In this Episode, James Parkyn & François Doyon La Rochelle discuss the updated PWL long term expected returns on asset classes with PWL’s senior researcher Raymond Kerzérho.
Then, they review with him a research paper from Professor Scott Cederburg on life cycle asset allocation.
Read The Script:
1) Introduction:
François Doyon La Rochelle:
You’re listening to Capital Topics, episode #61!
This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.
Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio managers with PWL Capital.
In this episode, we will discuss the following points with Raymond Kerzerho, PWL’s Senior Researcher:
First, we will give you an update on PWL Capital’s long term expected returns on asset classes.
And next, for our second topic, we discuss a groundbreaking paper from Professor Scott Cederburg on life cycle asset allocation.
Enjoy!
2) Update On PWL Capital’s Expected Returns
Francois Doyon La Rochelle: Hello, James! How are you today?
James Parkyn: I’m very good, Francois, and how are you?
Francois Doyon La Rochelle: I’m good. Thank you.
Francois Doyon La Rochelle: So, as I’ve mentioned in my introduction to help us tackle the 2 topics at hand for today, we have invited Raymond Kerzérho, PWL Senior researcher.
So good morning to you, Ray. It’s good to have you back on the podcast.
Raymond Kerzérho: Great to be here.
Francois Doyon La Rochelle: Okay. Ray in our first topic we would like to review with you your latest update of the financial planning assumptions, with your estimates of future asset class returns and volatility numbers.
To clarify for our listeners. This report is updated twice a year, and the latest version of your report is now available on the PWL capital website and will also be available in the podcast link. So, Ray, let’s jump right in. What’s new in your report this year? I believe you made some changes to estimate inflation. Is that correct?
Raymond Kerzérho: Yes, that’s correct.
Previously part of our estimate for inflation was based on the pricing of real-return bonds. Canadian real return bonds, however, the Government of Canada decided in November 2022, so more than a year ago, to stop issuing these bonds.
Seeing that, we decided in the latest financial planning assumption preparation to remove that from our estimate or method to estimate inflation. And as a result, we get an estimate that is slightly higher than it was a year ago.
A year ago, we had an inflation estimate for the upcoming 30 years of 2.2%. Now we’re up to 2 and a half percent. So that’s the average of the target inflation rate by the Bank of Canada, so as we know 2%, and the long-term historical rate of inflation for Canada, which has been 3% exactly over the last 120 years.
Francois Doyon La Rochelle: Okay, so you take an average of the two inflation estimates to get to 2.5%.
James Parkyn: Ray. Can you now update us on the latest numbers of the expected returns and inflation? And can you also highlight how these numbers differ from the numbers in last year’s report?
Raymond Kerzérho: Yes! So, as I mentioned before our estimate for inflation for this year is at 2.5 %, and in addition to that, we provide the expected return estimates for fixed income and global equity on a nominal basis. We’ve got a small reduction in expected return for the fixed income portfolio from 4.2% last year to 3.9% currently. Changes due to the decline in bonds yields in the last year.
For all equity portfolios, we have a slight increase in the expected return from 6.9 to 7.1%. However, most of these increases are because we have a higher inflation estimate. So that directly impacts our estimate for expected equity returns.
James Parkyn: So Ray, why does it directly impact our estimate for expected equity returns?
Raymond Kerzérho: That’s a good question. As we know. We’ve discussed in other episodes of this podcast when we look at fixed income, we find that gross yield to maturity has the best forecasting power for future returns.
However, for the markets, we use the methodology where we start by estimating the expected real return on equity, and we add back the expected inflation for the upcoming 30 years. So when we add those two components and we change our inflation assumption, it adds back directly to the real expected return for equity.
James Parkyn: That is a really important answer to my question. Thank you, Ray, because we get the reaction often when we do financial planning projections of “Hey, your inflation estimate is at 2.5%… Inflation is a lot higher and I think it’s going to be much higher going forward…” With recency bias, people are sort of projecting out into the future based on current experiences.
Our standard answer is that if we’re going to adjust for higher inflation rates, then really, we’re going to have to adjust the expected nominal or before inflation rates of return on the asset classes, be it bonds or equities.
Francois Doyon La Rochelle: Yeah, those were the returns on bonds, the asset class of bonds and international equities. Now, what’s the expected return for classic balanced portfolio of 60% stock and 40% bond?
Raymond Kerzérho: Actually, it didn’t change compared to last year and is still at 5.8%. For fixed income, we have a lower expected return in comparison with last year while it’s higher for equity. So, if you mix those two for 60% stock and 40% bond portfolio, we have an expected return that is slightly less than 6% expected in nominal terms.
Francois Doyon La Rochelle: I see ! So, they compensate each other.
James Parkyn: Ray, the 60% stock & 40% bond portfolio, the classic balanced portfolio, historically had generated over the long term about 85% of the return of a 100% stock portfolio. There are times, even recently when rates got ultra-low, when that was not the case, especially before the global financial crisis in 2008.
If we look at your report now that we’re in a period of more normalized interest rates, and we take the expected returns of 60% stock and 40% bond portfolio versus the expected return of a 100% stock portfolio, you will find that it comes close to that 85% number. So, what do you conclude from that, Ray?
Raymond Kerzérho: Well, I think it’s appropriate and that the historical data is confirmed by my calculations of the expected returns.
Francois Doyon La Rochelle: Yes, we should say that the 100% stock portfolio comes with a lot more volatility than the 60% stock and 40% bond portfolio.
Raymond Kerzérho: Agreed, and I would also add that once you take account of compounding, the additional 1% or 1+ fraction of a percent you get with a higher equity allocation makes a
big difference from what you may think at first glance.
James Parkyn: Ray, I don’t know if we quoted for our listeners, but what is the expected return for a 100% stock portfolio?
Raymond Kerzérho: We’ve mentioned that it was at 7.1% So again, for that extra pickup and return, you’re going to get a hell of a lot more volatility. And that’s what the listener should remember.
3) Review Of Professor Scott Cederburg’s Paper On Life Cycle Asset Allocation:
James Parkyn: That leads us to our next topic. Recently, there have been some academic papers published by a group out of the University of Arizona, led by Professor Scott Cederburg, and the latest published out of a series of 3, is called “Beyond The Status Quo: A Critical Assessment of Lifecycle Investment Advice”.
We feel that the findings in this research paper are really important and should be shared with our listeners. You will find that the major finding is that most investors, including both, people in the accumulation phase of their investing career, so that’s between the ages 25 and 65 and then, people in retirement, should be 100% invested in stocks, but must be broadly diversified, including domestic and international stocks.
So, Ray, let’s address that today. We’d like your thoughts on what those research papers are all about as they challenge the common investment advice that we’ve been applying throughout our career, which is that: “Risk and return are related. You need a part of your portfolio in the safe bucket and a part of it in the volatile. And it’s a function of your risk, tolerance, risk, capacity, etc…”
Francois Doyon La Rochelle: Ray, before you go into this great topic for listeners and discuss these findings with you, it seems that the debate about the relevance of bonds has been revived.
A recent article in the Globe and Mail, which quotes our colleague, Ben Felix, suggests again that most investors should be 100% invested in stocks. Is that correct?
Raymond Kerzérho: I don’t think so. I disagree with that statement, I think, Ben, and also Professor Cederburg have been much more nuanced in the way they talked about this topic.
I think it’s worth it to look more in detail at the work of this group of professors from Arizona, State, and other universities.
James Parkyn: So, let’s get right into it Ray? What are they saying?
Raymond Kerzérho: Yes, so recently the big noise was about their most recent paper. But this same group of researchers has published 3 papers in the last 2 to 3 years, and to understand what they’re saying in these research papers and how it might influence the way an investor may choose to invest, it’s important to take these 3 articles in the broad frame of how we analyze all this.
The start of all this story is a database that they started working with, and that they improved it. This database is of 39 developed countries, including stock market returns, government bonds, and short-term Treasury bills. They also documented the inflation rate of inflation for these 39 developed countries over 130 years. They had to plug in a lot of holes in the data to reflect investor experience.
Francois Doyon La Rochelle: I don’t want to dwell on the questions of methodology here of how they managed to create this new database, but can you give us an example so our listeners can understand this better.
Raymond Kerzérho: Yes. An example of that is in 1914, at the start of the First World War. The U.S. market was closed for about 4 months and a half from July to mid-December.
Our professors had the methodology to take that into account.
The investor experience was certainly not perfect because there was a grey market at the time. People continued to exchange shares outside the market, but they added this methodology to plug in these types of holes and a bunch of others as there are plenty, of course, because it’s a database of 39 countries over a long period.
James Parkyn: So Ray, what was this methodology?
Raymond Kerzérho: Well, in the example of the year 1914, they simply considered the period from July to mid-December when the market was closed as one single period instead of making assumptions about the return of each month. They used the pricing as a source of return which comes back to the investor experience that an investor who stayed in the market would have experienced.
The other important thing we be conscious about, it’s that 130 years of data is not a lot by itself. A lot of the research that’s published on long-term returns, is based on returns starting from 1926. In a couple of years from now, it’s going be a hundred years of U.S. data.
For us as humans, 100 years seems like a lot. But if you look at long-term investing, there’s not a lot of 30-year periods into 100 years. So, by having 39 countries, you’re expanding the number of long-term periods of investing.
Also, the other thing that they’ve done is that they’ve put together a simulation technique to extract a maximum of information from the data. What they call the block Bootstrap is that they can generate hundreds of thousands of scenarios out of this database. Although there’s not that much data, they were able to extract a maximum of information.
Francois Doyon La Rochelle: Interesting ! Thank you, Ray, for the technicalities. Can you also share the results with us?
Raymond Kerzérho: Yes! We have 3 papers and I’ll try to go quickly on their first 2 because although we won’t do a deep dive on them, they’re important to mention.
If you look at the first paper, they studied risk, but instead of defining risk as volatility or drawdown, they defined it as the probability of losing money in the long run. In this case, the long run is 30 years. They concluded that there’s a significant probability of losing money on the stock portfolio, and they estimate that risk to be about 12%. There’s more than 1 chance out of 10 of losing money in the stock market even over 30 years on a real basis. You can make money on a nominal basis but if you lose money after inflation, it’s not interesting. So basically, there is a significant risk of losing money over the very log-term, according to this database and their research methodology.
James Parkyn: Ray, our listeners understand the risks of investing in the stock market. But to tell most of these people that over a long period – and it’s nice to know that they define a long run as 30 years because most people would agree that 30 years is a long time – they think the market goes up.
That said, as we’re recording this Podcast, the Japanese market has just broken through the high it reached 31 years ago. So, if you’re an investor in Japan who only invests in your domestic market, you have gone 31 years without equities going up.
What are the academics saying here?
Raymond Kerzérho: Well James, what they’re saying is that the stock market returns are not guaranteed even over the long run, and I think that it contradicts their statement that we’re currently discussing, which is that everybody should be 100% invested in stocks.
If you look at the first paper, it says exactly the opposite. It says that you should be prudent with stocks. And there was a thesis that’s been out for several decades now, which implies that you’re going to end your volatility when investing in stocks over the long term. If you stick with stocks for the long run, you’re almost guaranteed to make money with your portfolio.
Francois Doyon La Rochelle: This kind of contradicts the thesis put forward by Professor Jeremy Siegel in his famous best seller “Stocks For The Long Run”. Doesn’t it?
Raymond Kerzérho: Exactly. I think it tests the hypothesis of Professor Siegel and I remember, a long time ago, that when reading his book “Stocks For The Long Run”, I thought that the problem with this statement is that It was mostly based on the U.S. data.
And I say that because the U.S. Market has been the big winner of the last 100 years but there’s no guarantee that It’s still going to be the case in the future.
James Parkyn: Ray, we talked about this in our podcast last year, when we did the review of the annual yearbook for the Credit Suisse Research Institute. If you’re an American and you start looking at international investing, you’d sort of scratch your head and question why I should do that. American exceptionalism has gone through extensive periods in the 80’s and 90’s. And now, in the last 12 years since the global financial crisis, you’d be tempted just to say to hell with the rest, I’ll just invest in U.S. stocks.
Raymond Kerzérho: And that’s understandable. But if you look at the scientific evidence, and if you consider opinions of financial economists in general, you will find that there’s no scientific evidence to support the idea that the U.S. will continue to outperform going forward.
James Parkyn: Indeed Ray, we can’t be sure that the U.S. market won’t become the Japanese market. We saw a lost decade after the tech bubble burst, but not a lost 30 years. In any event, it’s food for thought. So, let’s go from there.
Francois Doyon La Rochelle: Yes, that was based on the first research paper. What does the second research paper say, Ray?
Raymond Kerzérho: The second paper expands on the first one. Obviously. And they say now that if risk is defined as the probability of losing money in the long run, like we’ve said for the first paper, fixed income is riskier than stocks and that’s what is interesting about this!
What they’re saying is the least volatile asset classes are the riskiest from the perspective of losing money in the long term.
And I’ll give you some details. So, here’s the probability of losing money over 30 years with short-term T-bills, and I must remind our listeners that we’re not only talking about U.S. T-bills here but T-bills from any of the 39 developed countries in this study.
Francois Doyon La Rochelle: And it’s real return again. Right?
Raymond Kerzérho: Real returns. Absolutely! So, the probability of losing with short-term Treasury bills is 37%, which comes to more than 1 chance in 3. It sends a message. Lots of people in the last few months were saying: “Well, I can get 5% in a high-interest savings account. But I entered short-term interest rates.” So, it changes very, very fast. We could be at 0% in a couple of years from now.
Now let’s get back on the topic of the 37% probability of loss for T-bills. This is the riskiest asset class that they’ve studied. The other asset class they’ve studied is intermediate-term government bonds, and the probability of losing money with them is at 27%. It comes to more than 1 chance of 4.
Regarding domestic stocks, for example, a Canadian investor investing in Canadian stocks, or an investor in any of the 39 countries investing in his own stocks market, the probability of losing money drops to 13%, which is a huge drop.
Even more interesting, a conclusion they had that I’m sure your listeners have heard a number of times: if you invest into an international stock’s portfolio, then the probability of losing money drops to 4%.
James Parkyn: Well as Canadians, we sit right next to the U.S., and we know that over-investing in our domestic market can confer very long periods, and give very underwhelming returns, especially when we compare ourselves to our neighbors to the South and their market. So, we’ve been internationally diversified, as we’ve explained on our podcast. We’ve had 20% Canadian equity in our model, and 80%, most of which is U.S. and then international developed and emerging markets.
What they’re saying is that’s the way to go, and you should not stick to your domestic market, and that reduces the risk of losing money by 2 thirds over the long term. And again, losing money is also included, losing it relative to purchasing power, which is the key that our listeners should be focusing on. This notion of real returns is what matters.
Raymond Kerzérho: Absolutely! And I would like to add, that by moving or by making an equities portfolio more international, you’re reducing the risk significantly while not sacrificing expected return. Not at all. It’s the same expected return.
Francois Doyon La Rochelle: Well, with the traditional investment advice, good quality bonds are considered safe assets. However, Professor Cederburg’s research concludes that bonds are only safe over the short term, but over the long term, inflation kills the real return of bonds. In effect, he’s saying that Treasury bills and government bonds are much riskier over the long term.
Raymond Kerzérho: Yes François, but we must keep in mind, we’re talking to a financial economist. So, for a financial economist, even 10 years is short-term, right?
If you remember gentlemen, when we were working together in the first decade of this century, we had very poor equity return over 10 years with 2 successive bear markets and stocks. If I may say, very severe bear markets. One was with the tech bubble bursting in the early 2000, and when the market had barely recovered from that, it crashed again in 2008-2009. So, at the end of the decade, there was barely any return on stocks. Bonds were your saving grace.
In conclusion, yes, it’s on the long term, but also 30 years is a long, long time to wait for your return. I don’t think Professor Cederburg is saying that volatility risk, should be ignored. What he’s saying is that there’s a balancing act or a trade-off you should make between having your long-term return or minimizing your long-term risk and minimizing or optimizing your volatility risk. It’s a trade-off there.
James Parkyn: Now Ray, let’s discuss the third research paper, which is the one that prompted us to address the topic. What does it say, Ray?
Raymond Kerzérho: So basically James, this group of researchers proposed another definition of risk that is an extension of what we’ve seen before. They define risk as the probability of running out of money in a lifetime. We’re putting ourselves into the shoes of an investor here.
Once again, they used the same database of 39 developed countries’ stock and bond bills, and asset classes, with the incorporation of inflation, and they simulated the financial journey of 1 million couples across 39 countries. All these couples save 10% of their income from ages 25 to 65, with a career starting at age 25 that lasts for 40 years. All these couples withdraw 4%, inflation-adjusted, after age 65 until they pass away.
What is interesting, is that it’s not only a simulation about stock returns and Treasury bonds and T-Bills, but also a simulation that incorporates both mortality and job security risk. So, they expand this thing to answer the question, what gives me the best chance of not outliving my money?
Secondly, they compared 5 strategies:
- First, it’s a strategy of investing all your money, 100% in Treasury bills.
- The second strategy is 60% stocks and 40% bonds portfolio.
- The third strategy is the one of 120- age. At the start of the simulation, our investors of 25 years of age, are 95% invested in stocks and 5% in bonds, and each year they grow old, they reduce their stock allocation. So, at age 26, it’s down to 94% in stocks 6% in bonds, and so on.
- The fourth strategy is 100% in domestic stocks. If it’s a Canadian couple, there would be 100% invested in Canadian stocks.
- The fifth strategy is 50% domestic stocks and 50% international stocks. So that’s a basic strategy that simulates a couple that adopts an international diversification with a home bias in the portfolio.
The third stage of this research paper is to make a comparison, and for that, they needed to have performance criteria. Our researchers propose 5 performance criteria:
- Wealth at retirement, so how much wealth you add at the time you reach the age of 65?
- Wealth at the time of death of the spouse. Keep in mind, that we’re making simulations for couples. So really, what matters is to finance the retirement of both spouses.
- Retirement income replacement. Which is, that the more money you accumulate at the time of retirement, the more you can withdraw from your portfolio. Especially, if we assume it’s a 4% of a bigger portfolio which means a higher retirement income.
- Drawdown, so the risk of having a short or even prolonged decline in the portfolio wealth.
- The risk of outliving one’s money. So that’s the one that is innovative here.
James Parkyn: It’s innovative, Ray, but it’s also, top of mind for virtually all investors and our clients, which is: “I don’t want to run out of money”. So, the longevity risk is important., and I think that it’s great they tackled that subject.
Francois Doyon La Rochelle: This all makes a lot of sense to me. So, Ray, what were the results?
Raymond Kerzérho: Some of these results François were not surprising at all:
For wealth at retirement, wealth at the death of the spouse, and retirement income replacement, the internationally diversified stocks portfolio dominated all other options, beating the balanced portfolio. T-Bills and what have you. It dominated completely as it created more wealth and more retirement income.
The other straightforward results were for all domestic or all international equity portfolios. They both created a large drawdown compared to either T-bills or versions of a balanced portfolio with 120-age or 60% stock and 40% bond. So, it’s much riskier to have a null stock portfolio from a drawdown perspective.
James Parkyn: Again Ray, these findings make sense to me. What’s innovative here is that they’re telling us that most of the academic financial economics are using a one-month return data series. While they should be using much longer data series.
That conclusion piggybacks to our most recent Podcast, where we discussed the book “The Price of Time” by Edward Chancellor, where he looks through the millennial, on how interest rates have evolved and how that impacted economic activity. So, not too many big surprises, portfolios fully invested in stocks, including international stocks, will generate higher returns over the long term.
But it’s not a free lunch. Risk and return are related, is therefore normal to expect more return for taking more risk.
Raymond Kerzérho: Absolutely. But at this stage, we’re discussing the volatility risk because drawdown is an expression of extreme volatility, positive or negative volatility, as you call it often.
The new result, I think, is a lot more interesting. And frankly, I must tell you that I was a little bit surprised by it, is that the internationally diversified stocks portfolio minimizes the risk of outliving one’s money. It surpasses all other portfolios in this term. And that’s why some commentators have extrapolated from that and started recommending investing your portfolio at 100% in stocks.
Once again, they’re not denying that volatility risk exists, but if you want to optimize or maximize your chances according to this study, the internationally diversified portfolio is far better compared to all of the other scenarios, including domestic stocks.
Francois Doyon La Rochelle: Obviously, the probability of outliving one’s money is a big issue for most of our clients.
James Parkyn: Absolutely François. Longevity risk is a big issue. And we’re seeing that in the client base we’ve had for over 25 years, where they’ve gone through the life cycle of mid-fifties to age 75, and now looking at age 95. In Scott Cederburg’s research here, they’re talking of saving from age 20-25 to 65, which is 40 years, and then you’ve got another 30 years after that. Which makes this an extremely long-time horizon.
The other thing that we found recently, actuary Fred Vettese wrote about this subject in the Globe and Mail last year, where he had these interactive charts highlighting the longevity risk and made the point that people who are well off, their life expectancies are much longer because they have less stress, better diets and better health. Because they’re financially more secure, they live longer than the average population.
Raymond Kerzérho: I would like to reemphasize once again, in this study, they pushed aside all the emotional side of investing and the stress that it is to endure even a short or prolonged period of financial wealth decline. They’re not saying it’s not important, they’re just saying, here’s the result we get once we take away these factors. In their study, these researchers assumed that our investors are rational, and they invest like robots, they don’t care almost about seeing their wealth decline.
Francois Doyon La Rochelle: Ray, if understood this correctly, a couple who invests throughout their lifetime in a 100% well-diversified stock portfolio, has less risk of running out of money than if they invest in a balanced portfolio, and that’s whether they maintain a proportion of 60% stock and 40% bond throughout their lifetime, or start with a 100% stock and gradually reduce stocks in favor of bonds as they age.
Raymond Kerzérho: One other thing that is important to mention is that they assume that markets are going to behave in the future similarly to how they behaved in the database, which, as you know, is not guaranteed. It’s a very good database and methodology, but we shouldn’t take for granted that it is 100% sure that it can be projected in the future.
James Parkyn: Ray What I also find interesting in their findings is that you can look at it from another angle, which is what amount of savings is required. What they’re saying here is that based on investing your portfolio 100% in equity with 50% domestic market and 50% international unhedged, you need to sav 10% to get to your goal by age 65. But if you are more risk averse, as most people are, and you have a stock and bond portfolio, and you decrease your stock allocation as you get older, they use a sample based on target date funds in the U.S. that, by regulation, has specific rules of how you re-allocate more funds to bonds as investors age, they came out with: you will have to save 41% more or 14.1%. So, there’s no free lunch. Again, if you’re not willing to accept the risk of a very high drawdown in certain periods and it may stay that way for a very long period, then you’re going to have to save more and that’s just basic logic.
Raymond Kerzérho: Exactly James. Like everything in economics, it’s a trade-off. There’s rarely any free lunch, you have to make a decision.
Francois Doyon La Rochelle: Yeah, if you’re more risk averse, you’ll need to save more to get the same standard of living when you retire.
Ray, can you now explain to us why the 100% internationally diversified equity portfolio is so dominant?
Raymond Kerzérho: Yes, absolutely. That’s another very interesting part here because it’s all nice to observe the results but the most important thing here is the why.
They identified 4 reasons:
- The first, and the most obvious one is that the 100% stock portfolio has a higher expected return. In an interview with Professor Scott Cederburg, he mentioned that by his estimate, stocks have about 4 times the expected return of bonds on a real basis, so net of inflation in my opinion, 1 can argue that it’s more like 3 times.
- But the other important thing is that, just like in Jeremy Siegel’s book, he mentioned that stocks have mean reversion working in their favor. It means that when stocks go through a very prolonged period of good returns, they tend to revert to the mean which means stocks will underperform for a period. Following a long period of underperformance, stocks will also tend to revert to the mean which mean stocks will overperform over a period to rebalance over the long-term. Unlike stocks, bonds do not revert to the mean. Historically, when bonds start underperforming, they may underperform for a very long time.
- One more reason in favor of stocks is that an internationally diversified stock portfolio protects from domestic inflation. For example, let’s say the lack of housing in Canada, there’s a big binge of inflation that is not observed in other markets. Having investments in international stocks, helps the investor being protected against that in the long run.
- The fourth reason is that over the last 20-30 years, a lot of investors including professional investors, have been assuming that bonds perform positively when stocks go down. But it’s not always the case. This research provides evidence that to the contrary, in the long run, and I’m not talking about 3 to 4 to 5 years here, the correlation between stocks and bonds is much higher than it is in the short run. Correlation may be as high as 0.5. So basically, in the long run, bonds don’t provide much protection against poor stock returns.
James Parkyn: So, Ray, let’s wrap it up. What should our listeners take away from this research?
Raymond Kerzérho: Well James, the real takeaways here are:
- We have a strong confirmation that an internationally diversified portfolio dominates a home-based portfolio. It’s less risky, and it provides a similar expected return, if not the same expected return.
- My other conclusion is that the job of financial advisors is to keep clients invested in stocks in the long run, even for retirees. Maybe, an exception is for retirees, who have a lot more wealth than they need to fund their retirement. But for most retirees, the job of advisors is to keep clients invested in the market with a significant portion of their assets.
Francois Doyon La Rochelle: For a Canadian investor, is there a better mix of international and domestic equities?
Raymond Kerzérho: Well François, these researchers started from a 50% domestic stocks allocation, but they have also made simulations with lower domestic stocks allocations. They came to an optimal allocation with the lowest risk of outliving your money, and it’s a portfolio with 35% allocation to domestic stocks.
It’s important to note that there’s been an exception for U.S. investors. An all-U.S. Stocks portfolio would have given the same results as an internationally diversified portfolio. For other countries, it’s between 30 to 35%. But I must mention that a 35 or 50% allocation in domestic stocks has made but a small change in the risk of outliving the money.
Francois Doyon La Rochelle: So, what researchers are saying Ray is that for a Canadian, a better mix would be 35% Canadian stocks and 65% foreign stocks.
Raymond Kerzérho: Exactly, but we should always remember that the conclusion is based on a list of assumptions, one of which we assume that investors will behave rationally over their lifetime.
James Parkyn: Ray, Professor Cederburg was on The Rational Reminder podcast number 284, with our colleagues Ben Felix and Cameron Passmore. He acknowledged that this is a big “If”. As a portfolio manager and financial planner with over 25 years of experience, this research tells me that clients need to continue creating wealth even during retirement. And we’ve seen that! Because, again, if you’re retiring, especially if it’s an early retirement and you have an age 95 to 100 life expectancy assumption, then that’s a long period where your assets have to provide, inflation-adjusted financial resources. So, you should have a higher percentage in internationally diversified equities to protect against this longevity, risk, and inflation. But that inflation is what grinds away over the very long term. The combination of the longevity risk and the inflation risk supports the findings of this research.
Finally, I would like to say that one of the assumptions that investors will behave rationally is the fundamental challenge. When we think back at the global financial crisis, we were meeting clients, and senior executives of major corporations, who were losing faith in the capitalist system and in the central banks. That’s important, assuming that you can always stay the course. And we know from experience that most investors if they’re not backed up by a financial advisor who’s able to help them with behavioral coaching, they’re more than likely to underperform the markets because of their behavior.
Raymond Kerzérho: I agree, James. I think, having a portfolio invested with a fair share of stocks, is a big source of stress for most investors. And they need to have some support to be able to handle that challenge.
4) Conclusion:
Francois Doyon La Rochelle: Couldn’t agree more Ray. Well, I think this wraps it up.
Thank you. Ray. It was a very interesting discussion, and we hope to have you back soon on our podcast.
Raymond Kerzérho: My pleasure, Francois.
Francois Doyon La Rochelle: And I thank you too, James, for sharing your expertise and your knowledge.
James Parkyn: My pleasure. Francois.
Francois Doyon La Rochelle: That’s it for episode #61 of Capital Topics!
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Again, thank you for tuning in and please join us for our next episode to be released on April 11th. In the meantime, make sure to consult the Capital Topics website for our latest blog posts.
See you soon.
Links to share:
–Financial Planning assumptions (Factor-Tilted Portfolio) by Raymond Kerzérho
–Financial Planning assumptions (Market Capitalization Weighted Portfolio) by Raymond Kerzérho
–Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice by Aizhan Anarkulova, Scott Cederburg & Michael S.O’Doherty
–Stocks for the Long Run by Jeremy J. Siegel