4 essential investing lessons from the last two decades

by James Parkyn

At PWL Capital, we believe it’s crucial to take a long-term view of investing. That’s why I sat down recently with my colleagues François Doyon La Rochelle and Raymond Kerzérho to talk about our investing lessons since 2000 for an upcoming episode of our Capital Topics podcast.

The common denominator in our discussion was the importance of patience for successfully building your wealth over the long term.

You only have to consider the many momentous events that have occurred during the last two decades to understand why patience is so important. The list includes the bursting of the tech bubble in 2000, 9/11, the Afghanistan and Iraq wars, an extended bear market in 2001-03, the financial crisis of 2007-09 and, most recently, the COVID-19 pandemic.

Through it all, the stock market has kept going up. Since September 2001, the S&P 500 has gained an annualized 8.2% per year in Canadian dollars, while the S&P/TSX Composite in Canada is up an annualized 8.1%, and the combined MSCI EAFE and Emerging Markets index is up 6.6%.

If you had let your emotions get the better of you and bailed out of the markets in response to any of the events listed above (or the many others of lesser importance), you would have deprived yourself of those gains.

With that in mind, here are the four most important lessons to take away since 2000.

1. You don’t know what you don’t know

This phrase encapsulates the deceptively simple observation that no one knows what the future holds or what impact events will have on the markets. For example, no one could have predicted the terrorist attacks of September 11, 2001, or the devastation of the global pandemic.

Howard Marks, co-chairman of Oaktree Capital Management, summed up the importance of intellectual humility when investing this way: “No amount of sophistication is going to allay the fact that all of your knowledge is about the past and all your decisions are about the future.”

2. You can’t forecast the future, but neither can anyone else

This lesson is a corollary to the last. Despite the impossibility of predicting the future, many economists, analysts and active investment managers earn their money trying to do just that.

All the noise they create can lead you astray from your investment plan with dire consequences for your wealth.

3. Investor behaviour and discipline are crucial

To avoid pitfalls, it’s essential to develop a disciplined investing mindset. This means filtering out the noise of the moment and sticking resolutely to a long-term view that’s guided by your investment plan.

A well-designed investment plan is a roadmap you can return to when times are tough and you are tempted to stray off-course. Your portfolio should be aligned with your risk tolerance and risk capacity. It should also be tax efficient and broadly diversified. These are the factors you can control.

4. Evidence-based investing works

I recall in 2003 when as a firm we made the decision to implement fully passive portfolios. My experience in the years that followed has confirmed my belief that adhering to scientifically verified principles of sound investing is the best way for our clients to have a successful investing experience.

It has produced solid investment results for them and remarkable growth for PWL Capital as more and more people have embraced the power of low-cost passive investing and the other best practices we follow. It’s an approach to investing that gives clients the confidence to stick with their investment plan through good times and bad.

Be sure to download our podcast to hear more investment lessons from the past two decades. You can also learn more about the fundamentals of evidence-based investing by downloading your free copy of our eBook, 7 Deadly Sins of Investing.

Steps you can take to manage the risk due to cognitive decline

by James Parkyn

Cognitive decline is a topic most people would rather not think about, and that’s the danger when it comes to preparing for this risk.

Diminished mental capacity can lead to a devastating loss of savings built up over a lifetime due to poor bad decisions, unfortunate misjudgement or financial exploitation.

With the large baby-boom generation growing older, it’s a subject that’s starting to gain more attention. Indeed, a recent article in the Wall Street Journal called cognitive decline the biggest financial risk facing baby boomers.

The Canadian Securities Administrators (CSA), the umbrella group for the country’s securities regulators, has published new rules for registered investment firms and advisors to enhance protection for older and other vulnerable clients.

The following rules will come into force at the beginning of next year:

• Trusted contact person—Registrants (firms and advisors including PWL Capital) will be required to take reasonable steps to obtain the name and contact information of a trusted person from clients as well as their written consent for the trusted person to be contacted when there are concerns about financial exploitation or the client’s mental capacity to make financial decisions.

• Temporary holds—A regulatory framework is introduced to guide registrants in placing a temporary hold on transactions, withdrawals or transfers in circumstances where they have a reasonable belief that there is financial exploitation of a vulnerable client, or where there are concerns about a client’s mental capacity to make financial decisions.

The stakes are high for seniors and their families. Canadians who are 65 or older now represent nearly 17% of the population. They control $541 billion in non-pension financial assets, representing 39% of such assets controlled by Canadian households, according to Statistics Canada data cited by the CSA.

The Wall Street Journal article reports that rates of mild cognitive decline and dementia increase from a combined 12% for ages 70 to 74 to 45% for those 80 to 84, according to a report by the Center for Retirement Research at Boston College.

Mental capacity can diminish gradually and may not immediately affect a person’s ability to perform routine financial tasks such as paying bills. However, it can make complex or unfamiliar decisions even more difficult, including buying and selling investments, calculating asset allocations and efficiently managing withdrawals from registered and taxable accounts.

Do-it-yourself investors are of particular concern. The use of discount brokers has rocketed during the pandemic and DIY investors typically have little or no contact with an investment advisor.

The WSJ article notes: “Do-it-yourself boomers may be more vulnerable in some ways because they’re calling the shots solo, without help from wealth advisers. So, if they go off the rails, no one else may know. ‘That’s the danger with do-it-yourself investors—they may be overconfident,’ says Michael Finke, a professor of wealth management at the American College of Financial Services.”

---

 At PWL, we believe it’s important to have a long-term plan to mitigate the risk exposure due to the possibility of cognitive decline. In putting your plan together, you should involve your loved ones and professional advisors, so they understand where your assets are located and your wishes for their management.

Here are some steps you should consider when planning in the event of diminished mental capacity.

• Simplify your finances before possible cognitive decline begins. This may include reducing the number of accounts you have, selecting simpler investments and transferring investments from DIY accounts to advised accounts.

• Identify a trusted advocate and an alternate who understand your financial objectives and will act as your trusted contact person. These may be family members, close friends or outside professionals, such as accountants or lawyers. However, it should never be the investment advisor who is managing your investments.

• Regularly review and update any general or limited powers of attorney you currently have and get an enduring power of attorney (or mandate of protection in Quebec) that will be used if you lose the capacity to manage your affairs.

• Collect either in a binder or an internet vault a list of financial goals and all your financial account numbers and passwords as well as a list of regular monthly bills and any other important information and records.

For more information on this subject, please listen to our discussion in episode 22 of our Capital Topics podcast.

We are sensitive to the concerns people have about cognitive decline and the many issues it raises. Please contact us if you wish to discuss how we can help you prepare yourself or your loved ones for this unfortunate possibility.

Should you be worried about high inflation?

by James Parkyn

If you follow the business news, you know there’s been a lot of speculation lately about whether we’re heading into a period of persistent high inflation.

The trigger for these concerns has been a spike in prices that saw May headline inflation hit 3.6% in Canada and 5% in the U.S.

Some economists are concerned that long-term inflation is being stoked by massive monetary and fiscal stimulus to fight the pandemic recession, combined with pent-up demand from consumers and supply chain bottlenecks as the global economy reopens.

Should we be worried? While we don’t make forecasts about where the economy or the markets are heading, there are signs inflation fears may be overblown.

Both the Bank of Canada and the U.S. Federal Reserve insist the current inflation surge is transitory and there remains a lot of slack in the economy. Although disagreement has emerged recently within the Federal Reserve leadership over the seriousness of the inflation threat.

More importantly, the bond market is not signalling high inflation expectations. If the millions of investors who make up the bond market foresaw a sustained bout of higher inflation on the horizon, they would bid up interest rates. In fact, rates did move sharply higher earlier this year, but since mid-May, they have dropped by .10% in Canada and .25% the U.S.

Looking at the longer term, many observers believe high consumer and public debt and an aging populations are secular trends that will keep a lid on inflation. Economist David Rosenberg believes once things settle down towards the end of the year, the focus will shift back to deflation as the real threat.

Certainly, the stock market hasn’t shown any negative effects so far from the upswing in inflation. It remains at or near all-time highs in Canada and the U.S.

While the stagflation period of the 1970s produced terrible equity returns, inflation has historically been good for stock prices when it’s accompanied by economic growth.

The Credit Suisse Global Investment Returns Yearbook looks at the impact of inflation on global stock and bond returns from 1900 and 2020. It shows that real returns turned negative only in the worst 20% of inflation occurrences. It also found that long-term bonds were hit far worse than stocks during bouts of high, sustained inflation.

So, how should investors think about the today’s cross-currents of information and opinion about inflation?

Your first reaction should be to tune out the day-to-day noise in the media. Nobel Prize winning economist Eugene Fama noted in a recent webinar that future inflation movements are even harder to forecast than interest rate and stock movements, which is to say they are impossible to predict.

Nevertheless, we know inflation is an important variable in financial planning and a risk to be considered. To manage it and other risks, it’s critical to have a financial plan and to be disciplined in sticking with it through market volatility.

To protect against inflation, choose high-quality, short duration bonds for the “safe” portion of your portfolio. Shorter duration bonds turn over more quickly and thus avoid the heavier losses that longer-term issues suffer when inflation and interest rates rise.

Allocate the rest of your portfolio to stocks and higher yielding income securities, ensuring you are globally diversified because inflation might not hit all countries at the same time.

Ignoring the noise and focusing on the fundamentals of prudent investing are the best ways to grow your wealth and keep your peace of mind, no matter what happens in the economy and markets.

To learn more about good investing practices, get a free copy of our new eBook, the Seven Deadly Sins of Investing.

How to participate in the IPO boom without taking the risk

by James Parkyn

One of the remarkable features of the bull market over the past year has been frenzied activity in initial public offerings (IPOs). Around the world, investors have shown an extraordinary interest in new stock issues and been willing to pay high prices for a piece of the action.

An IPO occurs when a private company raises capital by issuing shares to institutional and retail investors. IPOs have been setting records for both the number of companies going public and the amount of money being raised. The boom has gathered steam as investors have become increasingly enamoured of tech stocks and upbeat about the prospects for post-pandemic economic growth.

Globally, IPOs raised a record US$140.3 billion this year to May 10 through a total of 670 offerings, another record.

Most of those issues were in the U.S., which has by far the largest stock market in the world with over 55% of global equity value. The U.S. IPO market is coming off an unprecedented year in 2020 when 494 issues raised US$174 billion, a 150% increase over 2019. In the first quarter of this year, IPOs were even hotter with 365 issues, raising US$129 billion.

In Canada, the results were more mixed. The 77 IPOs in 2020 were fewer than in 2019, but the $5.6 billion raised was an increase of 116% over 2019. In the first quarter of this year, there were 32 IPOs worth $3.2 billion.

Investors have been willing to pay extraordinary prices for IPOs, especially tech issues. Between 2002 and 2019, the median tech IPO price-to-sales ratio never went above 12 in a calendar year, according to IPO expert Jay Ritter. In 2020 the ratio was 23, by far the highest since the dot-com era. To the end of April this year, it was 20.

The excitement surrounding new stock market entrants is quite a contrast from the tone just a few years ago. Back then, media attention was focused on the low number of IPOs and the shrinking size of the stock market.

A 2017 Wall Street Journal article titled Where Have All the Public Companies Gone? noted that the number of listings on U.S. exchanges had dropped to just 3,617, half the number there were in 1996. IPOs had fallen to 128 from 845 in 1996.

Plentiful money from private equity and venture capital investors meant companies could fund their growth without going public and taking on all the accompanying regulations, public scrutiny, and investor activism and lawsuits. Merger and acquisition activity also contributed to the disappearance of existing public companies.

As the Journal article noted, what was good for the private equity and venture capital investors was bad for retail investors who depend on public equity markets. The shrinking number of public companies meant passive investors who purchase whole markets through index funds were getting less diversification for their money.

From this point of view, the current IPO boom is positive news. However, there is also danger for small investors in the IPO frenzy as we discussed in a recent episode of our Capital Topics podcast.

Attracted by all the hoopla, many small investors are being drawn into buying individual IPO issues. Besides the well-known perils of buying individual stocks, IPOs tend to underperform the stock market following their first day on the market, according to research by Ritter, a professor at the Warrington College of Business at the University of Florida, who is known as Mr. IPO.

In an interview on Rational Reminder podcast hosted by our PWL colleagues Benjamin Felix and Cameron Passmore, Ritter said IPOs underperform the market on average over one-year and three-year periods, following the close of their first day of trading. (He noted it’s the smallest companies that tend to underperform the market. Larger companies, on average, neither underperform nor outperform.)

What’s more, brokerage firms often ensure large investors get IPO shares at the offering price. Small investors are left to purchase stock at higher prices on the secondary market (although online platforms are making it easier for individual investors to buy IPO shares). Additionally, brokers are sometimes paid bonuses to sell the IPO shares of lower quality companies to clients.

There’s been a lot of excitement and lots of headlines about IPOs over the last year. The good news for passive investors is IPOs are quickly included in indexes and thus you get to own them without taking the risks involved in buying individual stocks.

Investment returns are expected to be lower in the future—get used to it

by James Parkyn

Readers who are familiar with PWL Capital’s philosophy will know we don’t make predictions about where the markets are headed in the coming months or years.

We believe no one can predict the markets, despite all the time and money spent by active fund managers, analysts and media commentators trying to do just that.

Look no further than 2020 for the proof of the futility of forecasting market movements. No one predicted the COVID crash or the remarkable rally that followed.

Nevertheless, financial planning requires investors to consider not only personal factors such as their time horizon and tolerance for risk, but also to make assumptions about future rates of return.

What mix of stocks and bonds might provide you with the level of growth you need to achieve your retirement income goals? How bumpy might the ride be? To answer these questions, financial planners use expected rates of return and risk levels for different asset classes.

At PWL, Research Director Raymond Kerzérho provides us with his best estimate of stock and bond returns over the next 30 to 40 years. His projections are based on current asset prices and their return history. The methodology Raymond uses is explained in this paper.

In his latest report, his analysis produced an expected real return (not including inflation) of 4.7% for global equities, or a nominal return of 6.0%, if you factor in 1.3% inflation going forward. Of course, these are averages; there will be lots of ups and downs along the way.

Following a segment on expected returns in a recent episode of our Capital Topics podcast, a listener wrote in to ask why equity returns are expected to be so low in coming years.

The first observation is that they are not that low by historical standards. Over the last 121 years, global equities provided an annualized real return of 5.2%, according to Credit Suisse’s Global Investment Returns Yearbook. Over the last 20 years, global equity markets generated a similar real return of 5.0% per year.

However, strong returns over the last decade might be colouring investor perceptions of how much they should be earning from stock market. Recall that in 2011, the stock market was starting to recover from the financial crisis and stock prices, especially in the U.S., were much lower than they are today. Since then, global equities have generated an annualized return of almost 11%.

Today, it’s a different story. The Shiller-CAPE price-to-earnings ratio has risen to 35 from 21 in 2011 for the U.S. market. The price appreciation has been less dramatic in Europe, but stocks are still much higher than a decade ago.

This is a key reason why equity returns are expected to be lower in the future. Combining lower equity and bonds returns, we conclude a portfolio composed of 60% equities and 40% bonds has an expected return of just 4.34% annually. This is almost two percentage point lower than 6.15% that markets actually returned over the past 20 years.

What does it mean for investors? First, it’s a strong signal to temper your own expectations. In a low-return environment, investors are often tempted to take undue risk in an effort to beat the market.

Egged on by the financial media, they fall prey to recency bias, chasing the latest hot investment idea and ending up getting burned. Last year, they might have decided to load up on high-flying growth stocks. But markets can turn around quickly and without warning. So far this year, value stocks are outperforming growth by a wide margin.

The second conclusion investors should draw from lower future returns is that it’s critical to capture every bit of return that is available. That’s why at PWL we put so much importance on portfolio diversification, tax efficiency and rebalancing.

Building wealth over the long term requires you to make decisions based on the best available evidence and then patiently stick with your plan through good times and bad. A realistic view of future returns is an important part of the equation.