Does Diversification Still Make Sense?

By James Parkyn

It’s been a difficult year in the markets and it seems there’s been no safe harbour. With interest rates rising to combat inflation and a tense geo-political situation globally, stock and bond markets around the world have been falling.

As you know, diversification is the fundamental strategy for reducing portfolio risk. Noble Prize-winning economist Harry Markowitz famously described it as “the only free lunch in finance.” Markowitz demonstrated that broadly diversifying within and across assets classes and countries allows investors to increase expected returns while reducing risk.

However, it often seems – especially since the financial crisis of 2008-09 – that when trouble strikes, the markets tend to move down together. So, this raises the question: Does it still make sense to diversify?

To answer this question, we turned to a remarkable resource—the Credit Suisse Global Investment Returns Yearbook. It’s a guide to historical returns for all major asset classes in 35 countries, dating back in most cases to 1900.

The 2022 edition of the yearbook includes an examination by financial historians Elroy Dimson, Paul Marsh and Mike Staunton of the power of diversification across stocks, countries and asset classes. Their study of the historical data led them to several important conclusions.

• Globalization has increased the extent to which markets move together, but the potential risk reduction benefits from international diversification remain meaningful.

• The extent to which international diversification can fail investors in a crisis is limited to quite short periods and is relevant only if an investor is forced to sell. “For long-term investors, the enhanced correlations are of less consequence.”

• Over the last 50 years, investing in stocks globally has generated higher reward/risk ratios than investing only domestically in most countries.

• A notable exception has been the United States, where over the last 50 years investors would have been better off investing domestically. This finding reflects the excellent returns and lower volatility of the U.S. stock market during this period. However, the authors also note past performance is no guarantee of future returns. “We are observing these results with hindsight…There is no reason to expect American continued exceptionalism.”

• Investors in smaller markets, especially ones that are highly concentrated in certain sectors, have more to gain from global diversification than U.S. investors because “the U.S. market is already very large, broad and highly diversified.” Canadian investors take note.

• Despite well-known advice to hold a broadly diversified portfolio, the authors highlight academic studies that show most investors are woefully under-diversified. For example, they quote a study (Goetzmann and Kumar 2008) that analyzed more than 60,000 investors at a large U.S. discount brokerage house and found the average holding was just four stocks.

Investors with concentrated portfolios pay for it dearly. A Danish study (Florentsen, Nielsson, Raahauge and Rangvid 2019) analyzed a database for 4.4 million Danish investors and found they could increase their expected return by up to 3% a year by moving from the concentrated portfolio they typically held to an index fund with the same overall risk.

• On asset diversification, the authors write: “Stock-bond correlations have now been mostly negative in major world markets for some 20 years. This negative correlation means that stocks and bonds have served as a hedge for each other, enabling investors to increase stock allocations while still satisfying a portfolio risk budget.”

However, an increase in interest rates is a common variable for both stocks and bonds and this should lead to a positive correlation between them or, in other words, a more limited diversification effect. What’s more, the yearbook notes the correlation between stocks and bonds has been positive for extended periods of time since 1900. So, in the future, the correlation may be positive.

But unless the correlation is perfect, investors will still see the benefits from being diversified in stocks and bonds. And we can’t forget the important fact that bonds are less volatile than stocks.

The yearbook’s authors conclude that “there is a compelling case for global diversification, especially at the current time,” but observe the benefits of global diversification can be oversold if they are presented as a sure-fire route to a superior return-risk trade-off. Diversification should lead to a higher expected level of return for the same risk, but this is not assured.

Therefore, the best we can do is to make well-informed, prudent investment decisions and then patiently stick to our plan, especially when the markets are bleak.   

The Bear Market in Bonds: Short-Term Pain, Long-Term Gain

By James Parkyn

Most readers will be aware that Canada and the rest of the world have an inflation problem. You’ve no doubt noticed on your trips to the grocery store, your local restaurant, or Canadian Tire that prices are up for all sorts of things.

You also probably know that central banks are fighting inflation by increasing interest rates to cool down the economy. The other day, the Bank of Canada increased its benchmark rate by 0.5%, the largest one-time increase in over 20 years. It’s a safe bet the U.S. Federal Reserve will raise its rate at its next meeting in May. And both banks are expected to announce several more hikes in the months ahead.

What you may be less aware of is the extraordinary effect rising interest rates are having in the bond market. They’ve created a bear market like nothing we’ve seen since the mid-1990s.

You can be forgiven if you don’t follow twists and turns in the bond market. It’s usually quite staid compared to its flamboyant cousin, the stock market.

The stock market’s ups and downs are driven by investor emotions and that naturally draws the attention of the media and the public. By contrast, movements in bond prices are much more driven by boring, old math.

Bond yields—the current interest rate paid by bonds—move in the opposite direction to bond prices, meaning rising interest rates cause falling bond prices. This is because investors who wish to sell bonds have to accept lower prices since the purchasers of those bonds now expect to earn the new higher interest rates.

This effect has meant a steep decline in bond prices this year in response to higher rates. The FTSE Canada Universe Bond Index—the benchmark for bond ETFs held by many Canadians—is down 8.5% (excluding interest payments) year to date and 10.8% since hitting its high mark of the last 12 months in August 2021.

A decline of that size would be bad enough in the stock market; in the normally less volatile bond market it’s an epic debacle. In fact, there have only been two other bear markets on this scale in the Canadian bond market since 1980 – in 1980-81 and in 1994. The one in 1994, which also occurred in the U.S. was dubbed by our southern neighbors the Great Bond Massacre!

This year’s decline will be unsettling for investors, especially because the bond portion of their portfolios is supposed to be the “safe” bucket. However, there a couple of mitigating factors to keep in mind when thinking about this bear market.

The first point is that the decline in bond prices is more pronounced when you hold bonds with longer maturities. The longer a bond’s duration, measured in years, the more sensitive its price is to changes in interest rates.

Short-term bonds, as measured by FTSE Canada Short Term Bond Index, have lost 3.3% (again excluding interest payments) this year and 5.8% since hitting its high of the last twelve months in April 2021. This is still a significant drop, but a lot less severe than the one for longer dated bonds.

In our client portfolios, we prefer short-term bonds with maturities ranging from one to five years. The ETFs we use have a duration of roughly 2.7 years which compares to 7.9 years for the FTSE Canada Universe Bond Index.

Besides being less sensitive to interest rate increases, short-term bonds also provide better protection against rising interest rates in response to higher inflation and are less volatile than longer maturity bonds.

They offer better protection against rising interest rates because with shorter maturities, the portfolio turns over more rapidly, and the bonds can be reinvested at higher rates more quickly. In this context, it’s important to keep in mind that high inflation is a greater risk than rising interest rates because it eats into the value of your savings.

The second point to remember is that higher interest rates lead to better bond returns in the long run. Long-term investors, who have suffered through years of rock bottom interest rates, should want rates to rise, even if it means some capital losses in the short-term.

This is one clear case where short-term pain will produce long-term gain.

War in Ukraine: What Should Investors Do?

by James Parkyn

Watching Russia’s horrifying invasion of Ukraine unfold, I was reminded of one of Winston Churchill’s famous quotes:
“The statesman who yields to war fever must realize that once the signal is given, he is no longer the master of policy, but the slave of unforeseeable and uncontrollable events.”

It seems that Vladimir Putin and the Russian military are learning this lesson, but so too unfortunately are the people of Ukraine. Our hearts go out to all those who are suffering as a result of this senseless conflict – the human tragedy must remain uppermost in our thoughts.

Having said that, Churchill’s words also have salience for investors who worry their portfolio may sustain collateral damage from this war.

While the invasion does appear to mark a geopolitical inflection point on a scale not seen since the 9/11 attacks, the consequences for the economy and capital markets remain – in Churchill’s phrase – unforeseeable and uncontrollable.

The invasion has added a huge new element of uncertainty to the global economy that could reverberate for months and even years to come. Right now, markets are trying to digest the potential impact, especially for corporate profits.

Clearly, there will be an impact. Some 400 corporations, including some of the largest names in the world, have announced they will pull out of Russia. Heightened uncertainty and lower profits would normally lead to lower stock prices.

Yet, the reaction in the markets has so far been remarkably muted. While it’s true the U.S. market has entered correction territory, having lost 10.3% this year through March 15, the decline started well before the invasion on February 24. The S&P 500 was already down 11.3% on February 23. So, the U.S. market actually gained 1% during the first three weeks of war.

It’s a similar story in Europe, which being closer to Ukraine, you would expect to be more heavily affected. The FTSE Europe Index is down 9.5% for the year, but just 0.6% since the war started.

The Canadian market has actually been a beneficiary of the Russian invasion. It was up 0.3% for the year, as of March 15, thanks to a 28% rally in energy stocks in response to a surge in global oil prices.

So, the war’s impact on the markets—at least for now—is far less than you would have expected if you had based your judgment solely on dire predictions emanating from the financial media.

While the long build-up to war was probably reflected in lower stock prices before the actual start of the invasion, there were many other factors weighing on the markets. Importantly, investors were faced with much higher inflation and the prospect of higher interest rates.

The media had been focused on that bad news before turning its attention to the war. Meanwhile, it gave short shrift to all the good news on the other side of the balance. This includes strong GDP and job growth, record corporate earnings and the reopening of the economy from pandemic restrictions.

So, what to make of all these developments? Well, there’s the evergreen lesson that the media might be a good source of information and entertainment but is a terrible guide for making investment decisions.

More importantly, we are seeing another proof of just how impossible it is to predict how an event like war will affect the economy or the markets.

In this wonderful article, journalist Robin Power put it this way: “We crave certainty. We want to be authors of our own destiny. And we shrink from the notion that, to a large extent, our lives are governed by luck — both good and bad — and simple random chance.  Everything seems so obvious with the benefit of hindsight. But history happens in real time, and nobody knows — not even the generals or political leaders directly involved — how events will unfold from one day to the next.”

Powell’s advice for how investors should react to the invasion of Ukraine? “The vast majority of investors, and certainly those with a proper financial plan in place, should do precisely nothing.” 

We agree. When we’re asked what we are doing in response to events like the war, we answer: Sticking with the plan. Indeed, risk management is about engineering portfolios to cope with periods of high volatility before they occur.

Volatility comes in many forms and from many sources and that’s the exact reason why you get higher returns for investing in equities. You get paid to take risk, but you must be ready to deal with volatility before it comes. You do it with a portfolio that is broadly diversified across asset classes and geographies. 

Then, it’s a question of staying the course and resisting the urge to trade when the headlines are scary. That’s simple but not easy. It takes discipline and why it’s so important to have a long-term plan to rely on at times like this.

4 Ways to Prepare For the Next Bear Market

by James Parkyn

They say hindsight is 20/20 and that’s never truer than when it comes to the stock market.

When looking back at past corrections and bear markets, it’s natural to see all the factors that led to the downturn. However, the picture is much foggier when you’re trying to figure out when the next one might happen.

In fact, the evidence is that no one can consistently forecast the future direction of the markets – either up or down. Of course, this doesn’t prevent analysts, media pundits and investors from trying to predict the next crash.

As we’ve observed in recent episodes of our Capital Topics podcast, the doomsayers have been particularly vocal of late. They’re saying we are headed for a stock market correction or even a bear market because of the relatively high valuation levels of the markets.

The equities markets have had a strong run. For example, the U.S. market’s total return over the 10 years to January 31 was 17.8%, more than double the long-term expected return. However, experience teaches us that relative valuation metrics tell us very little about the timing of market pullback.

What are corrections and bear markets? A market correction is a drop of 10% to 20% from a recent peak. They usually don’t last very long. After a few weeks or months, the market recovers the losses. Corrections are quite normal; they allow the market to consolidate and take a breather before going higher.

A bear market is more serious. It’s when markets drop more than 20% from their recent highs. They usually last much longer. The triggers for a bear market vary greatly, but they are generally related to poor economic data, a geopolitical crisis or the bursting of a market bubble.

Since 1926, the S&P 500 has experienced 17 bear markets with declines ranging from -21% to -80%, according to this report from Dimensional. The average length of these bear markets was 10 months. The longest bear market was in the early 1930s, lasting 27 months, and the shortest one was the COVID crash two years ago. It lasted just one month.

As humans, we’re not wired for negative market volatility. Behavioural science has demonstrated it triggers our fight or flight instinct, and that’s why investors often make wealth destroying errors during a downturn.

Bear markets are when Investors learn their true tolerance to risk. For the long-term investor, they’re actually a time of great opportunity. But for those who panic, they almost always lead to a permanent loss of capital. That’s why it is crucial to be mentally prepared. A big drop may not happen tomorrow, this month or this year, but you can be sure one will occur sooner or later.

So, how should you prepare yourself for the next drop?

• Have a plan—You won’t be surprised by this piece of advice. You need to have an investment plan that you’ve laid out when the markets were calm and your emotions were in check. The plan must take into consideration your need and willingness to take risk as well as your time horizon. Remember that taking too much risk may lead you to bail out of the markets at the wrong time.

• Have a safe bucket—The best way to reduce risk in your portfolio is to have an allocation to high-quality short duration bonds. This safe bucket should be built with government and other top-quality bonds. Bonds hold their value in a bear market and may even gain, offsetting some of the losses in your equity bucket. If you are a retiree pulling money from your portfolios for living expenses, our advice is to have enough money invested in bonds to cover five or more years of annual withdrawals. This will help you stay the course until equities recover.

• Rebalance regularly—Rebalancing ensures your portfolio reflects your risk profile and capacity for risk. This is especially important during a prolonged bull market when many investors grow comfortable holding a larger percentage of stocks in their portfolios

• Tune out the noise—Finally, keep your emotions in check by tuning out the media noise. Embrace the fact that corrections and bear markets are unavoidable and unpredictable. One day they will end. Remember that if you stay disciplined and stick to your long-term investment plan in a bear market, you will be rewarded when the next bull market comes around.

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.