The business difference between financial product and advice

Fees are important to investors. In most cases, lower fees increase the likelihood of a positive long-term investment outcome. Index funds globally have seen enormous growth in the past decade. That growth (and the competition to capture it) have resulted in fees literally going to zero on some index funds. Even if most index funds are not yet at zero, they might as well be with fees typically around 0.10%. Index funds embody the idea that fund management cannot add value; if that is true, then the most obvious way to compete is to lower costs. In general, this is beneficial to investors. It isn’t bad business for fund companies either.

Fund management is the ultimate scalable business. The marginal cost for Vanguard to manage an additional billion dollars is negligible, but they are taking in $1,000,000 at 0.10%. That is good business, and that is why we have seen a price war. Securities lending revenue makes the price war even more interesting – fund companies are still taking in revenue even if they are not charging any fees to their fund unitholders.

The increased awareness and disclosure of fees in Canada has resulted in new business models. Robo advisors, online firms that depend on technology to offer low-cost portfolio management and financial advice to investors of any size, have seen significant growth since they entered the market. In the United States, massive companies like Vanguard have also created low-cost advice services. The CEO of Vanguard has apparently stated that one of his big initiatives is to drive adviser fees to index fund levels.

This might be a good soundbite, but financial advice does not fit the same scalability model as fund management. Financial advice requires people, and not just any people. It requires people with expertise, experience, and soft skills to make their clients comfortable with their financial decisions. The last point, the ability to make clients comfortable, may be the most important. Behaviour management is arguably the most valuable component of financial advice. Of course, good behaviour is contingent on having received sensible advice, which requires expertise and experience. None of these attributes is sufficient alone. This poses a problem for scaling an advice service while also minimizing costs. Each adviser has a limited number of clients that they can advise. That limit is increased by technology, but only to a point. Time is the ultimate constraint regardless of technology. I don’t know what the upper limit is for clients per adviser. I once spoke to the CEO of a robo firm who explained that their target was 5,000 clients per adviser. Last I checked, Wealthsimple had more than that. Let’s say it’s 5,000.

I don’t know what the price ticket for a good adviser with the right credentials is, but let’s go low and say it’s $60,000. At a 0.10% (index fund level) fee, each adviser would need to oversee $60M just to cover their costs. That is not unmanageable with an asset minimum of $500,000, which is what Vanguard requires to access a dedicated adviser through their Personal Advisor Service. The trouble is that the adviser has a lot of other options. If they truly have the right combination of skills, credentials, and experience to win and maintain the trust of clients, then they are also attractive to traditional wealth management firms who might be willing to pay them more. A great adviser also has the option of starting their own firm. The inherent result is that the best advisers might not want to go to work for the lowest cost operator.

This would be fine if financial advice were the exact same for everyone. Everything could be systematized. That is not reality. Things like risk tolerance, how much you should be saving, and what funds you should own are very easy to determine. If those are the only decisions that you’re making, you probably don’t need to pay even 10 basis points for advice. People pay for financial advice when they have complex or niche situations, and to have someone that they know and trust keep them from making bad decisions. This is where scaling advice at index fund-level fees starts to fall apart.

I am not criticizing low-cost generalized financial advice; it is much better than the product distribution commission sales model that financial advice has followed for decades. I do believe that firms on a fiduciary fee-based model that specialize in a niche and offer highly personalized services are unlikely to feel much pain from these low-cost competitors. This story has already played out in other professional services industries; there are plenty of CPA firms with lots of great clients willing to pay their relatively high fees, even though H&R Block is cheaper.

Vanguard has a bit of a business advantage, they not only get fee revenue on the advice, but their advisers only recommend Vanguard products. Even if they break even or lose a bit on the advice, they are keeping assets in their funds. This is an advantage to Vanguard, but it poses a problem for their clients. Is it possible to receive objective advice from an adviser who is only able to recommend one product provider? Leaving asset class funds from companies like Dimensional Fund Advisors out of the conversation could be detrimental even after advice fees at index fund levels.

Keep the deferred sales charge, more for us

Since well before my time in the financial services industry PWL Capital has been one of the strongest advocates for improving the experience of Canadian investors. Not only has the firm been an advocate, we have been leading by example. We were offering fee-based accounts, index fund portfolios, performance disclosure, and comprehensive advice well before consumers were asking for them, or regulators were requiring them.

Advocacy from PWL and firms with a similar stance has played a role in improving regulations. We have seen a requirement to disclose fees and performance with CRM2, and more recently we have seen proposed improvements to the suitability standard that most financial advice must adhere to. We have also seen the result of consultations, lasting years, on embedded trailing commissions and the deferred sales charge (DSC) used by many commission-based financial advisors.

In June, the Canadian Securities Administrators decided that they would maintain embedded commissions, but ban the DSC. Those proposals were released in September, and were met with surprise opposition from the Ontario government.

Advocis, an industry group that largely represents insurance and mutual fund salespeople, praised the decision of the government. The President and CEO of Advocis, Greg Pollock, stated

Our intention as an association is to ensure Canadians have equal access to trusted financial advice. Today’s announcement demonstrates that the Government of Ontario shares that vision, and intends to work alongside stakeholders to protect consumers.

The typical household in Canada starts investing with less than $25,000 and 80% of Canadian households have less than $100,000 in total investible assets. Restricting access to professional financial advice would make it harder for the public to save, invest and achieve their financial goals.

The argument follows that eliminating the deferred sales charge makes it harder for investors with small accounts to access financial advice. For example, taking on a $25,000 account as a fee-based advisor charging 1% results in a monthly revenue stream of about $20. On the other hand, a commission-based advisor using the DSC would earn an upfront commission over $1,200. It is obvious, from the perspective of the advisor, why DSC makes it more attractive to work with smaller clients.

There is a big problem with this scenario: funds that offer DSC are actively managed and have high fees. Is owning a product like that worth it to get access to what Pollock is referring to as professional financial advice? Let’s back up and think about what exactly professional financial advice might be. Obtaining a mutual funds license requires one course that the Canadian Securities Institute estimates to require 90 - 140 hours of study, and a 90-day training period. The cost to the consumer for that “professional advice” on a $25,000 account at a 2.5% annual fee is $625 per year, and growing as they add more assets. Not to mention the implied cost of an actively managed fund’s statistical likelihood of underperformance.

At a time, this was what it was – there were no alternatives. Today there are plenty. There are fee-only financial advisors, not tied to any product, charging $400 per year for ongoing, unbiased financial advice. There are also so-called robo-advisors, or online firms that will manage a portfolio of index funds for 0.50% per year, plus the cost of the underlying index funds. The combined cost of ongoing fee-only advice and a robo-advisor-managed portfolio of index funds would come in at under $600 per year for a $25,000 account, and that fee would grow much more slowly as assets grow because the $400 advice fee is fixed.

With alternatives like this there is no place for the DSC.

As much as PWL advocates for investors, we have been one of the largest beneficiaries of an industry that refuses to change. People are actively seeking out low-cost portfolios and financial advice that is not tied to commissions. There are still over $840 billion Canadian dollars invested in commission-based mutual funds in Canada.

If Advocis wishes to praise the continued practice of the DSC, effectively lobbying against the interests of the clients that they themselves serve, firms like PWL Capital will continue to reap the benefits.

Responsible/ESG investing

Let me preface this post by saying that I have nothing against social responsibility or having social responsibility reflected in an investment portfolio.

I read an article in Investment Executive recently discussing the evidence that Responsible Investing (RI) leads to as-good or better returns compared to traditional investing. The article compares the performance of well-known indexes to demonstrate the long-term benefits of RI. In the article, long-term seems to be defined as the trailing 10-years. In my opinion, and the opinion of most researchers, a 10-year period is insufficient to draw any conclusions.

It is true, as the article states, that the MSCI ACWI ESG Leaders Index has beaten the MSCI ACWI index since 2007, when the indexes became available. The performance difference has been 0.22% per year on average. However, this difference is not due to the responsible nature of the companies in the index.

The difference in returns between diversified portfolios is almost completely explained by exposure to certain types of securities. The characteristics that define those certain types of securities are called factors. Factors explain the differences in returns between diversified portfolios extremely well. A factor is a long-short portfolio where the portfolio is long one side of a characteristic and short the other. For example, the size factor is determined by subtracting the returns of large stocks from the returns of small stocks. If small beats large, the factor exhibits a performance premium.

Currently there is a five-factor model that has been published by Eugene Fama and Ken French, the men who pioneered factor research in the 1990s. The factors in the model are market (market minus the risk-free asset), size (small stocks minus large stocks), relative price (value stocks minus growth stocks), profitability (stocks with robust profitability minus stocks with weak profitability), and investment (stocks that invest conservatively minus stocks that invest aggressively).

We can use statistical analysis to see how much a portfolio’s return is explained by these known factors. It is probable that an ESG (environmental, social, governance) index is offering naïve factor exposure. In other words, by targeting ESG companies the index is likely getting exposure, by accident, to known factors.

To put to rest the idea that an ESG index is inherently better I have run five-factor regressions on an ESG index compared to a total market index using Ken French’s data. What we should expect is that exposure to the factors will explain the return differences between the ESG index and the total market index.

In the following table, the coefficients tell us how much loading the portfolio (index) has to each factor, and the t stat helps us to understand if the coefficient is statistically significant. A t stat over 2 indicates statistical significance.


In this case we see that most of the factor exposure is statistically insignificant and small, which we would expect for a total market index, except for RMW, which is a little bit larger and statistically significant. RMW is the profitability factor. This is indicating that the ESG index has more exposure to stocks with robust profitability than the market.

The research shows that more profitable stocks tend to outperform less profitable stocks over the long-term. The RMW premium over the time period in question (12/1/2007 – 7/31/2018) was 3.34%. That is, more profitable stocks beat less profitable stocks by 3.34% per year on average over the period.

We can estimate the amount of additional return that we would expect from RMW exposure for each index by multiplying the regression coefficient by the premium. Multiplying the difference in coefficients (0.23 for ESG minus 0.11 for total market) by the factor premium we get an expected performance difference of 0.40% per year on average.

Put simply, when we adjust for factor exposure, the ESG index has actually done a little worse than we would expect it to compared to the total market index.

The article that I am responding to also offers that the Jantzi Social Index, an index of socially responsible Canadian stocks, has beaten the S&P/TSX 60 since inception of the index in 2000. That is true.

Ken French does not publish factor data for Canadian stocks. AQR does have Canadian factor data, but they look at slightly different factors. They do not look at Profitability (RMW) or Investment (CMA). They add in QMJ (quality minus junk) which does include profitability among other characteristics. We will look at a four-factor regression including market, size, relative price, and quality. I was only able to obtain total return data for the Jantzi Social index back to May 2009, but the regression results should still be informative.


In this case we see similar negative loading to SMB for both indexes, which we would expect as these are both large cap indexes. We see slight loading to value, statistically significant for the Jantzi and insignificant for the TSX 60. The big statistically significant difference comes from QMJ, which for the sake of discussion is very similar to RMW. A relatively large and statistically significant loading to highly profitable stocks would easily explain the higher returns of the Jantzi index.

So far, we have seen that the higher returns of an ESG index can be attributed to factor loading as opposed to the inherently better returns of ESG companies.

The article cites an academic study showing that ESG mutual funds beat their benchmark 63% of the time. That study looked at a handful of Canadian mutual funds included in the Responsible Investment Association listings. The study, as far as I can tell, does not address survivorship. ESG investing aside, this study conflicts with the massive body of evidence that active mutual funds typically fail to beat their benchmark index.

I won’t recreate the study with a correction for survivorship for this post, but consider that over the trailing 10-year period about 50% of Canadian mutual funds have closed down, likely due to poor performance. Basing a study on funds currently in existence ignores all of the funds that have closed. The surviving funds are likely to have done better by nature of having survived, but that may well have been due to luck. I suspect that a survivorship correction would drastically change the results of this study.

The article also cites a report from MSCI which found that high ESG-rated companies tend to be more profitable with higher dividend yields and lower idiosyncratic tail risks. We have proven this to be true, at least the profitability part, with regression analysis. The problem for investors is that if you want to maximize risk adjusted returns through exposure to factors, including profitability, then ESG investing is a very inefficient and potentially inconsistent way of getting it.

Not to mention that the fees on ESG funds tend to be high. In the case of index funds, an ESG index fund will typically carry a higher fee than a total market fund. XEN, the Jantzi Social Index ETF has an MER of 0.55% while VCN, the Vanguard FTSE Canada All Cap Index ETF has an MER of 0.06%. Most ESG funds are actively managed, and carry fees well over 2%. The notion that an ESG screen will magically allow actively managed funds with high fees to beat their benchmark is not sensible.

Finally, investors need to understand that buying the securities of a company on the secondary market does very little to impact that company’s future. It is perfectly reasonable to feel guilty profiting from a company that engages in business that you do not agree with, but it is important to understand that owning shares in a company does not benefit the company.

As I mentioned at the beginning, I have no problem at all with ESG investing as long as it is done for the right reasons. The reason to be an ESG investor should be that it makes you feel happy. There should be no expectation that an ESG investment will outperform a non-ESG investment with similar exposure to the factors that explain returns.

As opposed to buying ESG investment products it might make sense to optimize a portfolio for low costs, diversification, and factor exposure – all things that an ESG portfolio typically gives up – and donate money directly to causes that are important to you.

Money you can afford to lose

If you go to any online community related to money you will find people talking about their desire to learn about investing by researching and selecting individual stocks. They understand that this is risky, they will say, but they will only try it out with money that they can afford to lose.

This statement implies a lot more than people realize when they write it. What puts you in a position to have money that you can afford to lose? At the very least, you need be financially independent. That is, have enough financial capital that you do not need to rely on your human capital to meet your desired lifestyle.

Let me give you some context to understand that: to spend $5,000 per month, adjusted for inflation, for 30 years, you would need to have about $1.7M in an investment portfolio. Most people, especially people wanting to get their feet wet with stocks for the first time, are not in this position. Until you have attained financial independence you cannot afford to lose any money.

Not only are most people not financially independent, but they are probably not saving enough to eventually become financially independent with the lifestyle that they want. They are also likely to have debt, a lack of emergency savings, and a lack of life insurance coverage. Where is this money that you can afford to lose coming from?

It’s not just losing money that you have to worry about either. You might pick a stock that drops a little bit and then sputters along for a while before you sell it. Great learning experience, right? Even if you do not sell it at a loss, you may have missed an opportunity if the market has gained over the holding period. This opportunity cost is as good as a loss in terms of achieving your financial goals.

It would be one thing if you had a reasonable chance at picking winning stocks, but you most certainly do not. For example, if you had picked one of the S&P 500 constituents at random in January 2017, you had a 53% chance of underperforming the index as a whole by the end of December. For anyone keeping score, that is worse than flipping a coin.

I know that the premise of this conversation is based on the idea that you are able to learn about investing by picking stocks, and maybe you can even get better at picking them as you learn. Unfortunately this is not how the stock market works. You may be able to learn a little bit about how to open a brokerage account, how stocks trade, and even how to analyze companies. Those things might be empowering to know, but there is no reason to believe that they will make you better at investing.

The stock market is a pricing machine. For the most part, it instantly prices stocks based on the aggregate information of market participants. No matter how much you may know about a company’s earnings, growth prospects, or business model, you have to know more than everyone else in order to have a performance edge. Put another way, it is not your absolute information and skill that matters in picking stocks, it is your relative information and skill.

If you do not have better information and more skill than other market participants, then they may be taking advantage of you when you trade. When you buy a stock, you are buying it from somebody. When you sell, you are selling it to somebody. Who are these people on the other side of trades? They are mostly large institutions whose core business is buying and selling stocks. I think it is a bit of a stretch for any individual person, especially a person trying to learn how stocks work, to believe that they have an edge in terms of information or skill.

The odds are massively stacked against you. But don’t worry, it’s not just you that the odds are stacked against. Even those institutions have trouble beating the index. For the 10-year period ending December 2017, only 1.67% of mutual funds in Canada that invest in US stocks were able to beat the S&P 500 index.

If you get to a point in your life where you are financially independent and you still want to trade stocks, the next question that I would be asking is what causes are important to you? Is it more fulfilling to make risky bets with a negative expected outcome by picking stocks, or to donate all of that extra money that you can afford to lose to support something that is important to you?

Stock picking is well documented as a losing game. It is, by all accounts, akin to gambling. Experience trading stocks does not make you a better investor. I do not see how the average Canadian has any money to lose in an effort to learn about something that will not benefit them in any way.

I’ll leave you with a quote from the 1967 classic book The Money Game: “If you don’t know who you are, [the stock market] is an expensive place to find out.”

Figuring Out Factor Investing

Everyone likes to believe they’re smart consumers. That’s probably why the term “smart beta,” also known as “factor investing,” is so hot right now. “Stupid beta” probably wouldn’t attract many takers. 

So what is factor investing, and are you smart to use it? That’s what today’s post and related video are all about

A simple way to think about factors is as quantitative characteristics shared across a set of securities. If you look past their current, flashy popularity, there really is some substance there. For decades, evidence-based investors have been structuring their investment portfolios to tilt toward factors that are expected to drive investment returns, without the need to rely on random stock-picking or market-timing.

In this respect, factors are pretty smart. Unfortunately, lately, I’ve seen them being used in some pretty dumb ways, to market products that may be factor-based in name, but no longer in evidence-based substance.

Factors: Bringing Order to Evidence-Based Investing

Why does one investment portfolio do better than another? Unraveling this mystery, of course, is at the heart of what evidence-based investing is all about. Before we understood factors, most of the performance difference was usually attributed to the skill of the portfolio manager. In the absence of understanding, it was an easy, if erroneous assumption to make.

As factor research emerged, it became clear that the bigger determinant of different outcomes among different diversified portfolios was, by far, not the prowess of the manager (their “alpha”) but rather certain characteristics, or factors (the portfolio’s “beta”). No wonder we started caring about what those factors were, and which ones in what combinations were expected to deliver the most powerful, positive performance differences. Isolating and incorporating positive return differences exhibited by certain types of stocks has an obvious benefit to investors.

Fast forward to today. Currently, we have factor models that can explain over 95% of the return differences among diversified portfolios. It doesn’t take a guru to incorporate these models; you just need to seek the most efficient, cost-effective funds for doing so. 

This is problematic for active fund managers who are still chasing after “alpha.” In the past, their ability to “beat the market” was assumed to be due to their skill. We now know it’s far more likely to be a result of the factor exposures they’ve chosen, whether deliberately or as a random byproduct of their other activities – no prognostication skills required or desired. 

In other words, if you can manage your expected returns and related risks through one or a few simple factor-based funds, who needs an active manager or the additional costs they’re expected to incur? 

If you’re not quite convinced, check out my related video. [hyperlink] In it, I describe a classic 2015 blog post, “Active Funds Exposed,” in which my PWL colleague Justin Bender runs some real-life numbers for us.  

Figuring Out the Factors

Research on factors emerged in a landmark 1992 Journal of Finance paper by Nobel Laureate Eugene Fama and Kenneth French, entitled The Cross-Section of Expected Stock Returns. In the paper, they observed that, over time and in aggregate, small-company stocks outperformed large-company stocks, and value stocks outperformed growth stocks. The explanation for the return differences is that stocks with these characteristics, (small and value), were riskier – more volatile. Investors required higher expected returns before they were willing to take on these riskier assets,

In 1997, Mark Carhart added the momentum factor to the body of research; in 2012 Robert Novy-Marx added the profitability factor. This gave us five factors, which come together to explain over 95% of the return differences among diversified portfolios, as touched on above. In 2014, Fama and French came out with their own five-factor model. Their model combined market (i.e., investing in anystocks, versus risk-free assets), size, relative price (value), profitability, and investment. They left out momentum. 

Which factors form THE ideal model that explains 100% of the return differences among diversified portfolios? This is unknown. Frankly, it’s unlikely we’ll ever arrive at a universal answer. But researchers continue to test new factor models aimed at inching us ever closer to the elusive nirvana of a perfect model.

And therein lies the challenge. 

Faux Factor Investing 

Factor research has become not only important to our understanding of finance and investing, but a way for academic researchers to make a name for themselves … and for fund companies hungry for a fresh marketing hook to differentiate themselves by injecting “new & improved” factors into the mix. 

Duke University’s Campbell Harvey, Texas A&M’s Yan Liu, and University of Oklahoma’s Heqing Zhu have identified over 300 factors in academic literature. This is problematic for investors. Cost-effectively targeting five factors in a portfolio is hard enough. What do you do if there are 300 of them? Unfortunately for the researchers (and fortunately for investors), many of these factors do not pan out. In many cases they turn out to be a re-packaging of the original factors.

In my video, I cover the sniff tests you can use to help decide when a new factor is really all that new or worth pursuing … and, conversely, when common sense tells us it’s safe to ignore it. To be taken seriously, I would suggest a factor should be persistent, pervasive, robust to alternative specifications, investable, and (my personal favorite) sensible. Check out my video to dig into each of these characteristics in more detail. 

Now, about those fund families and their marketing programs. As we know from our experience with other retail products, “new and improved” is usually just the same old you-know-what, stuffed into a fancy new box. Same thing with factor or smart-beta investments. With some 300 “flavors” to choose from, countless new factor products have emerged, but very few of the companies creating them have impressed me. 

Maybe that’s because, these days, factor research has become a commodity that any fund manager can access. The difference between implementing the evidence well or poorly comes down to how well the company vets the research, who does the vetting, how they interpret the data, and how effectively they manage the inherent limitations of factor models. 

So far, Dimensional Fund Advisors – the company that introduced factor investing (with Fama and French on their board) – continues to stand apart in the field. That said, Dimensional’s funds can only be accessed through vetted advisor firms like PWL Capital. Where does that leave the DIY investor? For now, I think you’re better off focusing on simplicity rather than trying to sort out all these factors on your own. 

The Canadian Couch Potato model portfolios used to pursue the size and value factors, but my colleague Dan Bortolotti changed the models in 2015 to ignore factors entirely. Part of his explanation was that “many DIYers make costly mistakes when they try to juggle too many funds. Meanwhile, there are exactly zero investors in the universe who failed to meet their financial goals because they did not hold global REITs or small-cap value stocks.” I agree with him in full. 

Have you tried to implement a factor portfolio? Tell me how it went in the video’s comments.

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When GICs beat bonds

The fixed income component of the Dimensional Fund Advisors global portfolios has been low to-date in 2018, and also for the past 12 months. It is down 0.51% year-to-date at July 2018, and down 0.27% for the 12 months ending July 2018.

Fixed income is typically the safe portion of a portfolio of risky assets. Fixed income is not held for the primary objective of maximizing returns, but for minimizing volatility through diversification. Fixed income assets tend to have imperfect correlation with stocks. This offers a buoy effect if stocks are falling. The opposite is also true; when stocks are doing well bonds do not tend to do as well. Similar to stocks, there are many sub asset classes within fixed income. These sub asset classes have different risk and return characteristics.

Fixed income factors

Some characteristics of fixed income have been identified as responsible for most of the asset class returns. The two factors that explain the majority of fixed income returns are term and credit; longer-term bonds and bonds with lower credit tend to have higher long-term returns. This is intuitive as each of these characteristics, term and credit, result in an asset that is riskier to hold. As always, risk and return are related.

Assuming the CDIC limits are followed in portfolio construction, a GIC is close to risk-free. In other words, it has no exposure to the credit factor. GIC terms longer than 5-years are not covered by CDIC, so an investor would typically limit themselves to 5-year or shorter GICs. This limits exposure to the term factor. 

With this in mind we would expect two things: 

  1. GICs will outperform bonds in some years
  2. Bonds will have higher long-term returns than GICs

Similar to owning stocks in lieu of bonds, owning bonds in lieu of GICs will inevitably result in years of underperformance. This is one of the risks that investors endure to access the higher expected returns of an asset class. If bonds were guaranteed to outperform GICs at all times then bond prices would increase, decreasing their yields, and we would not even be having this conversation.

Historical data

Looking at annual returns going back to 1985 through 2017 we observe a few things that illustrate my previous comments. 5-year GICs have outperformed bonds in 5 of the 33 calendar years examined, or 15.15% of the time. Interestingly, 5-year GICs have outperformed stocks in 9 of the 33 years, or 27.27% of the time. In a year where GICs beat stocks we should not abandon stocks. The same is true for GICs beating bonds. Bonds are riskier than GICs, but they also have higher expected returns. This relationship shows up in the historical data.

Asset Class Annualized Return 1/1/1985 - 12/31/2017
Average 5-Yr GIC CAD* 4.97%
World Government 1-5 Yr (CAD Hedged) CAD 6.13%
Canada Universe Bond CAD 7.97%
US Stocks CAD 11.10%

Any asset class with a positive expected return in excess of the risk-free rate carries risk. The higher the risk, the higher the expected return. While it may not always feel good at the time, holding an asset class through periods of underperformance is a necessity when seeking higher returns.

Through all of this we should not lose the primary objective of holding bonds: reducing volatility through diversification. While bonds are riskier than GICs, they are still much safer than stocks in terms of volatility, and they tend to shine when stocks are crashing. For example, when the global stock markets dropped 31.21% in CAD between March 2008 and February 2009, the Bloomberg Barclays Global Aggregate Bond Index (hedged to CAD) returned +2.82% for the year.

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All time highs are normal

We may have just witnessed the longest bull market in US market history. There is some disagreement on the definition of a bull market, but no matter how it is defined it is clear that the S&P 500 has been rising without too much interruption for a long time. When the market is rising, it tends to hit levels that have never before been seen.

Information like this makes a lot of people feel uncomfortable. What goes up must come down. I don’t want to invest at the top. It may be normal to feel this way, but it is probably not sensible. Fortunately, we have price data on the S&P 500 from Robert Shiller going back to 1871 to help us think sensibly.

Going back to 1871, and ending August 21, 2018, a dollar invested in the S&P 500 has hit an all time high in 16.3% of months; in other words, 289 of the 1,771 months going back to 1871 have seen all time highs. In hindsight we know that despite hitting all time highs the market has continued to rise. We also know that most of these all-time highs have been followed not by crashes, but by more all-time highs. Of the 289 all-time high months over the period, 194 of them were followed by another all time high. That’s 67% of the time.

Think about that. Investing in a month when the US market is hitting an all time high has historically been followed by another all time high 67% of the time. This strong post-all-time-high performance has not only been true for the US stock market. The MSCI EAFE and S&P/TSX Composite have shown similar results, with 63% and 66% of all-time highs being followed by another all-time high.

The green bars in the chart represent all-time highs.


Are markets expensive?

Hitting all-time highs may not be out of the ordinary, and they are probably not a reason to get nervous, but as prices rise faster than earnings, the Shiller PE also rises. As of August 22, 2018, the Shiller PE is sitting at 32.89, compared to a historical mean average of 16.56. Based on that it seems that the US market is expensive. Whether or not that is meaningful information is another story entirely.

A 2012 white paper from Vanguard showed that the Shiller PE does have some ability to predict future returns, but probably not enough to base any investment decisions on, especially short-term decisions. The paper found that the Shiller PE explains about 40% of the variance in future 10-year stock returns. More importantly for anyone feeling nervous based on current valuations, the paper found almost no explanatory power over 1-year stock returns. Put simply, even if the Shiller PE is high, that tells us almost nothing about the returns for the following 12 months. Stay invested.

The S&P 500 is not the world

If normalizing the S&P 500 hitting all-time highs and debunking a high PE as an indicator of a coming crash is not enough to calm the nerves, it is always important to remember that the S&P 500 is not representative of the world. While the US market has been soaring since March 2009, International and Canadian stocks have been much more restrained.

Total CAD Return March 2009 – July 2018

S&P 500 Index


S&P/TSX Composite Index


MSCI EAFE Index (net div.)         


Source: S&P Dow Jones Indices, MSCI, Dimensional Returns Web

A globally diversified investor has less to worry about in terms of an extended period of abnormally high returns. Even an investor who owns the total US market, or better yet a US market portfolio tilted toward small and value stocks, would have much less to worry about as those asset classes have not followed the S&P 500’s trajectory. That is, if all-time highs were anything to worry about, which they are not.

The MSCI EAFE hit an all-time high in January 2018, but has not surpassed that level since; it also finished its last bear market in early 2016. The S&P/TSX Composite index has reached all-time highs through 2018. While not quite a bear market, the Canadian market did see a drop of over 17% between 2014 and 2016.

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Asset Location: Promising Theories vs. Practical Applications

The nonsense of trying to come out ahead by picking stocks or timing the market has long been one of my recurring themes. So, if you’ve stuck with me so far, you probably already know to avoid these sorts of active pursuits. There are other, more sensible ways to seek more from your investments – such as effective tax planning to help you keep more of your returns as your own. Asset location is one form of tax planning. 

So far, so good. But now, I’m going to shake things up a bit. While asset location sounds great in theory, once we work the actual numbers, we often discover it may not be all it’s cracked up to be. At the very least, you don’t want to get lost in the weeds when trying to locate your assets. 

What Is Asset Location?

First things first: What is asset location? I am not talking about asset allocation, which is deciding how much of each asset class you should hold overall. Asset location is the practice of holding certain asset classes in certain account types. Typically, you follow a set of rules for holding the assets with the highest expected tax costs in your non-taxable accounts. For example, you may deliberately hold less-tax-efficient bonds in your RRSP and more-tax-efficient Canadian stocks in your taxable account. 

Easy right? Well, it is easy in theory, but there’s a catch. To know where the highest expected tax costs will occur, it helps to know in advance what your future taxes and returns are going to be. Without a crystal ball to help you peer into the future, it can be really, really hard. 

Can Asset Location Add Value?

On the plus side, much has been written about asset location and its potential contribution to after-tax returns. Here are several analyses that compare an asset location strategy versus holding the same asset mix in each of your accounts (such as the same 60/40 stock/bond allocation in every account you own): [Can you hyperlink to these papers?]

  • In a 2013 paper from Morningstar, David Blanchett and Paul Kaplan determined that asset location might add up to 23 basis points (bps) of value per year to after-tax returns. 
  • In a 2014 paper, my PWL colleagues Dan Bortolotti and Justin Bender found that optimal asset location would have added 30 bps per year to the after-tax returns in an ETF portfolio held from 2003–2012.
  • In a 2017 paper, I used statistical analysis to test an asset location model and found that optimal asset location could ideally add an average of 23 bps per year to after-tax returns. My ideal situation included an investor taxed at Ontario’s highest marginal rate, with enough room in their RRSP to hold most of their bonds while staying in line with their target asset allocation.

But, again, we cannot know in advance what returns a portfolio will actually earn. So, in my own paper, I used Monte Carlo analysis to stress test my optimal asset location strategy across a range of about 1,000 potential outcomes. I found that asset location did in fact add value about 80% of the time. 

While this was an interesting finding, it was still based on forward-looking assumptions. Any asset location optimization decision is based on the expectation of future returns … which, of course, we cannot know except in hindsight.

To test the robustness of my optimal asset location decision against my inability to know the future, I next ran the Monte Carlo model against actual returns instead of the expected returns that had been used to make the optimal asset location decision. Under these circumstances, the average value-added dropped from 23 bps to 7 bps. More importantly, the optimal asset location strategy only outperformed holding an identical asset allocation in all accounts 58% of the time.

Should You Pursue Asset Location?

When we realize that asset location does not guarantee higher after-tax returns, we should start to wonder about other issues that may arise. I explore these possibilities in more detail in my related video, but to name a few, there are: 

  • Regulatory risks – What if tax rates or other tax laws change? 
  • Room for error – Given all the future unknowns, even financial professionals and academics often heatedly debate just what qualifies as “optimal” asset location. 
  • Added complexities – Obviously, it takes a lot more time and energy to engage in asset location than to simply duplicate the same asset allocation in each account. Is the potential value-added worth it?
  • Debilitating distractions – Asset location may cause more harm than good if it distracts you from other investment best practices, such as remaining fully invested and engaging in periodic rebalancing. 

In response to a comment on one of his blog posts, my PWL colleague Justin Bender echoed my own thoughts perfectly: “There are many thoughts on the asset location decision and in the end, it probably doesn’t matter much.”

Put simply, since we cannot predict the future, I often question the value of trying to optimize for asset location. It may even make an investor worse off if they’re struggling with the complexity or, worse, delaying the implementation of their portfolio due to asset location concerns. 

Do you have an opinion on the asset location decision? Leave me a comment about it in my asset location video.

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Mortgage debt and asset allocation

Mortgage debt is a normal thing to have in Canada. Based on 2016 census data, 61.7% of Canadian families owned a principal residence, and 57.3% of those families had a mortgage.

If you have both a mortgage and an investment portfolio you might have wondered if it makes sense to use your investments to pay off your mortgage or keep investing while following a normal mortgage repayment schedule.

I think that the most common advice out there, and probably the most common thinking, is that it makes sense to keep the portfolio in tact to benefit from the higher expected returns of financial market investments compared to the relatively low cost of mortgage debt.

This might seem logical from the perspective of maximizing expected returns, and for some people it might be logical. However, if the investment portfolio is not allocated 100% to stocks, paying off the mortgage and increasing the portfolio’s equity allocation may be a more sensible approach to increasing expected returns.

To illustrate this point I will use the PWL Capital financial planning assumptions for expected portfolio returns and a mortgage rate of 3.00%.

I will imagine someone with a $500,000 home, a $900,000 investment portfolio currently invested in 50% stocks and 50% bonds, and a $400,000 mortgage. They are deciding between continuing to pay off the mortgage using their income over time or selling their investments to pay the mortgage off immediately.

Here are the two options up for consideration. Keeping the mortgage and a 50/50 portfolio or paying off the mortgage and keeping the remaining capital a 50/50 portfolio.

Keep the mortgage + 50/50 Pay off the mortgage + 50/50
Home 500,000 500,000
Portfolio 900,000 500,000
Mortgage (400,000) -
Net Worth T+0 1,000,000 1,000,000

Initially there is no impact on net worth. There could be some consideration for taxes payable on selling $400,000 of the portfolio, or penalties to pay off the mortgage in a lump sum, but I will ignore them to keep things simple.

I will also ignore the impact of mortgage payments on the mortgage balance. In reality the payments would decrease the mortgage balance, but they could also be assumed to be added to the portfolio in the no-mortgage scenario. It is easiest to ignore them on both sides.

If we assume that the 50/50 portfolio earns 4.68% per year and the mortgage costs 3.00% per year, here is how it looks after one year:

Keep the mortgage + 50/50 Pay off the mortgage + 50/50
Home 500,000 500,000
Portfolio 942,120 523,400
Mortgage + 3.00% interest (412,000) -
Net Worth T+1 1,030,120 1,023,400

Clearly keeping the mortgage and growing the larger portfolio was better, but we are not comparing apples to apples. Keeping the mortgage results in a substantial amount of leverage. Leverage increases risk.

Comparing apples to apples

Based on this, it might be more reasonable to compare keeping the mortgage and a 50/50 portfolio to paying the mortgage off and increasing the portfolio risk level to 95/5, that is 95% stocks and 5% bonds, with a higher expected return of 6.09%.

Keep the mortgage + 50/50 Pay off the mortgage + 95/5
Home 500,000 500,000
Portfolio 942,120 530,450
Mortgage + 3.00% interest (412,000) -
Net Worth T+1 1,030,120 1,030,450

With the more aggressive portfolio you get a nearly identical expected outcome whether you keep the mortgage or not. Despite the appearance of taking more equity risk, arguably your overall risk has decreased.

If you do not think you could handle a 95% equity portfolio, it might help to think about this another way. In either case you have a $500,000 home. Keeping the mortgage and investing $900,000 effectively means investing $500,000 of your own money and borrowing the remaining $400,000 as a mortgage. This is a leveraged investment.

In the worst 12 months of the financial crisis, a 50/50 portfolio lost 20.58%, so a $900,000 portfolio lost $185,220. In our example only $500,000 of that was your own money. A $185,220 loss on $500,000 equates to a 37% loss, but you also paid 3% in mortgage interest on your $400,000 mortgage that year for a total loss of 39.44%.

Alternatively, owning a 95/5 portfolio through the financial crisis resulted in a portfolio loss of 38.92% for the year, with no interest costs. You should be almost indifferent with a slight preference for the riskier portfolio with no mortgage debt.

If a 95/5 portfolio still seems way too risky, then you may have purchased a house that is outside of your risk-appropriate price range! Whether you actually have the 95/5 portfolio, or you have a 50/50 portfolio with the mortgage, you effectively have the 95/5 portfolio.

In the case of a starting equity mix that is more aggressive than 50/50, say 70/30, it would not have been possible pay off the full mortgage balance without affecting expected returns. However it would still be possible to pay off a substantial portion of the mortgage while increasing equity exposure to maintain expected returns.

Keep the mortgage + 70/30 Pay some of the mortgage + 100/0
Home 500,000 500,000
Portfolio 900,000 644,444
Mortgage (400,000) (144,444)
Net Worth T+0 1,000,000 1,000,000

And one year later:

Keep the mortgage + 70/30 Pay some of the mortgage + 100/0
Home 500,000 500,000
Portfolio 947,880 684,658
Mortgage + 3.00% interest (412,000) (148,778)
Net Worth T+1 1,035,880 1,035,880

In either case, having a mortgage and a conservative portfolio, or having no mortgage and an aggressive portfolio, the risk and return characteristics are very similar. Paying off the mortgage has the added benefit of eliminating the guaranteed mortgage interest cost. Where this does not work is if the portfolio is already at 100% equity. In that case there is no way to increase expected returns other than adding leverage.

Mortgage debt should be considered when evaluating the risk and return characteristics of a portfolio. Where possible, paying down mortgage debt while increasing the portfolio’s equity allocation can result in equivalent risk and return characteristics without the added risk and cost of leverage.

Then, and now

Charley Ellis was on the Capital Allocators podcast with Ted Seides last week. Charley has been in the investment management business since the early 1960s. Today he is one of the most vocal proponents of index funds as the most sensible investment for most people.

I write often about why index investing makes sense, and why it is challenging for active investment management to generate consistent outperformance. While that has always been true, there are some good arguments for why it is harder now than ever for active managers.

On the podcast, Charley offers some reminders about how the world and the stock market have changed since the 1960s.


According to Charley 10% of trading, at most, was done by institutions, and 90% was done by individuals. Most of those individuals were, as Charley describes, “nice people” who were investing their savings in stocks without doing much, if any, research. In other words, there were lots of easy targets for an active manager to exploit.

In the past, it was possible for an analyst to set up a private meeting with a company’s management in order to get an information edge.

Charley estimates that there were less than 5,000 people in the active investment management business.

Securities firms had 10 to 12 analysts who were only searching for interesting investments for the firm’s partners, and were not publishing their research.

About 3 million shares traded each day.


Charley says that 99% of all trading today is done by computers. Most investors involved are highly skilled and have instant access to information. In other words, there is no easy target left to exploit.

Today, under Regulation FD, the SEC requires that any material information that is disclosed must be disclosed publicly. Under Reg. FD It is not possible, legally, to get a competitive information advantage.

Charley estimates that there are over 1,000,000 people in the active investment management business. There are around 154,000 CFA Charterholders in the world today.

Securities firms today have hundreds of analysts with diverse expertise in every major financial hub constantly publishing their research.

More than 5 billion shares trade each day.

The Paradox of Skill

Piling an increasing number of skilled professionals into the investment management business might seem like it would benefit investors, unfortunately it does not. Michael Mauboussin and Dan Callahan explained the paradox of skill in a 2013 Credit Suisse white paper:

In investing, as in many other activities, the skill of investors is improving on an absolute basis but shrinking on a relative basis. As a consequence, the variance of excess returns has declined over time and luck has become more important than ever. Still, differential skill continues to exist. This process is called the paradox of skill.

Put simply, if equally skilled and informed investors are competing with each other, the winner will be defined by luck rather than skill. It is not absolute skill that matters, but relative skill.

If there has ever been a time for active money management to flourish, that time is not now. This shows up consistently in the results of active fund managers; the vast majority of them underperform the index over any given time period.

There is little question that simple low-cost index funds are the most sensible investment for most people. Paradoxically, the case for index funds grows stronger as the investment management industry gets more skilled.

Foreign Withholding Tax

First things first: If your long-term investments are not yet globally diversified, they almost certainly should be. Robust evidence and common sense alike support the wisdom of managing your risks and expected sources of return by investing in both Canadian and international markets. 

But, once you go global, there is a tricky little detail, often overlooked, which can eat into your investment returns. I’m talking about foreign withholding taxes.

When a foreign company pays a dividend to a Canadian investor, the company’s home country will often impose a tax on the dividend. The amount of tax withheld by the foreign government depends on the arrangement between the two countries. 

For example, the US government keeps 15% of any dividend paid by a US company to a Canadian resident investor. These taxes are withheld before you receive the dividend in your investment account. This makes them easy to overlook, but foreign withholding taxes can still do significant damage to your returns. Left unchecked, the impact can be even greater than the management expense ratio (MER) on most ETFs.

While you cannot eliminate foreign withholding taxes, you can seek to minimize them by tending to two main things: the structure of the investment vehicle you’re using, and the type of account in which the vehicle is held.

Thing One: Investment Structure

In the world of ETFs, there are three main structures that a Canadian investor can choose from to obtain global market exposure: 

  1. A US-listed ETF
  2. A Canadian-listed ETF that holds a US-listed ETF 
  3. A Canadian ETF that holds stocks directly

Depending on how the ETF is structured, you may be subject to two levels of withholding tax. In their 2016 white paper, Foreign Withholding Taxes, my PWL colleagues Justin Bender and Dan Bortolotti explained it this way: 

  • Level One Withholding Taxes – These are like a departure tax you pay when flying from a foreign country to Canada. Level One taxes are levied by any foreign country (including the US), on dividends paid to a Canadian investor.
  • Level Two Withholding Taxes – These are like a tax you pay to the US government when an overseas flight has a layover in the US on its way to Canada. It’s an additional 15% withheld by the US government on dividends paid to a Canadian investor by a Canadian-listed ETF that owns a US-listed ETF. Taxes are first withheld when the dividend is paid from a foreign company to the US-listed ETF. More taxes are paid when the US-listed ETF passes that dividend on to you, a Canadian investor.

Thing Two: Account Type 

The account type also matters. 

  • Retirement Accounts – The US government does not withhold taxes on US security dividends if they’re held in an RRSP or other retirement account (like an RRIF or LIRA). This is thanks to the current Canada-US tax treaty. Thus, a US-listed ETF of US stocks will not have any tax withheld on dividends paid to an RRSP account. This special treatment does not apply to TFSAs and RESPs. Also, other countries do not have similar arrangements, which means that foreign withholding taxes will apply on dividends paid from non-US international stocks, regardless of the account type. 
  • Taxable Accounts – In a taxable account, foreign taxes withheld are reported on your T3 or T5, and can generally be used to offset your Canadian taxes. In that sense, while foreign taxes are paid, they are recoverable. In a registered account, there are no T slips, so any foreign tax you pay cannot be used to offset your Canadian tax. This makes foreign withholding taxes paid in your registered accounts unrecoverable.

Thing One and Thing Two: Putting the Pieces Together 

Knowing which types of ETFs to hold in which accounts can save you a lot in the long-term. For details on the various possibilities, I highly recommend Justin and Dan’s white paper. Here are a few key caveats. 

  • Holding US-listed ETFs that hold US stocks in an RRSP account: As I mentioned earlier, you can employ this combination to eliminate any foreign withholding tax. But, as I explain in my video in more detail, you also need to manage additional currency conversion costs incurred by using a technique called Norbert’s Gambit. Once again, Justin’s YouTube channel is handy if you want to learn more.
  • Holding Canadian-listed or US-listed ETFs in an RRSP account: To contrast, this combination will generate an annual 0.25% unrecoverable foreign withholding tax cost, as will holding a US-listed ETF of US stocks in your TFSA account.
  • Canadian-listed ETFs that hold US-listed ETFs of international stocks, in a TFSA or RESP account: I know, that’s a mind-bender. But it’s worth wrapping your head around this scenario, because it’s among the worst offenders for generating double whammy, Level Two withholding taxes: Taxes are withheld by a non-US foreign country and by the US. Moreover, both taxes are unrecoverable.

On that last point, there are Canadian-listed funds that hold international stocks directly, so there is only Level One withholding. Examples include iShares’ XEF and XEC ETFs, and some Dimensional Fund Advisors’ funds. 

Now what? There is both an art and a science to determining which assets should be held in which account to optimize foreign withholding and other tax efficiencies. This is a practice known as asset location. Is it worth it? Find out in my next installment. In the meantime, I’d like to know what you have done to minimize your foreign withholding taxes. Tell me in the video comments … right after you subscribe to receive more Common Sense Investing ideas. 

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In these uncertain times

I am far from being a long-tenured veteran of the financial services industry. In 2007, when the last big drop in financial markets began, I was studying mechanical engineering on a full athletic scholarship. I have no recollection of worrying about the market; all of my expenses were covered as long as I met my athletic and academic obligations (which I did). As far as I could tell, I had financial certainty in my life. 

How blissfully ignorant was I?

Uncertainty is a constant. It is a constant in general, but it is like a spectator sport in the case of the financial markets. Uncertainty shows up immediately in prices. That can be scary. Humans struggle with the idea that there are more possible outcomes than we can plan for.

Making matters worse is our tendency to focus on recent events while largely ignoring the past. One of the most common themes that I hear from other people is the constant feeling that right now is exceptionally uncertain. 

It’s hard to say whether times are more or less certain now than they have been in the past. As much as we try we can’t measure uncertainty. Nassim Taleb explained it elegantly in Antifragile:

Man-made complex systems tend to develop cascades and runaway chains of reactions that decrease, even eliminate, predictability and cause outsized events. So the modern world may be increasing in technological knowledge, but, paradoxically, it is making things a lot more unpredictable.
An annoying aspect of the Black Swan problem— in fact the central, and largely missed, point —is that the odds of rare events are simply not computable.

A proxy for uncertainty in financial markets might be volatility. It is far from a perfect proxy, but if there is a perception that the future holds more risk, asset prices may drop due to increased discount rates. To see if we are living in exceptionally uncertain times as measured by volatility we can look at the historical standard deviation of the US market by decade.

1926 33.49
1936 21.23
1946 12.83
1956 11.71
1966 16.49
1976 14.84
1986 14.98
1996 16.15
2006 15.35
2016-present 8.98

Data Sources: Data source: Dimensional Returns Web, CRSP

It is clear that market volatility has been relatively stable through time. Each of these decades has seen trade disagreements, political scandals, wars, or recessions. Each day in the past, at the time, felt as uncertain as tomorrow feels today.

Today we have less volatility than past decades. This does not tell us much about current or past uncertainty. What it does tell us is that it might not make sense to expect more or less market volatility based on what we perceive as uncertainty today.

Delaying investing due to the feeling of uncertainty is not rational. Uncertainty is exactly why any investor expects a positive long-term return.

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Is Amazon changing the world, and the stock market?

Amazon has been on a tear. Its market cap is expected to reach US $1T. Apple recently made history by accomplishing the same. Headlines have been focusing on this massive growth. It’s almost as if massive, successful, and innovative companies are a new thing. When massive growth companies dominate the market and the headlines it is natural to wonder if it’s different this time.

It is not different this time. At least not yet. New technologies and ideas driving huge growth in the value of companies has been happening for as long as we have data available.

The oldest verifiable example is the Dutch East India company which was worth US$7.9T in 1637 if we adjust for inflation. We might look back on that now and say ah well it was a bubble. At that time, though, they were opening up global trade and exploring uncharted parts of the planet. That valuation did not last, and surely there were people who lost a lot buying at the peak.

The challenge with investing in growth stocks is that we never know when the tide will turn. It is improbable that FAANG will continue their current trajectory. That is not a prediction, it is a common-sense observation.

We have to remember that technology as we know it today with the cloud, web-based applications, and massive scalability is relatively new. Older technologies or even emergent ideas had similar impacts on the market in their time.

  • In 1900 well over 50% of the US stock market consisted of rail companies. 
  • In 1900 Standard Oil was worth US $1T if we adjust for inflation.
  • 20 years ago, in July 1998, AT&T was the largest company in the US by market cap by a significant margin, followed by GE.
  • Adjusted for inflation, AT&T’s July 1998 market cap would be 504B, about the same as Facebook (pre-Facebook’s July crash).
  • In July 1998 AT&T was 3.4% of the total US market cap. In June 2018 Apple is 2.6% of total US market cap. That trend has remained relatively stable over time.
  • The 5 largest companies in 1998 made up 11.6% of the US market. The 5 largest companies in 2018 make up 11.5% of the US market.

I think it’s fair to say that the well-known growth companies today are not anomalous. Similar to past storied growth companies they are leading the market by changing the world which is driving up both their earnings, and their prices relative to their earnings.

None of this makes it any easier to invest in growth companies. The 5 largest companies in the US in 1998 currently rank 18, 44, 5, 27, and 10 in 2018. Growth companies are easy to spot after the fact, and next to impossible to invest in before their massive growth. Even harder than that might be hanging on through their massive growth, which tends to be highly volatile, and then knowing when to get out. Further complicating things is the fact that, on average, growth companies have produced lower returns over the long-term than value companies.

The world is changing. There are innovative companies creating value by changing the world. That innovation is what drives capitalism. This is nothing new for the stock market.

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What are normal stock returns?

2018 has seen modest returns for Canadian and International stocks, both coming in a bit under 2% in CAD at the end of June. US stocks have seen stronger returns, a little over 7% in CAD, driven mostly by currency. These numbers might seem low after years of double digit returns. 
The S&P/TSX Composite has seen double-digit returns in 3 of the last 6 years, the MSCI EAFE has seen double digit returns in CAD in 4 of the last 6 years and the S&P 500 has seen double digit returns in CAD in 5 of the last 6 years.
Are this year’s returns low, or have the last 6 years been unusually high? 
Double digit returns for Canadian investors have been the norm, on average, for the past 47 years.

Here are the compound average annual returns since 1970 in CAD:

S&P/TSX Composite Index (CAD) MSCI EAFE Index (net div.) (CAD) S&P 500 Index (CAD)
10.55% 11.24% 12.23%

Data Sources: S&P Dow Jones, MSCI, Dimensional Returns Web

Positive Returns

Returns have been positive for Canadian investors in Canadian and International markets in 34 of the last 47 years, or 72% of the time. The US market has had 36 positive years out of the last 47.

Of those positive years since 1970, Canadian and International markets have had 26 years with positive double-digit returns, while the US had 27 such years. Canadian markets have had 14 years with returns greater than 20% for Canadian investors, International markets have had 13, and the US market has had 15.
Negative Returns
Since 1970 Canadian investors have experienced Canadian stocks with double-digit drops in 6 years – 2 of those drops were greater than 20%, International stocks with double-digit drops in 9 years – 3 of those drops were greater than 20%, and US stocks with double digit drops in 5 years – 3 of those drops were greater than 20%.
Normal Returns?
20 of the last 47 years have seen Canadian stocks return between -1% and 15% for Canadian investors. International markets have seen 20 of the last 47 years’ returns fall between 9.33% and 29.33%. For the US market 20 of the last 47 years have shown returns between 5.14% and 21.14% for Canadian investors.
Expected Returns
PWL Capital uses a combination of historical risk premiums and current market valuations to determine reasonable expected return assumptions for stocks. As at the last update in December 2017, the expected returns for Canada were 5.95%, 6.68% for International stocks, and 5.50% for US stocks.
The Privilege of Knowledge
Markets will always be volatile. Even extreme negative returns, while less common, are normal in some years. Nick Maggiulli recently had a post extolling the benefits of having past market data available. Before we had easy access to data, there was no way to know what normal was.

However, though buy and hold might seem obvious now, that’s only because we have the benefit of hindsight, ubiquitous data, and modern computational resources.  A century ago, who had access to anything remotely this useful?  No one.  People didn’t have the documented market history and technological capabilities we have today, so why should we have expected them to “buy and hold” back then?  If anything, their history was riddled with banking panics and far more instability, so I can’t blame them.

We do not have the slightest clue what future returns will be, but what we can do is draw on the past to understand how the relationships between different assets work. It is probably reasonable to expect that there will be some risk premium for owning stocks going forward. It is probably reasonable to expect that there will be some risk premium for owning small and value stocks going forward. 

The market outcome of any individual calendar year should not be a concern. Normal is volatile. Normal is random. Understanding that makes us smarter investors.

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DFA International Equity performance since inception

The Dimensional Fund Advisors International Core (DFA295) and International Vector (DFA227) equity funds offer exposure to the global equity markets, including emerging markets, excluding the US and Canada. As with all DFA equity funds, these products offer an increased exposure to small cap and value stocks relative to the market, with the Vector product having the most pronounced small cap and value tilts. These funds also have higher fees than comparable market-cap weighted index funds: DFA295 has an MER of 0.49% and DFA227 has an MER of 0.61% compared to a weighted average MER of 0.27% for an 87%/13% mix of XEF and XEC. Fees tend to be one of the best predictors of future performance, but with Dimensional’s tilts toward small and value stocks, and their careful implementation, we might expect slightly better long-term performance.

DFA vs. Index ETFs

Index returns cannot be captured by investors, so we will compare the DFA returns to live ETFs with their own fees and implementation costs.  There is insufficient data for XEF and XEF, which are Canadian listed, for a since inception comparison. We have instead constructed a hypothetical ETF portfolio consisting of 87% EFA and 13% EEM until October 2012, 87% IEFA and 13% IEMG from November 2012 through April 2013, finally switching to 87% XEF and 13% XEC through June 2018. In a live portfolio an investor would be unlikely to switch ETFs with this frequency due to tax implications and transaction costs. This has been ignored for the comparison. It is also worth noting that IEFA, IEMG, XEF, and XEC offer some small cap exposure, while EFA, EEM only offer large and mid cap exposure.

  • For the ETF comparison we use EFA + EEM / IEFA + IEMG / XEF + XEC

DFA295 Index ETFs Difference
1-Year Total Return (%) 9.24 8.95 +0.29
3-Year Annualized Return (%) 7.83 7.37 +0.46
5-Year Annualized Return (%) 11.89 11.40 +0.49
10-Year Annualized Return (%) 6.00 5.60 +0.40
Since Inception (07/2005) (%) 5.97 6.03 -0.06

Data Sources: iShares, MSCI, Morningstar Direct, Dimensional Returns Web

DFA227 Index ETFs Difference
1-Year Total Return (%) 9.37 8.95 +0.42
3-Year Annualized Return (%) 7.95 7.37 +0.58
5-Year Annualized Return (%) 11.94 11.40 +0.54
10-Year Annualized Return (%) 5.63 5.60 +0.03
Since Inception (07/2005) (%) 6.68 6.83 -0.15

Data Sources: iShares, MSCI, Morningstar Direct, Dimensional Returns Web

DFA295 and DFA227 have managed to outperform index tracking ETFs after fees for the trailing 10-year period. This is no small feat. Some credit must go to DFA for implementation of these strategies, but most of the credit goes to the fact that International small and value stocks have delivered excess performance. Both funds have trailed since inception. This is again driven by the weaker performance of International small and value stocks at the beginning of the funds’ lives.

Tax Considerations

Holding EEM, EFA, IEFA, and IEMG would result in one level of unrecoverable withholding tax from the foreign countries for a Canadian taxable investor. DFA holds securities directly, meaning that the taxes withheld by foreign countries could be could be recovered. Today this is somewhat less of an issue for an ETF investor as XEF holds securities directly. However, XEC continues to hold the US listed IEMG resulting in one level of unrecoverable withholding tax. On after-tax basis we would expect this to further improve the performance of DFA over a comparable International equity ETF allocation.

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Should you be trend following with managed futures?

The holy grail of investing is finding assets that are imperfectly correlated with each other. Adding assets that behave differently together in a portfolio improves the expected outcome. A reduction in volatility has obvious behavioural benefits, but it can also increase long-term wealth creation by smoothing returns.

There is little question that stocks and bonds belong in a portfolio. There is also substantial credible research demonstrating that adding exposure to certain factors – quantitative characteristics of stocks and bonds – increases portfolio diversification and expected returns. While many factors such as size, value, and profitability are relatively well-known, there are others that are discussed less frequently: trend following is one of those factors.

Trend following strategies are implemented with managed futures. Managed futures attempt to capture a factor known as time-series momentum, or trend momentum. This factor consists of long exposure to assets with recent positive returns and short exposure to assets with recent negative returns. The strategy is agnostic to the type of assets, meaning that it can be implemented with equities, fixed income, commodities and currencies.

Managed futures have historically proven to have strong returns, low correlation with stocks and bonds, and low volatility in general. Notably, the Credit Suisse Managed Futures Liquid Index returned 23.05% in USD in calendar year 2008 while the Russell 3000 – an index of US stocks – returned negative 37.31%.

This was not the first time that managed futures offered strong returns in bad markets. In a 2017 paper from AQR titled A Century of Evidence on Trend-Following Investing, the authors found that the performance of this strategy has been very consistent, including through the Great Depression and other substantially negative market events. Beyond the returns being strong, the asset class has maintained nearly no correlation with stocks or bonds, providing a substantial diversification benefit over time.

Research Criteria

We do not consider implementing an investment product unless it is backed by great research. To meet that criteria, the research must show that a strategy is persistent, pervasive, robust, sensible, and investable. The research on managed futures does check many of these boxes – it is persistent, pervasive, and robust. The biggest questions are whether or not there is a sensible explanation for managed futures to outperform going forward, and is it investable?


Small cap and value stocks are riskier assets and therefore it is sensible that they would have persistent higher expected returns. The explanation for managed futures’ outperformance is harder to grasp. From the AQR paper:

The most likely candidates to explain why markets have tended to trend more often than not include investors’ behavioral biases, market frictions, hedging demands, and market interventions by central banks and governments. Such market interventions and hedging programs are still prevalent, and investors are likely to continue to suffer from the same behavioral biases that have influenced price behavior over the past century, setting the stage for trend-following investing going forward.

This is a bit of a stretch as far as expectations for the future go. Betting on persistent risk premiums makes sense. Betting on persistent behavioural biases and market interventions is not something that I am comfortable with. Is it reasonable to bet on behaviour persisting? Human behaviour can change, especially when we have knowledge about our past behaviour. Behavioural errors are notably different than risk premiums.


To be investable a strategy has to be cost effective and tax efficient to implement. We can look to a real-world example to examine how investable the managed futures strategy is.

In Canada, Horizons launched the Auspice Managed Futures Index ETF (HMF) in 2012. It closed in 2018 due to a lack of assets. A managed futures index is quite different from a typical low-turnover total market cap weighted index; managed futures indexes use a pre-defined quantitative methodology to follow the managed futures strategy. Similar to any momentum-based strategy, managed futures have an inherently high turnover.

HMF had a management expense ratio of a little over 1%, but it also had a substantial trading expense ratio in each year of operation due to the high turnover of the strategy. The TER is a real cost that reduces returns and must be considered.

Horizons Auspice Managed Futures Index ETF TER

2012 2013 2014 2015 2016
0.68% 0.68% 1.56% 1.39% 0.69%

Data Source: Horizons' HMF MRFP

As a point of reference, the Dimensional Fund Advisors US Vector Equity fund, which is a US total market fund with a heavy tilt toward small cap and value stocks, typically has a TER of 0.01%. This is not an apples to apples comparison as the two strategies are vastly different, but you see the difference in implementation costs between a small cap value strategy and a managed futures strategy.

The total costs of implementing this strategy are high, exceeding 2% in some years. These costs could be justified with a sensible reason to continue expecting substantial outperformance, but I believe that aspect of this strategy is too uncertain to bank on.

High turnover leads to tax inefficiency. Much like expenses, taxes lower investor returns. A managed futures fund could be held in a tax-preferred account to mitigate this issue, but the tax inefficiency is another drawback to contend with.

Does It Belong in a Portfolio?

I cannot argue with the fact that managed futures look excellent in a back test, and there are a lot of people much smarter than me selling managed futures products based on these back tests. Without a sensible risk-based explanation, the high costs and tax inefficiency of this strategy will keep me away for now.

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Cash flow ≠ wealth

There is more to being wealthy than having a high income.

Cash flow can come and go. Ben Carlson recently had a post citing research from Thomas Hirschl at Cornell. The research shows:

  • 50% of Americans will be in the 10% of income-earners for at least one year during their working lives.
  • 11%+ of Americans will be in the top 1% of income-earners for at least one year.
  • 94% of Americans who make it to the top 1% income status will maintain that position for only one year.
  • 99% of Americans who make it to the top 1% will lose their top 1% spot within a decade.

Johnny Depp might be the most current and extreme example of this; he has reportedly squandered $650M of earnings on a lavish lifestyle with nothing left to show for it.

Cash flow

Cash flow is not wealth. High spending during years of strong cash flow may afford the appearance of wealth, but when the cash flow is gone the lifestyle goes with it. Saving a portion of that cash flow can lead to a base of assets.


Growing a base of assets is by no means easy. It takes some combination of planning, discipline, and luck. The fortunate side effect is that anyone who has applied planning and discipline to build up their assets is likely to maintain their planning and discipline into the future.


Without discipline, a large asset base can be easily spent. Based on this someone with substantial assets relative to their neighbour may not be wealthy. Wealth is assets relative to current and future expenses. This is where the intersection of assets and expenses becomes interesting.

Take a financially independent 45-year-old with an $8,000 per month lifestyle. They would need about $3.8M to be financially independent, and each additional dollar of desired lifestyle spending would require about $40 of additional assets. That magnifying effect works in both directions; the required assets to fund financial independence for a 45-year-old drops to $1.5M if they can manage to live on $3,000 per month.


Expenses are the link between cash flow, assets, and wealth. If wealth is defined as independence and freedom, then low expenses can be one of the strongest drivers. Lower expenses lead to a higher savings rate while also reducing the amount of assets required for financial independence. It is easy to spend more by becoming accustomed to luxuries while effectively robbing your future self.

Spending wisely is an idea that has been popularized by Mr. Money Moustache, among other frugality bloggers:

When you wriggle yourself into the narrow nook of luxury, your perspective on the world, and your ability to survive and thrive in it, also constricts dramatically. Like any drug, it can be fun to indulge in occasionally. But to seek to constantly maximize luxury in all areas of your life to the limits of what you can afford? Pure insanity.

There is, of course, a balance between frugality and comfort. The takeaway is the true cost of expenses. If you have cash flow, high expenses reduce your ability to build assets. If you have assets, high expenses reduce the value of those assets relative to your lifestyle, making financial independence less attainable.

Wealth is relative. Not relative to other people, but relative to your own expenses.

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Banning embedded commissions would not have fixed financial advice in Canada

There was a small uproar when the Canadian Securities Administrators decided that they would not move forward with banning embedded commissions. Rob Carrick commented:

The dream of creating a standard of transparent, client-focused service in the investment industry died Thursday.

It is certainly true that eliminating embedded commissions would have increased transparency and more closely aligned the interests of clients with those providing advice.

The problem that nobody is talking about is that most financial advisors are still convinced, despite the mountain of evidence to the contrary, that active management is necessary for their clients to be successful.

Eliminating embedded commissions would not change this view. I do not know if anything would. The industry perception seems to echo that of Fischer Black when he left MIT for Goldman Sachs:

The market appears a lot more efficient on the banks of the Charles River than it does on the banks of the Hudson.

In other words, the market looks a lot more efficient in the academic research than it does on the ground in practice. Fischer’s comment was lamenting the challenges of implementing his research, but in my experience most financial advisors have the same sentiment.

Those clueless academics pushing index funds have no idea what it’s like on the ground…

Those giving financial advice are subject to the same biases as individual investors, leading them to believe that they are able to provide market-beating advice. This usually leads to higher risks and costs to the client, and a relationship that is based on performance over financial advice. In the face of irrefutable evidence, the broad community of financial advisors in Canada is still intent on using active management in order to serve their clients in what they deem to be the best possible manner. From a recent survey:

In fact, 86% say the risks in the market add up to an environment that favours active management. These professionals demonstrate a clear preference for actively managed investments and continue to allocate the majority of assets to these strategies.

I am not the first person to suggest that a best interest standard would not solve the problem. A 2017 paper titled The Misguided Beliefs of Financial Advisors found that Advisors trade frequently, chase returns, prefer expensive, actively managed funds, and underdiversify their own personal investments, just as they do for their clients’. This indicates that the bad investment advice is not malicious, but misguided.

Financial advice is not at a point where there is consensus by practitioners on how evidence should be applied. There is academic consensus about the evidence, just not a willingness of practitioners to apply it. In a 2016 Freakonomics episode Vinay Prasad, MD, MPH, explained that there was a time not too long ago when medicine was practiced in a similar manner to the way that investment advice is given today.

The reality was that what we were practicing was something called eminence-based medicine. It was where the preponderance of medical practice was driven by really charismatic and thoughtful, probably, to some degree, leaders in medicine. And you know, medical practice was based on bits and scraps of evidence, anecdotes, bias, preconceived notions, and probably a lot psychological traps that we fall into. And largely from the time of Hippocrates and the Romans until maybe even the late Renaissance, medicine was unchanged. It was the same for 1,000 years. Then something remarkable happened which was the first use of controlled clinical trials in medicine.

In the world of financial advice, we are still in this phase, where evidence does not have the final say in the advice given to clients. This may take a long time to change. In the same Feakonomics episode, Iain Chalmers, a British health services researcher, explained:

There was a great deal of hostility to [evidence-based medicine] from, I’d say, the medical establishment. In fact, I remember a colleague of mine was going off to speak to a local meeting of the British Medical Association, who had basically summoned him to give an account of evidence-based medicine and what the hell did people who were statisticians and other non-doctors think they were doing messing around in territory which they shouldn’t be messing around in. He asked me before he drove off, “What should I tell them?” I said, “When patients start complaining about the objectives of evidence-based medicine, then one should take the criticism seriously. Up until then, assume that it’s basically vested interests playing their way out.” I would say it wasn’t actually until this century [that evidence-based medicine took hold]. So one way you can look at it is where there is death there is hope, as a cohort of doctors who rubbished it moved into retirement and then death, the opposition disappeared.

Until we reach a point of acceptance of evidence as the most sensible way to guide investors, a best interest standard is meaningless. If the medical profession is any guide it may be a generation or more before evidence-based financial advice becomes mainstream.

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Does active management work for institutional investors?

It is increasingly well-understood that low-cost index funds will, on average, beat actively managed mutual funds for average investors. I think that there is still a perception that large institutions like pension funds and endowments, with access to the supposedly best money managers are able to outperform.

Fortunately there are some good sources of information that we can turn to to see if this is true.

It has been well documented that fees can vary substantially depending on who is investing. Retail investors typically pay much higher fees in terms of percentage of their assets than institutions. Institutions are also able to access asset classes, like real estate, private equity, and hedge funds, that might not be readily available to a retail investor. A proponent of active fund management might argue that these factors should be conducive to market beating performance for institutional investors.

A 2017 report from Standard and Poors looked at the net and gross of fee performance for institutional investment accounts with the intention of seeing if fees were the sole cause of underperformance for retail active managers. The data in the report show that the overwhelming majority of actively managed institutional accounts underperformed their benchmark over 10 years, before fees. The underperformance was only exacerbated after fees. Well that answers that. While it may help, the lower fees that institutional investors are able to negotiate do not mean that active management will work for them.

Every year, the National Association of College and University Business Officers (NACUBO) releases their report on the performance of college endowment funds. With people like the legendary David Swensen at the reins of the Yale endowment, endowment funds have often been looked to as thought leaders for the investment world. Taking advantage of their exceptionally long time horizons, endowment asset allocations will often allow for less liquid asset classes like private equity and hedge funds. These asset classes do also tend to be more expensive to invest in and require more staff on hand to manage. It’s all worth it if the returns are great.

The 2017 NACUBO report shows that the 10-year average return for all 809 institutions that they track has been 4.6%. A simple 60% stock and 40% bond index fund portfolio has returned a little more over the same period, for a tiny fraction of the costs and far less complexity. Endowments have not generated the stellar performance that we might expect.

In the great financial crisis, Harvard’s massive endowment was famously left with no cash to cover their margin calls, and had to go into debt to stay afloat. Much of their capital was tied up in illiquid private equity and real estate. They lost nearly 30% in 2009, about the same as a 60/40 index fund portfolio.

Some pension funds have gotten the message. Steve Edmundson, who manages the Nevada State pension fund, a 35 billion dollar fund nearly the same size as Harvard’s endowment, does nothing but invest in low-cost index funds. It’s also worth mentioning that the Nevada State Pension fund has consistently outperformed Harvard’s complex and expensive endowment fund.

In a 2013 report, the Maryland Public Policy Institute wrote that:

“State pension funds, including Maryland, have succumbed for years to a popular Wall Street sales pitch: “active money management beats the market.” as a result, almost all state pension funds use outside managers to select, buy and sell investments for the pension funds for a fee. the actual result — a typical Wall Street manager underperforms relative to passive indexing — is costly to both taxpayers and public sector employees.”

The report continues:

“Getting pension fund administrators to support the policy and to educate legislators about indexing will be an uphill battle. By agreeing to the policy, administrators essentially admit they made mistakes by betting heavily on active managers. Who wants to admit an error? Investment consultants and Wall Street money managers will vigorously oppose such a policy.”

With their ability to negotiate lower fees and gain exposure to more exotic asset classes, it might be expected that large institutional investors could beat the simple low-cost strategy of index investing. That data do not support this assertion. What we do know is that complexity increase costs, and costs decrease average returns. Even the largest and most sophisticated investors cannot escape this truth.

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How much risk should you take?

Risk is more than an important part of investing. The whole concept of a financial market exists on the basis that taking risk can result in financial gain. If you do not take risk in financial markets, you expect very low returns. Of course, with risk also comes the potential for loss. Elroy Dimson of the London School of Economics said “Risk means more things can happen than will happen”.

In other words, risk means that there is a distribution of outcomes, and you will not know which outcome you actually get until it happens. As much as we like to think that we can understand risk, the possible distribution of outcomes is beyond our ability to comprehend.

While we are not able to control or predict the distribution of outcomes, we are able to choose the type and amount of risk that we take with our investments.

To start this discussion, I need to introduce two types of risk. The first type of risk is called idiosyncratic risk, which may also be referred to as company specific risk, or diversifiable risk. Idiosyncratic risk is not directly related to the market as a whole. Individual stocks will typically move to some extent with the market, but they may also fluctuate due to their specific circumstances. Think about Volkswagen’s share price plummeting after their emissions scandal.

There is no reason to expect a positive outcome for taking on idiosyncratic risk. It may work out in your favour, but it may result in substantial and unrecoverable losses. Idiosyncratic risk can be diversified away. Owning all of the stocks in the market eliminates the specific risks of each company. What is left is market risk.

Market risk is the risk of the market as a whole. It cannot be diversified away. For taking on the risk of the market, investors do expect a positive long-term return. When you invest in one stock, or one sector, you are getting exposure to both market risk and idiosyncratic risk, but the idiosyncratic risk can easily dominate the outcome. The most reliable long-term outcome would be expected when idiosyncratic is diversified away. Practically, this simply means owning a globally diversified portfolio of index funds, an idea that is not new to anyone who has been watching my videos.

Most investors do not own a 100% equity portfolio. Portfolios will typically consist of some mix between equity index funds and bond index funds. Long-term outcomes are uncertain, but we know that over the past 116 years stocks have outperformed bonds globally, while bonds have been less volatile. A portfolio becomes less risky and has a lower expected return as the allocation to bonds increases.

The decision about how much risk to take is driven by the ability, willingness, and need to take risk.

Equity market risk has tended to pay off over long periods of time, and the distribution of outcomes also tends to narrow. For example, over the 877 overlapping 15 year periods from 1928 to 2015, the US market outperformed risk-free t-bills 96% of the time. The ability to take risk is primarily driven by time horizon and human capital. We have been talking about risk as an unpredictable distribution of outcomes. A more tangible definition might be the probability of not meeting your goals.

For a young person with lots of remaining earning capacity, the market underperforming t-bills hardly affects their ability to meet their goals - in fact, it would be a good opportunity for them to buy cheap stocks. On the other hand, a near-retiree taking substantial losses in the years leading up to retirement would be devastating to their ability to meet their spending goals. In general, it is sensible to take less risk for goals with short time horizons and more risk for goals with longer time horizons.

Even with an unlimited ability to take risk, most investors are constrained by their own willingness to take risk. An investor may look at the history of market risk and decide that it is too volatile for their preferences. The MSCI All Country World Index was down 33% in Canadian dollars between March 2008 and February 2009.  That’s a pretty big drop. In his book Antifragile, Nassim Taleb introduced what he calls the Lucretius Problem: we tend to view the worst historical outcome as the worst possible outcome, but that is nowhere near the truth. If a 33% drop scares you, you would need to be comfortable with the potential for a far deeper decline to be confident investing in a 100% equity portfolio.

The need to take risk brings us back to goals. If someone wants to spend $5,000 per month adjusted for 2% average inflation for a 30-year retirement, they would need about $2.5 million dollars to be able to afford to take no risk. They could hold cash in savings deposits and deplete their assets over time without any volatility. Most people do not accumulate enough to fund a risk-free retirement, so they must introduce some level of risk to increase their expected returns..

The right amount of market risk in a portfolio is sufficient to hopefully meet the goal for the assets without introducing the potential for catastrophic failure due to large declines at the wrong time. There are rules of thumb out there, like having 100 minus your age in stocks, but they have little basis. Truly there is no optimal answer, but there is little debate that expected returns and expected volatility are highest with a 100% equity portfolio, and investors might add in bonds to match their ability, willingness, and need to take risk.