64. Your Investment Approach: Stocks and Bonds

Transcript:

Hello, and welcome back to the Canadian Money Roadmap Podcast. I'm your host, Evan Neufeld.

Today is the first episode of our series on building your own investment approach, and we're talking about the critical aspect of setting up your asset allocation between stocks and bonds.

If this is your first time joining us. Thank you so much for being here today and your joining at a great time because this is the first episode of our series on building your own investment approach. The whole point of this series is to dig a little bit deeper beyond just general dogmatic advice that you might have seen on the internet and actually understand what is important to you and building an approach for you that you can stick with.

Before I get started, I wanted to give a shout out to listener Jeff, who sent me an email this week and outlined his investment approach. And the cool thing about that is that he started by wanting to be (in his words, and he's joking here) by wanting to be the next Warren Buffett and kind of building his portfolio along that style.  But then over time, as things changed and he had less time to commit to it and things like that, he pivoted his portfolio to something a little bit different. I'm not going to give away everything that he talked about because they cover off a lot of the options that we're going to discuss in future episodes. But it was pretty neat to see that he was able to understand his limitations or even preferences and adapt his portfolio to change over time to something that he can stick with. Because the best portfolio for anybody is the one that you can stick with for the longest. Kind of like Warren Buffet. A lot of his success is because he's in his nineties, not because he's brilliant. He is brilliant, but also the fact that he's been investing for longer than most people are alive makes a huge difference. So anyways, thanks so much, Jeff, for sending your email. If anybody else has their own investment approach that you'd like to share with me, I'm always curious. I'd love to respond to emails.  Please feel free to send me an email. I've got my contact info in the show notes of this episode. So this first episode we're looking at. Stocks versus bonds or what we call asset allocations. So stocks and bonds are different assets. And how much of your money should you allocate or put towards investing in stocks versus investing in bonds?

This is a really good place to start because it's pretty critical for understanding your return expectations, but also how your portfolio's going to perform in different market conditions. So let me just start with stocks here. What is a stock and why should you bother? Well, stock is just an ownership of a company, and so that's why stocks are often referred to as equities.

I like watching Shark Tank and Dragons Den and shows like that, and they often refer to you know, coming on the show and they say, I'm going to ask for a hundred thousand dollars in exchange for 10% equity in my company. Equity just means ownership. So when you buy stocks or equities, you actually own a piece of that company.  Not every company is publicly available or publicly traded but many of them are.  A lot of big brands that you would know and like, are publicly available and you can buy their stock and you can own a little piece of that company.  Stocks have been one of the best builders of wealth available and they're very accessible now, and so to be able to participate in the profits of other companies is a really great way to have your money working for you. Over the last 50 years, a diversified portfolio of stocks has returned an average of about 10% a year.

I'm going to stop right there, because that historical number is exactly that and going forward, I wouldn't expect that to be the case, but 50 years is a long period of time. I never do assumptions when I do financial planning at that 10% figure. Sure, we'd all love to get it. But anyways, all that to say is just something that we can learn from the past that stocks have been a great way to build wealth over time because of that great average return.

However, average return and consistent returns are very, very different. So what does that difference actually equate to? Well, that's what we call risk, right? So stock market doesn't go up 10% every year. If we look at last year, US market was down approximately 20% by the end of the year. That's risk.  That's risk happening. And so over time, the pathway that you get to your average return is your risk and reward trade off.

So again, investing in stocks is really cool because you get to participate in the profits of other companies. Let's give a few examples here or just put it into real terms. I was at Costco on Saturday. Have you ever been an absolute crazy person like me and been to Costco on a Saturday? Well, there's lineups virtually out the door to get in.  It's lineups down the aisles to get just to pay. Plus everyone that's in there is a member and has to pay to walk in the door. Little alone the lines to get a $1.50 hot dog and all that kind of stuff too. But if you were to just look around and say, man, wouldn't it be nice to own a piece of a business like this?

Like yeah, boy, that looks like a place that has a license to print money. Like it's a really good business and people love it. I'm not advocating investing in Costco necessarily, but it's just something you can look around and you can. Maybe in the community near you, the Tim Horton's drive-through, has a line 10 cars deep every morning.  Boy, wouldn't that be nice? Yeah. Okay. So you can kind of see how participating in the profits of some of these other companies that have come before you is attractive. Now, I'm not talking about valuing stocks today. I'm going to get into that in a another episode because sometimes everybody on earth can see that Costco is a great business and so they bid up the price and it's no longer actually affordable to buy, or not really reasonable.  It could be very, very expensive. So not everything is worth buying, but you can kind of see where the benefit is of participating in the benefits of those. A couple different ways to make money with stocks. Price appreciation and dividends. So price appreciation means that the price of that, that stock goes up over time, and then eventually you sell it for a higher price.  That makes sense because these companies make more money over time and they become more profitable and they grow and they grow and they grow. They also can go the other way too, of course. But that's how you make money is through price appreciation. But also, some companies pay dividends, which means it's a portion of the profits that they share with you and millions of others as shareholders.

Very simple there, but that's essentially what stocks are. And some of the benefits of investing in stocks. Now, bonds are essentially a loan. They're a little more difficult to understand, even though the concept around them is less theoretical. So companies and countries in government specifically issue bonds to raise money to either run the country or run the company. And the way that it works, I'll just give a hypothetical example here. So say the government of Canada wants to raise some money. What they'll do is they can sell some bonds. Again, this is just going to be a hypothetical number here, but say they are selling bonds that pay 2% interest, and we'll call that a 10 year bond.  So every bond has a few characteristics. It's the duration. So in my example here, it's 10 years and they have a coupon payment, which is the interest rate. So that's 2%. And they have a price. And so let's say theoretically they, they're going to sell this for a thousand bucks. So a thousand dollars, 2%, 10 year bond.

What that means is that you give the government your thousand dollars, meaning you buy the bond for a thousand dollars, then every year they're going to give you 2% a year. So that's 20 bucks every single year for 10 years, and then at the end of the 10 years, you get your thousand bucks back. It's just like a loan.

So, let's, let's say Apple for example, Apple's almost as big as many countries around the world, but there's a lot more risks associated with a company as opposed to a country. So, Corporate bonds might pay a little bit higher interest because those companies could go bankrupt, likely a lot easier than a country can.

And so there's a little bit more risk in corporate bonds. So that same example, perhaps an Apple 10-year bond might pay 4% or something like that, but you have a little bit more risk associated with that. I'll talk about a few more risks with bonds in a second here, but over the last 50 years, bonds have returned about 5% a year and alert alert, again, this is a situation where 5% a year, if you assume 5% a year going forward from here, you'll be sorely disappointed because the way that bonds return money to you is a little bit different than you might expect, because most bonds aren't held for the entire duration of that bond.

 Even though the income portion or the coupon stays the same, the value of that bond typically changes over time. Due to other things in the  market. So like prevailing interest rates and both supply and demand as well.   So in a falling interest rate environment, bond values have actually increased.  And the opposite is also true. When interest rates go up, bond prices come down.

Long story short, since interest rates have been falling, practically speaking for about the last 40 years, let's use a hypothetical example here again. So back to my government of Canada Bond. Forget 2%. Let's say 40 years ago, they're paying 10%. Okay? And then the next year interest rates decline. And when they issue new bonds, perhaps they sell them at 8%.

Which one is more valuable? The one that was sold for 10%, or the one that has 8% coupon on it? Well, 10%. This isn't a trick question. You want the one that pays the higher rate, and so, when interest rates fall, existing bond values actually increase in value, right? And so when interest rates have declined pretty well straight down for 40 years, that made the returns on bonds much, much higher.

Now the bonds have been issued in an interest rate environment that's been so low. Forget this last year, but it's been very, very low, if not zero for almost 10 years. Returns on bonds have been a lot harder.

The opposite is happening here a little bit as interest rates are kind of going up. But prices change based on prevailing interest rates and the duration of those bonds. Over time, the value of adding bonds is that they typically have a low correlation to stocks, which means that historically, oftentimes when stocks went up and bonds went down, that's okay because stocks have gone up much more than bonds and vice versa.

If stocks went down, bonds went up. That's called low correlation. Doesn't always happen necessarily, and last year was one of those unique times where they kind of moved in tandem. But the point of adding bonds to a portfolio is to smooth out the ride. Because if we go back to the stock portfolio, if it had a standard deviation, about 15% bond, standard deviation is closer to seven, it would be much lower than that. And so you add bonds to a portfolio to smooth out the ride. Sometimes people will call it an airbag. And so a good line that I've heard is that bonds help you sleep well and stocks help you eat well. So stocks are where you're going to make money, but bonds are going to be the part of your portfolio that helps smooth things out. So when stocks are really going crazy, hopefully bonds are a little bit less.

So if you're looking to make the most return possible, regardless of risk, you wouldn't really look at stocks and bonds and say like, oh boy, I got to get some of those bonds in there. Not necessarily, but you include bonds when you cannot take on the risk of an all-equity portfolio, and that could be for a number of different reasons. There are still risks associated with bonds for sure, like interest rate risk, currency risk and default risk. And those aren't necessarily as present with stocks, but they will generally be lower risk than stocks. So adding them to the portfolio, yes, it might decrease your total amount of money that you could make, but it will smooth out your investment experience along the way, and hopefully allow you enough comfort that you can stick with your approach even when things get rough in the stock market.

So how do you determine the allocation between stocks and bonds? Well, here's the million-dollar question, another trillion-dollar question, whatever you want to say. Because risk and return are linked, people often confuse them for one another. Let me flesh this out a little bit because I've heard people say, I want to take on more risk or I'm a risky investor, Do you actually want to take on more risk?  No, you don't. No one wants more risk. You want more return. Don't confuse them for one another. They do not go hand in hand all the time. The optimal portfolio is the one that provides the best returns with the least amount of risk. So no one wants to take on more risk for the sake of taking on more risk. The times when you hear people say, yeah, I want to take on more risk, is when the times that return has actually been more common than risk, right? So risk is the shadow side of return. You want more return and risk is the price you pay for it.  So you don't want to pay more in terms of to get less return. So there is a bit of an optimal like, balance there perhaps. And even within equities, there's different risks that you can take on for different expected returns. That's another thing that will flesh out over time through these episodes here, of course, but you don't want to take on risk just for the sake of taking on risk because it doesn't turn into return immediately.  That's why it's called risk. Risk is the chance that you'll have a negative outcome or one that you didn't expect. And so the more of that you have, the more chances you're going to have a negative outcome. So let's go back to that standard deviation thing for a second. And in any given year, returns could be anywhere, they could be positive, they could be negative, they could be low, they could be high. If we piece together the annual returns for the last, let's just call it 50 years, it doesn't matter, but, and, and you line them up from smallest to largest, what happens is if the average is, say, 10%, most years will kind of hover around that 10%.

But as you get further and further away, meaning higher returns than that and lower returns than that, there'll be less instances of those happening. So you can kind of start visualizing in your mind something that we call a bell curve or a normal distribution. Let's take you back to stats class here, and so you can kind of see that we're on the tails on the left, there'll be a few instances of those really extreme outliers. And then as you get closer to the “mean” or the average, there's going to be more and more instances there. And so you can see where it's like a hill going up and then a hill coming down, and then a couple of tails on the end where it goes out a little bit further.

So what is standard deviation? Well, if we look at the top of that hill, that is the average. Let's call that 10% whatever, and a standard deviation just encompasses the returns on either side of that average. So one standard deviation looks at 68% of the outcomes. Two standard deviations gives about 95% of the outcomes, and three standard deviations away gives over 99% of potential outcomes for that portfolio.  And so standard deviation isn't perfect, but what standard deviation does is it helps you know in advance or anticipate in advance what the expected range of outcomes could be for a given portfolio.

Let's give some real-world examples here. This is probably going to be helpful for a concept like this. Okay, so I have three different ETFs here. These are ones that I'm not specifically Vouching for, but they're really popular and ones that you might have heard of before, they're from Vanguard and they are their asset allocation portfolios.

So the first one is VEQT, which is just an all-equity portfolio. V Grow, which is an 80% stocks, 20% bonds portfolio.  And V-bal, which is balanced which is 60% stocks, 40% bonds. Don't worry about the tickers, but these are real numbers for real portfolios that have existed and I looked at the numbers just this morning, so they should be pretty accurate. However, if we look at the returns and things like that, we're in a period of time that is lower than what we've seen in the last year or two, and so the three year returns will change drastically over time.  But I just wanted to use real numbers today so you can actually see what a potential range of outcomes. Okay, looking at the three year returns for the all equity portfolio, it's about six and a half. So 6.46%. per year on average for the last three years. Now to get that 6.46%, you had a standard deviation of 16%. Now, what does that mean? Well, let's take a look at two standard deviations away. What we do here is we will multiply the standard deviation by two, and we can add and subtract that from the average to get your range of expected outcomes historically.  Okay, so two standard deviations again means that 95% of the time you could expect this portfolio to provide returns anywhere between negative 25% in a given year, all the way up to about 38% a year. Pretty big range of outcomes there. Again, the higher the standard deviation, the larger the range of potential outcomes.  So if you're needing a portfolio to return 50% in a given year sorry, you're going to have to get lucky somewhere else, but a diversified portfolio, 95% of the time, if you can average about six, you can also expect a range of potential years to be between negative 25 and up to about 38 or 39%. Okay? This is the risk component.  This is why they call it risk, because you never know when you're going to be in one of those higher tiers or one of those much, much lower tiers.

Let's go over to the 80/20 portfolio. Over the last three years, it's averaged 4.75% return per year with a standard deviation about 13.7. So again, for the 80/20, this is just adding 20% bonds to the previous portfolio, so you add 20% bonds.  What that does is it shrinks the range of outcomes now down to negative 22.6. All the way up to 32%. So the highs aren't as high, but the lows aren't as low. Again, this is lower risk, right? So lower risk comes with the potential for lower returns as well.

And if we go down to what we often call it, traditional 60/40, Vanguard's balanced portfolio in the last three years. It averaged about 3% per year. That doesn't mean it's going to be 3% going forward or anything like that. We're kind of at the, the bottom of a bit of an ugly year for both stocks and bonds. So to me that kind of makes sense. But the standard deviation there is much lower. Again, because we have 40% bonds here, this is 11.3%.  So for a balanced portfolio, 60% stocks, 40% bonds, the range of potential outcomes here is about minus 20 all the way up to positive 26%. I'm rounding here a little bit just so you can stay with me on these numbers without visualizing them, but I hope you can see there that the range of outcomes as you add bonds shrinks down, and so your risk or your potential for a negative outcome actually decreases when you add bonds.  That will ebb and flow over time as bonds perform differently, of course. But that would be the reason why you had bonds in the first place. Not everybody has the capacity or the preference to invest for absolute most return that you can possibly find. No, you have to be honest with yourself and invest in such a way that you're actually going to be able to stick with it.

So for someone that thinks they have the capacity to be an all stock investor, and if you listen to a lot of places on the internet, they just say, “oh, just buy the s&p 500 index, or just buy an index fund and you'll be fine”. What if being down 25% in a given year doesn't feel very good? What if 22 is just at the range where you kind of tip over and say, oh, okay, well I can handle that, right?

It would be better for you to be invested in such a way that you stick with a portfolio than to just follow the dogmatic advice of the internet and just buy a hundred percent stocks. It's okay to add some bonds if that means that you're going to stick with your portfolio a little bit better.  That's a good thing. A financial advisor can help you to evaluate that for sure. But here's a few other ways that you can kind of think of it and just think of it for yourself where you would. So when we talk about risk tolerance, I don't really like that because it comprises two often competing differences.  Risk tolerance is comprised of both risk capacity and risk preference or risk attitude. Okay, so risk capacity, that means do you actually have the financial wherewithal to be able to take on risk regardless of how you feel. So let's go to an extreme here. So if you're young, you have low debt, you have high income, you got lots of cash saved, I would say you have a high risk capacity.  Now, the opposite is also true if you're old, you have lots of debt, you have low income, and you have no cash saved, you have a very low risk capacity.  Regardless of what you want for returns, understanding your risk capacity is really, really important.  Now on the other side, risk attitude or risk preference, you know, let's go to the extreme again.

If you're a high stress person, if you have a lot of negative thoughts, you worry all the time. You are kind of running these constant what if scenarios? What if this happens with the government? What if this happens? If you're prone to selling diversified investments at a bad time, I would say you have a low-risk attitude or low risk preference.  So even if you're in a high-risk capacity, if you don't have a high-risk attitude, you shouldn't be a high-risk investor. Let's go to the opposite again, if you have a low-risk capacity, and you have a high-risk attitude. You say, I'm going to keep buying all the time. I'm going to borrow money to invest in the markets when prices are low.  You know, it's just like all these things that the far extreme of risk, it doesn't matter because you don't have the capacity to do it. And so if and when something goes wrong, you're going to blow up. Okay, so the push and pull of risk capacity and risk attitude is really important to evaluate.

So the best way to do that is to just start with a really simple questionnaire. I'm not going to go through the questionnaire here. There's a, a bunch of them out there. Many of you, if you're using a robo-advisor or things like that, you've probably done one already, but I'll attach one in the show notes here from Vanguard.

I have no affiliation with Vanguard. I've mentioned them a couple times today. I have no affiliation with them. They're just a large firm that many people are familiar with that I think does a lot of good things for investors. But starting with a questionnaire is great to get started. So remember, the main thing is to be honest with yourself and answer the things in a way that is actually how you feel. Because answering the most aggressive way just to get the most aggressive result isn't helpful if you're not going to stick with it. So go through there, take a second and see where it kind of comes out. So it's going to ask you a handful of questions and then at the end it'll say you're probably in 80/20 or maybe even a hundred percent stocks or maybe only 20% stocks and 80% bonds. It doesn't matter. There's no right or wrong. Again, this isn't a quiz. That's why we call it a questionnaire. It's not a quiz with a right answer and a wrong answer. It just kind of helps you peg where you might fall on the asset allocation spectrum.

So this episode ended up being a little bit longer than I was hoping for, but when you're building your investment approach, understanding your starting point for how much you want to have in both stocks and bonds is really important. I think it’s a great place to be, but again, consider not only the return prospects of investing in stocks, but also the risk that comes along with it and that huge range of potential outcomes that you could find with it.

So looking forward to next week's episode. I'm going to take a look at something that'll probably be a little bit quicker to explain. I'll be looking at strategic versus tactical allocations and what I described here of an 80/20, a hundred percent stock, 60/40, whatever. That would be a typical strategic allocation but what do you do when things change? And so that's kind of the determining factor of whether you want to be a strategic investor or a tactical investor and I'm excited to talk about that a little bit more. Thanks so much for listening today. If this is the first time you've been here, click follow at the top of your podcast player screen and you'll hear a few more episodes in this series as we go along.  Thanks so much for coming, and we'll see you on the next one.

Thanks for listening to this episode of the Canadian Money Roadmap Podcast. Any rates of return or investments discussed are historical or hypothetical and are intended to be used for educational purposes only. You should always consult with your financial, legal, and tax advisors before making changes to your financial plan.  Evan Neufeld is a Certified Financial Planner (CFP) and Registered Investment Fund advisor. Mutual funds and ETFs are provided by Sterling Mutuals Inc.