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.

Why worry about whether we’re in another speculative bubble?

by James Parkyn

It’s been almost a year since the World Health Organization declared a global pandemic in response to the spread of COVID-19. As we discussed in our recent portfolio performance review 2020, no one could have predicted the extraordinary events of the past year or the markets reaction to them.

The market crash in February and March 2020 was the worst since 1929 as the gravity of the pandemic crisis became clear. Then, the markets came roaring back with extraordinary speed and ended the year at all-time highs.

It was a year like none other in memory and provided a remarkable lesson on the importance of disciplined asset allocation and the danger of trying to outguess the markets by jumping in and out of investments in hopes of cutting your losses or maximizing your gains.

That’s called market timing and researchers have found it to be one of the worst wealth-destroying mistakes you can make. For example, the Dalbar research firm found that poor trading decisions caused the average U.S. equity fund investor to earn annual returns that were 4.7 percentage points below those from the S&P 500 index in the 20 years to the end of 2015.

People who try to time the market are often driven by a fear of losses or a desire to make big profits, but as we’ve seen in dramatic fashion this year, it’s impossible to forecast where the markets are headed.

The danger becomes clearer when we dig a little deeper into recent market trends. Growth stocks in general—and big tech stocks in particular—produced by far the best results in 2020. In the U.S., large and mid-cap growth stocks returned 36% versus just 1% for value stocks—the largest divergence ever recorded.

Skyrocketing prices have captured the imaginations of many investors who have bought into tech stocks and other hot investments like electric car maker Tesla and cryptocurrency Bitcoin. Meanwhile, others are dumping their stocks because they fear a speculative bubble has inflated of the kind seen during the dot.com era of the late 1990s.

Which side is right? A rational investor doesn’t have to engage with either. The antidote to the stress of worrying about current market conditions is a portfolio that is broadly diversified across asset classes and geographies and a patient, long-term perspective.

We make no judgment about whether U.S. growth stocks are in a bubble, but we do observe that value stocks and markets in other parts of the world are currently trading at far lower valuations. The beauty of diversification is that when one market is falling, others will be performing relatively better.

The real danger in investing is not missing out on a hot sector bet or suffering through a market correction. It’s making poor decisions in the heat of the moment that can lead to a permanent loss of capital.

Our discipline of sticking to diversified asset allocation may not produce the excitement of jumping on the latest zooming tech stock or cryptocurrency, but it has been proven to be the prudent way to build wealth over the long term.

Last year was a high-speed test in managing our emotions

by James Parkyn

In year-end retrospectives over past few weeks, we’ve been reminded just how extraordinary 2020 was on so many fronts.

From the COVID pandemic to the Black Lives Matter movement to the fraught U.S. election and many other momentous events and devastating outcomes, it was a year that challenged our emotional resilience like none other in recent history.

It was no different in the markets. The stock market crash in March gave way to a lightening fast recovery. For investors, 2020 was a real-time, high-speed test of our risk tolerance and how well we’re able to control our emotions in the face of exceptional volatility.

To learn the investment lessons of 2020, it’s instructive to think back to how we all felt at various points during the year. The initial market plunge understandably provoked fear in many, especially because it came at a time of great uncertainty in other areas of our lives, as we navigated a health and economic crisis.

When the markets rallied, many investors were still processing the crash and were distrustful the recovery could be sustained. As it became clear, massive governments and central banks interventions were supporting the economy and markets, investors became increasingly confident in the rally’s durability.

The remarkable market gains since March have once again been concentrated in the technology sector where enthusiasm has been fuelled by the economic effects of the pandemic, including remote work and online shopping. And then there’s Tesla—a phenomenon unto itself.

When fear fades, regret often takes over. How much money could you have made by betting on a few big tech names rather than broadly diversifying your investments?

How about the strength of the U.S. stock market versus developed and emerging markets elsewhere in the world? Wouldn’t it make more sense to concentrate on the U.S. market.

However, if 2020 taught us anything, it’s just how unpredictable the markets can be. Our portfolios must be designed to both weather unexpected developments and take advantage of favourable outcomes.

As investment author Larry Swedroe observed in his review of the book, The Psychology of Money by Morgan Housel, these are not easy psychological waters to navigate.

“Unexpected events and random luck can lead to good decisions having bad outcomes and poor decisions having good outcomes,” Swedroe writes. “Success is a lousy teacher because it can seduce us into thinking we cannot lose. Thus, we should not become overconfident in our judgments when things turn out well. Similarly, failure is a lousy teacher because it can seduce smart people into thinking their decisions were poor, when failure was just the unforgiving reality of risk showing up.”

It’s not easy for bright, successful people to accept their inability to outsmart the markets. However, sticking with a well-engineered portfolio through good times and bad is the hallmark of intelligent investing.

Helping clients manage their emotions is an important part of what we do here at PWL Capital. In that sense, we see our role as advisors helping people make good decisions, not facilitators of risky moves driven by passing emotions.

The coming year will no doubt hold more surprises, but there is much to be hopeful about with the roll-out of vaccines around the world. We will be here to keep your investments and personal finances on track, and the whole PWL team wishes you a happy, healthy and prosperous 2021.