money into theirs. But perhaps worst of all is the fact that the vast majority of assets inside those TFSAs is made up of cash, GICs and short-term government bonds.
That’s a clear misuse of the TFSA, like using a Ferrari to deliver newspapers. “If you can get your higher-growth investments within your TFSA, that’s going to save you more in taxes over the long run, which is taking better advantage of the vehicle itself,” says Blake Griffith, a financial advisor with Sun Life Financial. Investments made in an RRSP are, after all, something of a joint venture, given that the government eventually gets its share when it comes time to cash out. But in a TFSA, the gains are all yours. “When most Canadians have their TFSAs sitting in near-cash instruments,” Griffith says, “they’re not taking advantage of the long-term compounding benefits that they could get.”
Really Alternative Investments
With stocks at record highs, bonds vulnerable to any increase in interest rates, gold in the dumps and bitcoins swinging more wildly than a drunk on the dance floor, it might be time to explore alternative investments.
And while there are some perfectly defensible options out there like fine art and fancy cars, we thought we’d try to find some really alternative investments.
Sriracha Hot Sauce
With apologies to the marketing team at Alexander Keith’s brewery, when it comes to Sriracha sauce, that paste of chili peppers, distilled vinegar, garlic, sugar and salt, those who like it really like it a lot. And when a U.S. judge ordered the temporary shutdown of a California factory owned by Huy Fong Foods, the maker of the ubiquitous rooster brand of the hot sauce, due to its habit of giving nearby residents a permanent burning sensation, it caused a minor panic among Sriracha devotees. In order to avoid any future runs on the product, you might want to stock up now. If nothing else, it’ll leave you well-prepared for the apocalypse.
We’ve reached peak wine. At least, that’s what a report from Morgan Stanley suggests. In 2012, global demand for wine surpassed supply by 300 million cases. And it might be about to get a lot worse: while the level of production is expected to continue dropping – it’s been in decline since 2004 – worldwide demand will only increase. In other words, it might be finally time to kick that half-employed millennial out of your basement and replace him or her with something that will actually make you money.
Age-dated single malt scotch
The scotch producer Macallan recently decided to end the release of its 10-, 12- and 15-year-old bottlings, replacing them with something it calls the 1824 series that distinguishes the products by colour – Gold, Amber, Sienna and Ruby. It’s a pragmatic response to the growing demand from China for single-malt whiskies, one that has overwhelmed producers and forced them to blend whiskies of different vintages and depart from attaching age statements to bottles. If you’re a fan of a particular vintage, make nice with your local spirits salesperson.
Time, Meet Money
Most investors worry about being too heavily invested in equities, and exposing themselves to the full consequences of a market correction – or, worse still, a crash. But if the results of a survey conducted by the BMO Wealth Institute last year are any indication, they ought to be far more concerned about not being heavily invested enough. Take the baby boomers – they are, on average, $400,000 short of their $658,000 nest egg retirement goal, according to BMO’s survey, despite entering their peak earning years right as the biggest simultaneous bull market in bonds and equities in history was just getting underway. Worse still, that $658,000 goal undershoots what their actual needs will be by nearly half.
The reason for this sorry state of affairs is simple. We’re living longer than we ever have before, and therefore need our assets to sustain us over a longer duration than our grandparents ever did. Combine that with a culture that prioritizes consumption above saving – where saving for a rainy day is less important than buying a nice umbrella in which to weather it – and the usual potpourri of self-destructive mistakes that the average investor makes and you end up where so many 50- and 60-somethings are today.
And if you think it’s bad for the boomers, well, it could be even worse for their kids. That’s because the defined benefit retirement plans that some boomers will be able to count on to shore up their underwhelming savings almost certainly won’t be there for today’s 20- and 30-somethings. Moreover, they almost certainly won’t be able to rely on the same favourable market conditions as the boomers, or take advantage of a housing market that effectively gifted everyone who bought a home prior to 1995 a winning lottery ticket.
That’s why it’s imperative for younger investors to summon the courage to invest as aggressively in the stock markets as possible. Yes, they’re trading at rich valuations right now, and yes, they could certainly drop – perhaps even precipitously – in the near term. But for them it’s not about the near term, or even the medium term. It’s about the long term, and in the long term the evidence is clear: stocks are still the best place to be. And the sooner they start, the faster they’ll get to where they want – and need – to be.
“Compound interest is the eighth wonder of the world,” Sun Life Financial’s Griffith says. “For many young Canadians, there’s a tremendous opportunity for saving for the future and getting those investments compounding from an early age.”
Still, that’s a lesson that’s having a hard time getting through to younger investors. “They’re a little shell-shocked at the moment,” Griffith says. “But that’s a healthy fear. You don’t want to sit on the sidelines forever, but if you look at the last 10 years it has been a fairly challenging marketplace in many sectors.”
Rookies (under 30)
The good news is that you’ve settled into your first good job, paid off those loans and started saving for the future – or, at least, stopped borrowing from it. But the bad – or, at least, the less good – is that you’re faced with the prospect of making investments that go beyond having an extra case of beer on hand for the weekend. Well, take heart: for a generation raised on video games, there’s a perfect solution out there for you. They’re called practice accounts, and they let you learn the hard lessons of investing without actually having to pay the price. “Until it’s happened to you, until you’ve actually been through a down market, you don’t know what to expect,” BMO’s Armstrong says. “So if you’re not comfortable yet, maybe it’s about setting up a practice account where you can dip your toe in the water and learn about the various investment products.”
And you should also feel free to ask people questions too – dumb ones, even.
After all, you’re a potential client – and unlike dealing with, say, your wireless provider, when it comes to financial advisors and even institutions, you have both a choice and some clout. “Sometimes, if you’re just starting off, you don’t have a lot of assets,” Armstrong says. “But there is advice out there, and it’s always best to ask. This is your money: ask a question. And if you don’t like that answer, ask someone else. Eventually, you’ll have that knowledge where you’re confident in the products you’re going to use.”
Ideal asset allocation: As much in stocks as you can stand
The Strategy: Pull the goalie
If we’re sticking to this metaphor (and we are!), it’s technically the first period of your career as an investor, so the idea of pulling the goalie might not make much sense. But the point still stands, even if the way we got there didn’t. When it comes to investing, anyone who’s under 30 needs to be playing offense – maybe even a reckless, pulled-goalie version of it.
Mid-Career (30 to 50)
You’re busy. You probably have a young family. You’re almost certainly climbing the ladder at work. And you still have to stay in shape, eat right and give to charity. The last thing you want to do is spend hours monkeying around with your investments. That’s why you need to discover the miracle of dollar-cost averaging if you haven’t already. “Setting up the dollar-cost averaging plan is the hardest thing to do,” BMO’s Armstrong says. “People put that off, but once you’re set up you don’t have to worry about it anymore.”
The best part is that it forces you to buy when markets fall – and fall they will. Rather than having to figure out how and when to buy into a falling market, a regular investment program (be it monthly, bi-monthly or quarterly) will do the heavy lifting for you. “That’s probably the hardest trade you can ever make: buying when it’s uncomfortable,” Armstrong says. “But the trade, is probably the best purchase you’ll ever make. The people that were dollar-cost averaging in 2008 and 2009 – look where they are today.”
When it comes to saving for your kids’ post-secondary education (you are doing that, right?), you might consider target-dated products, which are geared toward paying out at a particular point in time – say, right when your twin daughters get admitted to Harvard. Because the plans gradually ratchet down the risk (by increasing the proportion of fixed income assets in the portfolio), you don’t have to worry about market volatility forcing you to send them somewhere lesser.
Ideal asset allocation: A portfolio that leans heavy towards stocks without being needlessly aggressive – in other words, make sure at least a quarter is in fixed income
The Strategy: Dump and chase
Don’t run the risk of carrying the puck across the market’s blue line, where careless mistakes tend to get punished. Instead, play it safe – shoot it in deep and let the percentages work in your favour. Over the long-haul, equities will outperform bonds. Don’t let up.
Veterans (51 and above)
It used to be that as you approached retirement you decreased your exposure to equities just as surely as you increased your exposure to the pharmacist. But with bonds sporting pitiful yields and GICs delivering negative returns after inflation, more experienced investors need to rethink how they scale down their risk profile. “A lot of people assume that once you hit retirement, you just put it in GICs and you’re done. But that’s the wrong approach,” Armstrong says. “There are a lot of years out there for your assets to grow, and you actually need them to continue to grow when you hit retirement.” In other words, your investments don’t have to stop working once you do.
One of the best ways to do that is by investing in “bond-like” equities, those companies (or sectors) that offer some of the stability of a bond along with much of the upside of a stock. That means blue-chip dividend paying stocks like those of telecom companies, utilities, banks, REITs and insurers. When it comes to fixed income, meanwhile, don’t discount the role that bonds can still play. “I always look at the U.S. 10-year as the ultimate benchmark for bonds,” Armstrong says, “and the U.S. 10-year bottomed on July 25, 2012, at around 1.4 per cent. Today, we are at 2.8 per cent. And over that time frame, Canadian bonds as a whole have lost [after including yield] very little – maybe one per cent. That was basically the worst period we’ve had for bonds in 50 years in terms of rising rates, and we survived it. I suspect we will survive the next increase.”
Ideal asset allocation: Most but not all of your portfolio should be in fixed income
The Strategy: Play the Trap
Sure, it’s boring. But it works, doesn’t it? (note to non-hockey fans: yes, it does). It doesn’t mean that you won’t score now and then, and it allows you to be opportunistic when the situation calls for it. Most importantly it keeps pucks out of your net – exactly what you’re aiming for at this point in the game.
It all started back in 1975, when John Bogle, a 40-something money manager with an underwhelming track record created the world’s first publicly investable index fund. Nearly 40 years later that fund, the Vanguard 500, has attracted over $100 billion in capital, while the company he founded a year before its flagship fund was born has $2 trillion in assets under management. Bogle’s belief that the best way to invest was through low-cost index funds like his own, meanwhile, has become an article of faith among many people in his profession.
But Shane Shepherd, the senior vice-president at a California firm called Research Affiliates, thinks investors can do better than Bogle’s funds. In fact, his company is banking on it. In 2005 it came up with a concept called “fundamental indexing,” which adheres to the same basic precepts Bogle helped popularize but with one key difference: rather than weighting its funds using the market capitalization of the stocks in it, as all major stock indices do, it uses performance-based measures instead. That “weight” can be anything from earnings to sales to return on equity – anything, Shepherd says, other than market capitalization.
The results, he says, speak for themselves. “What we’ve seen is that historically, the fundamental index has added about two per cent of excess return above a cap-weight benchmark back to 1962.”
Two per cent might not sound like much, but as Bogle himself has noted, over the longer-term it makes an enormous difference. Over a 50-year horizon, for example, a portfolio that earned that extra two per cent would be worth more than double one that didn’t.
Fundamental indexing is particularly powerful, Shepherd says, during times when markets might be running ahead of themselves – like, say, right now. That’s because as the value of particular stocks get driven up, they occupy an ever-larger proportion of the index – and therefore expose cap-weighted index investors to ever-greater risk. “The technology bubble in 2000 is probably a good example,” Shepherd says. “If you were a cap-weighted investor, you had a relatively high weight to technology stocks. And as their prices got more and more expensive, you took on a bigger and bigger weight to those technology stocks in your portfolio.”
But the real magic of fundamental indexing is that it rebalances every year, effectively forcing investors to sell high and buy low. “We think that the rebalancing is really the key driver of the returns,” Shepherd says. “It doesn’t matter as much what you’re re-balancing back to – you could choose your weights in a hundred different ways. But your trade will remain the same – you’re always going to sell stocks that have gone up, and you’re always going to buy stocks that have gone down.” Cap-weighted indexes, he says, don’t do that.
Not everyone is sold on the merits of fundamental indexing, though. Dan Bortolotti, a columnist and editor-at-large at MoneySense and the author of the popular index investing blog Canadian Couch Potato, says the performance of fundamental index-linked funds in the real world – that is, the one with taxes, fees and tracking errors – is less impressive than it is in theory. For example, if a fundamental index-linked fund was held outside of an RRSP or TFSA, it would incur capital gains every year because of the re-balancing, something that isn’t a problem with cap-weighted funds. And those fundamental index-linked funds have also shown some tracking errors (that is, the divergence between the price of the fund and the index it tracks), and while they haven’t adversely affected returns so far, that’s not to say that they couldn’t in the future.
Shepherd thinks the fund flows speak for themselves. “There’s over $100 billion invested in fundamental indexing. If it wasn’t a high-capacity strategy, this wouldn’t be a story,” he says. “We’ve increased assets every single year, including 2008 – I don’t think many financial firms did that. But it just goes to show that this is a story that more and more people find compelling, at the retail level, the advisor level and the institutional level.”