The experts’ crystal balls were as foggy as ever in 2022

by James Parkyn

To kick off the new year, our Capital Topics podcast looked at investing lessons from 2022. In this article, I want to focus on two of those lessons because they are so important for your financial health.

For our first lesson, we looked at last year’s events to see what they could teach us about what’s to come in 2023.

That’s just what’s done by the many financial experts who produce forecasts about the economy and the markets. We take a different approach. We look at those forecasts and wonder why anyone would pay attention to them.

To understand our attitude, let’s step back a year and consider some of the events you would have had to predict at the beginning of 2022 to have made winning bets.

• Russia’s invaded Ukraine to start the biggest land war in Europe since 1945.

• For the first time ever, both U.S. stocks and long-term bonds registered double-digit losses for the year. Value stocks outperformed growth by the largest margin since 2000, amid a tech stock crash.

• Runaway inflation took hold around the world, including rising to a 40-year high in the U.S. Major central banks hiked interest rates aggressively in response.

• China abandoned its zero-COVID policy as its economy stalled and widespread street protests emerged.

No one could have predicted these developments, but that’s not unusual. Every year, the markets are buffeted by unforeseen events that make a mockery of expert forecasts. If you want another example, look no further than early 2020 and the start of the global pandemic.

Yet, economists, analysts and money managers continue to confidently predict what’s going to happen at the beginning of each year. Why? It’s precisely because the future is unknowable that people crave the illusion of certainty that comes from predictions.

“The inability to forecast the past has no impact on our desire to forecast the future,” financial author Morgan Housel writes. “Certainty is so valuable that we’ll never give up the quest for it…”

Despite this deep need for certainty, one of our most important lessons from 2022 is to ignore the forecasts and outlooks. Instead, we recommend you focus on maintaining a steadfast commitment to controlling risk through broad diversification and a long-term investor mindset for whatever may come in 2023.

The second lesson we take from 2022 is related to the first. It’s to watch out for hindsight bias in your thinking and decision-making. This is the tendency to look back and delude yourself into believing you knew what was going to happen all along.

Writing in the Wall Street Journal, Jason Zweig explained it this way: “Countless hunches and gut feelings flicker through our consciousness over the course of a year. We naturally remember the ones that turn out to be right. The multitude of other hunches that turn out to be wrong go into our mental garbage can.”

Zweig writes that that hindsight bias translates into “what if” thinking. What if I’d only acted on this or that hunch last year, I would be so much richer today. However, our memory of past predictions is often faulty.

To prove the point, Zweig surveyed readers of his newsletter in late 2021 and asked them to forecast where a series of market indicators would be in a year’s time. Then, a year later he asked them to recall those predictions with the knowledge of how the year had actually turned out.

On average, the readers’ recollection of their forecasts was closer to how the markets actually performed in 2022 than their predictions back in 2021, which turned out to be far too optimistic.

This points to the human tendency to reconstruct the past based on what we know now. As Zweig notes the danger is that mistakenly thinking you knew what was going to happen in the past may lead you to think you know what’s going to happen in the future.

For more insights on how to navigate the markets, please check our PWL team website. 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. 

Our best investment advice of 2022

by James Parkyn

As 2022 draws to a close, we wanted to look back at the blog posts that drew the most positive reaction from our readers during the year.

As markets gyrated, the focus in 2022 was on how to deal with a protracted downturn and prepare for the next bull market. I looked at everything from how to keep a tight rein on your emotions to avoiding poor decisions when markets are falling to the importance of not falling prey to unhelpful predictions.

1. You can’t catch a market rebound if you’re not invested—U.S. stocks and bonds suffered through one of their worst ever six-month periods to start the year. The Canadian markets were also down, although by a smaller margin. Naturally, these declines made many investors nervous about just how bad the losses would get. Then, the markets rebounded powerfully over the summer. A similar pattern played out in the fall. A steep decline in September was followed by rebound in October and November. These episodes show just how fast the markets can move.

2.  4 ways to prepare for the next bear market—I wrote this piece before the U.S. stock market had fallen into bear market territory by dropping more than 20% during the spring. It contains timeless advice on how to prepare for serious market downturns and ride them out when they inevitably come.

3. Ask yourself this simple question before changing your portfolio—From the field of behavioural finance we know that people tend to feel the pain of losses much more intensely than the joy of gains. That’s why falling markets can provoke so much anxiety and lead investors to make wealth-destroying decisions. One way to deal with the temptation to overhaul your portfolio in the heat of the moment is to ask this simple question: Once I make this move, then what?

4. Will higher interest rates push the economy into recession? —Predictions come in many shapes and sizes. This year the media has been focused on how high interest rates will have to go to bring down inflation and whether these hikes will push the economy into recession. In this article, I discuss an interview with former Bank of England Governor Mervyn King who offers some sage advice about the value of predictions. (Spoiler: He’s not a big fan.)

5. Does diversification still make sense? —With stocks and bonds falling around the world this year, there seemed to be no safe harbour. Since the financial crisis of 2008-09, global markets have appeared to move in lockstep during times of trouble. This has led some investors to question the value of portfolio diversification. I take a closer look at this question with the help of the Credit Suisse Global Investment Yearbook, which is a guide to historical returns for all major asset classes in 35 countries, stretching back in most cases to 1900.

To get more advice on investing and personal finance, please subscribe to our Capital Topics podcast and download our popular eBook, Seven Deadly Sins of Investing.

We hope you are enjoying a restful and joyous holiday season and the whole team joins in wishing you a healthy and prosperous 2023.

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.