Focus on tax optimization, not tax minimization

by James Parkyn

For many years, Canadians have been conditioned by investment industry marketing to focus on maxing out their RRSP contributions to realize as much income-tax deferral as possible.

While reducing taxes is always enticing, a tax minimization mindset may not be the best approach in the short term, especially for high-net-worth individuals. Instead, you should cultivate a tax optimization mindset.

What is a tax optimization mindset? It’s thinking not just about the current tax year, but how your assets will evolve over the long-term and planning to fund your retirement in a tax efficient way.

We like to discuss this issue with our clients by getting them to imagine three buckets. In the first bucket is assets in registered accounts – RRSPs, Registered Retirement Income Funds (RRIFs) and other similar accounts. When you withdraw money from them, you pay income tax on it.

The second bucket is for non-registered investment accounts and Tax-Free Savings Accounts (TFSAs). Here, income tax has already been paid on the money that went into the account, so you don’t have to pay when you withdraw funds from these accounts. Obviously, if you realize capital gains in these non-registered accounts, 50% of these gains will be taxed at your marginal tax rate.

The third bucket is for business owners who have moved earnings from their operating company into an investment holding company to defer paying personal income tax. Many entrepreneurs accumulate large amounts of money in their holding company and eventually have to pay tax on it, just like on their RRSP savings.

As they head to retirement, people are often focused on the year they will turn 71, knowing they must convert their RRSP into a RRIF by the end of that year. However, they fail to plan for the tax implications of having huge amounts of money in buckets one and three – accounts where they will have to pay income tax on withdrawals.

They work on the assumption they’ll have a large pool of savings to draw on during their retirement but, in reality, they could have only half the amount in after-tax dollars. What’s more, their mandatory RRIF withdrawals might trigger clawbacks on their old age security pension.

That’s why it’s so important to plan early for how you will fund your retirement tax efficiently.

Your plan should include maxing out your TFSA contributions. As I explain in this article, there are no taxes to pay on capital gains, interest or dividends in a TFSA and you withdraw your money from it free of income tax. That makes your TFSA a highly attractive investment vehicle that gives you tremendous flexibility in retirement income planning and in distributing assets to your children upon your passing.

Besides taking full advantage of your TFSA, your retirement income planning may also involve withdrawing money from your RRSP and holding company in the years before you reach age 71 to reduce your tax bill after that age.

While the right mix of assets in different accounts will depend on your individual circumstances, it’s never too early to take a long-term view and start planning.

With the end of the year fast approaching, it’s also time to make sure you’ve made all the moves you need to for your 2022 income taxes. These may include crystallizing capital losses to offset capital gains, making charitable donations and several other possible actions we discuss in detail in the latest episode of our Capital Topics podcast.

While tax planning keeps us busy at this time of year, please remember that optimizing your taxes should be a year-round process and that we’re always here to help.

For more insights into investing and personal finance, please download our Capital Topics podcast.

Ask yourself this simple question before changing your portfolio

by James Parkyn

We know from the field of behavioural finance that people tend to feel the pain of losses much more deeply than the joy of gains. That’s why a bear market like the one we’ve experienced this year can be so hard to take.

When the markets become turbulent, most investors know they should keep a tight rein on their emotions. But in the heat of the action, when markets are sinking, it’s not easy.

There’s just so much uncertainty. You don’t know how bad the bear market will get or how long it will last. And don’t look to the media for help. Stock market commentators tend to focus on the negative and trot out clichés like “It’s a stock-pickers market” or “Buy and hold is dead.”

These bromides encourage people to trade their investments, but if you’re tempted to veer away from your long-term financial plan, ask yourself one simple question: Then what?

Once you make the decision to sell stocks to avoid further losses, what comes next? At some point, you will have to buy back into the market. But how will you know when it’s safe? In the meantime, you risk missing out on returns when the markets rebound.

Or you might be persuaded to purchase an actively managed mutual fund based on its past performance. However, we know that only 18% of actively managed Canadian equity funds outperformed their benchmark over the 10 years to December 2021, according to the S&P SPIVA Canada Scorecard. Actively managed U.S. and international funds have similarly dismal track records.

If the mutual fund you’ve chosen underperforms, then what? Do you go in search of yet another fund in hopes it will do better? Or perhaps you try your hand at picking individual stocks even though we know investors tend to fare even worse when they try this DIY approach.

In an insightful column, David Booth, Executive Chairman of Dimensional Fund Advisors, acknowledges that the uncertainty of the markets and life is highly challenging for people. However, he also observes that with uncertainty comes opportunity.

“Most of what happens in our lives is unpredictable, and it’s impossible to forecast the future,” Booth writes. “But you can live your life fully without knowing what’s going to happen. And you can have a good investment experience without forecasting what the market is going to do, because you’re not trying to guess which companies will succeed and when. You’re investing in the ingenuity of people to solve problems and make their companies run better.”

While the future course of the markets is impossible to predict, we can control how much risk we take; how broadly we diversify our investments; and who we turn to for financial advice.

When our emotions start to boil, we can remind ourselves that the key to investing success is to remain in markets long enough for compounding to work its magic. Blogger Ben Carlson put it this way: “The bedrock of my investment philosophy is based on the idea that it’s best to think and act for the long-term. But you have to survive the short-term to get to the long-term.”

Your goal should be to make decisions based on a well-structured financial plan and a tried-and-tested evidence-based approach to investing.

Then what? Then, you face the future with courage and optimism and let time do its work.

For more insights on how to navigate the markets, please download our eBook the Seven Deadly Sins of Investing. And if you’re not already a listener of our monthly Capital Topics podcast, I encourage you to download the latest episode and subscribe to receive future episodes.

It’s a terrible time to be bailing out of bonds

by James Parkyn

Most readers of this column will be familiar with the unfortunate tendency of some investors to buy high and sell low. They rush into rising markets and flee when they come back to earth.

That’s a pattern we usually see in the stock market, although this year U.S. equity investors have shown patience in the face of falling markets. Where they’ve been running from is the usually staid world of bond funds.

Bond prices have been going through a downturn in 2022 like we haven’t seen in 40 years. Our latest market statistic report shows the total global bond market (hedged to Canadian dollars) was down 12.3% to the end of September, while the Canadian total bond market was down 11.8%.

Those are pretty horrible numbers for what’s supposed to be the safe bucket in your portfolio. Investors in the U.S. have responded by cashing out of bond funds in droves. Morningstar data shows that year-to-date to August 31, US$330 billion had flowed out of U.S. bond mutual funds and ETFs. Surprisingly, the opposite has occurred in Canada where bond mutual funds saw net inflows of $1.3 billion and bond ETFs saw net inflows of $4.5 billion.

The discrepancy in bond fund flows between the two countries is hard to explain; however, Canadian balanced funds—those that hold a mix of stocks and bonds—followed the U.S. pattern, experiencing a net outflow of $6.5 billion for the year.

Those investors who are fleeing bonds are focusing on the short-term pain they’ve experienced from falling fund prices but are missing out on the several reasons why bonds have actually become more attractive this year for long-term investors.

Before we look at those reasons, let’s recall why it’s been such a challenging year for bonds. Coming out of the pandemic, inflation has been surging around the world. That’s prompted central banks, including the Bank of Canada and the U.S. Federal Reserve, to raise interest rates aggressively to cool the economy and bring down inflation.

What’s more, central bankers, led by Fed Chairman Jerome Powell, have also been clear that they will do what it takes to bring price increases under control, meaning they will keep raising rates until the inflation rate comes down to around their target of 2%.

Bond prices are inversely related to interest rates so that when rates rise, bond prices fall. Therefore, rising rates have meant capital losses on bond investments. But when watching bond fund prices drop, it’s important to remember the other side of the equation – falling prices mean bonds are paying higher interest rates, or in industry parlance, they are yielding more.

In fact, rising interest rates are creating a whole new investment landscape from the one we’ve known since the financial crisis of 2008-09. The rock-bottom interest rates we’d become accustomed to are now in the rear-view mirror.

Bonds are generating more interest income than in years past and that increases expected portfolio returns – good news for long-term investors. That’s the first reason why it’s a better time to invest in bonds than it was a year ago.

The second reason is that bonds will continue to be an important diversifier for your portfolio and thus reduce its riskiness – even in periods of rising interest rates.

The stock and bond markets have been relatively well correlated this year – going down in tandem – but that’s a highly unusual occurrence. Bond prices usually have a lower correlation with stocks than most other major asset classes and are also less volatile.

Mark Haefele said in his weekly blog, published on September 26th that History suggests bonds will resume their traditional role as a diversifier. Periods when 12-month rolling total returns fall simultaneously for both stocks and bonds have been followed by periods of strong bond performance. In fact, since 1930, the 12-month bond performance following such periods has been positive 100% of the time.

No one can predict the course of interest rates, as former Bank of England governor Mervyn King has pointed out. However, the picture for bonds has brightened not worsened this year. If anything, investors who reduced their bond holdings in favour equity during the long period of low interest rates may want to revisit their asset allocation.

For more insights into investing and personal finance, please download our Capital Topics podcast.

Will higher interest rates push the economy into recession?

by James Parkyn

With so much global economic uncertainty, investors are more sensitive than ever to the comments of central bankers. They parse every word, trying to figure out how high interest rates will go and whether the hikes will push the world’s major economies into recession.

A couple of weeks back, we saw just how sensitive the markets can be to the words of Jerome Powell, Chairman of the U.S. Federal Reserve, the most powerful central bank in the world.

At the Annual Economic Symposium in Jackson Hole, Wyoming, Powell said the Fed’s “overarching focus right now is to bring inflation back down to our goal of 2%.” He went on to say that “restoring price stability would take some time and requires using our tools forcefully to bring demand and supply into better balance.”

The market interpreted the statement that there will be no quick respite from large interest rate increases, raising the odds of a severe recession. The S&P 500 dropped by over 4%.

Central bankers must be careful about every word they utter publicly because they can have that kind of outsized effect on the markets. That’s why I like to listen to what former central bankers have to say because they can speak more freely about the current situation and what’s led to it.

I recently came across an interview with the former Bank of England Governor, Mervyn King, that I found highly insightful and recommend to everyone interested in where interest rates might be headed in the coming months.

King, who was Governor from 2003 to 2013, calls inflation a sign of a sick economy because wages are constantly chasing after rising prices, creating instability and hardship for households and businesses. That’s why it’s so important to bring inflation under control as quickly as possible.

King believes the current bout of the inflation is the result of two errors committed by the major central banks and the economists who advise them.

When the pandemic hit, central banks printed money to stimulate spending and boost demand. At the same time, you had governments injecting massive stimulus into the economy through direct support programs for households and businesses.

However, the pandemic caused a shutdown of economies, constraining production and the supply of goods and services. “You [had] a classic case of too much money chasing too few goods and the result of that is inflation,” says King, speaking in May. He believes government stimulus should have been sufficient to support the economy without the need for central banks to print money.

The second mistake was to rely on economic models that failed to take into account what was actually happening in the economy and instead relied on inflation targets. King noted central bankers can’t make inflation return to a 2% simply by setting a target. Words have to be backed by aggressive interest rate hikes to bring demand back into balance with supply.

As we saw during the inflationary spiral of the 1970s and 1980s, the sooner tough action is taken the better to avoid the need for even more draconian action in the future, he says.

As if they’d listened to King’s advice, that’s exactly the approach that’s been taken in recent months by the Federal Reserve under the leadership of Powell and the Bank of Canada under Governor Tiff Macklem as well as by other central banks. They’ve hiked rates aggressively and clearly signalled more increases are to come until inflation is brought under control.

How high will interest rates go? King says there is no way to know in advance. But he does note the near-zero rates in recent years were historically unusual and unhealthy for the economy because they distorted investment decisions. Will the rate hikes cause a recession? Here again, he won’t make a prediction, except to say it’s likely but not inevitable.

In fact, this former central banker doesn’t have a high opinion of forecasts in general. Who predicted, for example, the pandemic in 2020 or the Russian invasion of Ukraine this year?

“The mistake is to believe you can make accurate forecasts,” he says. “The more important thing to do is not to pretend that we know inflation is going to be 3.2% in a particular year but try to identify the risks. What are the risks on the upside and the downside? What actions can we take to mitigate those risks?”

This is exactly the approach we take in managing investments. We don’t try to predict the future but instead construct portfolios that reap returns from markets while prudently managing risk.

No one knows how high interest rates will go or whether a recession is in the offing. But we can prepare ourselves for different scenarios and then meet challenges as they come with patience and optimism.

For more insights into investing and personal finance, please download our Capital Topics podcast.

You can’t catch a market rebound if you’re not invested

by James Parkyn

What a difference a month can make. At the end of June, I shared some pretty grim market numbers from the first half of 2022.

It was one of the worst ever six-month periods for U.S. stocks and bonds. South of the border, stocks dropped 20%, falling into bear market territory, while bonds were down 8.8%, the biggest decline in four decades. In Canada, stocks were down 9.9% while bonds were off 12.2%.

Then, the markets rebounded powerfully. As of August 18, the U.S. stock market had recovered 13.2% in U.S. dollars while Canadian stocks had gained back 7.4%. The Canadian bond market gained 2.6 % in that same period.

The turnaround may seem surprising but actually, it isn’t unusual, judging by the historical market data presented in a recent webinar from Dimensional Fund Advisors. The webinar highlighted the fact that stock market declines of 20% or more occur fairly regularly and so do bounce backs.

Between 1979 and 2021, intra-year declines in the U.S. stock market averaged 14% from peak to valley. In 10 of those years, the drop was 20% or more. However, when looking at the market history of annual returns, only 8 of the last 46 years were negative.

So, at some point in a year you’re going to have a decent correction if not a bear market, but it doesn’t necessarily mean the year will end in negative territory. That’s why it’s so important to prepare yourself for market declines and not give into fear during those episodes.

The last time we had a first half as bad as this year was in 1970 when the S&P 500 lost 21%. Today’s investors can imagine just how gut-wrenching that must have felt. But in the second half of that year the market rocketed 29% higher and the S&P 500 finished the year at +4%.

Investors who sold their stocks that year because they feared more losses would have ended up missing on a huge rally and gain for the full calendar year.

Indeed, trying to time the market by jumping out to avoid losses and then getting back in when things appear calmer is often a very costly mistake as Dimensional demonstrated in another chart presented during the webinar.

It shows that had you stayed invested in the U.S. market during the 25-year period from 1997 to 2021, $100,000 would grown to slightly more than $1 million, or 10 times your initial investment

Of course, it wasn’t all smooth sailing during those years. There were many times when you could have become spooked by a market decline and decided to go to cash.

If you had and missed out on the best month during this period, your returns would have melted to $865,000. Had you missed the best three months, you would have earned just $731,000.

And as the presenters remind us, you would have also given up a lot of peace of mind. It can be just as stressful to be out of the market when it’s rising as it is to be in it when it’s falling

Now, I’m not predicting that when the end of 2022 rolls around the stock market will show a positive return for the year. We don’t know what’s going to happen between now and then.

However, the reason we earn returns from stocks and bonds is because we are willing to accept a measure of uncertainty and risk in return for the expectation that returns will be positive over time.

And while positive returns don’t come every day, the longer you are in the markets, the more you should expect positive returns. Therefore, the antidote to volatility is to stick to your financial plan and keep focused on the long-term.

As we saw last month, the markets can turn quickly and rise substantially in a short period. To capture those returns, you must be invested.

I encourage you to watch the full Dimensional webinar where not only bear markets but also inflation and recessions are discussed. And be sure to listen to our Capital Topics podcast for more insights into evidence-based investing and personal finance.

Sources: Quotestream and Dimensional Fund Advisors