There’s No Ideal Asset Mix, but 60/40 Is Still a Good Place to Start.

There’s No Ideal Asset Mix, but 60/40 Is Still a Good Place to Start

By James Parkyn

The classic investment portfolio is a 60/40 split between stocks and bonds. In thinking about this asset mix, we consider stocks to be the risky or volatile component and bonds to be the “safe” component. Equities provide growth while the bonds provide steady income, reduced overall risk and capital preservation in that part of the portfolio.

However, those assumptions didn’t hold in 2022 – far from it. Both the stock and bond markets fell by double-digits for one of the few times in history. According to Vanguard, the typical 60/40 portfolio declined for U.S. investors by a painful 16% in 2022. And that has led some observers to question the soundness of the strategy going forward.

Those doubts turn on the evolution of interest rates that occurred during the four decades to the end of 2021. Through those years, rates as measured by the yield on a 10-year U.S. Treasury bill declined from 15.8% in 1981 to 0.5% at the end of 2021. This drop in rates supercharged capital gains on bonds. (Bond yields and prices move inversely).

The result was exceptional, low-risk returns for a 60/40 portfolio. A speaker at a recent Morningstar conference in the U.S. noted that the Barclays Aggregate U.S. Bond index returned 7.75% annually over the 40 years through 2021, generating 87% of the return you would have received just investing in stocks with 45% lower volatility. That was a pretty sweet deal.

The party ended abruptly last year when central banks, led by the U.S. Federal Reserve, began ratcheting up interest rates to slow the economy and bring down soaring inflation. Rising rates hurt both the stock and bond markets at the same time.

With the bond portion of a 60/40 portfolio no longer enjoying a tailwind from falling interest rates in an environment of high volatility and sticky inflation, some asset managers argue investors should abandon the strategy.

Leading the charge is giant asset manager BlackRock, which argued in an article that higher interest rates to fight inflation could cause stocks and bonds to continue to fall simultaneously. “In the end, bonds may lose out as well [as stocks], potentially exacerbating losses in a diversified 60/40 portfolio.”

BlackRock and other 60/40 doubters say investors should devote a greater share of their portfolio to so-called alternative investments to generate better returns. These investments include hedge funds, private assets, inflation-protected bonds, infrastructure and commodities.

Other heavyweight asset managers, including Vanguard and Goldman Sachs Asset Management, have lined up on the other side of the debate. They note that the 2022 losses have substantially improved expected returns from a 60/40 portfolio, a development I highlighted in a recent blog post.

In that piece, I discussed PWL Capital research that showed a remarkable improvement in expected returns, mostly thanks to higher bond yields. Our expected return estimate for a 60/40 portfolio went from 4.97% annually at the end of 2021 to 5.81% in the latest edition of our Financial Planning Assumptions.

Vanguard noted a similar improvement in their expected return estimates and declared: “Far from dead, the 60/40 portfolio is poised for another strong decade.”

What’s more, Goldman Sachs observed that a loss like 2022 is exceedingly rare. Indeed, U.S. stocks and bonds simultaneously lost money over a 12-month period just 2% of the time since 1926. While a big loss like in 2022 will occur, Goldman argues that 60/40 remains a valid approach.

We remain firmly on the side of those who see the 60/40 portfolio as a good starting point for the construction of a broadly diversified portfolio, especially now that formally ultra-low bond yield have normalized.

We take a skeptical view of alternative investments. They generally carry high fees and we have yet to see convincing evidence that they produce higher returns at equivalent risk levels. When you add in liquidity risk for some of the strategies, our advice is to proceed with caution. Indeed, many alternative investments suffered through a terrible year in 2022.

As I’ve discussed in earlier blog posts, longer life expectancies mean most people need the growth that comes from stocks to ensure their money lasts as long as they do. However, with bond yields returning to more normal levels, those who had previously increased their equity allocation can now consider dialling it back to reduce portfolio volatility.

Why do I say 60/40 is a good starting point? Because there’s no ideal asset mix. Your portfolio has to be customized to fit your age, life goals and risk tolerance.

In the end, the right asset allocation is the one that allows you to stay the course through inevitable market downturns. That’s the right strategy 100% of the time.

For more insights on the markets, personal finance and growing your wealth, be sure to listen to our Capital Topics podcast and subscribe to never miss an episode.

Why Your Investing Perspective Needs to Get Much Longer ?

Why Your Investing Perspective Needs to Get Much Longer ?

By James Parkyn

We often talk about the need for investors to take a long-term perspective and look at periods of volatility through the lens of market history.

That’s why we’ve made it a tradition to report each year on the latest edition of the Credit Suisse Global Investment Returns Yearbook. The yearbook is an invaluable resource for investors because it draws lessons from a database of asset returns from 35 countries dating back to 1900.

This year’s yearbook includes an important discussion of just what constitutes a long-term perspective. That’s especially useful after an unusual year when investors suffered negative returns in both the stock and bond markets, amid high inflation, rising interest rates and the war in Ukraine.

The yearbook notes that stocks have outperformed all other asset classes in every country since 1900. The U.S. market, for example, provided a 6.8% annualized real return between 1900-2022. But it’s been far from a smooth ride.

With last year’s decline, we’ve now lived through four bear markets in equities since 2000, including the brief but harrowing COVID crash in 2020. While these episodes have been difficult, the important thing to remember is that living with that kind of volatility is the price you pay to earn a risk premium from stocks, and to a lesser degree bonds.

But to actually bank that premium, you must remain invested and well-diversified through positive and negative periods in the markets. And those periods can be deceptively long. The yearbook offers two examples where 20 and even 40 years of market data could be deceiving.

The first is what occurred in the stock market in the 20 years leading up to 2000. During those decades, global stocks performed exceptionally well, delivering a 10.5% real annualized return. Then, the dot.com bubble burst, kicking off what’s known as the lost decade for stocks when world equities generated a negative real return of -0.6% a year.

The yearbook’s second example is from the bond market where many investors were shocked by heavy losses in 2022. They’d become accustomed to reliable gains over the last 40 years. Indeed, in the four decades to the end of 2021, the world bond index delivered an annualized real return of 6.3%, not far below the 7.4% return from world equities.

It turns out those 40 years were a historic golden age for bonds, meaning, by definition, they were exceptional. When the turning point came in 2022, it was drastic. In just one year, the real return of world bonds plummeted 27%!

“To understand risk and return in capital markets…we must examine periods much longer than 20 or even 40 years,” the yearbook says. “Since 1900, there have been several golden ages, as well as many bear markets; periods of great prosperity as well as recessions, financial crises and the Great Depression; periods of peace and episodes of war. Very long histories are required to hopefully balance out the good luck with the bad luck, so that we obtain a realistic understanding of what long-run returns can tell us about the future.”

In other words, it’s important to guard against recency bias, the tendency to give undue importance to recent events. And, when it comes to the markets, recent should be measured in terms of decades.

Investors are too often lulled into complacency by trends that are too short to make prudent asset allocation decisions. Maintaining a disciplined approach to diversification and portfolio rebalancing through thick and thin will remain the best way to combat recency bias and other mental errors that can undermine your financial plan.

For more on the Credit Suisse yearbook and a discussion of the new First Home Savings Account, download episode 52 of our Capital Topics podcast and subscribe to get more insights into the capital markets, personal finance and growing your wealth.

The Challenge of Ensuring a Secure Retirement for All

The Challenge of Ensuring a Secure Retirement for All

By James Parkyn

Government pensions have been much in the news lately and that’s not surprising given the demographic headwinds hitting retirement plans around the world.

The most dramatic events have been in France where there have been widespread, frequently violent protests against a government plan to raise the pension age to 64 from 62.

In the U.S., there’s an acrimonious debate going on among the political parties about a looming funding crisis for Social Security. The issue came into sharper focus recently with the release of a government report showing that Social Security won’t be able to make full payments to retirees starting in 2033 unless Congress does something to shore up its funding.

Meanwhile in Quebec, last month’s provincial budget introduced changes to the Quebec Pension Plan. Among the changes, the government moved up the latest age at which a QPP recipient can start receiving an enhanced pension, advancing it to 72 from 70. As well, Quebecers who are still working at 65 and older, and receiving a pension, will be able to opt out of contributing to the QPP.

The common factors in all these developments are an aging population, the retirement of the large baby-boom generation and longer life expectancies.

The OECD highlighted just how widespread pension problems are in its Pensions at a Glance 2021. It warned that “putting pension systems on a solid footing for the future will require painful policy decisions: either asking to pay more in contributions, work longer, or receive less pensions. But these decisions will also be painful because pension reforms are among the most contentious, least popular, and potentially perilous reforms.”

While demographic trends are challenging for Canada’s economy, it’s important to note that actuarial projections for both the QPP and CPP show their funding is on a solid footing for many decades into the future. (The QPP changes are mainly aimed at keeping more older Quebecers in the workforce, not shoring up its finances.)

However, the funding picture isn’t as rosy for the other principal government pension plan in Canada – Old Age Security. Unlike the other plans, OAS – and the Guaranteed Income Supplement for low-income retirees – are funded from the federal government’s general revenues, rather than a pool of accumulated savings.

As more baby boomers retire, these plans are taking an ever-larger chunk of the federal budget. OAS and GIS together already make up Ottawa’s largest spending program at nearly $60 billion in 2023-24.

Given their high cost, could OAS benefits be scaled back or the retirement age increased? It’s possible, but past attempts have proven a tough sell. Older readers will remember the famous “Goodbye, Charlie Brown” exchange between retiree Solange Denis and then prime minister Brian Mulroney that sank a 1985 attempt to limit OAS’s inflation protection.

More recently, a 2012 plan to move the OAS eligibility age up to 67 from 65 by Stephen Harper’s Conservative government, was reversed by the Liberals. Far from reducing OAS benefits, the Trudeau government increased payments in 2022 by 10% for those 75 and over.

One area where change may be in the offing is in how Registered Retirement Income Funds (RRIFs) are regulated. The Finance Department is currently studying potential changes to RRIF rules.

Several groups have advocated raising the conversion age and reducing or eliminating mandatory withdrawals as a way of ensuring that seniors’ savings last throughout their retirement years.

Currently, Canadians must convert their RRSPs into RRIFs by the end of the year they turn 71. They are then required to withdraw a rising percentage of their RRIF each year, which is taxed as income.

In a submission to the Finance Department, Laura Paglia, CEO of the Investment Industry Association of Canada, recommended raising the age at which RRSPs must be converted into RRIFs and reducing the RRIF annual withdrawal rates with the goal of abolishing them entirely.

“The existing rules date back to 1992 when interest rates were higher and seniors were not living as long,” Paglia writes. “Today, it’s unlikely real returns on safe investments will keep pace with the withdrawals. Seniors have a higher chance of outliving their savings.”

“Unnecessary RRIF payments may even trigger clawbacks in retirement income support programs such as Old Age Security (OAS), the Guaranteed Income Supplement (GIS) and provincial supplements, causing some seniors to forfeit some or all of the government benefits they might otherwise have received.”

It’s unclear how Ottawa will come down on the issue of modifying RRIF rules, given the potential impact on government finances. What is not in doubt is that pension plans and how retirement are funded will remain front and centre as the population ages and the number of retirees grows.

The silver lining from a tough year in the markets is higher expected returns.

by James Parkyn

Anyone who is familiar with PWL Capital will know we don’t make predictions about the future direction of financial markets, the economy or anything else.

We accept the large volume of academic research confirming that no one can accurately forecast the future. Renowned economist John Kenneth Galbraith may have captured our attitude best when he said: “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.”

Nevertheless, we still need estimates of future investment returns to use in financial planning models for our clients. For this purpose, we use future expected returns, and they are quite different from predictions made by analysts, pundits and gurus.

In estimating future returns our research team at PWL doesn’t pretend to know what will happen in the markets or the economy in advance. Instead, they take the average of all possible return scenarios for a broadly diversified portfolio of publicly traded investments over a 30-year time horizon.

They generate these scenarios by combining observations of current market conditions and more than 120 years of historical returns for various asset classes.

Of course, we don’t know which scenario will come to pass in the markets in any year, which explains why our research team also estimates standard deviation – the percentage that an actual return could fall above or below our estimate in a given year.

This last point is important. In the short-term, returns will likely be substantially different from the expected return. Over the long-term, however, the dependability of the expected return estimate increases (although there remains a substantial margin of error). 

Last year was an example of short-term returns coming in far below long-term expectations for both the stock and bond markets. Both asset classes fell by double-digit percentages for one of the few times in history.

That was painful for investors, but the silver lining is that those market declines improved long-term expected returns, especially for bonds. We can see this in PWL’s recently published update of our Financial Planning Assumptions, authored by Ben Felix, Portfolio Manager and Head of Research, and Raymond Kerzérho, Senior Researcher and Head of Shared Services Research.

It shows that higher bond yields in 2022 produced a remarkable increase in our estimate for expected bond returns going forward. It climbed to 4.15% a year from 2.5% the previous year.

Gains in expected returns for stocks were less impressive because PWL’s equity estimates are based much more on historical returns than on current market conditions. Our estimated return for global stocks is 6.9% a year, compared to 6.6% a year earlier.

For a balanced portfolio composed of 60% stocks and 40% bonds, PWL estimates an expected return of 5.81% annually. Again, we can expect actual returns to deviate widely from this estimate in any given year.

Specifically, if we say the expected return is roughly 6% with a standard deviation of 9%, it means that two-thirds of the time, annual returns will be between -3% and +15%. The other third of the time the deviation will be even further from the mean. This is why investing often calls for patience and discipline.

PWL’s Financial Planning Assumptions makes a few other observations that may come as a surprise to you. Our research team estimates inflation at 2.4% annually over a 30-year-time horizon. That’s well below the current 5%+ inflation rate in the U.S. and Canada.

The report also estimates future returns for Canadian residential real estate market. Here, the recommended planning assumption is that an investment in a primary residence will return just 1% a year net of inflation, or 3.4% including inflation.

Return estimates are an important planning tool, but you should always keep in mind that we can’t know in advance what markets will return. Instead, you should seek to capture available returns as efficiently as possible while controlling risk through broad diversification and prudent asset allocation.

Then, it’s a matter of keeping the faith and patiently letting compounding do the work of building your wealth.

I encourage you to download a free copy of PWL’s Financial Planning Assumptions, and for more insights on investing and personal finance, listen to our Capital Topics podcast and subscribe to never miss an episode.

Here’s a better way to think about risk

by James Parkyn

Our job as investment advisors and portfolio managers is to capture returns from global capital markets while controlling portfolio risk. We do this by maximizing diversification, minimizing costs and seeking to make portfolios as tax efficient as possible.

A critical element in this work is matching portfolio risk to our clients’ risk tolerance. Your tolerance for risk depends not only on how comfortable you are with uncertainty, but also your capacity to take risk given your age, financial situation and life goals.

Last spring, Ken French, in association with Dimensional Fund Advisors, published an essay entitled Five Things I Know About Investing. French, a professor at Dartmouth College, is a giant in the world of finance who is best known for his work with Nobel Prize winner Eugene Fama.

The first part of his essay deals with risk. French proposes a definition of risk that steers clear of such technical concepts as volatility, standard deviation and beta. Instead, he defines risk as “uncertainty about lifetime consumption.”

He explains that people invest because they want to use their wealth in the future to achieve important goals like enjoying financial security, supporting the people and causes they care about and retiring comfortably. Risk is uncertainty about how much wealth it will take to achieve those lifetime goals.

“Some might plan to spend all the money on themselves for things like food, shelter, travel, recreation and medical care,” French says. “Others may plan to spend some of their wealth on political contributions, charitable donations, or gifts and bequests to their children…Investors like a high expected return because it increases the expected wealth that will be available to spend or give away. And everything else the same, risk averse investors prefer less uncertainty about their future wealth.”

In this light, the financial author Morgan Housel makes some important observations in his book The Psychology of Money about how risk and unforeseen events can jeopardize your future wealth.

“A plan is only useful if it can survive reality,” Housel writes in this excerpt from his book. “And a future filled with unknowns is everyone’s reality.”

According to Housel, surviving future unknowns to build wealth for lifetime consumption comes down to three things.

• First, more than big returns, you want to be financially unbreakable. In other words, you don’t want to take the kind of risks that will deplete your wealth and prevent you from benefitting from the power of compounding over the long term.

• Second, the most important part of your financial plan is to be prepared for things not to go as planned. You only have to think about the pandemic, the war in Ukraine or rising interest rates to know you should expect the unexpected. “Room for error – often called margin of safety – is one of the most underappreciated forces in finance. It comes in many forms: A frugal budget, flexible thinking and a loose timeline – anything that lets you live happily with a range of outcomes.”

• Third, Housel writes it’s vital to have a “barbelled personality” – optimistic about the future, but paranoid about what will prevent you from getting there. According to Housel, sensible optimism is a belief that odds are in your favour for things to work out over time even if you know there will be difficulties along the way. To make it to that optimistic future, you have to make prudent decisions and stay the course when things are looking bleak.

I encourage you to read Ken French’s essay to benefit from his other observations about investing. I also invite you to download the latest episode of our Capital Topics podcast where we discuss French’s essay in more detail.