The fifth installment of our Ask Me Anything sessions begins with the inevitable volatility of the stock market as we urge investors to remain calm amidst recent US stock declines. Similarly, we unpack the historical resilience of stock markets and offer advice for dealing with market crashes before discussing why bonds are not the best strategy for boosting returns. We examine the proposed Alberta Pension Plan, the Rational Reminder Podcast guests whose impact still ripples across PWL, how to be a PWL-style advisor, and we revisit the DFA versus Vanguard debate. We also explain why spending rules aren’t for us at PWL, the relationship between the amount to withdraw and the stock/bond allocation, and alternatives for short-term horizon investing, saving, and equities. To end, we hear feedback from Atti Ilmanen as well as reviews from listeners, but before all that, Mark McGrath shares bittersweet news! Stay tuned for an episode full of reflection, strategy, and insight.
Key Points From This Episode:
(0:01:13) The inevitability of market volatility and the historical resilience of stock markets.
(0:13:04) How to approach a volatile market and advice for dealing with a market crash.
(0:18:06) Why bonds are not a return-enhancing strategy.
(0:21:04) A brief examination of the proposed Alberta Pension Plan.
(0:25:02) Impactful guests who have influenced how we work at PWL Capital.
(0:33:25) How to be a PWL-style advisor.
(0:35:37) Weighing Dimensional funds (DFA) against Vanguard and others.
(0:41:57) Why spending rules aren’t really our thing.
(0:44:56) The relationship between the amount to withdraw and the stock/bond allocation.
(0:49:50) Exploring alternatives for short-term horizon investing, saving, and equities.
(0:57:00) An important announcement from Mark!
(1:02:51) The Aftershow: feedback from Antti Ilmanen, listener reviews, and final thoughts.
Read The Transcript:
Ben Felix: This is the Rational Reminder podcast, a weekly reality check on sensible investing and financial decision-making from three Canadians. We are hosted by me, Benjamin Felix, Chief Investment Officer at PWL Capital, Dan Bartolotti, Portfolio Manager at PWL Capital, and Mark McGrath, Associate Portfolio Manager at PWL Capital.
Mark McGrath: All right. Fifth AMA, I think?
Ben Felix: Fifth AMA episode. Episode 353. I think we have some good AMA questions to go through. We do also have some comments on the recent market volatility that are hopefully still relevant by the time this episode comes out.
Mark McGrath: Hopefully not.
Dan Bortolotti: Actually, I hope they're not relevant by the time this episode comes out.
Ben Felix: That's a very good point, Dan. It's been crazy though, up and down. We do also have a segment after the AMA from Mark where he's going to reflect a bit on finding and funding a good life. And he's going to share some bittersweet news with us. So, make sure you stick around for that. And then at the after-show, we have some insightful feedback from a past guest, Antti Ilmanen. He sent me an email with some really good comments. We've also got a nice review, an email from a listener and a physical postcard that we'll read out from a listener. All right.
[EPISODE]
Ben Felix: We're recording this on April 10th. And like we were just kind of joking about, it's hard to know whether markets will have gotten worse or better by the time the episode is released a week from now. But we wanted to provide some comments and perspective anyway. I think a big piece of perspective on market volatility is that situations like this are normal. This is part of investing in stocks. This is going to happen always. There's not a whole lot we can do about that. They happen fairly frequently too. If you look at how often market returns are negative for US stocks, going back to 1926, it's about 25% of calendar years that have a negative annual return. Bigger declines of 20% or more, which is kind of the unofficial definition of a bear market, are a little bit less frequent, but they're still not uncommon by any means.
Now when they do happen, they tend to recover eventually. Not necessarily immediately like we saw with the COVID crash, but they do tend to recover. And that's one of the reasons that asset allocation has to be informed by your financial plan. You don't want to be in a portfolio that's too risky for your time horizon.
I think another important thing to keep in mind is that negative in tri-year returns don't always predict negative returns for the year. We've got 25% of years have negative returns, but a lot of years have negative returns at some point during the year and then finish the year positive. People thinking, "I'm going to get out of the market now." That may feel like the right thing to do at the moment, but it's not necessarily true that we're going to finish the year on a negative note.
Mark McGrath: Wasn't COVID like that? Was it 2020?
Dan Bortolotti: 2020 was exactly like that. Finished positively even though it had a 30% decline in there in the spring.
Ben Felix: Absolutely wild.
Dan Bortolotti: I think 1987 was like that too at a Black Monday in October.
Ben Felix: Yeah, the flash crash.
Dan Bortolotti: 20% decline in one day and the year-to-date or the full calendar year was still positive.
Dan Bortolotti: Crazy.
Dan Bortolotti: If you blink, you missed it.
Ben Felix: Yeah. One of the challenges with market drops is that everyone feels different and it's never obvious that things are going to get better. And there's always a narrative that surrounds the crash. And the narrative is typically scarier than the relatively abstract idea of the number went down, although the number going down can be scary too. But I think the narratives are fundamental to market crashes.
Economic data are pretty boring. I mean, the impact of tariffs, we have no idea what that's going to look like from an economic data perspective. We won't have that data for months to come. But the narrative is always this time is different, that classic phrase. That's always the beginning of the end of the world as we know it because of whatever the crisis of the day is. And that's what moves asset prices really quickly. And that's what gets people nervous and excited and not excited in a good way.
To get through situations like this, it's important for investors to understand the historical resilience of stock markets. We have a lot of that on that, which we'll speak to, the power of narratives to make people behave badly and feel anxious despite the data. And then I think people really need to understand their own tolerance for risk, and then situations like this can be a pretty good opportunity to learn about that.
On the data, as far back as we can go, which admittedly is a relatively small sample still, we can go back to 1900 in the DMS data. There are a couple studies that go back to 1600s for a couple of individual countries. The Cedarburg data go back to 1890. It kind of no matter how you slice it, stock returns have been positive over long periods of time, going back hundreds of years, over periods of time where a lot of crazy stuff has happened in the world. I think that's number one piece of information to understand is that if history is any guide and maybe it's not, but if history is any guide, and it probably should be to some extent, things will be okay eventually.
Now that doesn't mean stock markets will be volatile. They have been historically and will continue to be, and they're not risk-free in the short run for sure, but also in the long run. I'm not saying stocks are guaranteed to give you good long-term outcomes. We have to expect that there will be years or groups of years with negative returns. That's completely normal.
The reason that stocks have positive expected returns and have had positive realized long-term returns is because they are risky. It's part of the game. It's a feature, not a bug. That's why we get the equity risk premium. You wouldn't expect that if they weren't risky. And that's kind of why they're great long-term investments for people who are able to take risk.
Dan Bortolotti: One of the most interesting things that I remember learning during my sort of years of studying the markets and market history was just how volatile stock returns are and how much people under-appreciate that. If you look, for example, at what's the average long-term rate of return for stocks somewhere in the ballpark of 8%, let's say. But the number of years where stock returns have been, let's say, somewhere between six and 10% is very, very small. They're usually very high or very low, and they average out to that 7%, 8% over the long term. But this idea that they tend to tick up 7% to 8%, even if you look at three to five year periods, it's not true. And you have to be in the market all the time if you're going to get those average returns. And that means you have to deal with events like this.
And yeah, they hurt, but they quickly make people forget that we got double digit returns for the two years previous to that. So this idea that if we just kind of hang on even over two, three year periods that returns average out, they just don't. You have to go out 20, 30-year rolling periods before you see that average start to become consistent. This really is par for the course. And yet it's just amazing sometimes how the media makes it sound like it's something unique every time it happens.
Mark McGrath: And that goes back to something you were saying earlier, Ben, around the narratives, and this time is different. It's different every time. That's the entire definition of a block swan is you can't see it coming. If we could see it coming, then it would probably be a much more tepid response and there'd be things you could do in advance to kind of temper the volatility. The event that drives the volatility is always different. It's, to your point, Ben, the reactions. What does that mean for markets? Well, markets are going to be volatile, markets are going to go down. And to your point, they're resilient over long periods of time.
I think that this time it's different feeling that investors get is reacting to the actual cause of the crash. But in terms of is it different this time in terms of how stocks are going to perform, assuming a long-term diversified portfolio over long periods of time, when we say it's not different this time and stay the course, we're talking about the portfolio itself, not the actual narrative.
Ben Felix: Yeah, definitely. This is something Robert Schiller's talked a lot about, obviously. That's his whole thing, is how narratives affect asset prices. He's got a paper where he explains how narratives played roles in a bunch of past economic events, and there's one that jumped out of this just kind of interesting reading the paper. In the 1920-21 US recession and end stock market decline, they had had World War I ended 14 months prior. They had had the 1918 flu pandemic, the effects that were still lingering at the time. The US had been dealing with race riots, and there was a public fear of communism growing.
There's a book called The Great Depression: A Diary by Benjamin Roth, and it's literally a diary. I think it was the guy's son or grandson that turned it into a book, but it was a diary of a lawyer who lived through the Great Depression. And he writes this firsthand account of just what's happening, and what people are thinking, and what the narratives are. And this is a different time period from the 1920-21 recession that we're talking about. But it's just such an interesting perspective because it's a first-person view of what people were thinking.
He talks about how it wasn't obvious to people at the time that the American political and economic system was going to last. And same thing, like you think about this 1920-21 situation, and Robert Schiller talks in this paper about how it wasn't just like, "Oh, the market's going down. This sucks." It was like what we're doing here as a country might not be working and we might have to change it in a material way. You put yourself in those shoes and the market declining is not such a big deal, but the market is declining because of much larger narratives that are affecting how people think about the future.
Of course, it wasn't that long ago that we all lived through another pandemic, a more recent pandemic that did shut down the global economy. We all remember living through that because it was relatively recent. We didn't know if things were going to go back to normal. We didn't know how bad it was going to get. Beginning of COVID, nobody knew how serious the disease was. And that was scary. And markets crashed like crazy so quickly. But here we are.
Today, we're living through this trade war situation. Most economists agree that tariffs are not good for the economy. And the stock market has clearly been expressing its agreement with that sentiment. Tariffs reduce expected earnings for a company, trade policy for companies. Trade policy uncertainty increases risk for companies. We're seeing the effects of that at stock prices. I don't want to get into the politics, but we all know why this time feels different. I think everyone kind of gets it.
Mark, to your point earlier, I'm not discounting the possibility that this time is different, but every time is different in its own way. That's kind of the point. That's why it's a crash. You said this earlier, Mark. If it wasn't different, it wouldn't be a crash. The other interesting thing is Will Goetzmann talked about this when he was on as a guest a while ago. Global financial markets have seen periods of financial globalization followed by contraction. I'm not saying that's what we're going to see now, but that's one of the effects that tariffs can have.
In the early 1900s, there were active stock and bond exchanges in at least 40 countries around the world, and developed country investors like European investors, very similar to investors today, were being urged by experts to internationally diversify their portfolios. There are people writing books on this and guides for investors on how to diversify and why that was a good idea. There's really a golden age for investing in the early 1900s and really, from reading the accounts of it, seems pretty similar to what we're seeing today, where a lot of retail investors are able to access the market and they are investing globally. But then everything changes starting with World War I. Global finance really contracted. There was a lot of protectionism and tariffs. It's eerie to see the parallels to what's happening right now. Communism and fascism saw a big rise. Some stock markets over this period closed temporarily. Some closed permanently. It was a bad time to be an investor. Returns were not great. Is it going to get that bad again? Nobody knows that. I don't know.
But despite those rough years of the contraction of global finance in the early 1900s, and even through to the mid-1900s, and including the total market closures and total losses for investors in Russia and China, global stock markets have been resilient. I could come back to that long-term data we talked about earlier. Despite those crazy things happening, returns have been okay for long-term investors, especially if they've been diversified.
The other interesting thing here is that every crisis is unique, and that's why it's a crisis, and the narratives are always different. But those situations, their effects on markets and markets recovering are a phenomenon that have been around as long as financial markets have existed. There's a paper from Will Geotzmann, 2017 paper called 'Negative Bubbles: What Happens After a Crash?" They study 101 global stock markets from 1692 through 2015. And they find 1,032 events where market declined by more than 50% over a 12-month period. And they find that those extremely large declines are typically followed by positive returns. That's just another example of we're probably going to be okay. Panicking is not good.
Dan Bortolotti: I think we all remember the 1692 crash.
Mark McGrath: Like it was yesterday.
Dan Bortolotti: I still feel scarred from that one. But markets really did rebound in the early 18th century. So I'm taking comfort from that.
Ben Felix: Yeah. Remember it like it was yesterday. I do think it's worth considering what should you be doing? It's almost dismissive to say just do nothing. It is really interesting to think about assessing your own risk composure, which is one of the elements of a risk profile, which is really just asking, "How do you actually feel right now?" Because people have not been through proper crash. May not know. And I don't know if COVID counts because it came back so quickly. Who knows how this one's going to play out?
But checking in with yourself, are you as risk-tolerant as you expect it to be? Or maybe are you more risk tolerant than you expect it to be? Maybe you chose a more conservative portfolio because you weren't sure and now you're just sailing through this psychologically. But likewise, on the other hand, if this is really stressing you out and you're not sleeping, then it's a really good time to assess your risk composure, which can change your risk profile.
One of the things Ken French said to us back in episode 100, that was a period of market volatility too. I can't remember what was going on. But Ken talked about this. He talked about how you don't want to change your asset allocation because you’re market timing. But if you're in a really aggressive portfolio and you're losing sleep during a market decline, that might be a sign that you should change your asset allocation. Not because you're timing the market, but because you can't handle downturns and you've learned something about yourself. I think that's an action people can take.
There's other stuff too, like tax law selling, rebalancing. And then another big one is just revisiting your financial plan. Updating the plan. A good financial plan should be not immune to, but pretty resilient to market volatility. But it's still, if anything, probably reassuring to check in with the plan.
Dan Bortolotti: It's a good reminder, too, for people who are close to retirement or in retirement. And again, maybe this goes against some of the discussion we've had on the pod recently about 100% equities being optimal at all time horizons. But we certainly get it from clients saying, "Do we need to do anything? We're making withdrawals from the portfolio. Is this something we need to stop doing because the markets have gone down?"
And we have to remind them. I mean, we take it for granted, I think sometimes. But we say to people, "You know, that's the reason why you have cash, GICs, bonds, some say fixed income investments in there to provide you with a buffer for a couple of years of cash flow." And the answer should be, "No, we don't need to sell stocks after a 10, 15% pullback to send it to you for your daily spending." If we're doing that, then chances are the plan wasn't very thoughtful.
It always irks me when I hear people say people are going to have to reconsider their retirement based on what happened last week. And I'm like, "Why? How is it possible that your retirement was based on the possibility that your plans could be torpedoed by a 10 or 15% market decline?" That's just a bad plan. I think we have to be careful to see all of these things in context and recognize if we know these kinds of crashes are going to happen periodically, and I think we all accept now that it's going to be the case, then you need to build a plan with a bit of a buffer so you can ride it out.
Mark McGrath: If you've stress-tested the plan, then these are the events that you stress-tested.
Dan Bortolotti: Exactly. We don't know where we're going from here. Again, it's April 10th, and it's been a wild week or 10 days, but we don't know where things are going. But it's funny the way you just described that the change in risk tolerance and risk composure, Ben. Because I sent virtually the same email to a client this morning. Yesterday, markets were down heavily. Email saying, "Sell my US stocks." I said, "I don't think you want to do that." And he was adamant, "Sell X amount of US stocks." I was like, "Okay, if I can't talk you off the ledge, then I got to do it." And then the announcement of the tariff pause game for 90 days. Markets went up. The swing was something like 10 or 12%. I email him back. I'm like, "Are you sure you want to do this? Markets just reversed in the most dramatic sense that I've ever seen." He's like, "Oh yeah, good call. Hold off." I'm like, "Okay, here we go. This is the return-chasing conundrum. Stock markets are down, let's sell. Stock markets are up, don't sell."
This morning, markets are down heavily. I think they were down at one point or 6% in the US. He emails me this morning saying, "We need to reduce the risk in our portfolio. We're not comfortable with this volatility, so we want to reduce the risk, and then we will reassess things stabilize." I'm like, "Ah, no. Here's what we're going to do. You want to reduce the risk because you find that the portfolio is too aggressive for your tastes, your profile, your risk profile. We can certainly reduce the risk in the portfolio overall, but we're not going to re-up the risk when markets stabilize because this is a pure market timing function. If we're doing this, then we're just literally selling low and buying high. Because by the time markets stabilize or the economic data stabilizes, stocks will more than likely have already led that recovery. To your point, Ben, if you have a fundamental change you need to make to your overall risk tolerance, your risk profile, your asset allocation, do that, but then you should be able to sit on that portfolio through the next type of event.
Ben Felix: Totally agree with that. That's it, I think, for the market volatility. I just thought it was important for us to say a few words about it because I'm sure it's on people's minds. Although, I did see a comment on our episode with Jessica Moorhouse, Dan, saying that it was a nice break from all of the market volatility talk.
Dan Bortolotti: That one was a nice break from a lot of the things that we do normally, and yeah, it was refreshing.
Ben Felix: We'll jump into some AMA questions here, see how many we get through, and then we'll head over to Mark's piece after that. All right, first one. I'll read it out. What is the probability that, over a period of 10-plus years, an addition of bonds to a portfolio will enhance returns? We've answered questions like this before, and then it goes on to ask about international bonds and whether that would change. I mean, it's possible for these to get repetitive. Hopefully, that's not too much of an issue, but I also don’t want to skip people's questions. Bonds are not expected to enhance returns. That's not why they're part of a portfolio. Dan, you talked with us a moment ago. They reduce volatility in nominal terms. They provide a buffer.
If you build tips on inflation-protected bonds latter perfectly match to your liabilities, that's pretty close to a risk-free asset. It might actually be volatile if you have long-term tips in there, but it'll perfectly hedge your liabilities if it's set up properly. But again, that's not a return-enhancing strategy. Bonds do offer exposure to distinct risk premiums like term and credit. But again, it's not expected that even a tilted bond portfolio, at least if it's not leveraged, is going to outperform stocks.
Now, the question asks about whether they serve any purpose other than being a behavioural anchor. I don't think that a behavioural anchor should be discounted in any way. It's very important, especially when we look at times like we're living through right now. Bonds have held up fairly well this year despite what's happening with the stock market. The main message here is that bonds are not return-seeking assets, and that should not be the expectation or reason to allocate to them.
Dan Bortolotti: It is interesting how often it comes up though, right? Somewhere along the line, when people have thought about diversification, there seems to be that they have inferred adding bonds to a portfolio will somehow reduce risk and increase returns, which is sort of classic efficient frontier thing. But yeah, it's just not the case. I mean, I guess at the margins, you could argue that what is the sweet spot? Something like 20% stocks, 80% bonds has a lower volatility than 100% bonds without sacrificing return. But that's adding stocks. That's not adding bonds.
There's really no portfolio that has a higher expected return once you add bonds. So you just need to accept that. You will have less volatility. You might have higher risk-adjusted returns on some level. I guess it depends on the mix, but they're not there to enhance returns, period. They're there to help you behave yourself when the market falls 30% and you're inclined to sell.
Ben Felix: That risk-adjusted returns piece is probably what people are thinking about when they ask this question. They probably remember seeing an efficient frontier in a finance class or something like that, but that's a very specifically risk-adjusted returns and very specifically adjusting for risk as volatility. But even then, you would be levering up that optimal risk-adjusted return portfolio to the expected return of stocks. You don't get the higher expected return just by combining the two assets together. Next one. One of you guys want to read it?
Mark McGrath: Sure. You've spoken lots about CPP, Canada Pension Plan, and the value of it for Canadians. Do you have any thoughts about the proposed Alberta Pension Plan and the ramifications it could have if actually implemented? You have to do this without getting political at all, Ben, remember. Politically neutral.
Ben Felix: I was going to say, I always want to avoid political topics. I just don't think they're super productive to discuss on a podcast like this. But I also don’t want to skip this person's question. I think there are lots of interesting actuarial questions in there. All else equal, what Albert's demographics result in better payouts for its plan members if they have their own pension plan, which I think is one of their claims. I don't know if I can speak to that intelligently.
I think there are also pretty interesting questions about how CPP would be split up if Alberta did exit. Again, I don't really have intelligent comments on that. Assia Billig, Canada's Chief Actuary, has commented on that question, and I think she disagreed with Alberta's analysis. That's an interesting thing to read about, but it's not something I have a lot to say about.
I think there is an interesting question from an investment perspective. CPP investments, which we've talked about in the podcast a few times, their fees are probably higher than they need to be for such a large plan. They employ more active management than I would if I were managing a similar fund, but they perform reasonably well. They've marginally underperformed their reference portfolio benchmark, which is an index benchmark, gross of fees, and they've marginally unperformed at net of fees.
One of the obvious candidates to manage an Alberta pension plan is AIMCO, the Alberta Investment Management Corporation, which is a Canadian Crown corporation established to manage several pension funds in Alberta. Now, this almost gets political on its own, I don't know. But AIMCO's returns have been not very good relative to CPP investment's returns. They're trailed by a pretty meaningful amount. They've also had a big management shakeup recently. They've had some pretty famous blow ups in some of their investments. AIMCO had a volatility trading program that blew up and cost the plan about $2.1 billion.
Now, I'm not saying CPP is immune to that stuff and maybe some of their private investments won't go well at some point. I don't know. But if you look at the data, CPP had outperformed AIMCO by a wide margin. Maybe they'd find somebody else to manage it or maybe they would just use index funds. I don't know. But I think CPP is a pretty good plan. Ripping it apart doesn't seem like a great idea.
Dan Bortolotti: I really don't see the advantage of so much separation on provincial grounds between things like that. I mean, Canadians move from province to province. They're going to contribute to one plan for part of their careers and another plan for another part. There's a separate plan in Quebec. Again, it's so similar in many ways in terms of its payouts and its premiums and whatnot. It would just simplify a lot of things.
I frankly think a lot of things in Canada could be simplified by not having provincial regulations and just having kind of one national regime. I don't know if that's a political statement in general. It is meant to be. It's just a matter of logistics and consistency. That's all it is.
Mark McGrath: I don't like this idea that Alberta or any province has contributed more to CPP, right? I mean, there's absolutely no subsidy from the province to CPP whatsoever. Individual people contribute to the plan and individuals gain the benefit as a function of what they as an individual contributed to the plan. If you want to stop there, you can get down into the municipal level and probably find that some cities have contributed more. Should they be taking out their portion of CPP to manage a municipal pension plan? It just doesn't make any sense to me that we need to put some kind of admissible border around it based on the province itself. And to your point, Dan, I think people move.
When this has been looked at as far as I know it, I think this is mostly based on the fact that Albertans contribute more to CPP right now because they have maybe a younger demographic. But people tend to retire outside of Alberta. And so they're putting in technically today more than they're getting out of it, but they're not tracking people who've left Alberta to retire in Vancouver Island. It's all based on kind of pretty wishy-washy math. That was political, I think. I apologize, Ben.
Ben Felix: Yeah, that was a little political. It's all right.
Dan Bortolotti: All right. Next question is, has there been a guest who got you to tweak your own or PWL's approach to investing in financial planning? Which one was the most impactful?
Mark McGrath: You probably got your own answers, but I'm just going to off the hop say that when we interviewed Andrew Chen about factor investing. That one, I remember, Ben, you and I interviewed him. And then when he signed off the call, I kind of looked at you, it was like, "Did he just kill factor investment? Is that it? Do we have to completely rebuild all the client's portfolios?" It was very clear, very well evidenced in his research, and I was like, "Oh man, can you go talk to him please and ask him what we should do now?" That was a bit of a light bulb moment for me.
Ben Felix: Yeah, that was a good one. One of the most provocative guests we've had is got to be Scott Cedarburg. I mean, it shows up in the Rational Reminder community where every time we do an episode with Scott, the discussion thread is hundreds, if not thousands of comments, which is many more than a typical podcast episode. And it's every single time he's on, it's like that. It's really an intentionally provocative topic. I mean, the title of their paper is 'Challenging the Status Quo', or whatever the title is.
Mark McGrath: 'Beyond the Status Quo.'
Ben Felix: 'Beyond the Status Quo." That's right. Yeah. I think it's had a few different titles. That's 'Beyond the Status Quo'. Now, I don't think that research has changed our approach because asset allocation is still constrained by risk tolerance and risk capacity. I would say it's probably changed how we talk about asset allocation for long-term investors, at least a little bit.
Now, to be fair, we had already been seeing similar things. I've got a video from many, many years ago talking about the different ways to think about risk in investing. And I did talk about how there's potential for bonds to look riskier than stocks from the perspective of funding your future real liabilities. This is what we've been saying for a long time, but I think that Scott's research really strengthened those convictions. That doesn't mean we're telling everyone to be 100% equity investors for the reasons I mentioned a second ago, risk tolerance and risk capacity. I think Scott's research is pretty provocative. It didn't change my portfolio. It was already 100% equity. Maybe that's why I like his research so much because it's just like hard confirmation bias.
There were a couple of older discussions on annuities. We had Wade Pfau, Moshe Milevsky, Alexandra McQueen on over a period of time. The case for annuities is just so compelling. And so we were like, "We have to do this." And we got ourselves all set up. We even had some software that Milevsky had developed to optimize the annuity allocation for clients. And we built the whole process and we started bringing into client meetings. And clients were like, "Ew. Annuities? No thanks." And we were like, "Oh, okay. Well, that didn't work very well." That kind of died out.
Dan Bortolotti: I think annuities, it's really one of the most interesting behavioural things in personal finance. Think of the pension envy that so many people have. They don't have a defined benefit pension and they're envious and angry about people who have had this opportunity. And yet you can take your RSP and buy an annuity and guarantee yourself a defined benefit pension. And the number of people who do that is vanishingly small.
It's just interesting. If you had presented the other way, if you say to somebody who has the defined benefit pension plan, "Why don't you take the commuted value and invest in your RSP?" Some will, but many won't. But it's the same question framed two different ways. If you've got an inflation indexing component, of course, it changes things fundamentally. But if it's just a sort of flat payout with no inflation adjustment, yeah, it's an annuity. People will sell them but not buy them. It's really interesting paradox.
Mark McGrath: I think very few people are making that decision based on the indexing component as well. I've tweeted about this before that people love pensions and hate annuities, and it's the same thing. Yes, there's a ton of differences between the two of them. But fundamentally, I think there's some endowment bias there. You like the thing you have. You've been contributing to the pension, you have it. Or you've been building your portfolio, you have it. And so you like the thing that you have more than the thing you could buy with it that you don't have. If we had a pure CPI index inflation hedged annuity here in Canada, which we don't, I think they have them in the US, we don't have them here, I think they'd be an incredible financial planning tool for many, many people.
Dan Bortolotti: It would be very expensive, but they would be much more popular, I'm sure. I would say jumping in on this question, one of the ones that I remember really distinctly is the series you did, Ben, with Dr. Mark Soth, which technically wasn't Rational Reminder. It was its own Money Scope series.
For a couple of reasons, I mean just as a reminder for people who haven't listened to it, it focused really heavily on the financial planning challenges for business owners, specifically people with private corporations that they're using as part of their investment portfolio and all of the different ways you could, A, optimize compensation, salary versus dividends, et cetera. And also, what makes the most sense in terms of building your portfolio in the corp, versus an RSP, versus taking the withdrawals from the corp and making TFSA contributions?
And it was extremely complex, for sure, which was part of the message, I think, was this is so complex and so difficult to model that you really have to temper your expectations because it's almost impossible to figure out what the optimal decision is. One of the important takeaways for me was this idea that you really want to take advantage of all three of those account types, corporation, RSP and TFSA as what you were calling tax diversification. Because this came up during the proposed changes to the capital gains tax rules and they were going to affect corporations differently from the way they affected personal accounts in ways that nobody could have predicted.
You could have built up a million dollars in your corporation and then the government changes the rules. And now your supposedly optimal plan is no longer optimal. One of the ways you can get around that is to take advantage of all of those different account types. And that way, if the government changes the tax rules on one or the other, you're not all in or all out. I think that's a really important thing that we have to take in mind or keep in mind for the financial plans of business owners. In a way, I didn't really appreciate it in that context until you guys discussed it. That one was eye-opening.
Ben Felix: Dr. Soth is a smart dude. I learned a ton working with him on that.
Dan Bortolotti: He really is.
Mark McGrath: It's really a form of concentration risk. That's how I've always framed it with clients. It's not concentration risk the way we think about it with a portfolio of four stocks, but it's a tax concentration risk. And this comes up all the time with accountants who historically have primarily paid their clients a dividend instead of a salary. That means there's no CBP contributions, there's no RSP room, and they end up with a disproportionately large corporate account. And then boom, one tax change has a very disproportionate effect on your overall financial plan. So I've always agreed with that. I'm a big fan of it. It's very difficult to optimize, but just the risk reduction I find in having a diverse set of accounts that you can draw from and the flexibility of having that, being able to choose which account to draw from when, huge financial planning benefit.
Dan Bortolotti: Participating in the CPP is a good point, too. Not opting out of it because you think it's going to be better to retain more in the corporation. Yeah, unless the rules change. And all of a sudden, you look back and you wish you had that CPP income as well.
Ben Felix: Yeah, that happened too with the recent proposed that ended up not happening, capital gains tax increase. But then there was the passive income limit. When was that? 2015 or 2016?
Mark McGrath: Was that before TOSI? That was the first one that changed, or was TOSI the first one that changed?
Ben Felix: Wasn't it TOSI first? And then passive income after that? I don't know.
Mark McGrath: I think it was TOSI first, and then the passive income. And TOSI is taxed on split income. And we don't need to get too deep into it, but it's just another example. And I'm sorry, I'm probably cutting you off here, Ben, but it's just other examples of changes to the taxation of small businesses that would have disproportionately affected your financial plan if you'd retain too much in your business and didn't take advantage of other accounts.
Ben Felix: I mean it's similar, I guess, to what we're talking about, the account diversification. But there are people who had everything in their corporation that never used an RESP. This was the one I'm thinking of, is there was TOSI that happened, which is tax on split income. Prior to that, you could pay a dividend to a child. And so there are people who retain everything in their corporation and then fund their education by paying them dividends. And all of a sudden, TOSI goes away. So you can't do that anymore. And then not long after that, the passive income rules change where it becomes less tax efficient basically to retain everything inside your corporation.
And so now you have people who had retained everything in their corporation with the intention of using that money to fund their kid's education, never using the RESP. Those rules change and that plan gets completely blown up. That was such a good example of the tax diversification. Well, in that case, lack of tax diversification.
I’ll read the next one. How to be a PWL-style advisor, evidence-based investing, financial planning-centric in the context of working for a large financial institution? There are communities of advisors. Mark, you and I are both members. Dan, are you a member too of FPAC?
Dan Bortolotti: Yeah.
Ben Felix: Okay, I thought so. We're all members of FPAC. It's a community of advisors who think, I think, largely the way that PWL does, but they're dispersed across multiple firms, but it's a community of like-minded people. They help each other out. There's a forum where they discuss financial planning problems. There's definitely communities like that that you can be part of. I also have to do a shameless pitch here, though, that PWL has built themselves to attract advisors who are in that situation and want a firm to join that is focused on exactly that, on evidence-based investing and taking a financial planning-centric approach. If you're at a bank and you have a constrained product shelf, I think it's going to be hard to use index funds or dimensional funds. That's a tough situation to be in if you believe that is what is best for your clients.
And even if you're an independent dealer, but you're surrounded by people using actively managed funds and alternative investments, that can also be a difficult position to be in. If you have beliefs similar to ours, I would say that just come join the mothership. We've built it. So, come on over.
Mark McGrath: It's tricky. And I've been in that position before where you're kind of handcuffed in a way. I think the evidence-based approach that we take and that PWL takes doesn't only apply to portfolio management. Perfect example is what we were just talking about the Money Scope podcast with Dr. Mark Soth. It's a very, very nerdy deep dive on some of this stuff, but advisors historically and still to this day often just use rules of thumb for decision-making for their clients. Where at PWL, from a planning perspective, it's taking a very evidence-based approach to this kind of stuff.
I agree with you, FPAC, which stands for the Financial Planning Association of Canada. Great place to find like-minded financial planners and advisors. And just the fact that this person is emailing you and us to ask that question means they're a listener. And so they're doing their best to incorporate some of the ideas, Ben, that you've been talking about for years. I think that's a good step. But sometimes you're just handcuffed in terms of what products you can use and you just have to pick amongst the best available option and then try to apply a more evidence-based approach to the rest of your practice like the financial planning stuff you do. But also, come join PWL.
Ben Felix: Thank you, Mark.
Mark McGrath: Yeah. I'm sorry. I wasn't trying to de-pitch there.
Dan Bortolotti: All right. Who wants to take the next one?
Mark McGrath: I think it's my turn. I'll read it. Could you explain in simple terms the difference between and why you would recommend a DFA fund, a Dimensional Fund Advisor's fund, over something like VEQT or VGRO?
Ben Felix: These questions were submitted before we had our epic factor versus market cap weight debate, Dan.
Dan Bortolotti: Yeah, I feel like we discussed this one at length for sure.
Ben Felix: It was also before we did our DFA versus Vanguard episode. We've covered this topic quite a bit since the question was asked. But as a very broad summary, I would say it boils down to two distinct reasons for why you would pick DFA over something like Vanguard. One is higher expected returns, which is a theoretical construct that has borne out in some cases historically. But for many recent years, it has not. Dimensional tilts towards stocks with theoretically higher expected returns, which empirically, in a lot of cases, at least over the long run, have worked out, including in the live funds. Quite a few of their funds have been able to outperform a Vanguard market cap-weighted fund, but also a style benchmark. We talked about that in some detail in our DFA versus Vanguard episode.
We expect for financial planning purposes about 40 basis points of access return net of fees, which is not a huge number. But if it works out, it is meaningful enough, at least, that we think it's worthwhile. The other reason is multiple sources of expected return. Even if we assume that the net expected return is the same as a market cap-weighted portfolio, I think having multiple sources of expected return can be nice in periods like 1968 to 1982, which is a pretty long period of time where US market cap-weighted real returns were about zero for the full period.
Likewise, 2000 to 2010, the lost decade, where US market was flat for 10 years. In both of those cases, small-cap value stocks performed quite well. So even if we assume that they're overall going to have the same return, I think the fact that you're going to get returns at different times from different sources of expected return is worth something. I think Dimensional calls it reliability, reliable long-term outcome.
Japan is another one. 1990 to today, it's been basically flat. Below the returns of T-bills, which is pretty crazy. But again, Japan's small-cap value and value have performed reasonably well over that period. Now, it's not a free lunch. It has not paid off for quite a while now, at least in the US market. It has in international markets. But it sucks when the market cap-weighted portfolio is doing really well and small-cap value isn't. That's not very fun. And you're always going to have tracking error. So you're going to have periods where you underperform. And your performance is going to be different year-to-year. And that likewise can be just not very fun. Because like it or not, people benchmark against market indexes because they're very visible. It's what's talked about in the media. And if your performance is different from that, that can be challenging.
I sit on an investment committee and I've talked to a couple other investment committees just as a volunteer. This is an interesting thing to think about. I don't think that I would ever tell an investment committee to use Dimensional funds because investment committees are groups of people typically with varying levels of financial knowledge and sophistication. We're all just working in the best interest of an organization that they care about, which is why they're on the committee. But tracking your own investment committees is one of the worst things that you can have because investment companies care about their performance relative to a benchmark. You've got these groups of people with different levels of knowledge. If you're underperforming the benchmark, that's just a red flag. That's bad. You have to have a ton of conviction to pursue a strategy like Dimensional. If you don't have that, which I think it's really hard for a committee to build, which is why I think that's an interesting example, I don't know if I would do it at all.
Mark McGrath: Most of the committees I've seen at least, I've only sat on one, used a whole bunch of crazy active funds and alternative investments and that type of thing would hire and fire managers when they underperformed or when tracking error was too great. I agree with that, Ben. But the funniest thing is they often have difficulty just accepting an index fund portfolio at the same time.
Ben Felix: I'm living through the same thing 100%. That is also a challenge. But the tracking earpiece is similar to what I've seen, Mark, where there's a lot of active funds. But what happens to the active funds? They get selected based on their five-year past performance, and then they get re-evaluated based on the three-year performance. And if they underperform, they get fired. New managers get added. This is just the institutional cycle of active manager selection and termination. Index funds are also a hard sell. It's a weird paradox or something.
Dan Bortolotti: We've talked a lot about it. I would refer the questioner back to our previous podcast. But I think it may make sense to just say, as a default, as a starting point, think about the cap-weighted all-in-one ETFs and only look at a factor tilt portfolio after you've put in the work to understand it. Because if you stop at the expected returns 40 basis points higher and you don't go any further, you're going to be disappointed and you're not going to stick with it.
Ben Felix: 100%.
Dan Bortolotti: Put in the work, understand it. Once you're comfortable with the risks, then, make whatever decision you want and stick with it.
Mark McGrath: And I think the other thing to consider in a lot of decisions like this, it's all about trade-offs. And stuff like this comes up all the time. Should I invest or pay down debt? If you need to, just do both, right? And then you can just anchor to whichever one's doing better in that time period. You're not going to get an incredible excess return out of a factor-based portfolio if half of it is in something like DFA and half is in VEQT. But the point being, you want to minimize regret at the end of the day.
And so if you're going to buy VEQT and then factor-based portfolios do really, really well over the next five years, you're going to regret your decision and vice versa. Oftentimes in these decisions with clients even, I'll just be like, "Oh, let's just do both." And then you can just feel good about whatever is working in that moment.
Ben Felix: I like that starting point of just using the market cap-weighted asset allocation ETFs. I've said this in the podcast a couple of times now. If I were a DIY investor and didn't have access to Dimensional or PWL to manage my portfolio for me, I would be using one of those asset allocation ETFs. I would not tinker with the factor tilting. I believe that it makes sense. I currently use Dimensional funds for my personal investments, and I will not change that unless for some reason I was forced to. But if I did not have access to them and I had to go and buy each individual ETF and deal with the foreign exchange and track my adjusted cost base and all that stuff, I honestly wouldn't do it. I would just buy the single ticket Vanguard or iShares' ETF.
Mark McGrath: Not TQQQ?
Ben Felix: Yeah. Probably not, Mark. I can live vicariously through your son for my TQQQ exposure.
Mark McGrath: Perfect. I'll keep you updated.
Dan Bortolotti: You can't have too many cues.
Mark McGrath: You can right now. He's down 60% or something. He's getting absolutely lit up right now. But he doesn't care. Okay. On to the next one.
Dan Bortolotti: All right. What type of dynamic spending rules are the most used with your clients?
Ben Felix: I would say we don't use spending rules really at all. I think spending rules are a good way to think about doing quick math. They're also an interesting way to model different types of spending. But for real client situations, clients are too messy. Lives are too messy. Reality is too messy to say we're going to apply this rule. I like modelling variable spending rules because you can see the effect of variable spending and you can show, "Oh, this lets you spend more, or this reduces risk, or whatever." And that's interesting. You can gain insights from that. But to actually apply that to someone's situation, if the market's down one year and a client was going to go on a big trip to see their grandchildren, we're not going to say, "Sorry, your spending rule says you can't do that this year." Tough. This is not how it works. That's not how people's lives are working. That's not how people make decisions. Because if we said that, the client would be like, "Screw you. No, I'm doing this. This is more important to me."
What we do is review clients' financial plans at least annually, in many cases, twice a year, and make adjustments as necessary based on the financial plan. But that's going to be based on the client's situation, the client's priorities, market conditions to an extent at that time. But all those things change. I think financial planning is just much more of an ongoing process and can be captured by any type of spending rule. To answer the question, we don't use spending rules. But we do some form of dynamic spending that is derived from the financial planning process.
Dan Bortolotti: I think a lot of clients impose their own dynamic spending rules. And in my experience, I try to harness that. I agree with you. To me, one of the most unsatisfying financial plans for someone in retirement or close to it is you have to watch the markets. And depending on the performance this year, next year, you have to change your spending. I mean, it's just not something anybody wants to do, and it just adds to the anxiety that people are already going to feel during periods of market volatility.
And it goes back to what we were saying at the top of the show where I was saying, "If your plan is robust, you should not have to adjust your spending just because the markets fell 15% last month. And you don't want to." I'd like to tell people in retirement, the possibility of a market crash is already baked into the plan. You don't have to reinvent the wheel after it happens. We don't know when it's going to happen, but we certainly expect it's going to happen a few times during your retirement. And you don't have to hit the brakes and revisit the entire plan every time it does. That's the one thing. But then people will just naturally do it.
I've certainly inclined to, after a bad year, they'll just say, "You know what? We just decided to take a more modest trip this year. I just feel a little more comfortable. And maybe we'll do it next year." And that's fine as long as it's them who are taking that initiative and not us imposing it on them and saying, "It's a condition of your plan. You must reduce your spending 15% this year." That is not a good outcome for anybody.
Ben Felix: No.
Mark McGrath: Totally agree. Well said. Okay. What is the relationship between the amount to withdraw and the stock/bond allocation?
Ben Felix: If your withdrawal rate is low enough, you can have whatever asset allocation you want. If you're withdrawing 0.1% of your portfolio, I mean, do whatever you want. I think at more, I don't know, realistic or common withdrawal rates, there's some maybe interesting stuff in here. If you look at the Cederburg lifecycle asset allocation paper that he talked about in the podcast recently, they do look for the optimal asset allocation for different spending rules. They test 3%, 4%, which is their base case, 5% fixed spending rules. That's like 3% of the initial portfolio value adjusted for inflation thereafter, 4%, 5%. They also test 4% proportional spending, so spending 4% of the remaining portfolio value each year. That's a variable spending approach called proportional spending. They're using those different spending rules and they're solving for the optimal lifecycle asset allocation. And they find that it's completely insensitive to those different spending rules. It's the same all equity, 33% domestic, 67% international portfolio.
Now, one of the reasons for that is because in that paper they have international stocks, which just perform so much better in real terms than bonds that bonds get booted out of the optimal portfolio no matter how you slice it, as Scott explained to us in the recent episode. Scott does have another paper that's actually a published paper on safe withdrawal rates specifically. This one, they're not looking at optimal life cycle asset allocation, they're looking at safe withdrawal rates.
In that case, it's confusing because they have different portfolio setups. But in this case, they're only looking at domestic stocks. International stocks don't play into it. They look at in the paper different mixes of stocks and bonds, and they ask what the safe withdrawal rate is for those different asset allocations. It's the same bootstrap methodology, as you've heard Scott describe in his recent episode. But in this safe withdrawal rates paper, they're only looking at domestic stocks and bonds. Still the international sample bootstrap, but only the domestic stock perspective, not the international stock perspective.
They sort things by a ruin probability at a 10% ruin probability. They find the safe withdrawal rate is 2.2% at 100% bonds. 2.7% with 20% stocks, 80% bonds. 3.02 with 40/60. 3.15 at 60/40. 3.11. Now we've gone up to 3.15 at 60/40. We're going back down to 3.11% safe withdrawal rate at 80/20. And then down to 2.82% at 100% equity. There is a bit of curvature there. It's not a monotonic relationship. The trend is similar, but the safe withdrawal rates are lower if we go to the 5% failure rate.
In that domestic only sample, it does look like there is a sort of optimal mix of stocks and bonds from the perspective of maximizing the safe withdrawal rate. But again, that's constrained to domestic stocks only. If we add in stocks, it kind of seems like the 100% equity portfolio is insensitive to the amount that you actually want to spend from the portfolio.
Dan Bortolotti: Can you expand on that a bit, Ben? Why is it that if the safe withdrawal number is 3.15% at 60/40, and it falls pretty significantly to 2.82% at 100% equity, what's the argument for being 100% equity in retirement?
Ben Felix: In this case, if we're constrained to domestic stocks only, there's not a very good argument. Because in this case, the increase volatility is eating up a lot of that safe withdrawal rate. Now, if we go back and add in international stocks, because this is all domestic, if we go back in and add in international stocks, it makes 100% equity look a lot better just because international stocks have performed quite well in real terms for long-term investors. And a lot of that is international stocks performing quite well when domestic inflation is high and domestic stocks perform poorly.
Dan Bortolotti: 100% equity volatility is much lower at 33% domestic, 67% international compared with 100% domestic.
Ben Felix: I'd have to go into the papers and look at if the volatility is better or that the expected real return is higher. I'm guessing that the expected return, real return is sufficiently higher in that case to make up for the increased volatility. But with domestic only, the trade-off is not as favourable.
Dan Bortolotti: Interesting.
Mark McGrath: And he looked at domestic regardless of where you live. This isn't domestic just from like Canadian or US perspective?
Ben Felix: That's correct. Yeah. The way that they set up their paper is that it's a representative domestic investor that could be in any developed country, but they sample from a whole bunch of different countries to kind of simulate possible outcomes for a domestic investor in any one developed country. That does answer the question. Scott's paper does answer, but it's also confusing because the one paper only looks at domestic stocks, and then the whole thing kind of changes when you introduce international stocks. There could be some insight there where if we don't have total faith that the international stocks in looking to the future are going to be as compelling of a case as they were in Scott's paper. For reasons like the correlation between international and domestic stocks has increased over time, then there could be some insight in this domestic-only sample.
All right, last one. This is a weird question. This is a common question. I never really know how to answer it. I put some thoughts down, but I'm curious to hear what you guys think too.
Mark McGrath: It's not a weird question. I think it's a great question. I think the answer is a bit tricky.
Ben Felix: I don't mean weird in the sense that it's a strange question. It's a tricky one to think through. Everyone talks about HYSA or alternatives for short horizon investing, saving, and equities, perhaps with some bonds for long-term. How do you go about optimizing for the medium term? Is it just really bond-heavy? Or do you take a fusion of bonds, equities, and HYSA, et cetera? I think the medium term is tough. I think if you have a large fixed liability, large relative to your assets, and you're absolutely required to cover it at a specific time. I don't know what that could be for a regular retail investor, but if that's the scenario, I think covering it with a duration-matched bond probably makes sense. If it's a medium-term liability that's a small percentage of your overall portfolio, you might not actually have to worry about it too much. If it's a large liability relative to your portfolio but it's flexible in the amount and timing, again, maybe you don't have to hedge it perfectly.
There's an old paper from David Blanchett talking about this, why liability matching, asset liability matching doesn't make sense for households because their liabilities do tend to be flexible. You could maybe dollar-cost average out of a portfolio if you know you're going to buy a new vehicle or something like that. Maybe you build up the cash position over time. Or if you're still earning income, that's if you don't have money going into the portfolio, if you're still earning income, you could think about how long you would need to save up to meet that expense and start building the position only when it's necessary, but not earlier.
Mark McGrath: I agree. It's a tough one. You laid out the options really, really well. When I talk to clients about this kind of stuff, it's like, "Well, are you comfortable with the chance that the money that you have invested for this particular goal could be worth 50% less by the time that goal comes?" And that just goes to the point of flexibility. Could you move out that purchase or that obligation? Could you make it smaller than you had planned?
And if the answer is absolutely not, there's this guaranteed cash outlay seven to 10 years from now, which I can't think of a situation off the top of my head where that might be the case. But yeah, then you need something guaranteed. But most of these medium-term purchases are oftentimes like loose goals. To your point, a new car. And the interesting thing with something like a new car is, well, if markets are just completely in the toilet at that time, like, well, then you could finance it, maybe. Maybe interest rates are down at that point because markets are in the toilet, and you do have flexibility in the way you might finance that goal later on.
I don't know that I have a particular strategy that I employ regularly for a medium term goal. I think it often comes back to client risk tolerance, client risk profile. You end up with these bucketing strategies. You've got cash for the short term, 60/40 portfolio for the medium term, and then 100% equity portfolio for the long term. If you take a 30,000-foot view of the portfolio, it turns out you're 80/20 overall. Maybe that's the approach you take with the whole portfolio and then just see how flexible you can be with the goals.
Dan Bortolotti: If there's a real-world scenario that is routinely medium term that we deal with, it's RESPs. I think they're a pretty good example of that. Depends. I mean, obviously, if your child is an infant, then it's much closer to long-term. But if you're looking at how do you invest in RESP when your child is 14 or 15 years old? Well, unless it's triple-leveraged NASDAQ.
Mark McGrath: I wasn't going to say it.
Dan Bortolotti: But I mean, for the rest of us, let's say the child's starting high school, you're several years away from starting the withdrawals, but then the withdrawals will be taken over four, maybe five years, it's hard to nail down what the perfect thing is. I will say for us in practice, we're just going to err on the side of conservative. We will most likely achieve slightly lower returns than we would have if we just put it all in stocks and hope for the best.
In many situations, the risky portfolio would work out well. But what we don't ever want to do is have a situation where the parent wants to take $20,000 out and we have to sell equities when they're down. I mean, it's just not very good planning, I don't think. You look ahead at GICs. If you're going to need it in five years, buy a five-year GIC. It's not really that complicated. You can build a ladder so you have a certain amount of cash available for each year that you expect to take the withdrawals. You can mix in some equities as well to give you the opportunity for some higher growth. You have to understand a little bit about if you're flexible.
For example, a lot of our clients are well-off enough that if it's going to cost $20,000 for a year of school and we take up 15, they can make up the difference. They have other sources of cash. If you're not in that position and you 100% need all of that money, I think you got to err on the side of conservative.
The other thing I would add to that is because the person asking the question talked about being bond-heavy, I think if there's a lesson that we all had driven home in the period between 2021 and 2022, bonds are a lousy short-term investment. And they're even a questionable medium-term investment. And I think we have to get specific here. I'm talking about bond funds. You buy a three-year bond, and yeah, you know what it's going to be when it matures in three years. If you buy a broad market bond fund these days, it has a duration of seven or eight. If you think you're going to need that money in less than seven or eight years, it's the wrong product. And if you've got a time horizon that's shrinking, and I mean that in a meaningful way, like if your retirement is 30 years away, yeah, okay, it's 29 years away next year. But I'm talking about if it's four or five years away, and next year it's getting closer and closer, you cannot stay in that broad market bond fund and not expect that there could be losses over that period.
Bond funds make a lousy medium-term investment, I think, unless you're going really short. A short-term bond fund that might have a duration of two or three, okay. If you have a four or five-year time frame, you can include that in there. But once that horizon gets close, you do not want to be in a bond fund because significant losses can result over the short term.
Ben Felix: I completely agree with that. I think a point that often gets missed by investors thinking about this is the time horizon matters. The proportion of the overall portfolio also matters. Because if you're retiring in five years and you're spending 2% of your portfolio, you don't need to worry about declines in stocks or bonds. If you need to spend 60% of the money that you're investing, then you really have to worry about short-term price declines.
But a retiree who their time horizon before they have to start withdrawing is zero because they're withdrawing from their portfolio now, they still have a very long-time horizon. And if they're withdrawing a small portion of their portfolio annually to fund their expenses, they can still afford to take risk in both stocks and bonds. The medium-term thing is what is the time horizon for the thing that we're talking about? How flexible is it? But also, what proportion of the portfolio is it? And if it's really small, it doesn't really matter. If it's really big, I think you have to to start thinking about some of the stuff that we just talked through.
Dan Bortolotti: This was a really good question actually because I think we've all kind of dealt with it, but I haven't really confronted it and thought about it as deeply as we've just kind of discussed. I think it's a really excellent problem to solve.
Ben Felix: It is. It comes up a lot. What do you do in the medium term? I agree. Glad the listener asked it.
Mark McGrath: After a lot of deliberation, after talking about this with my wife for a very long time, and I'll get into how we came to this decision, but I have decided to step back and effectively move into what I'm calling semi-retirement. I'm doing that as of April 30th. I'll be leaving the firm. I'll be leaving PWL. I'm leaving the podcast. It was a big decision that my wife and I have been kind of talking about this on and off for I'd say about 18 months. This kind of jokingly came up last Christmas. Christmas of 2023, 2024. My sister-in-law, my wife's sister, they live in Europe and they've got no kids and they're traveling around and just having a great old time. He's a photographer. Of course, every time we talk to them, he's showing us all these amazing pictures and my wife and I are kind of like, "Oh, we should go do that. You know, we should go bum around in Europe and hang out with the kids more and do that kind of stuff." We kind of laugh and joke about it.
And the more we kind of talked about that over the past 18 months, the more we thought, "Okay, maybe we're not joking about this. Maybe we should take a look at this more seriously." And I've had a number of experiences in my life that have left me concerned that I'm going to look back on it all and realize I worked too hard and didn't spend enough time with my family and doing the things that I love and spending time with the people that are important to me. Things like the story of my father, which we've kind of recounted on the podcast a couple of times. Even, Ben, the stuff that came up with your health scare recently was really eye-opening to me. I mean, you're like one of the healthiest dudes I've ever met. You're fit, you work out all the time, you eat healthy, you don't drink, you don't smoke, and boom, you can get sidelined by something like a cancer diagnosis. And thankfully, it looks like you're going to be okay. But you just don't know where that stuff's going to come from and when it's going to rear its ugly head. We made the decision.
It's funny, I was watching Hook the other day with my kids. I don't know if you guys remember Hook with Robin Williams. Absolute classic by the way. Still holds up great movie. I haven't watched it in like 20 years. But there's a scene in it, and anybody who's watched the movie will remember it, Robin Williams who plays basically Peter Pan is this kind of big-time corporate merger and acquisition type executive guy. He's got two young kids and he's just spending their whole Christmas holiday like on the phone doing deals and this kind of stuff. And there's a scene where he has a conversation with his wife, Moira, at the window and she's really mad at him and she throws his phone out the window, his work phone, the old flip phone kind of thing. And she basically gives him like a stern dressing down and tells him, "You're missing our. Your kids are only young once. They want you to show up at their baseball games. You're missing their games. You're missing their life." I don't feel that's me per se. It was just really interesting that after I made this decision, I went back and watched Hook with my son and I was like, "You got to watch this movie, man. It's a classic." I did not register that scene at all as a kid. But watching it now after having made this decision, I kind of pointed to my wife, I was like, "Well, that's timely." That's just exactly what we've been talking about.
It's a big decision. I think one thing that you guys are going to find really, really interesting is I didn't even run my own financial plan prior to coming to a firm decision on this. I didn't Monte Carlo anything. I didn't look at different projections. I didn't scenario test, or stress test, or what-if scenario any of this. I have a very good understanding of my own finances, of course, but this wasn't really purely motivated by the finances and whether or not the probability of ruin was 10% on a 3.11% withdrawal rate on a 60/40 portfolio. None of that actually came to the forefront in our discussions. It's like, "Look, we're young, we're healthy. We've done pretty well in our life. We've been very fortunate in a lot of ways. I think we can make this work." And then maybe we'll pick up some part-time work here and there. My wife's an engineer. She can pick up work here and there. But let's do this thing. Let's YOLO and see what comes.
We don't have big plans. I still really want to do a lot of content. I still really enjoy doing content. I'm still going to be on Twitter and social media while we're writing and talking about personal finance all the time. But other than that, we booked a trip to Europe for two and a half months this summer. That's it. And then when I get back, I'll kind of figure life out from there. That's the news.
Ben Felix: Nice.
Dan Bortolotti: Congratulations. It's a gutsy decision for sure. I'm sure it was one that you had to think about and talk about for a long time. And I admire you having the courage to do it for sure. It's something a lot of people talk about in the abstract, but it takes a real commitment to do it. Good on you for doing that.
Mark McGrath: We talk to our clients about this kind of stuff all the time, and we model this stuff for our clients, and we encourage them to think about things this way. And really, at the end of the day, this is all Ben's fault. Because Ben wrote a paper called 'Finding and Funding a Good Life'. When was that paper released, Ben? 2021?
Ben Felix: That sounds right.
Mark McGrath: It's about making decisions in life through the lens of what's going to create longer term happiness for you. Ben always says he references 642 academic papers across different disciplines, and rereading that a couple of times throughout this thinking process of mine was really, really enlightening. And it comes down to me for a few things. Experiences tend to be more important than material things. It seems obvious, but prioritizing for time leads to greater happiness over the long run than prioritizing for money. And people tend to regret the things they didn't do more than the things they did do. And so I tend to try to make decisions in my life by fast-forwarding and then looking back and saying, "Did I make the right decision?" And I just cannot envision a scenario where I look back on my life and think I should have worked more. I should have spent less time with my family and my kids. I think it's just one of those things where it's kind of a YOLO move. You only live once. I don't want to look back and say we had an opportunity to do that and we were too scared or didn't have the courage or just we wanted to make more money and be richer and that type of thing. That's what it came down to.
Ben Felix: Good for you, man. Excited.
Mark McGrath: Thanks. Bittersweet.
Ben Felix: I don't think much will change, but we'll talk to each other on WhatsApp instead of Teams. I guess that's the biggest change.
Mark McGrath: Yeah, exactly. I'll still dunk on you on Twitter when I get a chance. Nothing really going to change outside of that.
Dan Bortolotti: Well, we wish you all the best, for sure. We're going to miss you on the podcast, but it sounds like it's the right decision for your family.
Mark McGrath: Thanks, guys. Yeah, we'll find out, right? In five years, I might be back as a receptionist at PWL, and who knows?
Ben Felix: What did Ben Wilson say?
Mark McGrath: He said he'll keep an operation administrator position open for me.
Ben Felix: There you go.
Mark McGrath: Always got a backdoor, right? Always got a plan B.
Ben Felix: Cool. Yeah. Well, I'm excited to see how it goes, man. I'm sure we'll continue to chat, obviously, but we need to follow how you tell the story publicly as things develop.
Mark McGrath: I'll be writing about it.
Ben Felix: I figured you would be.
Mark McGrath: Yeah, exactly. Stay tuned.
Ben Felix: Cool.
Dan Bortolotti: Good stuff.
Mark McGrath: Thanks.
Ben Felix: We did get his feedback from Antti. He raised a very good point that was omitted from a couple of episodes where it would have been relevant. And it is a point that we've covered before. I just needed a rational reminder, I guess. It's the idea that to evaluate the long-term performance of an investment strategy, you need to consider how the relative evaluations of the strategy have changed over the evaluation period.
We did discuss this in episode 152, which is an episode on evaluating systematic equity strategies. We talked about Rob Arnott has a paper where he discusses this. Cliff Assens has a post where he discusses this. But if a strategy looked really good over a period of time and a large portion of its performance difference over whatever you're comparing it to is explained by rising valuations, you should not expect that portion of the performance, the multiple expansion, to repeat in the future. And if you want to get really spicy on that, you could even take the position that it's going to revert. And so that would have made sense to bring up. And this is why I decided to email in the DFA versus Vanguard episode, because we're comparing the long-term returns of factor-tilted small-cap and value-tilted portfolios to market cap-weighted portfolios.
And over that period, research affiliates as a tool where you can look at this, the relative prices of small-cap value stocks have been pretty stable, but large-cap growth stocks, of course, have increased. Their valuations have increased substantially. At these points, you found that in the US, DFA was less reliably performing Vanguard. But if you adjust for evaluations, how much of the returns of the S&P 500 came from multiple expansion, you would find that DFA's performance looks better. Go forward performance at least looks better because you don't expect the multiple expansion to continue for large stocks.
The other point where he mentioned that this would have made sense to touch on is the renting versus buying in Canada episode, where we did that modelling of renting versus owning in a bunch of cities. And we found there's about 50/50 split across those different cities. But again, at this point is that Canadian real estate price appreciation has been pretty significant over that period. If you adjust for that, or if you do a forward-looking estimate with a lower expected return, you'd find that renting will look better in a lot of those cases. I thought that was good feedback that was worthwhile to share.
Mark McGrath: Awesome.
Ben Felix: Review. One of you guys want to read it?
Ben Felix: All right. The first review we've got here is titled 'Simply the Best'. This podcast series is simply the best financial education available anywhere. It's delivered by unbiased and researched-backed professionals and the best guest researchers and thinkers in the world. I've listened to nearly all of them over the years and it's transformed my ability to confidently manage investments, put money to work towards a good life, and to figure out how to best do that as a newcomer to Canada. Joe Greenwood from Canada. Thank you, Joe, and welcome.
Ben Felix: Very nice.
Mark McGrath: I can read the next one. I just heard your podcast titled Episode 347, The Case for Index Funds. I'm not quite sure how I came across your podcast. It is a bit strange given that I currently live in India and have no direct connection to finance in Canada. Nonetheless, I worked at an index provider until December of last year, in fact, the very same that made the index for the global XETF that you mentioned. You guys were entirely on point about passive products looking more and more like an active fund, but with a more systematic approach. The information you provide is incredibly sane, sober, and useful advice. Global diversification is probably key to ensuring market returns. Market returns are by no means average returns. I would be surprised if over 20% to 30% of people even get market returns. Personally, I think it's even less than that.
Ben Felix: Yeah, I would say.
Mark McGrath: I feel there are three ways that one can generally do well in investing. You either have extra information than the market, you can have better analysis with the information, or you could be more disciplined. The discipline is hard, but in the long run, that allows your portfolio to perform better. Discipline is probably the most achievable and sustainably by most people over time. Thank you for doing such great research and promoting it. I wish that you have a great health and fast recovery.
Ben Felix: Nice. All right. Now, this was a physical postcard that we got in the mail from Christopher. I got a scan of the postcard. It didn't actually hold the physical thing, but it was still pretty cool. Kind of funny. It was exciting to get a hand-written communication. Like, "Wow, someone took the time to sit down and write something with a pen and mail it."
Dan Bortolotti: And it arrived.
Ben Felix: And it arrived. Yeah. It says, "Dear RR team, I hope this card finds you well. It's been a year since our last exchange, which you kindly gave credit on episode 281. Since then, I've kept learning about the science of evidence-based investing and started helping my parents with their own finances. I really enjoyed episode 315 with Eduardo Repetto. Glad to see that Avantis is entering the European market. Thank you for sharing your knowledge of markets and investing to the world. Heart. And then I quote from my video on index funds. Most investors should be using low-cost index funds. Anyone who disagrees with that statement is probably misinformed, conflicted or just plain wrong."
Mark McGrath: Savage quote.
Ben Felix: And that's from Christopher. All right. That's the end of the aftershow, and I guess we'll say, Mark, thank you for being on the podcast for the time that you've been here. You were a great addition, and it's been great doing the podcast with you and also working with you more generally in your time at PWL. We appreciate it. I know the audience appreciates it, and we wish you all the best in your next chapter.
Mark McGrath: It means a lot. Thank you so much. We're trying not to tear up here, so we're going to have to cut the cameras pretty quick. But thanks, guys.
Dan Bortolotti: Thanks, Mark.
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Books From Today’s Episode:
The Great Depression: A Diary — https://www.amazon.com/dp/1586489011
Narrative Economics: How Stories Go Viral and Drive — https://www.amazon.com/dp/0691182299
Papers From Today’s Episode:
‘Negative Bubbles: What Happens after a Crash’ — https://ssrn.com/abstract=3038658
‘Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice’ — https://ssrn.com/abstract=4590406
‘Financially Sound Households Use Financial Planners, Not Transactional Advisers’ — https://www.financialplanningassociation.org/sites/default/files/2023-01/APR19%20Blanchett.pdf
‘Finding and Funding a Good Life’ — https://pwlcapital.com/finding-and-funding-a-good-life/
Links From Today’s Episode:
Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582
Rational Reminder on Instagram — https://www.instagram.com/rationalreminder/
Rational Reminder on X — https://x.com/RationalRemind
Rational Reminder on TikTok — www.tiktok.com/@rationalreminder
Rational Reminder on YouTube — https://www.youtube.com/channel/
Benjamin Felix — https://pwlcapital.com/our-team/
Benjamin on X — https://x.com/benjaminwfelix
Benjamin on LinkedIn — https://www.linkedin.com/in/benjaminwfelix/
Dan Bortolotti on LinkedIn — https://www.linkedin.com/in/dan-bortolotti-8a482310/
Mark McGrath on LinkedIn — https://www.linkedin.com/in/markmcgrathcfp/
Mark McGrath on X — https://x.com/MarkMcGrathCFP
Episode 248: Prof. William Goetzmann: Learning from Financial Market History — https://rationalreminder.ca/podcast/248
Episode 100: Prof. Kenneth French: Expect the Unexpected — https://rationalreminder.ca/podcast/100
Episode 352: Jessica Moorhouse: Everything But Money — https://rationalreminder.ca/podcast/352
Episode 316: Andrew Chen: "Is everything I was taught about cross-sectional asset pricing wrong?!" — https://rationalreminder.ca/podcast/316
Episode 224: Prof. Scott Cederburg: Long-Horizon Losses in Stocks, Bonds, and Bills — https://rationalreminder.ca/podcast/224
Episode 284: Prof. Scott Cederburg: Challenging the Status Quo on Lifecycle Asset Allocation — https://rationalreminder.ca/podcast/284
Episode 350: Scott Cederburg: A Critical Assessment of Lifecycle Investment Advice — https://rationalreminder.ca/podcast/350
Episode 89: Wade Pfau: Safety-First: A Sensible Approach to Retirement Income Planning — https://rationalreminder.ca/podcast/89
Episode 289: Retiring Retirement Income Myths with the Retirement Income Dream Team — https://rationalreminder.ca/podcast/289
Episode 122: Prof. Moshe Milevsky: Solving the Retirement Equation — https://rationalreminder.ca/podcast/122
Episode 59: Alexandra Macqueen: Financial Economics and Annuities: Rational Planning for Retirement — https://rationalreminder.ca/podcast/59
Episode 283: When Volatility is Risk, and Introducing The Money Scope Podcast — https://rationalreminder.ca/podcast/283
Episode 351: DFA vs. Vanguard — https://rationalreminder.ca/podcast/351
Episode 254: David Blanchett: Regret Optimized Portfolios, and Optimal Retirement Income — https://rationalreminder.ca/podcast/254
Episode 152: Evaluating Systematic Equity Strategies — https://rationalreminder.ca/podcast/152
Episode 347: The Case for Index Funds — https://rationalreminder.ca/podcast/347
Episode 281: Lifecycle Asset Allocation, and Retiring Successfully with Justin King — https://rationalreminder.ca/podcast/281
Episode 315: An Update from Avantis with Eduardo Repetto — https://rationalreminder.ca/podcast/315