In this episode we will be covering portfolio management, including an overview of portfolio planning, portfolio execution, and portfolio maintenance. Much of the episode will focus on asset allocation. This topic builds on what we covered in our last episode. Asset allocation is the mix of investments that you hold. When designing a portfolio for your situation, you want multiple asset classes for diversification to mitigate uncompensated risk.

You also want to take as much compensated priced risk as you are willing and need to take. How much risk you are able to take is also vital. That includes the risk of not having the money there when you need it. However, it also includes the behavioral risk of not being able to stick with the plan when markets buck and gyrate. The balance of investment and behavioral risk is one of the most important investment decisions choices you’ll make. You’ll also have to occasional rebalance to keep your risk within your guardrails.

Building and maintaining your portfolio can be extremely simple or complex. You will also have to consider the trade-off between optimizing and being able to execute your plan.

TRANSCRIPT

FOOTNOTES & REFERENCES

RELATED RESOURCES

Transcript

Introduction

[0:00:02] BF: Welcome to the Money Scope Podcast, shining a light deep inside personal finance for Canadian professionals. We are hosted by me, Benjamin Felix, portfolio manager and Head of Research at PWL Capital, and Dr. Mark Soth, a.k.a The Loonie Doctor.

In this episode, we’re going to be covering portfolio management, including an overview of portfolio planning, portfolio execution, and portfolio maintenance. A lot of the episode is going to focus on asset allocation, and this topic is building on what we covered in our last episode.

[0:00:31] MS: In our last episode, we unpacked some of the fundamental building blocks of investing. We talked about asset classes, like stocks and bonds and commodities, and how they’re priced. We discussed that in the context of the idea of an efficient market, which is a market that incorporates all the available information pieces and puts that into the prices. That efficiency and collective intelligence makes it very difficult to profit from mispriced securities. In an efficient market, the market prices, the aggregate of all known information and probabilities. Well, any individual trader only has a sliver of all that available information.

[0:01:09] BF: Yeah. That concept is super important, because in that environment, even professional money managers with tons of dedicated time and resources and talent, they’re going to struggle theoretically, and they do indeed struggle empirically to outperform the market net of fees. Since we can’t reliably beat the market, the big things to focus on are things that you can control, like how much risk you should take and your fees, costs, and taxes.

[0:01:32] MS: At a fundamental level, investing in market is all about taking the right risks. When you own the market, you’re exposed to what’s called priced risk, which is known as market risk. By price, it means that you expect that you can earn a positive return with a diversified portfolio for taking that risk on because it’s reflected in the pricing. Now, if you try to pick narrow winners and avoid the losers, then you’re actually more speculating, rather than investing. The statistical outcome of speculation is actually to lose money.

[0:02:04] BF: Right. It’s like gambling. The longer you stay at the casino, the more likely you are to lose. The other big way that you can make yourself worse off in investing is by deviating from your plan with bad behaviour, or poor execution. In this episode, we’re going to discuss how to put the fundamental building blocks of priced risks and diversification together in a portfolio. The ultimate goal of portfolio management is to find the right mix of investments for you that maximizes the risk and expected return trade-off without provoking the bad behaviour, or execution errors that can lead to underperformance.

[0:02:41] MS: It’s a complicated process, but building a portfolio usually, it’s all like planning, preparing, and serving a great meal. For this episode, we’re going to break out the gastromoney scope to further examine the contents, while the raw ingredients are still fresh from our last episode.

[0:02:55] BF: The reason that we’re using the gastromoney scope for this episode is because it is a massive topic. We’re going to stuff you with a very comprehensive and detailed look at portfolio construction, a sumo wrestler-sized meal. We planned to pull the scope out before gastric rupture, but we do recognize that many people won’t make it through this procedure in one sitting. Plus, most people will need to revisit and ruminate on this episode multiple times.

As usual, we’ve organized and bookmarked the content sections meticulously, so that you can come back and find pieces that are relevant at that time later, and you’ll always be able to see how the pieces and processes logically fit together. We think that’s really important. But we do recognize that this is a big topic, and this is a big episode. We’re conscious of that, but we didn’t know what to cut, because it’s all really important stuff.

[0:03:45] MS: Yeah, it all fits together well, and I think it’s one of those things you just got to come back to.

[0:03:49] BF: All right, let’s begin the procedure.

[0:03:52] MS: Okay.

Portfolio Planning

[0:03:55] BF: All right, so we’re going to start this episode with portfolio planning, just a brief overview of that concept. In episode 6, we introduced the basics of investing. Investing by its nature means taking risks. Done properly, risk is a good thing. As long as we expect the risks that we’re taking to translate into investment returns, that’s the whole idea of positive expected returns. In contrast, the expected return from speculation, or gambling is negative. You expect to lose and increasingly so if you keep playing long enough. One of the funny things about risk is that it’s different for every investor. We’ll talk more about risk later in this episode, but it’s a really complex and interesting topic.

Things like your time horizon, your objectives, your constraints, your non-financial assets, and your psychology, and these are all things that are specific to each individual investor, those are all going to contribute to what the risk-return trade-off looks like for your specific situation. Choosing the right risks that belong in a portfolio is called asset allocation, and we’re going to cover that in the next section.

[0:04:55] MS: One of the simplest examples of how risk could be different between two different investors is cash. Cash is extremely safe for a short-term investor since you know it’s going to be there tomorrow, but it’s also extremely risky for a longer-term investor since that’s much more likely than stocks, or bonds to lose its purchasing power over time in the long run. Another interesting example is socially responsible investing. Some investors may be willing to give up a little bit of expected return in order to feel good about their investments, and that obviously plays a role in why you’re investing and what you’re trying to do besides the money component. There’s all these other non-financial factors that you consider as well.

The first step in managing a portfolio is figuring out your objectives and your constraints. Those are going to act as your guideposts as you’re building your asset allocation. This is actually why we spent so much time in the first few episodes talking about happiness, identifying our values, and setting objectives because you’re going to need to know where you’re going if you want to make a plan on how to get there. That’s why we’re investing. That’s implementation of that part of our plan.

Asset Allocation

[0:06:02] BF: That planning piece is huge. Then, given a set of objectives, that’s when we get into the type of stuff that people really like to think about in investing, which is what stuff do you pick. Once we’ve identified our objectives, we’ve got to find the right mix of assets to meet them, and that’s where we get to asset allocation.

Asset allocation aims to balance the risks in a portfolio in a way that, ideally, optimizes the trade-off between risk and expected return to match your specific situation and your objectives for the portfolio. Practically speaking, asset allocation is deciding which asset classes you want to invest in and how much of each with consideration for how those assets interact with each other in the portfolio. Your target asset allocation may change over time, as your horizon, human capital and financial wealth change.

[0:06:45] MS: I think that’s the big concept of what it is we’re trying to do with asset allocation. But just to put that concretely, when we talk about it specifically with our investment portfolio, we’re going to be talking about our specific allocations. For example, we may have something, like 60% stocks and 40% bonds. That would be one way of looking at asset allocation, but we can also then take that. We can divide that up into further, smaller pieces. We can say, for my stock piece, I’m going to have one-third Canadian and one-third US and one-third of the rest of the world, for example. I’m just throwing out the example that you can really take this and slice and dice it into many asset classes.

You can even take and divide it up within those countries and industries, into thinner and thinner and thinner pieces. That’s tempting, but the problem is that it’s really actually the big groupings that are the most important. We don’t want people to get lost in the weeds of trying to have super fancy slicing and dicing to tiny little slivers. It’s the big pieces that are going to matter the most. You can also take that investment piece of your portfolio and take an even broader view and look how that investment part of your portfolio actually fits in with your other assets.

People think about their investment accounts, but they may also have investment real estate. They may have a business that they’re running. They may have other stable income streams, which could be their current employment, or it could even be a pension or some other stream of income. All those actually factor into our overall financial situation.

“Optimal” Portfolios

[0:08:07] BF: We will touch on integrating other assets a little bit more later. I want to introduce the idea of optimal portfolios. I have in our notes “optimal” in quotation marks because I don’t think that optimal is a real thing in investing. I’ll explain why in a bit. The idea of optimal portfolios really started with a man named Harry Markowitz, who, unfortunately, passed away recently at the age of 95. We have a tribute episode on the Rational Reminder Podcast where one of Harry’s good friends came and talked about the work and life of Markowitz. Anyway, sounds like he was a really great guy, other than beyond being really, a mathematician and financial economist.

Anyway, Markowitz pioneered the idea that it’s possible to combine assets together in a portfolio in such a way that the risk-return trade-off will be optimized, at least when risk is measured as how volatile the portfolio is, which is how Markowitz’s work was measuring that. The idea is that if you can find assets with low, or even better negative correlations, you can reduce the riskiness of your portfolio without giving up expected returns. Now this theory is extremely valuable and it really transformed modern finance. Basically, everything that we know about financial markets today builds on Markowitz’s work. But its application, in practice, I think often misses the mark.

There are software optimizers out there that will take in a bunch of data points on different asset classes and it will spit out precise allocations for how much to hold in each asset class in order to maximize the trade-off between returns and volatility in your portfolio. Now, optimization is a really funny thing in portfolio management, because we can only optimize based on history or on our expectations about the future, but not based on the actual future outcome. Optimal allocations are extremely sensitive to the inputs used. In my opinion, this approach to optimal asset allocation is like astrology. I don’t know if that’s too extreme or not. I think it’s like that.

[0:09:59] MS: I think we try to take our best guess with mathematical models. I get drawn into this too, because you see a mathematical model, it’s back-tested in various ways and it sounds really good, and the math actually is math, it makes sense. But not being aware of how sensitive those models are to the inputs results in over-relying on the past. We really don’t know what’s going to happen in the future. We can make some assumptions about it and they are going to be off. The question is, are they off so much that the inputs and those sensitivities make it not a useful way to try to optimize things. You’re not really going to be able to build the perfect portfolio and it’s worth keeping in mind as we go through the asset allocation process because we’re going to talk about searching for the perfect portfolio, but it’s not really a thing.

Good enough is what we’re going to be aiming for because the worst thing you can actually do is let all that analysis and thinking get in the way of actually doing something. Good enough is what actually matters and time in the market is probably your biggest asset on your side. You don’t want to get analysis paralysis by thinking of the perfect way. You also don’t want to start portfolio tinkering, because as time goes by, the models are going to change and the results are going to change because the inputs are changing all the time. You don’t want to be tinkering and responding to different changes in mathematical modelling, just because things are unfolding differently. That’s expected. You just want to pick something that’s good enough.

The other reason why I say this is important is because this uncorrelated product that you want to have to put in there to your portfolio to make this theoretically better, that’s a very common route that’s taken as part of the sales pitch for selling some of these more complex products, which in the reality is they may not be as uncorrelated as you think. It’s just part of how they’re wrapped and evaluated. The reality is that the perfect portfolio for the future, it’s not noble today. The good news is that we have enough information to make pretty good portfolios and given the constraint of unknown future outcomes, pretty good is about as good as it’s going to get, even if we stick with this Markowitz framework for portfolio theory.

Because the theoretically risk-return optimal portfolio has effectively been chosen already by the efficient market. That’s the other good news. We can approximate that by using a stock and bond index fund. Even though there’s a lot of theory, the reality is it boils down to something we can actually implement simply.

[0:12:20] BF: There’s a lot of nuance to this, but as a broad statement, if we accept that the market is efficient, all assets are priced such that the market portfolio is mean-variance optimal. We could spend a whole episode to explain why that’s true, but just take that for what it is. That means that you can just own the market, which we can approximate using stock and bond index funds, and you are accessing the theoretically optimal portfolio.

[0:12:43] MS: Yeah. Even if it’s not perfectly efficient, it’s efficient enough that you’re not going to be able to take advantage of any little inefficiencies, or temporarily there.

[0:12:51] BF: Definitely. Now, one of the most important things to consider is that when we talk about asset allocation, we’re talking about allocating across asset classes, not finding managers within asset classes. We’ve talked about in our last episode and briefly at the beginning of this episode, why asset classes rather than stock picking and market timing are going to be what explains most of the difference in returns between diversified portfolios.

We reviewed in the last episode why low-cost diversified funds, like index funds are a really simple and effective way to get exposure to asset classes. Buying a single index fund makes diversification way easier than trying to buy all of the individual securities directly, stocks or bonds directly to get exposure to a market. We’ve also talked about why trying to pick the future winners, or time the market are examples of uncompensated risk that you don’t expect a positive return for. Then the flip side of avoiding uncompensated risk is that we want to take compensated risks. We want to get diversified exposure to asset classes that have priced risks. That’s what’s going to explain most of the differences in returns between diversified portfolios.

Most of the returns that investors earn are going to come from asset classes, not from managers. Asset allocation, the way that we’re going to talk about it today is about finding the asset classes that we want and then getting exposure to those asset classes using efficient financial products, like low-cost index funds, or similar products.

Asset Allocation Over the Lifecycle

[0:14:13] MS: The way this works with this asset allocation, it can change over our lifecycle as well. As I mentioned earlier, asset allocation includes not only your financial asset portfolio, but your human capital is also part of that as well, as your other non-financial assets. Your human capital is your ability to work and earn income. That could be income now, or in the future. But there’s some important considerations with that. One is that while you’re young, you have your peak human capital. You have this entire career ahead of you where you’re going to be earning income and different people with those types of careers, depending on their skills and demand, they’re going to have different human capital characteristics.

Some people might have income that looks risky, like stocks would be. Or, others may have income that’s very safe and stable, more like a bond rather than a stock, if you were to make that comparison. Many skilled professionals will likely earn more towards the bond-like side of human capital, just because of the stability of and demand for what they’re doing, but it can vary. Economic theory would suggest that a large, non-diversifiable position, because you can’t diversify your human capital that much in a bond-like human capital, means that young people should take on extra equity risk because they have all this bond-like performance from their income-earning. That could be even a 100% equity allocation. Very high-risk equity allocation, because you have that stable human capital fall back on.

There’s even an argument to even use more than a 100% equity by using leverage.¹ You borrow against future income to invest even more now and try to smooth out that asset allocation over time if you’re considering your income in addition to what you’re investing in. Now, we don’t see that actually play out in practice all that often, especially not at the extreme end. The reason why is probably most people don’t do it because it would exceed their emotional risk tolerance. There’s this theoretical optimal way of doing things, but we have to actually be able to do it and our risk tolerance usually does not allow us to stomach that. Early in your career, your income stream may not be as stable and you probably have some debt and debt makes everything scarier. It would be uncommon to actually do that.

[0:16:21] BF: We’ll talk more about the hyper-optimization of expected returns later, but it’s something that I think a lot of people that think like engineers anyway. That’s where I’ve had a lot of these conversations are like, “Oh. Well, this is the logical way to optimize. I must optimize.” That doesn’t always mean that it’s right.

[0:16:34] MS: I encountered that, too. It’s the same thing with physicians and other people. We tend to try to find the most efficient way of doing everything.

[0:16:41] BF: Efficient and logical. I had this conversation this morning with somebody about, actually, portfolio optimization. My response was that we were talking about the quantitative portfolio optimization that we were talking about a minute ago. My response was, that is a quantitative approach to optimization, but not a logical one. Those things can often be conflated.

Anyway, on asset allocation through the lifecycle, as you progress through your career, you’re exchanging your human capital for financial capital. Then the basic idea is that you’re going to reduce your exposure to risky stocks to account for your shrinking position and bond-like human capital. I think people are generally familiar with this idea that you, okay, you reduce your exposure to stocks over the lifecycle and that’s just what you do. There are rules of thumb that dictate this, like a 100 minus your age, for example.

There’s some nuance though to this basic idea. If we think back to the path of lifetime wealth that we talked about in earlier episodes, in the lifecycle model, your financial wealth is going to have a hump shape over time for most people. You’re going to convert your human capital to financial capital. The financial capital is going to grow, grow, grow, and it’s going to peak somewhere around retirement. Now, an interesting empirical observation just on this idea of reducing your exposure to stocks over the lifecycle is that people seem to have an increasing tolerance for risk with increasing wealth.²^,³

While the reduction in your human, your bond-like human capital, may be pushing your target allocation to stocks down, you’re increasing financial wealth and decreasing risk aversion associated with that. Maybe pushing your target allocation to stocks up. The end result can be approximated as something closer to a flat optimal asset allocation over the lifecycle, rather than a decreasing equity allocation. We got this from an academic named Francisco Gomes, who’s a guest on the Rational Reminder Podcast. He talked about his research on this.

For me, it was mind-blowing, because that’s just such a common thing that you reduce your exposure to stocks over the lifecycle. That empirical finding really throws a wrench in simple rules of thumb, like having a 100 minus your age in an asset class.

[0:18:35] MS: That’s a really interesting observation. I think it really actually is very personal, how this is going to play out with you as an individual. I’ve experienced it personally with myself and I’ve also seen it with other colleagues. There was a point where I felt like, I should become more conservative and add in more bonds because I was getting older and this is what you do. I had senior colleagues who were older than I was suggesting that as well, telling me it was going to feel a lot different and you really need to do this. But then, I was actually starting to consider early retirement at that point, so I did actually increase my bond allocation.

However, as my money continued to grow, I actually felt less nervous and I just ended up going back to my usual asset allocation again, and which is more on the equity side. For me, it was that I could see first-hand, even with some typical market crashes along the way that I would still be fine. I was also thinking in a way that that was really my bottom line. Even though I ended up back in the same place, I actually don’t think that was a wasted exercise. I think it’s really hard to know what the appropriate asset allocation is for your risk tolerance until you’ve actually grappled close up with the prospects of working less.

When you’re thinking about retiring, it’s looming, that changes your mindset a bit. Also, if you lived through some hefty bear markets and you’ve done that and you’ve weathered it well and it doesn’t bother you that much, then that gives you information about your risk tolerance. Or if it does bother you, that also gives you information. Importantly, you need to know that you have enough wealth that you’re going to have the financial reserve capacity to weather the ups and downs. I think that’s what makes this a little bit different for other people, besides how they react to it. I mean, I think this probably is a limitation for those that are just skimming the surface, or someone approaching retirement age with just enough money.

Now, that’s probably why it’s a rule of thumb is because that probably does encompass the vast majority of the population. However, I think those would have clearly more than enough financial assets. If you’ve achieved financial independence earlier in your career and then use that to take your career in different directions, like we’ve talked about earlier, then this is really not going to be the limiting factor. You’re back to your emotional ability to handle the swings and the up and downs, this limiting factor more so than just the math of it.

[0:20:41] BF: Yeah, it’s a great point though. It’s a very individual decision on how much, and we’ll talk much more about that later. The idea that there’s a rule of thumb, or that everybody should, that means your experience, right, Mark, where you just felt like, because that’s what you do, that you should reduce risk in your portfolio. But then based on your experience, you changed your mind. It’s so interesting that your personal experience matches up with the broader empirical evidence.

That was human capital over time, where your human capital position is decreasing as you convert it to financial capital, as you earn income and have fewer years remaining to work, that can affect, or maybe not, depending on how you interpret the evidence that we just talked about. That can affect your asset allocation.

Diversifying your Human Capital

The other area where human capital can affect asset allocation is in the way that your, and again, this is very individual, the way that your specific job, or your business and your skills interact with the broader economy. We touch on this in one of our cases later in a fun example. If you’re in a highly cyclical industry that’s sensitive to changes in economic conditions, you might take less risk with your investments. If you’re in an industry that does well when the broader economy does poorly, or maybe just isn’t affected by – less affected by the broader economy, you might be able to take more risk with your portfolio, with your financial assets.

Now, one of the easiest ways to address your human capital asset allocation from this perspective is just not owning the stock of your employer, and maybe not overdoing it with bets in your industry, or sector. It’s probably not practical to cut out your industry or sector from, or even your employer from your index portfolio, because to do that, you’d have to go and buy sector ETFs, or index funds for every sector, except your own, so it becomes just a ridiculous exercise for probably not a whole lot of benefit.

I definitely wouldn’t go and buy more of your employer stock, or more of an industry ETF in addition to what’s already included in an index fund. If you have an employer who’s got public stock, you already own a little bit of it in an index fund, I wouldn’t go and double down. Likewise, if you have an index fund, a total market index fund, you already own your industry, I wouldn’t go buy more. I wouldn’t try and carve it out, because that’s a real hassle, but I wouldn’t go and buy more.

Now, I think this comment is important to make, because people who have specific knowledge about their own industry, or about an industry often feel they can use that knowledge to pick stocks or make bets on their sector. I guess, this happens with employers, too, where people feel like they know their employer better than the market does, and therefore, they can make that bet successfully. I think it’s rare for these plays to work out. They can sometimes. If you worked at Amazon early and held onto that stock forever, hey, you did really well. But those are rare. That’s literally like winning the lottery.

[0:23:17] MS: Yeah, that was luck.

[0:23:18] BF: You weren’t that smart. It was luck. I mean, who does? You could still be smart and win that bet, but I would probably say, it’s mostly luck. Now, the result of doing that actually, as opposed to being a smart thing to do, what you’re actually doing is making your financial capital sensitive to the same risk as your human capital, which, as we mentioned a minute ago, is probably not the smartest thing to do, because you can use your financial capital to diversify your human capital, as opposed to doubling down on the risks.

Now, the advice to not own your employer’s stock doesn’t work as well if you’re a small business owner, because that’s harder to diversify away from. A lot of startup founders are very intentionally taking a lot of risk. Like, if they’re bootstrapping their company and maybe not taking any external equity investment, they’re doing that very intentionally with the potential for an unlikely, but if they do well extremely large payoffs.

Those are unique cases. But I think just generally thinking about the interaction between your business, your income, your skills, and the rest of your assets is something that’s really important to keep top of mind when we’re talking about asset allocation.

[0:24:19] MS: This is something that’s very difficult for us as professionals, or business owners. We covered a bit about this in episode six, but we have this sense of control over our business and our practice. That sense of control may lead us to concentrate or specialize in that area that you understand, but at best, it’s an illusion of control, because there are actually many external factors that we don’t account for, and we don’t even realize we’re not accounting for them. There’s all these things we don’t actually control, even though we think we have some control. There’s other factors influencing there that we don’t. It can really tie us up.

Other Assets

Now, there’s other assets, too. We mentioned this a bit earlier, but beyond your human and financial assets is important to take a global view of your financial life. We haven’t talked a lot about it, but a part of that could be social capital, which is how much you can rely on others to help you out. Being an investor in Canada and planning for retirement may be different than planning in the US. We have a public health care system. Some of those costs will be covered. If you have family members that are around and a strong community that’s going to help you out, that can affect how much you have to plan.

Putting that aside and then just sticking with the tangible assets, there are still some other important factors that we need to consider. For example, if you have a pension, or an owned home, that can affect your asset allocation strategy. A guaranteed pension can increase your ability to take risk now and in the future, because it’s basically a guaranteed income stream. If you take that and you try to value it, which is capitalizing it, and you value that as an asset, well, that’s something that value, you could actually include that into your asset allocation decision.

Now, usually, it would skew your overall portfolio more towards fixed income, because it’s a stable income stream. That means that perhaps with the rest of your portfolio, you may consider taking more investment in risky assets, knowing that that safe income stream is there. For example, let’s say, you had a 1-million-dollar portfolio that includes the pension, and your target allocation is 50% equity, and 50% fixed income based on your needs and your emotional risk tolerance. Well, if that pension’s valued at $500,000, so half the portfolio, well then, you’d also want $500,000 worth of stock exposure to have that 50-50 mix.

On the investment statements outside of your pension, you’d be seeing a 100% equity allocation and all of the swings that go with that. It would be a much higher risk wave investing with your investment portfolio, knowing that you have that pension there. Now, you get a pension to live on, but you don’t see your pension value every day. It doesn’t come with a statement all the time. In contrast, it is easy to see your stocks, and funds go up and down in value minute by minute, hour by hour, if you’re looking at it like that. People don’t process that information the same way.

Even though it’s an important consideration when you’re thinking about your overall risk tolerance and your risk capacity, you have to be very mindful also of these other behavioural considerations about how you’re going to handle that information. We’re going to talk a bit more about that later on in this episode.

Okay. Well, I think we’ve covered some background information on asset allocation. Now, we’re going to use that and try to apply that to see how we get into fitting financial assets together to build this portfolio.

[0:27:35] BF: I got a quick comment before we get there. Your example just now, I got to say this because it’s so interesting. The pension is a risk-free asset. Say, it’s a government pension. It’s a risk-free asset. Doesn’t have inflation risk. Doesn’t have longevity risk. They pay until you die. It is risk-free. You don’t see the value of it every day. If you could see the commuted value of your pension, it would be extremely volatile. Probably as volatile as a portfolio of stocks, you gave the example earlier, Mark, about cash being risky versus safe for a long and short-term investor. Same thing. If you had a pension and you needed to use the commuted value of that pension to buy something tomorrow, that’s an extremely risky asset. If you’re a long-term pensioner that’s collecting the income, it’s an extremely safe asset. It’s an interesting concept to think about as we move on to talking about volatility and risk and expected return and correlation.

[0:28:22] MS: How you plan to use that plays a role in there, too.

[0:28:25] BF: For sure. How you plan to use the asset. But it’s just so interesting that how it’s reported to you changes the perception of how risky it is.

Risk, Expected Return, and Correlation

Moving on to risk expected return and correlation of assets in a portfolio, thinking through asset allocation means thinking through the right mix of asset classes to meet your objectives. Now, a really important principle in asset allocation that we’ve mentioned in past episodes is that risk and expected return are related. Riskier assets command an expected return premium over safer assets.

At the portfolio level, we should not assess the riskiness of any individual asset in isolation. What matters is the contribution that it makes to a portfolio’s overall risk and expected return. That’s back to Harry Markowitz’s portfolio theory.⁴ Now, this matters a lot in thinking about how assets fit into a portfolio, but I think that the caution about over-optimization still holds. That’s a very important thing to keep in mind. Assets with low correlations to the rest of the portfolio will make them relatively attractive as an addition, but the problem is that we cannot reliably predict future correlations.

I think like, gold is one of the biggest culprits of this where in the post-1975 data, gold has a low correlation to stocks a lot of the time, and it looks really good in back tests. People get really excited about adding gold into a portfolio. I don’t think that makes sense for reasons that are beyond the scope of this episode. It’s just one of those things where I think you can get into trouble using past correlations and returns to find these hyper-optimized portfolio allocations.

Now, on the other hand, there is a strong and at least in the long run, somewhat predictable relationship between risk and expected return, and that carries through investing. Logically, investors in an efficient market would not be enticed to risk their capital in a riskier asset if they did not expect a higher return relative to a safer asset, like a short-term developed government bond, or a US treasury.

Volatility and Covariance

[0:30:19] MS: We’ve talked a lot about risk, so I think we actually probably should pause for a moment and talk a bit about what we’re actually meaning when we say risk. Risk can mean all sorts of things. The way that financial assets are priced and they move up and down over time, they just don’t smoothly rise year over year. They can fluctuate down minute by minute or hour by hour, it depends on how often you price them and the characteristics of that investment. As the market incorporates all of that new information into the pricing.

That’s what we usually call volatility. You’ll hear people talk about volatility when markets are dropping in price. That’s usually when it’s all over the place as a term that’s thrown around. It actually goes in both directions. It goes up and down. Volatility is movement in both of those directions. Actually, both directions are important for how it affects us as investors. It just happens that those downward moves, they tend to be more rapid and the media latches on to that because it’s more exciting. It’s also scarier, which also makes it more exciting. That’s why it gets talked about all the time when markets are going down. It’s actually for both directions.

The term volatility is also synonymously used with risk. It’s really actually one type of risk. There’s all sorts of risks that are out there. If you want to think what risk really is, risk is the probability that things don’t work out the way that you hope they’re going to work out. That’s what risk is. We’ve already mentioned other kinds of risks, like there’s market risk, which is that systematic risk of the overall market. We’ve talked about inflation risk, which is losing buying power by not keeping pace with inflation. Bond prices have risks that in their temporary pricing due to interest rate changes or interest rate risk. Risk means all sorts of things. Volatility is just one way of describing it.

[0:32:01] BF: Risk means so many different things in investing. Volatility is a big one. That is probably the most commonly discussed and perceived thing of risk. Think back to that pension example that we talked about earlier, where in that case, volatility is really not a good measure of risk. Even beyond that, I think there’s other stuff, like how a portfolio responds to bad states of the world. That’s a risk that’s distinct from volatility. That’s called covariance. Covariance with bad states of the world. An investor might be willing to accept a lower expected return on their portfolio separate from volatility if it doesn’t lose value in a recession, as an example of a bad state of the world.⁵

Another corollary of that is that a portfolio that does crash during a recession may command a higher risk premium. That’s another one of those things where logically, an investor needs a higher expected return to be compelled to invest in the asset that crashes in bad states of the world.

Another one is how portfolio volatility is related to future expected returns. If a portfolio’s expected return increases after its value declines, that portfolio is relatively safe for a long-term investor, because the drop in value is made up for with higher expected returns over time. On the other hand, if a portfolio declines and the expected return doesn’t change, that portfolio is much riskier for a long-term investor. Again, they would need a higher expected return to be compelled to invest in that asset.⁶

[0:33:19] MS: Yeah. That point about the expected return at the market pricing is really important because it’s exactly the opposite of what people feel. When markets have gone down, they feel the world is risky and everything’s bad, but that’s actually when the future expected returns are the best. Probably a lot of that risk in that investment is decreased by that.

[0:33:37] BF: For the long-term investor, the risk maybe is, I don’t know, unchanged or something, or at least the future value of the investment is unchanged before somebody who needed their money that day, it’s like boom, that risk showed up and the portfolio declined in value. It’s the same thing as the pension example, where if you needed that money tomorrow, that was risk. If you needed it in 30 years, we could argue that that volatility was completely irrelevant and that the downside was completely irrelevant, if the expected return increased when the asset value decreased.

Another one is conditional skewness.⁷ An asset that contributes to downside risk in a portfolio is riskier again and should command a higher expected return. I know this is getting pretty wonky and I’m not going to keep going. To try and bring it back to Earth, some of those return characteristics that I mentioned, like covariance with bad states of the world and conditional skewness, those are often associated with certain types of stocks, like value stocks is a common one that people might be familiar with. That’s stocks with low prices relative to their fundamental values, like their book value, or their earnings.

Now, value stocks, as you would expect based on having a lot of those characteristics have historically outperformed growth stocks, or stocks with relatively high prices. Value stocks have lower prices, at least in theory, because the market is pricing them as riskier, because they show a lot of those unfavourable characteristics that I just mentioned. Now, that risk and expected return trade-off shows up persistently in the data.

[0:35:02] MS: There’s a lot of risks there and we can measure some of them and consider them with how we build our portfolio. Just to summarize that, you can quantify risk in a bunch of different ways. There’s volatility, which is the price swings up and down. There’s covariance, which is the price going down at the same time, other bad things are happening, which makes it all worse. Then there’s conditional skewness, which is making the rare but catastrophic risk worse. Those are all different risks that we would consider when we’re thinking about building a portfolio, because people would expect that in an efficient market made up of logical investors, all of those logical investors would expect more potential return for taking any one of those types of risk. That does play out in some of the return premiums that you can see, like in value stocks.

Now, if you expect a return premium for an investment, but don’t think you’re taking an extra risk to get that premium, that probably just means you need to look more closely because there’s some risk that’s buried in there that you’re just not understanding.

[0:36:00] BF: That’s so important. Not a whole lot of free lunches out there.

Expected Returns and Historical Returns

[0:36:03] MS: No. Okay, well, let’s move over onto a little bit about expected returns and historical returns. You’ve talked a little bit about the expected returns for assets, which is a theoretical thing that they should do in the future. The problem is, is that our laboratory for financial economics is all historical data. In medicine, we’d look for prospective randomized controlled trials as our most valid way of assessing the impact of some strategy for treatment. But we don’t have that type of thing within finance. It’s all based on historical retrospective data. That’s also the best that we’ve got. When that’s the best that you have, that’s what we have to use. Just acknowledging that limitation is there.

Using that expected return and historical returns, we can look back at some US data.

There’s US data going back to 1926 that we can look at, that we can clearly see that longer-maturity bonds beat shorter-term maturity bonds. We’re going to have this up in the podcast on the video section of it and also on the site as well. Those longer-maturity bonds, they’re more sensitive to interest rate risks. You’d expect that they would return more over a longer period of time. They do. Of course, stocks are even riskier than those beat bonds. If you look within stocks, while the riskier kinds of stocks beat the safer kinds of stocks.

This relationship of risk and return that we’ve talked about theoretically, but historical data does also support that that’s what’s happened in the past. You can take a look at that on the chart that we’re going to show. What it shows is that if you take a dollar and you were to invest it. If you took a dollar and invested that in treasury bills, which are very low risk in 1926, well, that would be worth $21 in 2022. A dollar in the US market as a whole would be worth $7,586. If you took a dollar and invested in a US-value stock, so even riskier stocks, then the return would be much higher, $28,500.

That relationship of risk and return is there. At the most extreme, if you were to go up to US cap, small-cap value stocks, which are the small-cap and the value, which are even riskier, the highest risk asset that’s in that data set, it would be $142,000. Exponentially more. That risk relationship to the return carries out along higher degrees of risk historically.

[0:38:25] BF: Two things we see there. One is that there’s a risk premium. I guess, we see the effect of compounding, which we talked about in past episodes, too, where that difference in returns, I don’t remember what the number is, but it’s probably like a percent or a couple percent difference.

[0:38:36] MS: Yeah, it’s not much.

[0:38:37] BF: From 1926 to 2022, the dollar amount is tremendous. I do want to point out that investors in 1926 did not have index funds. We didn’t have those for retail investors until 1974, I think. They definitely didn’t have small-cap value index funds. Net of real implementation costs, all of those numbers would be a bit smaller, especially if they did have index funds in 1926, they would have been much more expensive. Because they didn’t, buying all those individual stocks to create the index would have been extremely expensive and just probably not practical.

That that small-cap value number, in particular, would be quite a bit lower, because those smaller stocks are more expensive to trade and small-cap value index funds. If they did hypothetically exist back then, tend to have higher fees than market index funds. Anyway, fees and taxes would shrink all of the numbers probably more so for small-cap stocks, but the relative performance is important.

Fees and costs and all that stuff aside, we do still see that relationship between risk and expected return, risk and realized return in the historical data. I do want to point out that at the safest end of the financial asset spectrum in this example, so that’s the treasury bills, we got $21. Now inflation, the consumer price index for the US over that period increased to $17 over the same period. The net return after inflation, the real return is negligible. It’s tiny. We barely increased our purchasing power at all, which is in the long run, what we actually care about. We don’t care about nominal returns before inflation. We care about how much stuff we can buy with our assets. I think this speaks to another important risk that Mark, you mentioned briefly earlier, which is related to inflation risk. It’s shortfall risk. The risk of just not achieving your goals. Because that can happen because you didn’t save enough, or it can happen because you didn’t earn enough in investment returns. You have to save a lot more if you are in a low return, like in this example. We’ve talked about that in, I think, one of our earliest episodes.

[0:40:24] MS: Yeah, that shortfall risk could probably be the risk that we care about the most.

[0:40:28] BF: Yeah. I would say, it’s probably the most important. What are we doing here? We’re trying to achieve our objectives. Anyway, that risk-return relationship, it’s clearly present in this US sample that we’re showing data for and that we’re speaking to now. It also persists around the world and going further back in time. If you’re on YouTube, on video, you can see the chart that we’re showing.

Basically, if you look around the world, for the most part, longer-term bonds beat bills, the shorter-term debt instruments and stocks beat bonds and bills around the world and globally in aggregate, going back to 1900 through 2022.

This is like, we don’t have gravity in financial economics. There is no constant, but that risk expected return relationship. I don’t know. It’s what financial economics wishes was gravity. Try and put it that way.

[0:41:17] MS: It’s pretty strong.

[0:41:19] BF: Yeah, it’s pretty strong. Just not guaranteed and not as predictable as gravity. Harder to run experiments to test it. Now, one thing I want to note is that I mentioned this when you brought up leverage earlier. It’s tempting to look at the data that we just brought up, like the huge number for the small-cap value stocks and want to just take the most risk possible. Like, okay, I want the 100% small cap value portfolio, because look how high the expected returns are. Look how high the historical returns are.

Now, I get this question a lot. Whenever I explain to someone, or if they have watched one of my videos or whatever, learn about small-cap value stocks and learn about differences in expected returns and risk and all that stuff and people are just like, “I want to take the most risk possible. I want a 100% small-cap value portfolio. Why would I not do that?” I think there are a lot of reasons why that’s a bad idea for most people. Assets with a lot of volatility that co-vary with bad states of the world and have negative co-skewness and all that stuff, they’re hard to own. Objectively hard to own. You have to be in a very resilient financial position to do that, but also psychologically hard to own.

We got to remember, the reason they have higher expected returns is because of that. It’s because they’re hard to own. Then I think the other practical thing here is that we can look at that data back to 1926 and say, “Wow, that was great.” In the interim, even over 10 or longer year periods, riskier stocks can underperform safer stocks. Right now, actually, we’re living through one of the worst periods of performance for low price-for-value stocks. That’s been going on for quite a while now.

You can say, I want to take the most risk possible, but that doesn’t necessarily mean you’re going to get a better return. You can have a higher expected return and still underperform for a long period of time. The riskiest and the highest expected return assets are not necessarily going to make sense in the context of everyone’s financial situation and goals. Realistically, they probably don’t need to take that much risk to meet their goals, especially given the trade-off between risk and shortfall risk and expected returns and all that stuff.

The other thing that I think is really important to remember is that it can’t make sense for everyone to do this, or there wouldn’t be a risk premium. There’s a risk premium because these things are hard to own. The portfolio’s got to match the investor’s ability, willingness and need to take risk, and we’re going to go deeper into that in a little bit. Objective measures of risk aside, I think risky assets pose a lot of behavioural risks for human investors.

Behavioural Risk

[0:43:35] MS: Yeah, definitely. That is the whole issue of behaviour is huge in portfolio design, because we can have design this perfect portfolio, or a good enough portfolio based on our assumptions, but still not actually achieve what we mean to achieve, just because we can’t behaviourally do it. That small cap value would be a good example of why that’s a bad idea.

When I’m talking about behavioural risk, which is our next section we’re going to talk about, behavioural risk is the risk that the investor will underperform their own asset allocation policy due to behavioural errors. We may plan this portfolio based on all of this evidence and historical data and try to get it as optimal enough for our situation financially. But then, we actually don’t stick to that plan, because it’s really hard to own really volatile assets. Behavioural errors can include all sorts of actions that we can take to sabotage ourselves. Some of the common ones would be over-trading,⁸ or performance chasing.⁹ There’s evidence to show that these actions all actually lead to lower returns.

We buy attention-grabbing stocks,¹⁰ or ETFs¹¹ and we reduce exposure to stocks based on our personal experiences with investing,¹² which changes how we do things. These are all well-documented behaviours that tend to be detrimental to our long-term returns. This happens, because investors are myopically loss averse. When I say that, what I mean that they evaluate the performance of their portfolios on short-time horizons. Even though we make this big plan that long-term should work out and we’ve told ourselves that, that’s not how we actually look at it as human beings.

Even if we have a long time horizon, we have to have some reduced risk-taking, because of the way that we behave. Investors who check their portfolios more frequently actually earn lower returns, too.¹³ The more that we mess with this, the worse off we perform. Presumably, to avoid pain, the investors that check their portfolios, they also check them more frequently in bull markets when things are going well. When things are not going well, it’s more painful to look at it, so then they look at it less during those bad periods.¹⁴ This is part of what drives us. It’s pain and emotions. Our emotions are one of the largest drivers of the way that we make behavioural errors.

While there’s some of the most powerful emotions are related to fear and greed, there are many other human behavioural biases and cognitive errors that work within investing.¹⁵ We could actually do a whole episode on that. We’re going to stick mostly to fear and greed as some of the powerful ones.

Meir Statman had a great quote when he was on Rational Reminder that people want two things in life. One is to be rich and the other is not to be poor. That is another way of getting at the fear and greed emotions that drive us. Fear of being poor is a very powerful emotion for investors. This can tie back to the idea of risk premiums. If owning an asset is scary, then investors are going to require a higher expected return to be compelled to own it. Otherwise, they’re not going to want to own something that’s scary, because that really drives us as humans.

When we say our investment’s dropping, it’s literally painful. We’re going to want to avoid that. There are studies out there showing that financial loss activates the same areas of the brain as physical pain.¹⁶^,¹⁷ This isn’t just about being tough for whatever. This is actually the way that we are wired. We can’t really change that per se. Losses are more painful than gains are pleasurable.¹⁸ It’s not a symmetric relationship. It’s asymmetric with losses having much more weight. This phenomenon is called loss aversion.

Now, naturally, a common-sense response to pain is to reduce exposure to whatever’s causing the pain. You’re getting bitten by something you want to remove whatever is biting you and get away from it. The problem here is that selling investments after they decline in value and are causing pain, as you mentioned earlier, that often means selling investments when the expected return is high. The future actually should look better. We have seen with the empirical data that large market declines actually are typically followed by positive returns.¹⁹ When it’s most painful is also when the future probably is the best.

[0:47:36] BF: Yeah, it’s back to the idea of expected returns and how expected returns change with asset prices. I want to come back on myopic loss aversion for a sec that you mentioned, Mark, because I think it’s super important. We can talk about devising the theoretically optimal portfolio for a long-term investor. My pension example from earlier, that’s a risk-free asset for a long-term investor. But investors are myopically loss of verse, which means that even if they have long time horizons, they behave as if they have short time horizons. That’s so important because it limits, like in the pension example, if you could see the commuted value of your pension every month or whatever, and you panic because it dropped by 20% in commuted value, well, that asset’s no longer risk-free. I think that behavioural consideration is really important.

Now, behaviour is not only a problem when investments are declining in value. Related to loss aversion, investors have a general disposition to sell winners too early and hold losers too long, known as the disposition effect.²⁰ I think people get nervous when markets are falling, but they also get nervous when markets are rising. They think, “Oh, we’re going to reach the top and there’s going to be a crash.” They probably think about the regret that they would feel if they keep on holding their investments and the market falls.

Now, the problem, the empirical problem, the objective analytical problem is that all-time market highs are most commonly followed by more all-time highs, rather than declines since markets are rising most of the time in historical data. When we’ve looked at this, we looked at this for a paper a while ago related to market timing. We found in the global stock index about 30% of months are all-time high months, but only 2% of all-time high months are followed by a decline of 10% or more in the following 12 months. Anyway, so people get worried about all-time highs and, “Oh, it’s going to crash.” But that doesn’t happen as often as people expect.

Now, selling out of fear, out of fear of a crash, out of fear that we’ve reached the top means missing out on those much more likely future gains. I think the other funny thing about this is that even if you do successfully sell before the drop, you’ve also got to time your re-entry. When do people feel good about re-entering the market after they got out, when it’s recovered, not at the bottom when they should be investing.

[0:49:47] MS: No. You see it play out all the time.

[0:49:48] BF: Yeah.

[0:49:49] MS: That fear works against us on the way up, or against us on the way down. As Meir Statman also said, people also want to be rich, too. That also plays on us with that emotional drive and people are willing to take risky gambles with lottery-like payoffs on the off chance that they will strike at rich. That’s the way that they pursue that. People don’t necessarily mean being rich in terms of absolute terms either. When they say they want to be rich, it’s actually probably being rich relative to their peers that matters to them.²¹

This affects us when we make our portfolio and make our financial decisions, because we’re going to be comparing ourselves to our peers when we do this. That happens. We have to make some of those decisions, knowing that that’s one of the risks that we face. We don’t want to be left behind when we’re seeing all of our friends try to get rich on a risky gamble.²² If you see that and you’re watching it, it can start to drive you to make some bad financial decisions. We’ve seen this play out with Bitcoin and other assets, where you have this good old-fashioned fear of missing out, or FOMO when it’s going up.

[0:50:52] BF: People for sure get influenced by what their friends and peers are doing. When what kind of stuff they hear about, “Oh, my friend made a bunch of money doing this.” I see this all the time with clients. I’d be curious, Mark, if you see this in the physician community.

[0:51:03] MS: Oh, I see it in the physician community all the time, too. I see it with colleagues, friends, family. It’s not even just friends and family anymore. Now things have changed so much, you have people who are plugged into social media, which is a lot of people, they actually have commercialized this with influencers. These influencers, their main job is to pop up on your newsfeed there and make money by making you want to be like them and do whatever it is they’re doing, which is in the case of investing, they’re often touting some rare bet that paid off big. You can be like them if you do that, too.

We see all of that and it influences us into what we think we should be doing with our financial situation, too. We’ve got to be aware of how that works. Otherwise, we’re going to do is we’re going to be speculating. That’s actually why we spend so much time talking about speculating in the previous episode, because this is one of the first things that often comes up in a discussion with family, or colleagues. Once they find out that I’m an investing nerd and I like to read about finance, the first thing they usually bring up is some trendy speculative investment.

It’s funny, because they’re usually stunned because I usually don’t have much to say about it, whatever it is, most recent hot investment. A lot of the time, I actually even heard about it at all. I haven’t been paying attention. It maybe undermines my status as someone who looks about investing to them, because I actually don’t pay attention to that stuff. In fact, it’s counterintuitive, but I’d actually deliberately avoid reading about all of these new things that are coming out. I know that I’m just as easily sucked into narratives and fear of missing out as anybody else’s, so my main coping strategy is just to try to avoid it as much as I can.

I want to know that I have faith in efficient markets and that my best hope is just to quietly track them. Eventually, the FOMO crowd becomes quiet, too. Usually, once the rational mania wears off and reality sets into whatever it is that hot investment was.

[0:52:55] BF: They get quiet eventually, but it’s pretty uncomfortable when they’re loud. I’ve lived that with technology funds that we’ll talk about Cathie Wood’s fund later, but I lived that and I lived with crypto, same thing. It’s like, a lot of times people who are winning in whatever’s hot at the moment are pretty vocal about it in a way that’s often not that nice to people who disagree with them. Anyway, that definitely happens with peers. But I think it happens at a more aggregate level, too. I think this is a market-wide phenomenon that we can see happening, when a stock, a fund, or an asset class has high recent returns, two things happen. It gets people’s attention and it invokes FOMO.

People can only absorb so much information. When they’re deciding which assets they should be paying attention to, they focus on whatever grabs their attention.²³ Now, what grabs attention? Things like, abnormally high, or low recent returns, mentions in the news or other media. Those are things that bring attention to assets. You combine that with stories of people getting rich. We think back to crypto, there were so many stories of people getting incredibly wealthy overnight. It’s hard for people to resist that. Really hard.

Unfortunately, the FOMO plays don’t tend to work out very well. We’ve seen some of those come full circle recently compounding all that, a lot of investors just follow the crowd. It’s a phenomenon called herding, herding like sheep. They don’t do their own analysis, so they just do whatever their peers, or their friends, or their favourite influencer, or whatever is doing. Now you combine all that together, it can be a real problem for a lot of people because attention-grabbing stocks and funds have a tendency to have lower future returns rather than higher. Now that phenomenon has been studied a bunch of different ways. One interesting one is thematic ETFs. Those are index funds that track an index that’s related to some theme, an attention-grabbing theme, like electric vehicles, or crypto, or whatever.

Now the way that these work, there’s a really interesting paper on this.²⁴ This is an empirical observation that I’m reporting on here. The way this tends to work is that the fund a provider finds, or creates an index that tracks a theme with strong recent past performance. Like cannabis, or crypto, or AI, or electric vehicles, when those things were on their way up and then they launch a fund to track that index.

Now, the problem for investors is that these funds typically launch just after the peak of excitement for the theme and often the peak of returns for the theme and then they tend to go on to deliver negative risk-adjusted performance to investors on average.

[0:55:20] MS: That’s what we see play out over and over again. There’s other data that shows up that helps us to see this affect the mutual funds. For example, mutual funds selected based on high recent past performance. Those are also the same funds that tend to underperform those selected based on low, recent performance. There’s data to show that.²⁵

Also, these attention-grabbing stocks are also heavily traded on investing apps. With that, we can now see that those heavily traded attention-grabbing stocks go on actually to deliver negative returns for the average investor that’s investing in them.²⁶ You mentioned earlier, the Cathie Wood’s Ark Innovation ETF. This is a great example of where you have one of these hot themes and a hot manager rolled up into one, and provides actually a really good illustrative example with the data when you follow through the lifespan of what’s unfolded so far.

This is a fund that it delivered huge returns for a few years and then it crashed really hard. People noticed the high returns when it was having these really high returns and the fund grew like crazy. Investors just piled into it. Of course, then it actually got to the point where it started to crash. Most investors actually got into this fund after these attention-grabbing returns. It was getting on everyone’s attention, because of high performance. People wanted to chase that performance and piled into the fund. The result of that is that the return of the average investor in the fund trailed the fund’s overall performance by a wide margin.

Morningstar uses, research uses fund flows to estimate the difference between the return of a fund and the return earned by investors in the fund because that can be different depending on when they put their money in and when they take their money out. Their behaviour can account for some of that difference. The investment return depends on the cash flow timing in and out.

The fund return is the return of a dollar invested and held throughout the entire time period. There’s probably, it’s always going to be a little bit of gap there because people don’t just put money in once and then leave it there for the entire period. People put money in and out of funds for different reasons, like when they have money or need money. A lot of it is directed by the decisions that they’re making and that difference can be thought of as an approximation of what we would call the behavioural gap. The behavioural gap is the difference between the returns of the fund and the returns of the investors that are driven by the behaviour to buy and sell the fund at different times.

It’s not perfect, because we do move money in and out for other reasons, but it’s interesting to observe. In the case of the Ark fund, since its inception in 2014 through to May of 2023, when Morningstar last updated the data, the behavioural gap for that fund was negative 35% annualized.²⁷ A negative 35% per year is what people actually experienced as investors in the fund compared to what the fund performed from its inception. This is an extreme case, but it shows how easily human behaviour can sabotage returns as people pile in to attention-grabbing funds, or stocks, or whatever it is.

The Behavior Gap

We mentioned the behavioural gap with the ARKK fund. But this behavioural gap is some good data for us to look at. Morningstar actually publishes a report called ‘Mind the Gap’. What they do is they cover many funds and asset classes over trailing 10-year periods looking at this behavioural gap. On average, for all US funds, it was minus 1.7% per year. The range when they look at different 10-year rolling periods is somewhere between 1.6% and 1.8% per year, depending on which period you’re looking at, but it’s pretty consistent.

There’s a gap there and it’s pretty substantial. What’s interesting for us when we’re considering portfolio design is what happens when you dissect some of this data, because there’s some takeaways that we can actually take from it and apply to our own portfolio designs. Three big takeaways from this are one is that diversification shrinks the behavioural gap, automation shrinks the behavioural gap, and volatility increases the behavioural gap. When we’re designing our portfolio, we can think about that.

We’ve already mentioned that there’s this massive gap for thematic funds. Those are a subset of sector funds in the report. That sector fund subset had a behavioural gap of minus 4.35% per year. It was a very large behavioural gap when you start to make these sectors bets. That really implies that investors that are using those sector funds are using them to speculate by moving money in and of those funds at different times, rather than just holding them.

[0:59:53] BF: Unsuccessfully speculating on average.

[0:59:55] MS: Yeah, unsuccessfully speculating on average by 4.35%. A lot. You can take that and in contrast, the lowest performance gap was actually with asset allocation funds. This is US data, so it’s important to note that these funds are a little bit different than what we’ve got in Canada, but they’re conceptually similar to the idea behind Canadian asset allocation ETFs that we’ve mentioned previously. They’re broadly diversified, they’re mechanically rebalanced at the fund level. With that happening outside of our hands, the behavioural gap was minus 0.77% per year.

Another factor that minimizes the gap with those US asset allocation funds are the fact that they’re often used as core holdings for employer-sponsored retirement funds. There’s this automaticity, not only with the rebalancing of those funds but also with the contributions. There’s automatic monthly contributions, instead of the investor making decisions about when to invest when it’s part of their pension setup.

Now, another reason why concentrated bets underperform seems to be volatility. Price swings are emotionally provoking and they’re attention-grabbing, and this causes us to misbehave. If you take the data and stratified out by the volatility of the different funds, that gives us a signal as well. The Morningstar data showed that the most volatile US equity funds had a behavioural gap of 1.48%, while the least volatile funds had a gap of 1.13%. That was a pretty clean dose response relationship there. It’s not just that this applies to stocks either. You can look at higher risk bonds and you’ll see substantial behavioural gaps there, too. US municipal bonds show a behavioural gap of 1.54% for the most volatile, or most risky municipal bonds and negative 0.7% for the least volatile bond funds. Stocks and bonds are actually subject to this risk that comes with volatility.

Then the last interesting point that I take from that data from volatility in the behavioural gap comes back to asset allocation. The other thing with asset allocation funds is that they had a gap of negative 0.76% for the lowest volatility funds and negative 0.77% for the highest volatility fund. Basically, it’s identical. The volatility wasn’t as big of a difference with those asset allocation funds. Another possible contributor to this decrease, behavioural gap is that these funds are actually a mix of stocks and bonds. We use that mix of stocks and bonds as one of the key decisions that we’re making in choosing an asset allocation for some reasons that we’re going to get into.

[1:02:31] BF: My bet would be that a lot of that difference in behaviour gap is because there’s less difference just in volatility between asset allocation funds because they’re more diversified portfolios to begin with. There’s probably a lot going on there. I think I’ve seen other research that it’s easier to own a single-ticket diversified portfolio.

To finish on investor behaviour and why it’s important to portfolio management, people are not rational robots who exist in a vacuum and invest a 100% of their portfolios in leveraged small-cap value stocks. People have needs, they have wants, they’re social, they have limited attention, and they make mistakes.

[1:03:08] MS: Emotions are so strongly hardwired into us. I mean, they may have helped us to survive and thrive as a species. I mean, fear may have helped us to avoid being eaten and greed may have helped us to eat more, but those emotions are easily able to sabotage us as investors. We’re this hot mess of emotions that will mix and affect each of us differently. Fear affects us differently, greed affects us differently, and it all happens in the context of our lives.

[1:03:34] BF: Since people are hot mess of emotions and we know that, we know that to be true, I think that when we’re designing a portfolio, having some objective data to quantify the impact of asset allocation decisions is important. That’s all the data that we talked about on risk premiums and all that stuff, but we also need to consider the emotional impact of possible investment outcomes and just the experience of investing in the portfolio and how that’s going to interact with the flawed, often flawed behaviour of people.

Allocating Assets

All right, so let’s move on to applying this thinking, to how we’re actually going to think about allocating assets. Portfolio management is thinking about how assets fit together in a portfolio. Now, we’ve talked about how that interacts with human capital. We’ve talked about risk as volatility and covariance and conditional skewness and shortfall risk and behavioural risk. We’ve talked about a lot of different kinds of risks. We’ve talked about how expected return is compensation for a lot of those risks. We briefly mentioned how assets with low correlations can reduce risk without giving up expected return.

We’ve also talked about how behaviour can sabotage even the best asset allocation strategy and how volatility is related to investor behaviour. People can quickly get into trouble trying to optimize their portfolio using historical data, or their assumptions about the future, which are very likely to be different from the actual future. The reality with portfolio management, and with allocating assets, is that ‘pretty good’ is about as good as it gets when it comes to managing portfolios. The main ingredients in broad strokes are for a good portfolio, for a pretty good portfolio are low costs, broad diversification across markets and within markets, and a tolerable level of risk, which is going to be achieved by, if necessary, adding some bonds to the portfolio.

[1:05:23] MS: The important thing is that those main points will get you most of the way there. Another consideration, if it’s appropriate, your situation is adding some exposure to those other priced risks beyond just owning the equity market. That could be with using certain types of stocks, like value stocks that you mentioned. That’s a minor piece. The main points are what you just described, and we’ll leave some of those minor points to future episodes.

Global Diversification

[1:05:47] BF: I want to touch on global diversification. We have these two big chunks. The two main pieces of portfolio. We’ve got stocks, we’ve got risky assets, and we’ve got bonds, which are relatively safe assets. Within stocks, I want to just talk about global diversification and why that is important. As a simple illustration, I’m just going to walk through a couple of examples about how asset allocation can impact portfolio risk and expected return.

Now, again, one caution before we start is that we can’t predict which country’s equity market will have the best future returns today. I see this a lot with US stocks, where people are like, well, the US market has beaten everything else. Why don’t I just invest in that? We’ll talk about why in a minute. This just ties back to that whole idea of over-optimization, which I think is a real problem in investing. People might be surprised to know that Denmark has had the highest stock market returns of all developed markets with history going back to 1970. Not the US.

Now, just like I wouldn’t invest 100% of the equity portion of a portfolio in US stocks, I similarly would not recommend investing everything in Denmark, because it has the highest past returns. It’s anybody’s guess which market will perform best for the next 50 years. I mean, if I had asked, I should have done that. I should have asked you, Mark. Mark, can you guess which market had the best and you would not have guessed Denmark. I can almost –

[1:07:05] MS: I would not have guessed Denmark. Nope. Not a chance.

[1:07:08] BF: Okay, so if you’re watching the video, you can take a look at the chart showing the annual returns of developed countries ranked from highest to lowest return.

What we see is it looks like this quilt pattern, if you’re just listening. It looks like a quilt, where there’s a bunch of different colours representing the countries and there’s no real discernible pattern. It’s random how a country performed. Now, this is only annual data, but I think it’s still illustrative. How a country performed in the past does not tell you very much about how it’s going to perform in the future.

Now, back to why diversification is so important at the portfolio level using monthly data for 18 developed markets going back to 1970, we can see that a globally diversified portfolio, including those 18 countries beats nine of the 18 individual countries over that 1970 to 2022, sorry, June 2023 period, and it does so with a lower standard deviation of returns than any single country alone.

That’s pretty powerful. We split the middle and got the average return of all those countries, but we did it with a much lower standard deviation of returns. That’s pretty neat. Of course, if we could pick the best country, we would just do that, but we can’t.

[1:08:15] MS: We got a good return with lowering the risk at the same time and not really giving up a lot for doing that. This is why, and one of the reasons why diversification is often called the ‘only free lunch’ in investing because you’ve gotten this performance and reduced risk at the same time.

[1:08:29] BF: All these country returns are all imperfectly correlated. It ends up being pretty nice to add them together in a portfolio. Now, to add to that, as we’ve discussed earlier, volatility is just one measure of risk. Another really important one is shortfall risk, the risk of not achieving your goals. One of my favourite papers from a past Rational Reminder Podcast guest, Scott Cederburg, looks at the probability of losing purchasing power in stocks over long horizons using historical data.²⁸ They find in that paper that you’re much more likely to lose in domestic stocks, which happens about 13% of the time, and this is over 30-year horizons than to lose purchasing power in international stocks, which happens about 4% of the time in their data.

I think we definitely want global diversification in the stock portion of most investors’ portfolios.²⁹ That means, ideally, both developed and emerging markets stocks in addition to Canadian stocks. That’s really thinking about Canadian stocks, US stocks, international developed, excluding North American stocks and emerging market stocks. That’s an approximation of a global stock portfolio.

Home Country Bias

Now, some important considerations to add on to that are in terms of how much global diversification should you have relative to Canadian stocks. Some important considerations there are going to be costs, taxes, and local consumption hedging, which I’ll explain in a second.

All those considerations lead us to think about something called home country bias. As a starting point, as I just tried to explain, it’s pretty clear that we want to be globally diversified. There are a lot of benefits from diversification. Considering the fees, costs, and taxes associated with investing in different countries and regions, that could sway our geographic allocations away from just buying them in their market capitalization weights.

For a Canadian investor, owning Canadian stocks tends to be very low-cost and tax efficient in both taxable and registered accounts, like the RSP and the TFSA. Whereas, foreign stocks and in corporations, actually, it’s worth mentioning, foreign stocks can be more expensive to own and they can have more challenging tax treatment on their dividends. Now, there’s also an argument that since we live in Canada, Canadian stocks can provide a hedge for local consumption goods. What that means is that if Canada starts doing really well economically and the cost of Canadian goods increases, owning Canadian stocks, which would reflect the positive economic conditions might be helpful.

The other one that I think is interesting is that we also know, as we’ve talked about, that people care a lot about social comparison. We also know that most Canadians hold a large portion of their portfolios in Canadian stocks, probably too much.³⁰ They probably have too much home-country bias. We’ve got a chart that we can show in the video, but Canadian investors, for people listening, the Canadian market in this data that I’m looking at makes up about 3.4% of the global market, but Canadian investors average allocation to Canada is 52.2%. A huge overweight to Canada relative to the rest of the world.

[1:11:21] MS: That’s important, because your average neighbour is probably overweight Canada by a substantial margin. You’re the only person on your street that’s not getting wealthy from owning Canadian stocks when they happen to have a really good period. That could impact your well-being. You’re hedging against that emotional risk to your well-being of not keeping up with the neighbours. These arguments all suggest that a Canadian investor should consider owning more of the Canadian stock market than their global weight. Their global weight’s tiny. It’s like, 3%, 3.50%, or whatever the number. Yeah, 3.40%. We owe much more than that, and we do that. It’s hard to choose exactly what the perfect allocation for that might be. As you mentioned, 50% is likely too much.

[1:12:02] BF: Again, there is no right answer here. This is another one of those things that we could try and optimize down to the decimal point using models. I don’t think that’s reasonable. We at PWL do about a third of our clients’ equity portfolios in Canadian stocks. It’s still a pretty meaningful home country bias. I really don’t think that there is a perfect answer here. I would probably not go higher than 30%. Going lower, I don’t think is crazy by any means. I think there are some interesting arguments to have some level of home country bias.

There is analysis from Vanguard that uses the optimization methods that I think are probably not super helpful, but it’s still information. Vanguard does have a paper where they do that and they show that about 30% is optimal from the perspective of volatility reduction, 30% home allocation to Canada. Yes, that matches up with what we actually do, which is nice, but I wouldn’t put too much weight in that analysis anyway.

[1:12:49] MS: When I look at the chart for that day that you’re showing there, the other thing I take besides the fact that we have to be sensitive to all the inputs changing, it is that really if you look between a wide range of Canadian allocation, the line’s pretty flat. I mean, it’s got a slight curve to it, but it’s not like a dramatic difference. I think there’s probably no point in trying to be precise, even if you could. I mean, it looks like a wide range there.

[1:13:11] BF: The other thing that you see from that chart, which we’ll show for people that are watching our video, is that there is a more meaningful reduction in volatility going from a 100% Canada, and kind of 50%, 60%, you start to see relatively diminishing returns. Again, these charts are so fun to talk about. They’re addictive. But we shouldn’t put too much weight in them still. Anyway, a bit of home country bias is okay, but maybe not too much.

How Much Risk?

[1:13:34] MS: Yeah, exactly. I mean, the biggest decision we’re going to make is how much risk that we want to take. We could talk about slicing and dicing into how much Canadian, or non-Canadian other stocks, but really the biggest decision is actually just choosing the big part of our asset allocation from a broad stroke, which is what’s our mix between our riskier part, which is going to be our stocks and our equity. It’s the same thing. And the safer part, which would be bonds, or fixed income. Here, we referred to in different ways, but basically, it’s the riskier part and the safer part.

You’ll hear people describing this in different terms. I’m just going to use the stock to bond ratio. I just find that the easiest for me to roll off my tongue. Our aim here really is to take as much equity risk, or stock risk that we can be able to meet our goals, while still being able to sleep at night while we’re doing it. We have to take as much equity risk as we can, but that has to be balanced with enough bonds in there to dampen the volatility, so that we can actually behave and stay invested.

Bonds reduce our portfolio volatility in two main ways. They are by themselves just less volatile than stocks. When you mix them in, well, that’s going to bring down the volatility just by averaging it out. Plus, they tend to also have a low correlation with stocks. That means that when stocks and bonds are going up and down, they’re not going up and down always at the same time. That smooths that ride out when you average out the returns for the portfolio as a whole.

We’ve also seen that a portfolio of stocks, it can be improved by diversifying across geographic reasons. That again, gets back to this idea that not all the countries are correlated perfectly, so they’re not going to go all up and down at the same time. However, I would say, that empirically, equity market correlations have been increasing since the late 1990s. That may not affect us too much as long-term investors,³¹ but again, it does affect us with our short-term portfolio behaviour, because that’s how we actually behave.

Since we know that investors are human and suffer from this myopic loss aversion, short-term portfolio behaviour really does matter even if we’re long-term investors. Even worse, I mean, when there’s a big shock, like the COVID pandemic, or the great financial crisis, stock markets, they may not be correlated to this much other times, but they tend to crash together. When something bad happens, the covariance can be high. To avoid mistakes, it can be important to have this safer asset allocation in your portfolio to keep your inner emotional beast from waking up and smashing your portfolio.

I mean, intellectually, you may be a Bruce Banner, and you can do all the math and make this perfect plan. But if you anger the inner Hulk, you’re just going to wake up later with ripped purple pants on and wondering what happened. You got to make sure you have enough bonds in there to fill that role of soothing the beast so that you can stick to that longer-term plan.

[1:16:21] BF: I think in an earlier episode, we talked about the elephant and rider analogy from Jonathan Haidt, but I like the Hulk better.

[1:16:28] MS: Yeah, one plus one equals smash. That’s Hulk math.

[1:16:31] BF: Yeah. Now, on that stock-bond correlation, this is something that I think people learned, relearned in 2022. The stock-bond correlation has been negative largely since the early 2000s, but I think that that has a lot of people lulled into a sense of security with bonds, where we might always think that when stocks go down, bonds are going to go up. Also, over that period, really, since the 1980s, bond returns have been uncharacteristically high, because interest rates have fallen down, down, down over that period until recently.

Now, both of those things make bonds look really good in portfolio backtests, but I think that the longer-term reality, people have to understand is that bonds tend to be – they tend to have relatively low but positive correlations with stocks. Sometimes that correlation can actually be quite high. I’ve seen it in the historical data be as high as 0.6 over some periods of time, which is pretty high. That’s as high as some equity markets are correlated with each other. The other thing is that long-term bond expected returns are probably a bit lower than the realized returns of less 40 or so years. Although, they’ve come up a lot again recently with bond prices having come down.

Anyway, I guess, it’s another caution about the backtest optimization and trying to find the optimal allocation of bonds, or over-allocating to bonds, because of how good they look in the historical data. But then, there’s also the correlation piece where in recent history, which is the data most people look at, that correlation is also a bit negative, which again, that favours bonds in a backtest, but in the longer run, that correlation is not guaranteed to be negative, and it’s not even guaranteed to be that low all the time.

[1:18:01] MS: Yeah, it’s a good caution about all of this optimization. I mean, it’s very hard to find really good data going back longer periods of time, but it’s definitely worth it, because the perspective is often quite different than what we’ve had over the last 20, 30 years, which is what anybody who models stuff is usually a 30-year time period and they don’t look back over market history, which you have a 100 years or more of data there.

I mean, the other thing I would say is important to think about when you’re thinking about bonds besides that correlation piece over longer timeframes, not being as much as what we’ve seen recently is that there’s different types of bonds and it’s similar to stocks. There’s riskier bonds that carry more risk and have higher expected returns. For example, corporate bonds are typically riskier than government bonds, because they’re not backed by the ability to tax and all the assets of government. They’re tied to a corporation, which may have cyclical behaviour, just like their stocks do.

When we buy total market bond index funds, it’s generally a mix of these government and corporate bonds together. Even with that mix of riskier and safer bonds, the cost of owning bonds in favour of stocks is that you’re going to have lower expected returns by owning those bonds because overall bonds are going to have lower expected returns than stocks.

[1:19:13] BF: That’s the trade-off. You want a less volatile portfolio, you accept lower expected returns and that is what it is. That stock-bond ratio is, from an asset allocation perspective, it’s probably, again, in broad strokes, the most important asset allocation decision that you’re going to use to balance expected returns and volatility. Of course, as we’ve mentioned, that volatility is going to impact behavioural risk and your ability to meet your long-term goals. The expected return piece is going to really affect your ability to meet your long-term goals. That’s another one of those trade-offs.

We often talk about this when we do long-term financial planning, where it’s like, you can look at the historical return or the expected return of volatility of different portfolios. It’s like, we talked about compounding earlier with small-cap value stocks and how big that difference is over time. One of the ways that we often look at this when we’re looking at figuring out what asset allocation makes sense for somebody is by framing it from the perspective of how it affects the long-term outcome. Taking a little bit more equity risk, even if it’s a few points of a percent per year of expected return difference, that makes a big difference over 30 years or 60 years, or whatever.

This asset allocation decision is really important, especially as it compounds over time. To make all of what we’ve talked about practical and figure out how much risk you should take in your own portfolio, there’s a pretty nice framework that I like, that includes looking at your ability, your willingness, and your need to take risk with your investments. That’s where we’re going to go next on to the ability, willingness, and need framework.

Ability, Willingness, and Need to Take Risk

This comes from financial author and researcher and past Rational Reminder guest, twice, I think, maybe even three times, Larry Swedroe, He breaks down risk tolerance as the ability, willingness, and need to take risk where ability looks at objective measures of risk, willingness looks at subjective measures of risk, and need looks at your expected return requirements.

Ability

[1:20:57] MS: When I think about the ability to take risk, I think of that as your risk capacity. It’s the financial ability for you to handle a market downturn. This risk capacity is why saving is a prerequisite to investing. You have to have a stable platform to be able to then take risks in investing in risky assets. We explore that in episode five. Because you really don’t want to be forced to sell your risky assets when they’re expected returns are highest, like after a crash, because you have to pay for some expenses, because you didn’t have that stable platform with some savings.

Now, another way to frame this is that accessing liquidity from your portfolio gets very expensive in a market downturn. It’s the worst possible time. Economist Myron Scholes said, finding an umbrella in a rainstorm might be impossible, or very costly. This is the same thing with your portfolio. You don’t want to be forced to sell your portfolio in an opportune time and lose out more than you would have otherwise because that’s the most expensive time to do that. Risk capacity also becomes really important around the time when you need to start drawing investments.

Predictably, we’re going to have to just start doing that at some point, that’s why we’re investing, so that we can use it. The money needs to be there when you need it. We’ll talk more about that in our retirement episode that we’re going to do. All that is to say that really your time frame for investments is also important.

Now, we can use model portfolios to try to get an idea of what different stock and bond allocations, like how they’re going to perform in market downturns. You can look at different mixes of stocks and bonds to see how far down the drawdown is. PWL Capital had some model portfolios that we can use to show some of those return characteristics with. Looking at those portfolios, one of the big declines they had was in 2007 and 2009. Just besides looking at the overall return in volatility, the performance in one of those big crashes is important. It’s not just about how much the portfolio went down by, it’s also about how long it takes for it to recover.

If you had a 100% equity portfolio using those model portfolios, it took 48 months after the crash for it to return back to its previous peak. That’s four years, basically. In contrast, if you had a 40/60 portfolio, it only took 11 months to recover, so much more quickly. If you have a shorter time horizon, then you may want to take less equity risk, because let’s say you are unlucky and you experience one of those big market drawdowns, you want to make sure that there’s been some time there for it to recover before you have to access that money. If you’re going to be forced in a shorter time frame, then you might want to have less of that risk baked in there.

This is important, because people often underestimate the frequency and duration of the market going temporarily down. We’ll show this in a log chart on the video, but 5% to 10% drawdowns are common.

They usually occur every several times a year and they can last week to months, so they’re pretty short-lived. Correction’s in the 10% to 20% range, so they occur every few years and they can last three to nine months.

A secular bear market, which is much deeper and longer lasting, they’re really nasty, but they’re rare. They may occur every five to 20 years, but they can even last years to decades. You should expect that these downturns are going to happen and they may even be long in duration. When I say that, those durations, I’m measuring the time to do all-time highs. Now, there’s usually a big drop near the beginning. Once you’ve experienced that, a good chunk of that duration is actually your portfolio is going back up, because the main damage has already been done. It can still be very difficult to stick with it and take that ride back up again. That’s the long-term direction of markets.

Now, even understanding that and understanding that bear markets can last years and that’s temporary, that’s vital. Even if we intellectually know that it’s still very difficult to endure. Charts aren’t going to provide us with a lot of comfort, because when you’re in one of these big secular bear markets, you’re also bombarded by bad news. It’s not just your portfolio that’s having problems, it’s all over the news about how bad things are, there’s smart narratives to explain what happened because we can find all sorts of ways of explaining what happened and then use that to try to predict what’s going to happen next. It’s not only all over the media. I mean, these big downturns, like for those secular bear markets usually affect people that you know personally, and they may even affect you personally, too. There can be job losses and people that are going to have financial shocks. You’re going to see this going on around you. It seems like it’s never going to end because it can go on for years.

Willingness

[1:25:25] BF: I think that starts to touch on the willingness piece, which is how much could you withstand of that? We’ve talked about how portfolio standard deviations change with asset allocation. Standard deviation, as we’ve mentioned a few times, is only one measure of risk if we just look at the drawdown. You mentioned the time to recovery there in your ability to take risk, Mark. On willingness, if we look at drawdowns from those same PWL model portfolios in that 2007-2009 period, bonds over that period had positive returns actually.

A 40/60 portfolio, the drop from peak to trough was 19%. Then for an all-equity portfolio, it was minus 48%. Even if we can make the argument that, well, you’re recovering four years, so if you have a long time horizon, you’re good. It’s not easy to do to imagine. I think you have to live it to really know how you respond. Try imagining how seeing a 48%, or a 50% drop in your portfolio value would make you feel. That starts to get into your willingness to take risk.

[1:26:20] MS: It is really hard to imagine how you’re going to feel and what you’re going to do in these types of experiences. For me, personally, I don’t find percentages necessarily have as much impact on my imagination as actual numbers do. One of the ways that I would do it is I’d also take that percentage, and I’d apply it to the size of my portfolio. For example, let’s say, I might be able to stop like, seeing my $100,000 portfolio drop by $48,000 using that model portfolio. I’m able to do that without panicking, if I know that my timeframe is going to recover. It’s also easier if I know that I’m adding that much money to my portfolio every year anyways. It’s really going to be a smaller blip.

It’s going to feel a lot different though, let’s say I had a 10-million-dollar portfolio and it dropped the same 40% to $5.2 million. Well, I don’t have a 10-million-dollar portfolio, but if I did, that probably wouldn’t bother me too much either, because my day-to-day life, my long-term goals, those would not be impaired if my portfolio dropped to $5.2 million. That’s still plenty of money to meet everything that I could desire and I could wait out a recovery.

If my portfolio is maybe a few million dollars and a 48% drop would endanger my impending retirement plans, or my basic spending needs, then I would be very uncomfortable. I think part of my risk tolerance is how the loss logically impacts me. But the most powerful part is still going to be purely emotional. Younger me, I probably would have felt very freaked out seeing my $100,000 dropped to $52,000. If it was my first bear market, then I didn’t understand about efficient markets and experience in the long-term record.

Now, I probably did probably have about that much at that time. It was pretty early on in my career, but I was fortunately too busy working and having babies to really notice the global financial crisis. That flew by me without me taking much notice of it. I would probably notice that now. Still, the point of that exercise is to think about it. Even though it’s hard to visualize it, play out some scenarios. For each of us, those are emotions and preferences and our financial circumstances are going to be a bit different.

Again, this comes back to the optimal stock-to-bond allocation is going to be different for all of us. There was a good message in Rational Reminder Episode 260 from Professor James Choi. He’s an academic in household and behaviour finance. I’m paraphrasing what he said, but the basic message is, you can educate yourself and you can do all sorts of mental exercises. That’s what we’re doing when we’re trying to think about and choose an asset allocation. Most people really only learn about their risk tolerance when they’ve experienced trouble first-hand.

Now, the good news is because we’re going to be doing this a lot of us starting out without having experienced those issues. The good news is that the stock-to-bond decision is that the differences between, say, a 60% equity, or an 80% equity allocation, they’re relatively small. We’re talking about small differences. It’s like horseshoes and hand grenades. Close is good enough. But the most important thing is to play. Or in the case of hand grenades, to make sure you toss the hand grenade away from you before your time runs out.

It’s like that with investing, too. You don’t want to get paralysis by analysis trying to find the perfect asset allocation, then you’re missing it on all this time in the markets. If you’re uncertain, you still want to probably get invested, but you want to make sure that you err on the side of being a little bit more conservative because you can also then get an experience that helps you to know your risk tolerance better. Then you can adjust it to fine-tune it a little bit afterwards.

[1:29:42] BF: Yeah. I remember when we had Ken French is a prominent academic researcher on this stuff. When he was on Rational Reminder, he talked about exactly that. He talked about how you can learn a lot about yourself in a bear market. It’s not a reason to time the market. It’s not a reason to drastically change your portfolio, to try and whatever do something fancy, but it is a time where you will learn something about yourself that you did not previously know if you haven’t lived through a bear market before. If that leads to maybe increasing, or decreasing your portfolio risk, that can be a pretty good reason to make that change.

Need

Okay, so we’ve talked about ability and willingness. The last thing in this framework is your need to take risk. Now, the need to take risk is related to achieving your goals. That’s the shortfall risk idea. If you have a massive financial capacity and very modest financial requirements, you’ve got lots of assets and low expenses, then you might not need to take as much risk. Your need to take risk in that case is low. If you have so much money that you can live off the interest from a savings account, for example, you don’t really need to take a whole lot of risk. You could still choose to take risk, but it’s not a need. That would be your willingness.

You would have ability in that case, you’d have a high willingness, but a low need. Now, that being said, that example is pretty uncommon. Most people do need to take some risk, especially early on in our investing lives, when we don’t really know what our future earning power is going to be, or how our financial requirements are going to change in the future. As we move through life, we learn about that and we can make adjustments along the way. Determining the need to take risk usually involves running financial planning projections that let you model your goals alongside your ability to save under different expected return scenarios. It’s what I mentioned earlier about framing these types of decisions as their long-term impact, as opposed to what they’re going to do over the next few years.

Or framing it as the difference in wealth accumulation, as opposed to a percentage. Like you said earlier, Mark, percentages aren’t always that easy to think about. Anyway, a big part of at PWL anyway, a big part of figuring out what the need is is running financial planning projections. If someone based on their ability to save is not able to achieve their goals with a 100% bond portfolio, then it’s, okay, we need to take some equity risk. How much do you need to take? We figure that out using financial planning projections.

[1:31:52] MS: Great. I think we’re getting next to the next section, choosing an asset allocation.

Choosing an Asset Allocation

[1:31:56] BF: Choosing an asset allocation. It can be one of the sticking points causing analysis paralysis, which is something you mentioned earlier when people are looking to manage their own portfolios. Now, a really simple way to do this is to just use the Vanguard investor questionnaire, which they have as an online – a free online tool. It’s a quick 11-question multiple-choice questionnaire. I’d ask about some of the key factors in choosing a stock-bond allocation, like your timeframe, how you feel about market ups and downs, your future income and your investing experience, and then it just spits out a stock-bond mix base in your answers.

Questionnaires like this are far from perfect. There’s been a lot of pretty interesting research on that on assessing risk tolerance, but we don’t want to let perfect be the enemy of good. This is a good starting point. It’s probably better than throwing a dart at a wall. But even throwing a dart at a wall is better than doing nothing.

[1:32:44] MS: You only need to get close and then make adjustments. I think that’s really the message about choosing your asset allocation. You’re not going to get it perfect. I mean, if there are DIY investors that are looking for a more comprehensive type of approach, I’ve made a risk tolerance assessment page, which is part of having an interactive guide to DIY investing in a DIY investing hub education area of my website. It has some background on a lot of the issues that we discussed here. There are also some fun exercises that you can do to try to imagine yourself in different situations and simulate yourself through a bear market.

[1:33:18] BF: If you’re doing this with a financial advisor, your expectation should be that they’ll spend considerable time on this, because it is such a big decision. The way that we do it at PWL is we have a psychometric test,³² where the score of that test that you get is compared to a huge database of other people’s scores. The tool that we use and the process behind it is all backed by some pretty interesting academic research. But that test result relative to other people produces a range of asset allocations that you’re likely to be comfortable with.

Then within that range, finding the right specific asset mix that’s done through a combination of further subjective discussion to cover willingness, and then we also do the financial planning, like I mentioned, to uncover your ability, like what is your ability to take risk and then also, the need. How much expected return do you need to meet your long-term goals? We have a pretty involved discussion and process around it. That’s, I think, what you should expect if you’re paying somebody to help you with this stuff.

[1:34:12] MS: I mean, that’s really cool. That sounds like a neat way to approach it with all that evidence and information baked in there to compare against another database of people’s responses. I think that’s very cool.

[1:34:23] BF: I always worry about over-optimization with this stuff. In this case, the cost of doing that is relatively low. You do a questionnaire, it’s not a big deal.

[1:34:30] MS: It’s one tool that informs the discussion. That’s the whole point of having an advisor is that it’s not just one piece of information. You have to have a human there to interact with you to put all those pieces of information and all that data together, which is going to be a little different for all of us.

Portfolio Maintenance

We spent a lot of time setting up and planning how we’re going to do this portfolio. We’re now going to come to a little section on portfolio maintenance. We’ve covered out a plan the portfolio, so we choose good ingredients like low-cost, index tracking type of funds. We figure out the mix of stocks and bonds to match our ability, willingness, and need to take risk. You want to make sure that you have this globally diversified portfolio to minimize uncompensated risks, so that you’re taking compensated risks as much as possible. Then once you’ve planned and you’ve gotten that started, then there’s still going to be some basic maintenance that’s required.

The mechanics of how you transfer money, buy and sell and track for tax purposes, that’s going to be some maintenance there, but it’s going to depend on whether you’re DIY investing, or using an advisor. I think one big key concept with portfolio maintenance that we should talk about for sure in some detail is portfolio balancing, but that’s going to apply regardless.

Rebalancing

[1:35:42] BF: After you spent all that time choosing your asset allocation and then picking the funds that you’re going to use to express that asset allocation, the thing is the values of funds are going to change at different rates over time. I mean, that’s good, because that’s diversification. They’re not perfectly correlated assets. That’s what you wanted. It also means that they’re going to drift from your carefully designed asset allocation targets.

To keep the portfolio on target, you have to do this thing called rebalancing. If you’ve built your portfolio using individual ETFs for each asset class, or whatever individual index mutual funds, or ETFs, or whatever you used, you’re going to have to do the rebalancing yourself. On the other hand, if you bought an asset allocation ETF, or something similar to that, it’s going to be rebalanced inside of the fund for you and you don’t have to do anything. That’s one of the really nice things about the asset allocation ETFs. If you’re using a financial advisor, they’ll hopefully, be rebalancing your portfolio for you. If they’re not, that raises some questions.

Now, rebalancing is probably going to mean selling some of what has grown more and buying some of what has grown less. In practice, that might just mean buying more of what hasn’t grown as much when your portfolio is small and you’re making large contributions. If you’re adding big dollars to the portfolio every month, or every year, you can probably do a lot of your rebalancing just with those new contributions. If your portfolio is very large relative to your contributions, if there’s not a lot of cash flow going into the portfolio to do that rebalancing, then it can involve selling some of your assets to execute on the rebalancing.

[1:37:07] MS: Some of that’s going to be pretty predictable, too. We know that bonds have this lower expect return compared to stocks over long time periods. For example, if you set up a portfolio with a 50-50 stock-to-bond allocation, we know that the stocks are likely going to grow more. Let’s say, the stocks grow 10% a year and the bonds grow 4% a year. Well, if you just keep investing the same amount each year and you just buy 50% stocks and 50% bonds every time you put money in the account, eventually, the portfolio growth is going to way outpace anything that you’re adding and your stock allocation is going to become very outsized, because they’re growing faster.

It could reach 80% or higher after 35 years, or some other long time period when your target was actually 50-50. An 80% equity portfolio is going to be considerably more risky than what you’d intended. That’s an extreme example of neglect, but it does illustrate why rebalancing is important. It’s important to control risk. That’s why we’re doing it. It’s not so much that we’re going to boost our returns or anything like that, especially we expect that we’re going to be doing and something we’re selling stocks, which grow faster to buy bonds which grow less.

Over long periods, you’d expect that to make the returns slightly less from just that mathematical standpoint. But we’re doing this on purpose to control risk which is important for our behaviour. Even though there may be a slightly less investment return, behaviourally, we’re going to perform better and be able to stick it out and stick to that plan better. Our actual return in real life might make it worthwhile and be better than just what the math is.

The other part of that is if you don’t want to experience a major drop at the time when you need the money. Now, 35 years now, that might be around the time you’re going to retire and start accessing that money. If you’re 80% equity, because you never rebalanced your portfolio ever, well, that’s a huge amount of risk that you could have an unlucky draw down at a bad time, which jeopardizes your plans.

Of course, the other aspect by, let’s say, even if you aren’t doing a stock and bond mix, well, even within the stocks part itself, you don’t want to over-concentrate in the areas that are outperforming. You want to invest in them and then rebalance. That forces you to stay diversified, rather than just getting over-concentrated in one spot.

[1:39:19] BF: You raise a really important point, which is that the effect of rebalancing between your stocks and your bonds is probably going to decrease your expected return. Again, it’s not a free lunch here. You’re purposefully selling, or not buying more of the risk your equity investments in your portfolio to buy more of the lower expecting return bonds instead. The idea here is not boosting expected returns. It’s avoiding taking more risks than you had intended to, avoiding larger losses than you are originally comfortable with when you set up your portfolio by letting your equity exposure drift too far.

Now it’s interesting, right? Because if you did let your equity portfolio drift further, you might end up still better off even if you did take on the downturn because you had a higher expected return. But if you can’t live with that drawdown and you bail on the portfolio, then that’s a big problem.

Now you mentioned this, Mark. I think, rebalancing to your target allocation, it can reduce your – it can increase your return net of the behaviour gap. It can decrease your behaviour gap if it keeps your portfolio on target with a level of volatility that you’re comfortable with. We saw a lot of that data on how important the behaviour gap can be. I think keeping your portfolio on target with where you can sleep at night is really important.

[1:40:27] MS: It’s going to translate into sleep and potentially more money from not sabotaging yourself. Even with this idea, there’s actually some practical questions that come up commonly when we’re talking about rebalancing. Specifically, what trigger do you use to rebalance? How often do you do it? How precise do you need to do it? This becomes a bit of a trade-off. More frequent and tighter rebalancing. Well, that could mean more transaction costs, because you’re doing more buying and selling. That’s effort that you have to do. It’s potential for errors and it’s possibly going to be taxes if it’s in a tax-exposed account.

You’re doing that to have – you would also have tighter risk control. You’re trading these two things off with each other. You really have to have a balanced approach to rebalancing about how much is actually needed. In terms of frequency, the one approach is to rebalance based on the calendar, like rebalance once a month, or once per year. I mean, in practical terms, that usually means that you have a schedule where you add, or remove money from the portfolio. I mean, it could be when you get your paycheck, or for me, it’s about four times a year when I know how much money I’ve got and I’m not going to need it and I can invest that money. That’s how often that I do it.

When you’re doing it like that, you’re not rebalancing just for the sake of rebalancing and you’re not buying and selling just to do that. You’re buying and selling, because you’d be doing that anyways, because you’re moving money in and out. You just happen to be trying to do that in a way that keeps you on target.

Now, another approach to rebalancing is when your asset allocation has straight off target by some threshold. Let’s say, for example, you set your bonds to be 40%, now they’re more than 5% off that at 50 something percent. Well, that might hit the threshold, where you want to rebalance the portfolio, whether it’s the calendar indication or not. The other question that comes up when you have one of these thresholds net, whether it’s calendar time, or whether it’s a change off of your target is how aggressively do you buy or sell to get back towards the target? Do you just try to get back to the edge of the guardrail that you’ve set for yourself, or you try to just you’re going to do it and do it exactly onto the target again?

With that threshold violation and those more complicated ways of trying to rebalance, that would become very cumbersome. I mean, really, you’d have to be tracking price movements up and down, maybe even every day. That’s probably even detrimental. You’ve mentioned before that the more we look at and mess with our portfolios, the more likely we are to misbehave because we keep getting stimulated by the movements.

[1:42:48] BF: There’s a saying in investing that a portfolio is like a bar of soap. The more you handle it, the smaller it gets. We did mention that study earlier that more frequent checking of the portfolios associated with lower returns due to myopic loss aversion. This comes up all the time though, this rebalancing question. People want to ask, what is the optimal rebalancing strategy? I don’t think there’s a great answer. Vanguard does have a paper on this that looked at different approaches to rebalancing.³³ They found the optimal frequency for a 60/40 stock-bond portfolio was once per year. After about two years, they found that the volatility of the portfolio strays too much. With more frequency, the transaction costs of rebalancing start to get too high.

In practice, we’re probably going to be rebalancing to some degree with contributions, or withdrawals, like we mentioned earlier. That might not get us quite to the target. According to Vanguard’s research, doing a more precise rebalance should be less frequent. Like, maybe once a year is a good benchmark. They also did an analysis using the calendar and threshold guardrails. Again, they found that rebalancing more than once a year was sub-optimal.

When rebalancing monthly in their model, using a more liberal guardrail of 7%, they found that was better than the tighter guardrails. Then when rebalancing annually, they found that a 1% guardrail was better than higher guardrails. Now, it’s also important to point out that the difference between guardrail performance was small. The big jump in benefit was by rebalancing annually, instead of monthly.

[1:44:10] MS: The final point that I took away from that paper, again, is that when you’re looking for the difference between the most optimal method and the other methods that you’re looking at, the differences are very small. I mean, they tested their findings across this broad range of stock-bond allocations, and the difference between portfolio growth with rebalancing was very similar, whether it was 35% equity, or 90% equity. It was under 0.1%, it was very tiny. Even using different rebalancing strategies was very small impact, like 0.06% per year to maybe 0.2% per year with the smallest drag there just being from an annual approach, which is great because that’s easier to do.

That’s important because rebalancing is one of those tasks that really scares people from investing. For example, if you’re a DOI investor, fortunately, now you can avoid it actually by getting one of these asset allocation ETFs, which automatically does that rebalancing for you. That helps to automate that process. If you’re using an advisor, they can provide value by doing that for you, hopefully not more frequently than is required. That may, again, be something to ask about, you want to make sure that they’re doing it, but they aren’t doing it all the time just for the sake of doing it.

I mean, otherwise, if you’re DIY investing and you’re using multiple ETFs, I think the good message is that lazy is okay, which I was very happy to find that out when I started looking into this. I know when I started DIY investing, this is one of the things that scared me. When I did a bit more reading into it and found that it probably less is okay, and it’s not super precise, probably doesn’t matter, I was quite happy. But not more than two years lazy. You got to do it once in a while.

There’s small differences, but those small differences, I think the big message for me is the small differences in rebalancing strategy, that pales in comparison to the risk of never rebalancing. That’s horrible that you’re going to discover that that’s a problem at a very bad time. It also pales in comparison on the other end that if you are not investing because you’re afraid of rebalancing, you’re missing all that time in the market. The tasks of planning a portfolio can seem daunting, but you have to do it and get invested.

Serving Up a Great Portfolio

Serving up a great portfolio can be done with using pretty simple recipes. Actually, that’s the good news. That’s more important to use one of those simple recipes than starving yourself where you’re waiting to plan some gourmet meal. You want to just get going. Just to do a bit of a recap of the process that we covered so far, because we’re now a couple hours into this, we’ve covered a lot of ground with a lot of detail. I just want to give a quick analogy and some perspective, because we’ve got a lot of different parts that are working here.

When we’re building this portfolio, we’re trying to balance a number of different types of risks in a way that matches our financial goals to our lives. That seems like a squishy, theoretical topic. The reality is that we can do this in a simplified task to put things together into a bundle that suits their situation. It’s like preparing a meal. That’s the analogy that I would use for this. Like preparing a meal, people often focus on the end result, which is the eating part. But there’s a lot of preparation that goes into it in the background before then. That complexity may not be readily apparent to most people.

You may have started this podcast not realizing it was going to be as long as this because we’re covering so much material, but this is for a reason. I can tell you, when I started making my own meals, I graduated from eating cereal and crackers to making many pieces in the oven. I thought I’d made it. I was at the pinnacle of cuisine. The thing is that’s all I actually really needed at the time, so it was okay. I could even save on dishes by eating it right off the pan. I felt like I was a total genius. My kids will say that I’m over-sharing by relating that, but as part of this analogy of a portfolio and creating a great meal, it’s important to realize that it’s okay to start by just turning on the oven, putting in some pizza out of the box, and getting invested, like using an asset allocation ETF, for example, or even using a retail mutual fund advisor. All you can afford is some fast food, the marketing’s great, and you didn’t realize how bad it was for you. At least, you didn’t starve. The key is to not just keep blindly eating fast food until you have your first heart attack. You need to learn more and adjust and the earlier being the better.

The other thing I would say is that when I was living off many pieces, I actually didn’t really know what I didn’t know. That’s the same thing that happened with managing my own portfolio. When you plan to manage your portfolio or hire a manager, you need to understand some key parts of the process. It’s going to take multiple episodes to cover the different aspects of building a portfolio. We’ve laid some of that groundwork already. Hopefully, you’ll come back to these episodes more than once, I hope.

I want to give you a big picture overview of the analogy to help us keep our bearing because this is going to all be spanning multiple episodes as we make this meal. A great meal starts with good ingredients. The portfolio ingredients would be stocks and bonds and funds, like we discussed in the last episode. We mix them together in the right ratios. For that portfolio, we get that mix called asset allocation. That’s where we spent a lot of time in this episode. You want to have enough of those risky spices, like stocks to make it tasty, but not so much that you get indigestion. You have to be careful of the risk mix.

Some people learn that the hard way, by exceeding what we call their risk tolerance. It’s like eating that extra waffle-thin mint after grossly overeating. The result of that can be that if you exceed your risk tolerance, it’d be very messy. That was a Monty Python reference. The different courses that you make, they’re held using different containers. For a portfolio, those containers are going to be the different accounts that you use, like an RSP, or a TFSA, or corporate investment account. They can all hold the meal, but they all are slightly different in how they do that. We’re going to get into that in our next episode.

I mean, one approach is to use all your best dishes first. Your tax-sheltered accounts, and then to just overflow into your tax-exposed accounts as needed. Some cooks are going to try to match the container to the specific ingredients. That’s what we’d call asset location, or tax optimization. That gets gourmet pretty quickly. Very complicated, just like cooking a gourmet meal. Similarly, the nutritional value for the time and expense of trying to do that may often be quite questionable. We’ll get into that in our next episode.

Now, the other point that we’ve tried to make through this episode is that the meal needs to suit your nutritional requirements and taste. Those are going to be your personal goals like we discussed in the first few episodes. Those tastes and needs are going to change as you age and your portfolio is going to need to change as you do that.

Execution Risk and Simplicity

[1:50:36] BF: One issue that I think we have to keep in mind when deciding how to operationalize all of this for yourself is the execution of the tasks. We spoke today about behavioural errors driven by fear and greed. People can also make execution errors. The two can often be related. Execution errors are mistakes that we make due to trying to construct a portfolio that’s too complex, or complexity can at least exacerbate execution errors. These can be behavioural, like missing time in the market, because we delay investing. It can also be a mathematical mistake, trying to account for complicated things like taxes and figuring out your asset allocation. That’s something that you and I, Mark, talked a lot about. I don’t know when that was. A couple of years ago, but on the topic of asset location, the difference between your pre and after tax asset allocation.

[1:51:19] MS: Yeah, it’s complicated fast.

[1:51:21] BF: Yeah, it gets complicated fast. Or just something that an unknown unknown, something that you unknowingly do so optimally, because didn’t know something, or just had incorrect assumptions about the future. There are two main approaches to minimizing these execution risks and behavioural implementation risks. One is simplification. An asset allocation ETF, for example, is super simple. It’s like the many pizzas that you referenced earlier. You take it out of the box and stick it in the oven and you have a pretty good meal. I mean, it’s a great meal. I like pizza.

[1:51:49] MS: I still use them.

[1:51:50] BF: Yeah. I make my own pizzas. We stop buying. I’ll make you pizza one day. I make a really good pizza.

[1:51:55] MS: Yeah, that’d be awesome.

[1:51:56] BF: It’s good enough that I’m comfortable saying that in public. You can do the asset allocation ETF thing, the box pizza. The other is to hire some professional help. Even if you’re hiring, I think you still have to understand the basics of what goes into portfolio construction, just so that you can have an informed conversation with the advisor that you’re dealing with. Not only to recognize whether the chef, or the advisor is focused on doing the right things for you, but also, because only you, the investor, the person trying to achieve their goals, only you can communicate and refine your tastes.

Now, it’s important to be able to put the costs and benefits of simplicity and outsourcing into perspective. It applies through the portfolio construction process. We actually started that discussion last episode. Low-cost passively managed funds are a simple and cost-effective way to get your basic ingredients compared to trying to pick individual stocks to be diversified. In this episode, we discussed balancing investment risk and behavioural risk using asset allocation. An advisor can add a layer of value in this aspect by helping you figure all this stuff out. They can also act as a barrier between your emotional beast and your buy-sell button.

Now, that’s not free. You pay a fee for a financial advisor that’s going to be managing your portfolio. I guess, there’s an interim step there, that could be a robo-advisor. Similarly, that does put a layer between less of a layer, but somewhat of a layer between you and the portfolio. In either case, you’re paying a fee, so you’ve got to make sure that you as an individual in your specific situation are getting value for the cost that you’re paying. We’re going to do a whole episode on that later. But asset allocation is one piece, but there are lots of other things that you should expect from a financial advisor.

In any case, if you’re paying a fee, you’ve got to make sure that you’re getting value in return for it. Now, the unfortunate thing, and again, we’ll do a whole episode on this, is that sometimes the advisor’s focus is on selling you products or recommending strategies that may actually detract value, like complex products, or opaque products, or products with high fees. A lot of times, we see things positioned as tax optimal, but they contain huge fees and they can be problematic. We’ll get into all of those topics in a later episode.

Keeping Perspective – Portfolio Pyramid

[1:53:58] MS: I think we’re going to finish off with trying to keep all that in perspective because there’s so much information, there’s so many steps, and this is something which I call the portfolio pyramid.

I try to attach some numbers to keep these different steps into perspective. The most important part of building your portfolio over time is actually just getting invested. Missing time in the market is going to cost you 6% to 10% per year, depending on what your asset mix and what the market’s doing while you’re not in it. More than fees, taxes, or even minor behavioural errors. We’ll put a picture of this in the video.

The base of the pyramid, because of that is just to be able to save and get invested. Being invested in broad markets, that’s worth 6% to 10% a year historically. Diversification to do that is essentially free. The next layer of the pyramid is behavioural risk, and we discussed some of the data today showing there’s that behavioural gap, which could be worth anything between zero and 2% a year, depending on how volatile and complex your asset mix is. It could be much more if you make a big mistake.

Now, mingling with that layer is what Ben was talking about with the value of an advisor. They can help you with that behaviour and help you get the asset allocation and stick to the plan, be a layer of protection between the buy-sell button. It comes with the cost of their fees, which could be in the 1% to 2% a year range, but it also has this benefit of a potentially smaller behavioural gap. More time in the market also, if they help you to get and stay invested.

Now, the tip of the pyramid is that small little piece at the top, which highly taxed professionals often get drawn into. Some advisors aim complex products at which is tax optimization. That’s natural for us because we pay a lot of taxes and it’s natural for advisors because it’s complex and interesting and there may be other factors to play. It’s also worth noting that it could be worth nothing, or close to nothing. Maybe up to a percent a year, but that really depends on a whole bunch of assumptions and circumstances that we’ll bravely dive into in a future episode. Of course, anytime you have complexity that also comes with more risk of execution errors, which can happen anywhere along the portfolio pyramid.

[1:56:00] BF: We’re guilty of this, too. You mentioned that highly taxed professionals get drawn to this stuff. We probably spend 20 minutes before we start recording every episode, sometimes longer talking about just ridiculously detailed complex tax optimization ideas.

[1:56:15] MS: Yeah. Well, there are ways where it’s predictable, like when you’re talking about compensation from your corporation. But then, you start getting into the future, it gets hazy.

[1:56:22] BF: Yeah. No, it definitely does. Okay, well, I think that’s about as much as we can stuff into folks for this episode. What is that dark, brown disc-shaped thing by the pyloric sphincter?

[1:56:31] MS: I think it is a waffle-thin mint.

[1:56:32] BF: All right, we better get out of here.

Post-op Debrief

All right, that was quite the procedure. Let’s jump into our post-op debrief. In this episode, we started our deeper dive into building and managing a portfolio. Mark used a cooking analogy to give an overview of what is actually a complex process. Your individual holdings are like the ingredients and you want to make sure that you have enough to diversify against uncompensated risks. Funds, like index funds make that easy, but you still have to get the right mix of funds by choosing an asset allocation.

[1:57:01] MS: Yeah. The most important asset allocation decision you’re going to make is your stocks-to-bond ratio. That’s a balance between taking as much investment risk using equity, or stocks to maximize your potential returns against having enough bonds in there to decrease volatility. The safest bonds are the government bonds that are the best at doing that. Volatility can translate into behavioural risk, which is the risk of buying and selling at bad times. Fear, greed, and biases causes to buy and sell at bad times, and we’re hardwired to do that as humans. The impact, it can be significant. 1% to 2% per year on average, and it can be much higher with really volatile investments.

[1:57:42] BF: Yeah. There are a number of ways that we try to find that balance for each individual investor, as we try to serve up a great portfolio. We try to assess our risk tolerance when choosing that stock-bond allocation. We’re unlikely to get that perfect, but the good news is that getting close is okay, especially if we are on the side of caution when starting out and then adjust as we develop comfort experience and whether some actual market volatility with our real portfolio is in real life.

[1:58:07] MS: We can also help to decrease our behavioural risk by taking tasks out of our hands, or automating them. For DIY investors, that could be using an asset allocation ETF. For those using a human, or a robo-advisor, setting up an automated contribution and investing plan helps. Behavioural coaching and providing an extra barrier between making rash buy and sell decisions can also help. Those are probably two of the biggest advantages of using a professional portfolio manager.

[1:58:34] BF: Yeah, and I’ve definitely seen that in real life through, like COVID being the most recent example, where there were some phone calls that had they gone a different way or had the decision gone a different way, it would have been very expensive in hindsight. Now, you can make choosing an asset allocation more complicated by trying to account for your other assets. For example, how your investments fit with the stability of your job, or your pension, and that may enable you to take more risk if you have stable bond-like assets.

Now, the important thing though is that only applies if you can emotionally handle it, because even if we devise the perfect asset allocation across your financial and non-financial assets, but you panic when your financial assets drop in value, well, that’s no good.

[1:59:12] MS: No. You can take this and make it complicated. You can slice and dice your asset allocation to tiny little pieces, for example, different regions, or industries, or company sizes, other characteristics. The possibilities are really endless, but the biggest issue is to cover broad markets. Usually, niche funds not only have higher fees, but also underperformance due to your behaviour on top of that. Plus, the more complicated you make your portfolio, the more likely you are to make just execution errors.

[1:59:40] BF: I think there are a couple of important considerations beyond the stock-bond allocation decision. One is avoiding over-concentrating your risk with a heavy overlap between your investments and your job, or a company. That’s like taking those bets that we talked about during the episode, based on the knowledge that you – your specialized knowledge. Then the second is to be aware of home country bias. As Canadians, it makes sense to overweight Canada to some degree, probably, based on fees and taxes and a couple of other considerations. But Canadian holdings should not dominate your portfolio, as they do in the portfolios of many Canadians.

[2:00:13] MS: Whatever allocation you do choose, it’s going to drift over time as different parts grow at different rates, and you must rebalance to get back on target. Fortunately, that does not need to be done very frequently. You can probably partially, or completely rebalance when buying or selling as you move money in and out of your portfolio for other reasons. If not, then once a year should be enough. You also don’t need to be perfectly precise.

[2:00:36] BF: There are a ton of moving parts to balance with portfolio management, which is why we spent two and a half hours talking about in this episode. Hopefully, the portfolio pyramid will help you to keep them all in perspective. The largest impact, the most important thing to do is to get invested. The middle section is a balance of managing investment and behavioural risk. We covered that today. In the next episodes, we’ll explore the very tip of the pyramid, which Mark and I enjoy talking about, even though it is at the little razor’s edge there. Investment taxation and the various products, or strategies touted to try and optimize that. That’s where we’ll go next. In the meantime, consider joining us for our next case conference related to today’s episode.

Footnotes

Ayres, I., & Nalebuff, B. (2013). Diversification across time. The Journal of Portfolio Management, 39(2), 73–86. https://doi.org/10.3905/jpm.2013.39.2.073 ↩︎
Wachter, J. A., & Yogo, M. (2010). Why do household portfolio shares rise in wealth? Review of Financial Studies, 23(11), 3929–3965. https://doi.org/10.1093/rfs/hhq092 ↩︎
Gomes, F., & Smirnova, O. (2021). Stock market participation and portfolio shares over the life-cycle [SSRN Scholarly Paper]. https://doi.org/10.2139/ssrn.3808350 ↩︎
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Investing Basics & Common Questions

In this Rational Reminder episode we cover the basics of investing, echoing many of the points made in this Money Scope episode.

RR Episode 231

Prof. John Y. Campbell: Financial Decisions for Long-term Investors

John Y. Campbell is one of the leading scholars on asset allocation for long-term investors. This is an advanced episode, but it is incredible.

RR Episode 250

Prof. Meir Statman: Financial Decisions for Normal People

Meir Statman is one of the creators of behavioural finance as a field of study. This episode covers many important

RR Episode 258

Lifecycle Asset Allocation, and Retiring Successfully with Justin King

We talk through a recent paper on lifecycle asset allocation which challenges much of the conventional wisdom.

RR Episode 281

When Volatility is Risk, and Introducing The Money Scope Podcast

While new research suggests that investors may be better-off in 100% stock portfolios, we discuss the behavioural considerations that affect the asset allocation decision. (We also introduce the Money Scope podcast!)

RR Episode 283

Prof. Scott Cederburg: Challenging the Status Quo on Lifecycle Asset Allocation

Scott Cederburg has co-authored some excellent research using a novel data set. We discuss his research and the implications for portfolio management.

RR Episode 284

The material in episode 7 is strongly related to the Investing Basics Module of The Loonie Doctor Core Financial Curriculum. The DIY Investor Basic Training section of The Loonie Doctor DIY Investing Hub expands on that. Here are a few other articles closely related to this one.

Determining Your Risk Capacity

Avoid Forced Sales

How soon you will need the money you are investing and how much flexibility you have around that influences your ability to take risks. Be sure that your asset allocation does not exceed your risk capacity.

Assessing Your Risk Tolerance

Think Before Riding Bears

Assessing your risk tolerance and choosing a suitable asset allocation is daunting. You could do the simple Vanguard questionnaire. Or you could try the different exercises and tools on this page from my interactive DIY investing guide for a more comprehensive attempt at it.

Rebalancing: What is it? Why Bother?

Manage Risk & Return

Precision & Timing of Rebalancing

Press the “Easy Button”

Do you need to rebalance your portfolio frequently and with high precision? Or can you be loose and lazy?

PWL White Papers

Dollar Cost Averaging vs Lump Sum Investing

Download From PWL Capital

Episode 7: Portfolio Design & Management