Building Wealth

For the first 30 or so years of working, saving and investing, you’ll be first in the mode of getting out of the hole (paying down debt), and then building your net worth (that’s wealth accumulation.). But don’t forget, wealth accumulation isn’t the ultimate goal. Decumulation is! (a separate category here at the Hub).

Is it reasonable to have irrationally high return expectations?

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Image courtesy Pexels: Jakub Zerdzicki

By John De Goey, CFP, CIM

Special to Financial Independence Hub

When I ask clients and prospective clients about the return expectations they have for their portfolios, the responses vary wildly …  anywhere from ‘about 5%’ to ‘over 10%.’  Almost all of these expectations are too high.

 Admittedly, clients have different risk profiles leading to different asset allocations and ultimately, different outcomes. That’s reasonable.  A problem crops up when otherwise reasonable people have been socialized into having out-sized expectations.  How does one ethically re-calibrate expectations for irrational optimists who nonetheless think they’re within their rights to have those expectations?

The behavioural finance concept is overconfidence, although the attitude involves elements of optimism bias, cognitive dissonance and old-fashioned hubris, too. To quote J.M. Keynes: “Markets can remain irrational longer than you can remain solvent.” Few investors are prepared to acknowledge that the recent bull market seems unlikely to continue and that a recession appears to be on the horizon.

Learning from past Crashes

If we have learned anything from the great crashes of 1929, 1974, 2001 and more recently, the global financial crisis, it is that investors (often spurred by accommodative policy positions) can come to think of themselves as being all but invincible when central bankers are accommodative. Too often, they also lose their nerve when markets tumble and stay low for a prolonged period.

A good deal of personal finance is grounded in social psychology: especially group psychology.  People can get ahead through investing not only by being shrewd about valuations and such, but also by accurately anticipating how other market participants might react to a given set of circumstances.  Of course, it cuts both ways: and having reasonable expectations in the first place often assists investors in staying the course.

My concern is with the messaging being offered by many in the personal finance community these days is something I call “Bullshift.”  The industry shifts peoples’ attention to make them feel more bullish. To hear many in the business tell it, there’s no appreciable need to be concerned about high valuations, high debt levels (both public and private), a long-inverted yield curve and interest rates at generational highs.  Any one of these considerations would ordinarily give a rational investor pause. Taken together, they pose a clear and present danger for investors in the second half of 2024. Few seem concerned and it is that very lack of concern that concerns me.

Misleading investors with “Bullshift”

There is a directionally and mathematically accurate ad running by Questrade making the rounds that doesn’t tell the whole picture, either. Again, even the ‘good guys’ tend to mislead the average investor with Bullshift. The advertisement shows what you would earn over a long timeframe at 8% and what you would earn at 6%.

My question to you is simple: is it reasonable to assume an 8% return is even possible? There is longstanding evidence that higher-cost active investment strategies actually fail to outperform cheaper strategies such as passive index investing and that product cost certainly does matter. Continue Reading…

U.S. stocks are a great way to boost your portfolio returns. Here’s why.

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Image courtesy TSInetwork.ca

In my experience — over 40 years of advising investors on how to build wealth — too few fellow Canadians have diversified their stock holdings into U.S. stocks.

Unfortunately, most Canadian investors still believe — falsely —  that it’s too costly or too much hassle to buy U.S. stocks.

Most importantly, these investors have also ignored U.S. stocks’ tremendous safety and profit advantages to Canadians.

I believe that up to 30% of every Canadian stock market portfolio should consist of U.S. stocks, for the following three reasons:

 

  1.   U.S. stocks give you risk-reducing diversity. Canadian stocks are great, but so many are focused on natural resources —so when such commodities sink, so do your returns. U.S. stocks are spread across far more industries, giving you a broader cushion during market volatility.
  2. U.S. stocks give you international opportunities. Top U.S. stocks are multi-national revenue earners, so you benefit from booming international markets. It means your portfolio is safer and stronger than just relying on Toronto exchange stocks.
  3. Investing in U.S. stocks is easy and extremely profitable. Don’t worry: Buying U.S. stocks through your regular broker is as easy as buying Canadian stocks. And no matter the dollar exchange rate, when you get good returns, the currency exchange costs are insignificant.

If your portfolio has no U.S. stocks —or if you’re not satisfied with the performance of your current U.S. stocks — I recommend you take a free look at Wall Street Stock Forecaster.

Here’s how to spot the best U.S. stocks

Now is a particularly good time to follow our three-part Successful Investor investment approach — including for U.S. stocks:

Rule #1: Invest mainly in well-established, profitable, dividend-paying U.S. stocks.

Our first rule in the most successful investment strategies will help you stay out of high-risk, low-quality investments. These investments are always available, in good and bad markets. They come with hidden risks due to conflicts of interest and other negatives. Every year, they lead many inexperienced investors to substantial losses.

Recent standout losers include bitcoin and other cryptocurrencies; a disappointing crop of new issues (IPOs), which tend to come to market when it’s a good time for the new-issue company or its insiders to sell, but not a good time for you to buy; and slapped-together promotional stocks that hit the market thanks to the SPAC phenomenon, which offers a short cut to IPO status.

Instead, focus on well-established, profitable, dividend paying U.S. stocks. But, when looking for dividend-paying stocks, you should avoid the temptation of seeking out stocks with the highest yields — simply because they have above-average yields. That’s because a high yield may signal danger rather than a bargain if it reflects widespread investor skepticism that a company can keep paying its current dividend. In short, high dividend paying stocks can come with pitfalls. Dividend cuts will always undermine investor confidence, and can quickly push down a company’s stock price.

Above all, for a true measure of stability, focus on stocks with a high dividend yield that has been maintained or raised during economic or stock-market downturns. Generally, these firms leave themselves enough room to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they also provide an attractive mix of safety, income and growth. A track record of dividend payments is a strong sign of reliability and an indication that investing in the stock will be profitable for you in the future.

Rule #2: Spread your money out across most if not all of the five main economic sectors.

This is our key to successful diversification and the widely disparaged resource sector saw some major winners last year. On the other hand, if you had disregarded resource stocks with the intention of doubling down on tech stocks, you might have wound up with excessive holdings in tech stocks just as they entered a plunge. Continue Reading…

Bad Moon a-Risin’ — The Curious Case of Missing Inflation

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By Noah Solomon

Special to Financial Independence Hub

I see the bad moon a-risin’
I see trouble on the way
I see earthquakes and lightnin’
I see bad times today

Don’t go around tonight
Well it’s bound to take your life
There’s a bad moon on the rise

  • Creedence Clearwater Revival

The Curious Case of Missing Inflation

Image by Shutterstock/Outcome

Prior to the global financial crisis of 2008, if you had asked me what would happen if the Fed and other central banks slashed rates to zero and then left them there for over a decade, I would have told you that it wouldn’t be long before the world faced a serious inflation problem. I would have been dead wrong!

The Phillips curve is an economic concept developed by A. W. Phillips that describes the relationship between inflation and unemployment. The theory holds that there is an inverse tradeoff between the two variables. All else being equal, lower unemployment leads to higher inflation, while higher unemployment is associated with lower inflation.

Phillips’ theory proved largely resilient for most of the postwar era. However, a notable exception occurred in the years following the global financial crisis (GFC). From 2009 to 2021, despite unprecedented amounts of monetary and fiscal stimulus and record low unemployment, global prices remained unexpectedly subdued.

The Evolution of the Phillips Curve

As the chart above illustrates, in the years following the GFC the Phillips curve seemed to have shifted downward. This change allowed global economies to sustain low levels of unemployment that historically would have been accompanied by runaway inflation.

The classic unemployment vs. inflation tradeoff seemed to have vanished, leaving central bankers in the enviable position of being able to leave rates at uber stimulative levels for an extended period without spurring runaway inflation. This dynamic remained in place until 2021, when the rubber of unprecedented quantities of monetary and fiscal stimulus met the road of Covid-related supply-chain disruptions. This combination brought an abrupt end to the disinflation party of the past decade, causing central banks to raise rates at a blistering pace the likes of which had not been seen since the Volcker era of the 1980s.

Declining Interest Rates: How do love thee?

The long-term effects of low inflation and record low rates on asset prices cannot be overstated. On the earnings front, low rates make it easier for consumers to borrow money for purchases, thereby increasing companies’ sales volumes and revenues. They also enhance companies’ profitability by lowering their cost of capital and making it easier for them to invest in facilities, equipment, and inventory. Lastly, higher asset prices create a virtuous cycle: they cause a wealth effect where people feel richer and more willing to spend, thereby further spurring company profits and even higher asset prices. Continue Reading…

Should you use an All-Weather portfolio?

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By Mark and Joe

Special to the Financial Independence Hub

Stock market volatility can and will happen, which can really spook many investors.

To help with that, should you use an all-weather portfolio for changing market conditions?

Would an all-weather portfolio be best long-term?

How would I build an all-weather portfolio using Canadian ETFs?

Read on and find out our take, including the pros and cons of this all-weather investing approach.

The portfolio is designed for all seasons

If you prefer a more passive approach to investing, building an all-weather portfolio may be right for you. While this portfolio is designed to perform well during all seasons of the market, from an economic boom or bust and the messy stuff in between, we’ll see below that this approach is not without some flaws and drawbacks – just like any investing approach. Further, you could be missing out on some important aspects or assets for investing entirely.

Understanding how an all-weather portfolio works can help you to decide if this path could be right for you, or even if a blended all-weather approach could make much more sense.

What Is an All-Weather Portfolio?

Just as the name sounds, an all-weather portfolio is a portfolio that’s built to do well, regardless of changing market conditions.

This investing approach was popularized by Ray Dalio, a billionaire investor and founder of Bridgewater Associates, the largest hedge fund in the world. At the time of this post, Bridgewater currently manages over $140 billion in assets.

(FYI – this sounds very impressive of course, but we don’t invest in hedge funds and neither should you!)

Dalio’s all-weather philosophy is largely this:

Diversify your investments, hold specific asset classes in certain allocations, such that the portfolio can perform consistently throughout most economic conditions. 

This includes periods of increasing volatility, rising inflation, and more. More specifically, this portfolio strategy is designed to help investors ride out four specific types of events:

  1. Inflationary periods (rising prices)
  2. Deflationary periods (falling prices)
  3. Rising markets (bull/booming markets)
  4. Falling markets (bear/busting markets)

How an All-Weather Portfolio Works

Based on back-testing, essentially Dalio and his Bridgewater team came up with a model after studying the relationship between asset class performance and changing market environments. The result of this relationship crystallized the following asset class allocation that would investors to benefit whether the market is moving up or down or sideways.

Here is the asset class breakdown:

 

We’ll provide more detailed funds to mimic this portfolio in a bit.

One thing you’ll realize from the portfolio above is the all-weather portfolio takes a much different approach than age-based allocations (i.e., more bonds as you get older in your portfolio), the traditional 60/40 balanced portfolio, or other popular couch potato approaches. It essentially ignores an investor’s personal need for changing risk appetite. A drawback we’ll discuss more in a bit.

The theory of the All-Weather Portfolio is that:

  • The equity portion will thrive in bull markets.
  • Commodities and gold should support the portfolio for inflation.
  • Bonds will help investors when stock market growth is suffering…

You get the idea. Continue Reading…

Three ways to lower Risk in your portfolio with ETFs

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Here are some of the ways ETFs can be used strategically to help you sleep better at night.

Image courtesy BMO ETFs/Getty Images

By Erin Allen, VP, Online Distribution, BMO ETFs

(Sponsor Blog)

Volatility is often seen as the price of admission for achieving investment returns, but too much of it can feel like paying a hefty fee for a ride on an intense roller coaster, only to find yourself feeling queasy by the end and unable to enjoy the rest of the amusement park.

If the recent stock market turbulence in early August has left you contemplating panic selling, take a moment to breathe. Market corrections are a normal and healthy aspect of investing, and your portfolio doesn’t have to experience such dramatic ups and downs.

Why? Well, various defensively oriented ETFs can offer strategic ways to manage and mitigate risk, helping you stay the course and remain invested through the market’s inevitable fluctuations. Here are some ideas featuring BMO ‘s ETFs lineup:

Low-volatility ETFs

Imagine the broad market, such as the S&P 500 index, as a vast sea where the waves represent market volatility, and your investment portfolio is your boat navigating these waters.

How your boat responds to these waves is dictated by its beta, a measure that indicates both the direction and magnitude of your portfolio’s fluctuations relative to the market.

To put it simply, if the market’s “waves” have a beta of 1, and your portfolio also has a beta of 1, this means your portfolio will typically move in sync with the market, rising and falling to the same degree.

Now, consider if your boat were lighter and more susceptible to the waves, symbolized by a beta of two. In this scenario, your portfolio would be expected to swing twice as much as the market: more pronounced highs and lows.

Conversely, imagine your boat is a sturdy cargo ship with a beta of 0.5. In this case, your portfolio would react more calmly to market waves, experiencing only half the ups and downs of the market. This stability is what low-beta stocks can offer, and they can be conveniently accessed through various ETFs.

One such example is the BMO Low Volatility Canadian Equity ETF (ZLB)1, which selects Canadian stocks for their low beta. Compared to the broad Canadian market, ZLB is overweight in defensive sectors like consumer staples and utilities, which are less sensitive to economic cycles.

Holding allocations are as of August 19, 2024; sourced here1.

This ETF not only offers reduced volatility and smaller peak-to-trough losses compared to the BMO S&P/TSX Composite ETF (ZCN)2 but has also managed to outperform it — demonstrating that it is very much possible to achieve more return for less risk2.

To diversify further, you can also consider low-volatility ETFs from other geographic regions. These include three; BMO Low Volatility International Equity ETF (ZLD)3, BMO Low Volatility Emerging Markets Equity ETF (ZLE)4, and the BMO Low Volatility US Equity ETF (ZLU)5.

Ultra-short-term bond ETFs

While ETFs like the ZLB1 are engineered for reduced volatility through low-beta stock selection, it’s important to remember that they still hold equities.

In extreme market downturns, such as the one experienced in March 2020 during the onset of COVID-19, these funds can still be susceptible to market risk. This is pervasive and unavoidable if you’re invested in stocks; it affects virtually all equities regardless of individual company performances.

To fortify a portfolio against such downturns, diversification into other asset classes, particularly bonds, is crucial. However, not just any bonds will do — specific types, like those held by the BMO Ultra Short-Term Bond ETF (ZST)6, are particularly beneficial in these scenarios.

ZST, which pays monthly distributions, primarily selects investment-grade corporate bonds6. The focus on high credit quality, predominantly A and BBB rated bonds, is critical for reducing risk as these ratings indicate a lower likelihood of default and thus, offer greater safety during economic uncertainties.

Moreover, ZST targets bonds with less than a year until maturity6. This short duration is pivotal for those looking to minimize interest rate risk. Short-term bonds are less sensitive to changes in interest rates compared to long-term bonds, which can experience significant price drops when rates rise.

Charts as of July 31st, 2024 6

This strategic combination of high credit quality and short maturity durations7 is why, as demonstrated in the chart below, ZST has been able to steadily appreciate in value without experiencing the same level of volatility as broader aggregate bond ETFs like the BMO Aggregate Bond ETF (ZAG)8.

Buffer ETFs

If you recall the days of using training wheels when learning to ride a bike, you’ll appreciate the concept of buffer ETFs. Just as training wheels keep you from tipping over while also limiting how fast and freely you can ride, buffer ETFs aim to moderate the range of investment outcomes — both up and down.

Buffer ETFs may sound complex, but the principle behind them is straightforward. These ETFs utilize options to limit your downside risk while also capping your potential upside returns.

For example, a buffer ETF might offer to limit your exposure to a maximum 10% price return of a reference asset (like the S&P 500 index) over a year while absorbing the first -15% of any losses during the same period.

If the reference asset rises, your investment increases alongside it, up to a 10% cap. However, if the reference asset declines, the ETF absorbs the first 15% of any loss. Only after this “downside buffer” is exhausted would you start to experience losses.

BMO offers four such buffer ETFs, each named according to the start month of their outcome period when the initial upside cap and buffer limits are set. These include: Continue Reading…