Investor Questions on Portfolio Construction and Bonds

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Portfolio Construction Principles

  • Investors can only achieve positive returns by assuming the risk of loss

  • Diversification improves your odds of having positive return over time

  • Diversification means holding assets that might not perform well at the same time

  • It can be a big mistake to sell an asset after it underperforms

Investments can only achieve positive returns by assuming the risk of loss.

You shouldn’t expect your investments to go up every day; losses can drag on for months or years but over time are expected to be positive. Your returns are compensation for taking risk.

Diversification improves your odds of having positive returns over time.

If you have a diversified portfolio of assets, you improve the likelihood that you earn returns because you’re not betting on any one asset, you’re betting on the concept that asset owners will get paid over time and spreading the risks around.

Our approach to diversification consists of:

  1. Geographic diversification

    , because individual countries and regions can underperform for significant amounts of time.

  2. Asset class diversification

    , because government bonds can perform well when economic growth, and the stock market, is struggling.

  3. Higher quality stock diversification

    , because higher quality stocks tend to be more resilient to market swings.

Diversification means holding assets that might not all perform well at the same time.

If you’re holding multiple assets in multiple geographies, it means that some assets in your portfolio won’t be performing as well as others, and they may even lose money from time to time. At times, the poor performance of one asset can be a significant drag on the entire portfolio. However, if you are taking the risk of loss in each investment, they should appreciate over time. And, as we’ve seen above, proper diversification increases your chances of making money in any given time period.

Our approach to diversification means that we will underperform major equity indices and many conventional portfolios when the stock market is experiencing very high returns, but may outperform when the stock market struggles. We believe that this smoother return stream will create higher compounded returns by avoiding extreme losses. For example, if you lose 50% of your portfolio, you have to make 100% to get back to where you started. But if you only lose 25%, you only need a 33% increase in portfolio to get back to where you started.

It can be a big mistake to sell an asset after it underperforms

It is tempting, and very natural, to think that the future is like the recent past. And it is painful to buy more of an asset that has recently underperformed. But to sell out of an underperforming asset undermines the value of diversification. For most investors, the best strategy is to pick an asset allocation and stick to it through good times and bad. Recent examples of tough periods for asset classes include:

  • 2020 equity market selloff - at one point in early March of 2020, the Canadian stock market was down by 33%. Many investors panicked; those who stuck with their allocations to stocks were rewarded and fully recovered by the end of the year.

  • 2013 bond market selloff - ZFL, the government bond ETF we use in our portfolios lost 13% in 2013 as government bonds in North America sold off due to fear of rising rates. They would rise 23% in 2014, however, so it would not have been a wise move to reduce or change government bond holdings after that selloff.

  • 2000-2002 stock market crash - The S&P 500 did not make positive returns for 5 years after the dot-com bubble burst in 2000 while diversifying assets, like higher quality stocks, international stocks, and bonds, performed well. Investors with more diversified portfolios were rewarded for not chasing the performance of US stocks during the dot-com bubble.

Source for data: Bloomberg. “Higher quality stocks” refers to the use of minimum-volatility stock indices in Wealthsimple classic portfolios, and factor screening, including quality, momentum, and low-volatility in Wealthsimple SRI and Shariah-compliant portfolios. Disclosures: The information complied here has been prepared using sources believed to be reliable. All statements contained here constitute our judgement as of the date of this report, and are subject to change without notice. The statements provided here are for information and educational purposes only and does not constitute advice or a recommendation. The indicated performance are historical for the period indicated. The rate of return does not take into account any fees or tax payable. Past performance may not be repeated.

Bonds at low yields

  • Bonds are useful diversifiers as long as yields can fall

  • Inflation and increases in interest rates are priced in

  • Bonds tend to be less risky than equities, so hoding longer-term bonds gives you more “punch per dollar”

Yields can still fall so bonds are still are a useful diversifier

Although the absolute level of yields in Canada are fairly low, bond yields have historically been much lower in Canada, and there are even countries now, like Germany and Japan, with much lower bond yields. Bond prices have room to increase, and they would increase at times that are extremely useful for our portfolios, like in March of 2020. Our investments team monitors the status of Canadian and international bonds and we have a plan in place to maintain diversification once we think bonds can’t go up in price anymore (effectively as yields approach zero), but we’re not there yet.

Inflation and increases in interest rates are priced in

Fears about inflation or rate increases led to the recent bond market selloff - that means that they are already reflected in the price of bonds. If inflation or rising rates fears get worse it could spell more bad news for bonds, but it’s just as likely that inflation fears subside and bond prices rise. That’s why predicting the direction is very difficult. We’d recommend that investors pick a strategic asset allocation and stick to it rather than trying to predict the direction of bond or equity markets.

Bonds tend to be less risky than equities, so holding longer-term bonds gives you more “punch per dollar“

We tend to hold longer-duration government bonds than many comparable investment advisors, which helps over most periods because higher-risk assets will have higher reward and provide more diversification benefit, but has hurt us lately as bonds have sold off. Switching to shorter-term bonds now would be selling a diversifying asset after it underperforms, which we believe is a mistake.

Disclosures: The information complied here has been prepared using sources believed to be reliable. All statements contained here constitute our judgement as of the date of this report, and are subject to change without notice. The statements provided here are for information and educational purposes only and does not constitute advice or a recommendation. The indicated performance are historical for the period indicated. The rate of return does not take into account any fees or tax payable. Past performance may not be repeated.

Last Updated July 5, 2021

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