Choosing an asset allocation is a crucial investment decision, as it determines expected returns and risk exposure. During this episode, we uncover what this means, exploring topics such as why risk may not always be the best assessment method. We unpack the three factors that John Grable’s risk profiling framework considers: behavioural loss tolerance, the ability to take risk (which assesses the financial capacity to withstand losses without affecting lifestyle), and the need to take risk. Many investors sabotage their returns by selling after losses and buying after gains, and we discuss the reasons behind this. We also explore why stocks tend to become less risky over long horizons, while bonds can be vulnerable to inflation and interest rate changes, before explaining why investors should focus on compensated risks. In the aftershow, we address listener comments on absolute returns, XEQT, why we have made certain sponsorship decisions, and more. To gain a deeper understanding of risk and avoid common pitfalls that can undermine your returns, tune in today!

Key Points From This Episode:

(0:05:10) The critical importance of choosing an asset allocation and understanding risk. 

(0:08:35) How behavioural loss tolerance impacts asset allocation.   

(0:18:42) Psychological theory on risk tolerance and willingness to engage in financial behavior. 

(0:30:48) Assessing your need to take risks. 

(0:39:24) Why market volatility is not where the true risks lie.

(0:47:42) Private credit, other portfolio alternatives, and GICs. 

(0:53:03) The aftershow: demystifying the AMA controversy.

(1:00:20) Absolute returns, XEQT, and sponsorship on the Rational Reminder.

(1:12:05) An update on Ben’s health and what he has learned from this experience. 

Submit your questions for upcoming AMA episodes!

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, and Dan Bortolotti, Portfolio Managers at PWL Capital, and Mark McGrath, Associate Portfolio Manager at PWL Capital.

Mark McGrath: It's been a while. Good to see you, guys.

Dan Bortolotti: Good to be back.

Ben Felix: Been a while since we recorded. We had some pre-recorded stuff to keep episodes flowing while we were taking some time off. I guess, Cameron and I did one episode on OneDigital, too, but it's been a while for the three of us.

Dan Bortolotti: Yeah, exactly.

Ben Felix: Episode 343. Our main topic this week is how to choose an asset allocation, which I think should be a pretty interesting discussion with the three of us. I'm looking forward to both of your comments as we go through that topic. We're going to talk about behavioural loss tolerance. We're going to talk about the ability to take risk, and we're going to talk about the need to take risk and how all of those work together to form a risk profile, that informs how much risk you should take. Then, we're also going to cover why downside volatility, which is how risk is typically framed when we're talking about investing is not always the best measure of risk.

Then we've also got a pretty significant after-show today, touching on some controversy that stemmed from our AMA episodes. Controversy is a funny word. I don't know. There's a big discussion in the Rational Reminder community about this one off-hand remark that Dan, you and I both made in those AMA episodes and it, for whatever reason, became this hot button issue that people went crazy about in the community. We'll debrief that. Then we're also going to cover the reaction to PWL being acquired by OneDigital in the after-show, which was also quite interesting. Then I've got a personal health update that I want to talk a little bit about in the after-show.

Real quick on the OneDigital thing, a lot of comments have said variations of, I hope this doesn't mean the end of the podcast, either literally, or due to a decline in quality. This podcast is not going away. I'm not going away. You guys aren't going anywhere. This is going to continue being a thing. It's not going to become a private equity mouthpiece, which is something some people I think are worried about. I still don't think private equity funds are good investments for most people most of the time.

This podcast, though, is an important part of PWL's identity. It's become an important part of our identity. I think our approach to no BS financial information is one of the things that put us on OneDigital's radar in the first place. It's not like they're going to cut the podcast. It's too expensive. I don't know even why they would do that. Anyway, like I said, we're also not going to become a private equity mouthpiece. Private equity funds are still terrible investments for most investors most of the time. I'm not being censored. Maybe. I mean, we'll see. I guess, if I'm being bleeped out, you'll know there's a problem.

I do still like how Don Calcagni talked about how they're doing private equity at Mercer in episode 327, so that there are maybe some ways to do it well. But anyway, private equity still sucks. We're going to do a little bit of a change to our episode formats. The AMA episodes were just so successful. They're so well received and they're downloaded more than a typical episode. We're going to keep running them as part of our regular episode cadence. Over a given four-week cycle, we'll have a guest episode, a deep dive episode, or whatever you want to call it, like what we're going to do today, where we dig into one specific topic, another guest episode, and then an AMA episode.

We still have that gigantic bank of questions that we collected for the year-end episode. We'll keep drawing from that for now, but then we're also going to open up a new form for people to submit their questions, so that we can keep those episodes going. We'll post that form in the community and on the Rational Reminder socials.

Mark McGrath: Love it. I think we tooled around with the idea of maybe just having a segment of the show at the end where we answered a couple of questions, but I know a couple of people reached out to me who were like, “No, no, no. They need to be standalone episodes.” They prefer that format. I'm interested to hear what other people think about it, but I think what you've just proposed is a great way to do it.

Dan Bortolotti: Yeah, it's really a great way to understand what material the audience is most interested in hearing about and we're happy to deliver.

Ben Felix: The nice thing, candidly, about the AMA episodes is that they are way less work for us to prepare.

Mark McGrath: We don't really prep for them. You scan through the questions, I think, maybe beforehand because you were trying to organize them a bit, but I just went in fully blind for the most part. For me, I think that's a fun way to do it.

Ben Felix: I think people like that. I think people like hearing us riff on our opinions on stuff, rather than digging into research, which is a little bit more rigid. They like to just hear, how do you think about that, or what are your thoughts on this topic without necessarily having 50 sources to back up what you're saying.

Dan Bortolotti: Yeah. A lot of the answers, I think, depend on our experiences, practitioners, not so much on academic research. That's usually pretty easy to share without a whole lot of preparation.

Ben Felix: And valuable for people to hear this thing. Then hearing our three different perspectives, I think, is that some of the feedback we got too, is that really helps other people frame issues that think through stuff. That's good for the introduction. Should we go ahead to the main topic?

Mark McGrath: Yeah.

***

Ben Felix: All right, here we go. Choosing an asset allocation. How much risk you take with your investments, as many listeners know, is one of the single most important determinants of your expected investment returns. That makes choosing an asset allocation, which is the mix between riskier stocks, safer bonds, and maybe other assets. In a portfolio, one of the most consequential decisions that every investor has to make. But how do you figure out how much risk you should take? The second question that's really important to think about is what even is risk? Because if we're framing risk as volatility, that's one thing. That's not necessarily the best way to think about it in all cases. I'm going to start off talking about risk as the risk of an investment declining in value. I do want to be super clear, and I will come back this later in the episode, but that's not the only way to think about risk. I think in a lot of cases, it's a deficient way to think about risk.

We're using a framework here to talk through how much risk you should take when risk is framed as volatility. We're using a framework from John Grable, who's an academic, who has done a huge amount of work on this concept on risk profiling for investors. He's got a bunch of published academic papers. He's also got a research book on what you call it like a PDF for the CFA Institute. We're really using his work and his framework for determining someone's risk profile.

The things we care about in making up the risk profile are your behavioural loss tolerance. That's your ability to sleep at night and not panic when a risky investment drops in value, not panic sell. Your ability to take risk. Behavioural loss tolerance is pretty subjective. It's pretty psychological. Ability to take risk is much more objective. That's your capacity to hold a risky asset without needing to sell in the short term to fund your living expenses. If a stock market crashes, can you still pay your rent, or do you need this cash that you are considering investing to fund your normal lifestyle? Behavioural loss tolerance, ability to take risk. And the last piece is your need to take risk. That's the amount of risk that you need to achieve the expected return needed to meet your goals. All three of those things interact with each other to form a risk profile.

Mark McGrath: The ability to take risk, I think a lot of people forget things like insurance, like disability insurance and those types of things when they're considering their ability to take risk. They think about their current financial position, but that usually includes their income. Just something to keep in mind that the ability to take risk, or the quantitative side of that should include more than just your current net worth. It's all about the foundational stuff too, insurance and that. I have a question for you. Maybe you're going to get to this later, but does loss tolerance, like a behavioural risk tolerance piece, do you know if that changes any time? Or what does Grable say about that changing through time?

Ben Felix: I believe behavioural loss tolerance is supposed to be a pretty stable psychological characteristic. Your ability to take risk will change over time. Your behavioural loss tolerance, I think, is supposed to be pretty stable.

Dan Bortolotti: That's the limiting factor too, isn't it? I think we'll talk a little bit about this. I mean, all three of those pillars are important. But at the end of the day, it doesn't matter what your ability, or your need is if you don't have the stomach to tolerate volatility up at a certain level, that's got to be the limiting factor. That usually is the one that determines your ultimate decision.

Ben Felix: That's exactly what I say next in my notes here. I say that behavioural loss tolerance is an important constraint on asset allocation. We can talk about all the fancy stuff, portfolio optimization and Sharpe ratios and expected returns and uncorrelated assets. People love to talk about that stuff. But you ultimately need to have a portfolio that you can stick with through good times and bad, and keeping in mind that all portfolios, no matter what you do, unless maybe you're holding a real return bond that's perfectly matched to the liability you're funding, and even then you're going to have volatility. You just won't have volatility relative to the liability. Anyway, you have to have a portfolio you can stick with through bad times, because every portfolio, no matter what you try and do to prevent it, is going to have bad times in some way.

Then we know, and this is what you were just alluding to, Dan, investors tend to sabotage their own returns by selling stuff after it's done poorly, or giving up on the strategy after it's done poorly and investing in stuff after it's done well. There's lots of different research on investor return gaps that they underperform asset classes or funds or whatever because of that behaviour. Ideally, having an asset allocation that you're really comfortable with is going to mitigate some of those common behavioural issues that can be a big drag in returns over time.

Behavioural loss tolerance is subjective, and it is unique to each individual, and it can be broken down, again, using John Grable’s framework into six elements. We have your risk tolerance, which is your willingness to engage in financial behaviour with an uncertain outcome and the potential for loss. Risk preference, which represents your general preference to take more or less risk. Financial knowledge, which is your level of financial education, training, and experience. And interestingly, higher financial knowledge is typically associated with a higher behavioural loss tolerance. Investing experience, which is your experience with investing specifically, and that's distinct from financial knowledge, because you can be financially knowledgeable, but have limited experience with investing. Again, investing experience is generally associated with being more comfortable with risk.

Risk perception, which is your subjective assessment of the riskiness of investing, separate from the objective reality of it, and that can be influenced by the media, by your social environment, or by a lack of understanding of financial concepts. The interesting point there is that people who perceive investing to be more risky tend to be less adaptable to market volatility. It makes sense when you think about that. If someone thinks investing is really risky, or thinks it's riskier than it actually is, however you define that, it's going to be harder with them to live through a period of market volatility.

The final element here is risk composure. This is a really interesting one. Dan, this is something that I think you've talked about in the past. Risk composure is your actual behaviour during difficult market conditions. The only way to know that is to have lived through market declines and the accompanying narratives. I think that's a really important part. And the accompanying narratives about why that crash is different. Because it's never like, oh, the market dropped 20%, but everything is fine. It's like, the world is ending and whatever.

Dan Bortolotti: There's a huge gap between theory and practice. People routinely overestimate their risk tolerance. I've talked to a lot of clients who've said things like, “If the market crashes, I'm just going to buy more. I'm waiting on the side lines.” I want to say, no, you're not. Because when the market crashes, you're going to come up with all kinds of reasons why it's going to go down even further. The number of times I've seen people give us a call after a market crash and say, “I don't know. I have some cash on the side lines. I'm really anxious to send it to you, because the market's down 20% over the last couple months,” zero. I mean, maybe it's happened. I can certainly recall the other conversations where people have called and said, “Should we be getting out?”

Mark McGrath: Totally. I tell people this all the time, that historical investment returns are easy to observe and difficult to capture. That's exactly what I'm talking about. There's so much hindsight bias. You can look at a chart of the past 25 years. You've got the tech bubble. You've got the GFC. You've got COVID. It's very easy to look at those charts with the benefit of hindsight and be like, “Oh, I totally would have sold there, bought there, sold there, bought there.” But when you're at the hard right edge of a market crash and you don't know if it's going lower and we're down 25% and then your mind are going, “This could go down 50%,” you're very unlikely, A, to time the bottom in the first place. But to your point, Dan, when things are crashing, it feels like the world is ending. You've got markets in turmoil, blaring on the news. You've got headlines coming out saying it's getting worse, it's getting worse.

To overcome that and to just take a robotic stance, you shouldn't have cash on the side line in my opinion in the first place, but to assess that objectively and to actually nail the behavioural component of an experience like that is incredibly difficult. I even find some of my older clients who have been through it a number of times are the ones calling me saying, “I know what you're going to tell me, but I just need to hear it, because everything is going to be okay.” They've been through all of these crashes and still have difficulty with that exact moment.

Ben Felix: I remember at the bottom of COVID, AVUV, the US small gap value ETF had been absolutely hammered. I thought about it like, maybe I should put some money into that, or maybe I should borrow from my line of credit. Because I don't keep cash sitting around. Then I was like, I shouldn't. Those businesses really could be the ones that get completely eviscerated by this situation. Of course, it went on to return some ridiculous amount after that.

Dan Bortolotti: That crash was much shorter than I think any of us expected it to be. I think it's the classic example. Again, I don't mean to suggest, again, that one was different. It was different in the sense that unlike a lot of previous crashes, that one had this huge health component. We had clients who were literally not just concerned they might lose their life savings. They were concerned they might die. I'm not saying that lightly. That was a genuine fear. Really? Do you think you were going to be in a position where you were going to confidently put money into the market in the middle of that? We rebalanced with clients, but we didn't get a whole lot of phone calls from people with sacks of cash ready to enter the equity markets for the first time.

Ben Felix: Yeah, exactly. Composure is an interesting one. I think I've heard you say that and I hope I’m not putting words in your mouth, but I think I've heard you say that people should tend to be relatively conservative, until they have actually lived through a crash.

Dan Bortolotti: I actually believe that. I mean, I think that for a lot of young investors, I probably first made that comment when I was dealing with these questions coming out of, let's say, a three, four-year bull market. People say, “I have a high-risk tolerance.” How old are you? How many times have you lived through a major market correction with an appreciable amount in the market? I mean, you might have lived through 2008, but maybe you were in university, or something and you didn't have any investments. Unless, you've truly lost a big chunk of your money, I don't think you really know what it feels like.

I don't think you can evaluate your risk tolerance, because you really enjoyed the previous four years of very high returns. You don't really understand that risk, until you've lived through it. I would say, if you've literally never invested in equities before, probably don't jump into 100% right away, unless you go in fully prepared that you could lose half of that investment and you really mean it. You don't just say you can deal with it. Then if it happens, you panic and sell the other half. Being battle tested really does help a little bit.

Mark McGrath: I got absolutely berated for that.

Ben Felix: I remember, Andrew Hallam gave us – I should have looked the story up before we recorded this, because it would have been perfect to talk about, but he told a story about being in a jungle somewhere, camping with a group of students, or something like that. And apparently, a village had been slaughtered there and he had this crazy experience with what he would describe as a ghost. It was a dream, but it was just this horrifying experience and he woke up absolutely terrified. He's comparing this to living through an actual market crash. He says, “If you asked me right now, do I believe in ghosts? No. No, I don't. But put me back in that place exactly where I was and I was absolutely terrified of ghosts.” He's saying the same kind of thing. You can say you can handle a 50% decline in your investment value, but until you've actually lived through it, it's pretty hard to know.

Dan Bortolotti: The other way of looking at it though is if you're just getting started in investing and you're only investing a couple of thousand dollars and you lose half of that, well, you'll recover. Maybe it actually helps you to lose that money, feel that despair, that anxiety, learn the lesson and then adjust your asset allocation after that point. I mean, I think either one of those two things is fine. The time to make the mistakes and misjudge your risk tolerance is when you're younger and you don't have a lot of money to invest. You don't want to be doing it when you're in your mid-50s and within shouting distance of retirement and realize, “I made a mistake.”

Mark McGrath: Especially with young people, and I'm sure you guys have been through it as well. I'm going through it right now with a long-time client of mine, has three children and they're gifting some money to the kids. The kids' financial literacy is very, very, very low. The first meeting is literally explaining what we consider to be the absolute basics. What is a stock? What is a bond? What is inflation? What is interest? That type of thing. What is a TFSA? To take somebody like that and even if the risk profile questionnaire came and said, high-risk tolerance, but with low financial literacy and with no experience and taking a pretty significant sum of money for these gifts and putting it into a higher risk portfolio with more equities, that could be damaging for a really, really long period of time, too.

If you were to experience that kind of volatility and that loss, it can spook you in the early heart of your investing career and you might then become a very conservative investor because of that experience and then miss out potentially on decades and decades of compounding as well. There's this formative period, I think, where to your guys' point, it might make sense to be more conservative until you've gone through something that, regardless maybe of the amount of capital you have, just because if it's a small amount of money, that might be all you have in the world right now and it might be a significant amount to you, even if it's only a couple thousand dollars.

Ben Felix: I know there's a paper on that specifically, people who have had really bad experiences losing money in equities tend to be much more conservative in the future, which I guess, makes sense. Your personal experience colours your perspective. We have risk tolerance, preference, financial knowledge, investing experience, risk perception and risk composure. I think I got all of them. All those come together to form a behavioural loss tolerance.

The risk tolerance piece, that was the willingness to engage in financial behaviour with an uncertain outcome and the potential for loss, that one is usually assessed using something called a psychometric assessment, best practices to assess it that way. That's going to be a questionnaire that has demonstrated reliability and validity in predicting the behavioural tendencies of investors. Those words in this context have pretty specific meanings. Reliability is the trustworthiness or consistency of a measure. Validity is the degree to which empirical evidence and theoretical rationales support an assessment.

You need to have an assessment that is reliable and valid. Then once it's been created and studied for its reliability and validity, then its results can be used to rank people who take the test in the future relative to the findings from a study. Typically, how this is done is someone comes up with a questionnaire that they believe to be reliable and valid, and then they run a whole bunch of people through it. Then there are tests, I guess, to show whether it's reliable and valid. Then going forward, people who take that test are ranked relative to the initial sample population. There are a bunch of software providers out there now that have done their own studies and have tests like this. I'll put a link in the show notes to one that is reliable and valid based on a 1999 study. The fact that it's a 1999 study means the questions probably feel a bit dated.

Dan Bortolotti: Yeah. Somehow, they feel if their Blockbuster stock would fall 20%?

Ben Felix: It doesn't mention Blockbuster. I've gone through this test a bunch of times, and we actually use it for our clients at PWL right now. A lot of people in the Rational Reminder community took it, too. I posted it in there, and I don't know, hundreds of people took it. I think it's easy to be critical of the questions, because some of them are funny and weird. Like, “Oh, well, I would never do that.” But I think if you go through the questionnaire thinking about the spirit of what the author of the question was asking about, it's obvious what they're trying to get out without you being like, “Well, I would never actually do that.”

Anyway, so I think if you take it in, good faith isn't quite the right term. But if you take it and just try and put yourself in the shoes of the author and what they were trying to ask about, I think it's fine. Questions are a bit funny, though. I'd love to do our own study and have our own questionnaire, which is something that we may do in the future. Anyway, so I'll put a link to that study in the show notes and people can take the quiz, because the authors of that study published their questionnaire online still to this day. You can go and take it and it'll tell you what your risk tolerance is. It comes back as a score telling you how you rank. You'll be high-risk tolerance, which means you're high relative to everybody else who's taken that assessment, the initial sample that the test was studied on.

The tricky thing about that, though, is it doesn't tell you that you should be 100% equity. It doesn't say, oh, you've got a high-risk tolerance. Therefore, you should be 100% equity. Somebody else has to do that. When we get the score from that test, we have to interpret it and map it to an actual portfolio. At PWL, if someone comes back with a high-risk tolerance, we map that to a portfolio somewhere between 70% and 100% in stocks. Then based on some of the other elements that we mentioned of a risk profile and based on the advisor's input, they'll land somewhere in there. But we use the risk tolerance as a psychometric assessment as a constraint. If you're high, then you're 70% to 100% equity, but if you're really low, then the advisor would have to manually override and document why they're doing something different. People can take that quiz online. It'll tell you whether you're high, or low, or medium, or whatever, but it won't tell you how to invest your money. You have to figure that part out yourself, I guess. I don't know. Makes it a little bit less useful, maybe.

One interesting insight from a big sample of a ton of cases that have been run through Morningstar's risk profiler is that risk tolerance follows a pretty normal distribution. Most people don't have an extremely high risk tolerance. There's not a big fat tail there. It looks like a very regular, normal distribution. To your point earlier, Dan, if you think you have a really high-risk tolerance, statistically, you probably don't. Most people are not sitting in that right tail.

Dan Bortolotti: It's interesting. I have the questionnaire, ranks you related to other people. I'm curious about the usefulness of that finding. For example, if you're an investor and you complete the questionnaire and it says, your risk tolerance is higher than 80% of the population. What do you do with that information? It's interesting, like you say. “Oh, I never thought of myself as a risk-taker. That surprises me.” Or do you think people are more likely to say, “Yeah, that's in line with what I expect based on talking to other people.” Because really, your risk tolerance relative to other people is not really relevant in terms of your asset allocation decision. But it is interesting and it does frame the discussion in a different way.

Ben Felix: It comes back to, how do you map the score? Because again, it's telling you how you rank relative to a bunch of other people. How does that map to an asset allocation? We built our own risk profiling tool at PWL and we had to do this. We had to do the mapping exercise. Prior to that, we're using Morningstar's tool and again, we had to do the mapping exercise. It's not something anybody gives you the answer to. There's a lot of subjectivity around if someone has a higher risk tolerance, what does that mean? Their portfolio should look like. The psychometric assessment does not give you the answer to that question.

Dan Bortolotti: Well, you've got those other two pillars to concern yourself with too, the ability and the need to take risk.

Mark McGrath: What does it say about the other end of the distribution? Are more people very, very conservative than expected?

Ben Felix: It's a normal distribution. The tails are not very big and most people are sitting somewhere in the middle. Another pretty interesting and related research finding is that men tend to overestimate their risk tolerance. If you ask a man, what do you think your risk tolerance is, and then also get them to do an assessment, they will tend to overestimate relative to where they land on the assessment and women tend to underestimate it. That's also research from John Grable. That holds for other factors linked to risk tolerance, like age, household income, marital status, and education.

Then that same study also finds that risk tolerance is overestimated by younger respondents and those with a graduate education. It's like a kind of overconfidence maybe, but just something to keep in mind. Again, when you're thinking about how a risk tolerant am I, men are more likely to overestimate it. This is really important. This behavioural loss tolerance piece is really important, because investing in a risky portfolio, then selling out after it does poorly can be really expensive. It can be really psychologically uncomfortable to be invested in something that is too risky for you, after the fact. You've realized it's too risky for you after the fact.

Ken French was a while ago. It was episode 100. There was something going on at the time that was causing market volatility. We asked Ken French about changing your portfolio after a downturn. His answer actually really surprises at the time, because we thought, well, you stick with your asset allocation. Ken said, it's like the risk composure thing. Ken said, if you're really stressed out about your portfolio after a market decline, you've learned something really valuable about yourself. Maybe you should go and change your portfolio to be more conservative. Just don't go and change it back after markets recover.

Dan Bortolotti: That's the key piece right there. I've had that discussion with clients who have called and said, “I want to decrease my equity allocation.” I've diplomatically said, that's fine. If we agree that your risk tolerance was overestimated and that this more conservative portfolio is more appropriate. Let's just agree though that this is, I don't want to say a permanent decision, but this is a long-term decision. We're not going to have this discussion in six months when the markets have recovered and all of a sudden, you're way more risk-tolerant than you were before. It's quite possible that you are so bothered by the volatility during a certain period that you just say, “You know what? This is not for me. I'm going to go down to 40% equities or 50%. This 70% is just totally inappropriate for me.” Fair enough. Better to make that mistake now and correct it.

Mark McGrath: I think going the other way is really tricky, too. I've had conversations lately with clients who were 70%, 30%, 80%, 20% investors, who were like, let's crank it up to 100%. We haven't really seen much volatility since, I guess, in 2022. But, I mean, that feels like a long time ago. Now we're 2025. It's a few years ago, really. People are like, “No, no, no. I can stomach more risk, because markets are going up.” They adjust to recent performance in the opposite direction, which can be detrimental as well, obviously, over the long run.

It's just funny how we react to recency bias. There's somebody, I can't remember who's quote it was, but it's like, nothing like price to change sentiment. Things are going up. Everyone's just like, “Oh, then I need to buy more and chase those returns.” When things are going down like, “Oh, I need to get more conservative and chase safety.”

Dan Bortolotti: The joke is, I have a high tolerance for upside volatility.

Mark McGrath: Exactly. Yeah.

Dan Bortolotti: But only in that one direction.

Ben Felix: It is funny. You're probably better off in a less risky, lower expected return portfolio that you can stick with and won't be stressed out about through bad times. We actually model in our risk assessment tool, behavioural loss tolerance as a binding constraint on asset allocation. If your behavioural loss tolerance says you can't be more than 60% equity, even if you score really high on everything else that would otherwise increase your asset allocation, it is constrained by behavioural loss tolerance.

We also use your ability to take risk as a binding constraint. Even if you max out the behavioural loss tolerance scale, you can't take much risk measured by downside volatility with the money that you need to pay rent tomorrow, or buy groceries, or invest in your business. I don't know. Risk-taking ability is your ability to withstand declines in your portfolio value, without compromising your lifestyle. We know risky assets, like stocks have positive expected returns, but they can also drop in value pretty significantly over the course of months, or even years.

Risk-taking ability breaks down into three elements. We've got the time horizon for the goal, the ongoing need for liquidity from the portfolio, and your capacity to absorb a financial loss, without compromising your standard of living. All else equal, a longer time horizon, lower liquidity needs, and a higher risk capacity imply a higher risk-taking ability. As an example, and this is from Grable's CFA textbook, if you have a time horizon, of less than five years before needing to access the full amount invested, or if you need to access 5% or more of the portfolio annually, and if you have no other assets, or income sources to maintain your standard of living, you have a low ability to take risk.

Then at the other extreme, if you've got a long-time horizon, say it's 10 years or longer, you have no ongoing liquidity needs and you have other assets, or income streams sufficient to maintain your lifestyle. If this specific investment we're talking about the ability to take risk for goes down, say you've got a pension, for example, that's a backstop, even if you lose your investment, then you have a high ability to take risk. Your human capital, and Mark, you mentioned disability insurance earlier, which is relevant here, your human capital, which is your ability to work and earn income, also contributes to your ability to take risk. If you've got really stable employment income, that's not really affected by the broader economy, or affected by the stuff that would affect the stock market, your human capital is more bond-like, and it allows you to take more risk with your investments. You have a higher ability to take risk.

Classic example is a tenured professor. Their income is probably not going to change much. Then on the other hand, if your income is unstable and has the potential to drop-in bad economic times, then your human capital is more like a stock. That allows for less risk-taking with your investments, all else equal. That's the ability to take risk, and then disability insurance, I think, fits in that nicely Mark, because in either of those cases, if you became disabled, all of a sudden, that asset goes to zero, unless it's been properly insured.

The last dimension in assessing how much risk to take is your need to take risk. Behavioural loss tolerance and risk-taking ability are constraints in the amount of risk that you can take. But someone with a high loss tolerance, behavioural loss tolerance, and high risk-taking ability, they may not need to take a lot of risk. Riskier investments have higher expected returns, that's why people invest in them. Someone who's very wealthy may not need to have a high expected return to meet their long-term objectives. In assessing your need to take risk, you need to understand the rate of return required to meet your goal. If your goal can be achieved with the expected return of a low-risk investment, it's worth asking you why you would want to take more risk. There can be reasons. Someone might change their goals. “Oh, wow. I can already retire. Then, maybe I want to leave a really big legacy.” Those are the questions you have to ask.

Dan Bortolotti: I like to frame that one when I speak with clients. I think I stole this line from Larry Swedroe. I definitely didn't make it up. The idea is you should take as much risk as you need to, but no more. Because sometimes, you will have clients will say, “Well, I'm thinking I should increase my equity allocation.” They might already be retired, or close to retired. We've done the plan. We've run the what if scenarios. You could achieve all of your goals with, let's say, a 4% return. Why do you want to shoot for a portfolio with a 7% expected return and a lot more volatility? There's no real additional utility in your life, probably. You might mean you leave a larger estate, which may or may not be important to you. But why do you want to choose a rougher ride for something that will not improve your life? Usually, when I frame it like that, people say, “Yeah, that makes sense. Let's leave it where it is.”

Mark McGrath: It's an interesting trade-off between the need for risk and the desire for risk. Then also, in these examples where you've got somebody who's very wealthy who doesn't need the risk, I generally agree. Ideally, you get to meet your financial objectives over the long run with the least amount of risk possible. But then, also, because you're so wealthy, you have such a high capacity for risk, that needs to be balanced in these discussions, because it's like, well, you can tolerate 30%, 40%, 50% drawdowns now without it materially affecting your long-term ability to meet your goals. I've had some clients who want to take more risk, because they're in that position and others who want to take less risk, because they're in that position.

Dan Bortolotti: If your goal is to leave a large estate, then the time horizon for that money is much longer than the time horizon of your own life. I think all of this comes down to your tolerance. You might have the capacity for your portfolio to fall 30% or 40%. But if that would cause you to lay awake at night for weeks, you don't really have the ability to do that.

Ben Felix: That stuff's expensive. Being stressed out is no joke. Not financially expensive, but it takes a toll.

Dan Bortolotti: Wealth is supposed to relieve some of that anxiety, not add to it. But so frequently, it does add to it. We know that.

Ben Felix: The other thing I'd be cautious of is that if your goal requires. We would establish this using finished planning software. We put all of somebody's information into the software and it'll tell us based on an asset allocation assumption, which is associated with an expected return, whether the goal is attainable. If a goal is only attainable with an extremely high expected return, like say, a 20% return required to meet the goal, it probably makes sense to revise the goal. We would say, this goal is not attainable. Somebody who is doing this on their own might think that they can get 12%, or 15%, or whatever, doing some type of investing, but I would be very careful there.

There is an interesting idea here, though, that some people invest in lottery-like assets. Could be meme stocks. It could be game stock, which I guess is a meme stock. Could be meme coins. Could be thematic investments. They'll all have lottery-like payoffs. You're usually going to lose, but sometimes you can win really, really big. I think Meir Statman talked to us about this. Some people invest in that type of investment, because it does give them a low probability of hitting that really high return to meet a goal. If you have a goal that's not important, if the damage of not achieving that goal is not very significant, then I'm not recommending people invest in lottery-like assets, but I can see the justification for doing so.

On that conversation about how much risk you should take if you don't need – to taking as much risk as you need, but no more, that gets even muddier when we introduce this next topic. We've been talking about risk as downside volatility, the probability of losing money on an investment in the short term. As we said earlier in the episode, that's not the only relevant measure of risk. We know stocks are volatile. They move up and down a lot day-to-day and year-to-year, and that's typically how risk is framed. All the risk questionnaire is everything that the financial industry uses are based on risk as that as volatility. But long-term investors are less affected by short-term volatility.

We know empirically that low stock returns, this is a pretty noisy relationship, but it is there. Low stock returns tend to be followed by higher stock returns, and higher returns by lower returns, that's called serial dependence or negative auto-correlation. That feature of stock returns decreases the risk of stocks for long-term investors, relative to if returns were just random. Bonds have historically exhibited positive auto-correlation, meaning that bad bond returns tend to be followed by more bad bond returns, and that's typically related to periods of high and persistent inflation. I do need to specify here that we're talking about nominal bonds in the US tips, or inflation-protected securities. They would not have the same problem, or at least it would express differently. In Canada, we're phasing out our real return bond program, so they're less relevant up here. They’ve also got weird tax effects, and they can still be super volatile in the short term. But anyway, we're talking about nominal bonds.

That positive auto-correlation of nominal bonds makes them riskier at long horizons than at short horizons. Now we have stocks getting a bit safer at long horizons and bonds maybe getting a little bit riskier at long horizons. Then, bonds also tend to have lower expected returns overall, and to be occasionally devastated by periods of high inflation. In their own way, they can be risky. Stocks are, by no means an inflation hedge, since they don't necessarily increase in value when inflation is high, but they have historically been able to outpace inflation at long horizons most of the time, because they just got higher expected returns. Stocks are more volatile, which is one important way to think about risk for all the reasons that we just went through, but they've also been quite a bit less likely to lose purchasing power at long horizons than bonds have, which is another way to think about risk.

If we believe that those characteristics of stock and bond returns will persist, but stocks will have higher expected returns and they'll have a bit of mean reversion and the bonds will have lower expected returns and have a bit of mean aversion, then optimal portfolios for long-term investors would generally have higher stock allocations, relative to if those things were not true. Behavioural loss tolerance and the ability to take risk are still super important constraints on asset allocation, but I think long-term investors just need to understand how risk changes from a short horizon to a long horizon.

I think this also connects back to the financial knowledge and investing experience inputs in assessing risk tolerance. If you can withstand volatility in the short term, there's a reasonable argument that higher equity allocations are a bit safer for long-term investors. I'm not saying 100% equity. I'll go through an example in a second. That's true even for retired long-term investors, but you have to get that. You have to understand the concept of why you're enjoying this volatility to live through it. There's a 2024 CFA Institute research paper, Investment Horizon, Serial Correlation and Better Retirement Portfolios, they model optimal asset allocation using historical data. They find optimal portfolios for long-term investors tend to have higher equity allocations if you use historical, data compared to if you use Monte Carlo simulation, which is random. It doesn't have the serial correlation piece in there.

For example, the optimal equity allocation for an investor with a low risk tolerance, who's concerned about their inflation-adjusted wealth moves from an optimal in their model, an optimal 20% in stocks at a one-year horizon, all the way up to a 50% allocation of stocks at a 20-year horizon. That horizon makes a big difference. Then the Scott Cederberg research, of course, which listeners are probably familiar with, they come to an even more extreme conclusion, suggesting that 100% stocks is the best portfolio, or the least risky portfolio for long-term investors, including for retirees. Now, even if we take Scott's research and say, yeah, we agree that's true, there's still a massive behavioural risk tolerance component there. That still is a binding constraint.

Dan Bortolotti: Virtually, all of this discussion has to be considered in terms of that behaviour, or risk tolerance, because let's agree that if your time horizon was infinite and your behaviour was perfect, it's pretty hard to argue against anything other than 100% equity portfolio. The problem is neither of those two things are true for anyone. It's those constraints, I think, that are going to really govern the decision. I mean, nobody's arguing that even over a 50-year, even over a 20, or 30-year time horizon that 100% equity portfolio is going to have the highest expected return, but only if you stick to it.

Ben Felix: The interesting piece on that is people would agree with that. In general, I think the surprising thing from the Cederberg research and even from that CFA Institute research brief is that that's true even if you're withdrawing from a portfolio. I think people get really worried about sequence of returns risk if you're spending down a portfolio, everyone agrees, yeah, stocks have higher expected returns than bonds. This recent research though is suggesting that even if you're drawing down a portfolio stocks, or a higher allocation to stocks, it's actually a bit safer than a higher allocation to bonds. Yeah, I agree with you, Dan. All of this is completely irrelevant if somebody can't stick with the portfolio.

Dan Bortolotti: Let's quantify the risk to the risk of running out of money is catastrophic. It is something that you cannot under any circumstances tolerate. Whereas, the risk of missing out on some other financial goal might be much less severe. That's the classic Russian roulette thing. You win five times out of six. Great. But the one time you lose, you lose big, so you cannot take that bet. I mean, that's an extreme example, but you see what I'm getting at. Any retired person drawing down their portfolio wants to have a pretty close to zero chance of running out of money. Not a sub-optimal portfolio that might end 15% of the time, or 20% of the time.

Mark McGrath: I was actually having this conversation on Twitter just this morning. It's funny we're recording this today, because I tweeted out this morning, intentionally somewhat provocatively, that I can't think of any situation where it makes sense to have zero exposure to global equities. Right now, I'm talking long-term portfolio. Sure, you're saving up for down payment for next year, like, yeah, you don't want exposure to global equities and over a long horizon. What I'm really getting in that tweet is more like market timing, going to cash and waiting to see what happens.

Even low-risk investors, somebody came back and was just like, “No. A low-risk investor should have a portfolio of locked-in five to 10-year GICs at 5%.” There's a lot of risk trade-offs in doing that. Now you've got liquidity risk, because your money is locked up. You've got inflation risk, Ben, as you pointed out with bonds and their serial autocorrelation. GICs probably experience the same thing, because it's a fixed income and there's reinvestment risk now as well and interest rate risk. It's a series of trade-offs always when it comes to risk. Dealing with hundreds of clients over the past 15 years or so, even low-risk investors, I can generally see why something like 15% to 20% global equity exposure and the 80% fixed income, that's still a low-risk portfolio. The type of person who would go 100% cash in GICs, that's effectively a no-risk portfolio when viewed through the lens of volatility. When we're talking about low-risk and being conservative, even in my mind, I'm not thinking cash under the mattress type thing.

Ben Felix: Makes sense. Last piece on this topic is thinking about the type of risk that you're taking. I'll often see risk-seeking investors, and it ties back to the lottery-like assets maybe that we were talking about earlier, but risk-seeking investors will try to increase their returns by holding big positions in one stock, or betting on one industry. I would say, it's probably not the right kind of risk to take. You expect a higher return for owning a diversified portfolio of stocks over bonds. That expectation has to be there for investors to be willing to hold riskier stocks, instead of safer bonds. That's a compensated risk. It's there empirically. It's there theoretically. There's a good reason to expect it to persist.

The specific risks of individual stocks, or individual industries are not compensated risks. You might do better. You might do worse, but the outcome is random around that. They're not risks with positive expected returns. It's closer to, I was going to say gamble, but as someone once pointed out to me, some forms of gambling can have positive expected returns if you know what you're doing. I won't use the word gamble. It's a negative expected return, or at least a random outcome.

In general, I think it makes sense to diversify away individual security risk and industry risk as much as possible. If people really want to have higher expected returns, they want to take on more compensated risk. They can increase their allocation to stocks relative to bonds. They can increase their allocation to risky stocks, like small cap value stocks. They can allocate to other established expected return premiums, which could mean a lot of different things, and we'll actually talk about that in the after-show. They could use leverage, which has its own trade-offs and downsides and messiness. Or they could do some combination of all of those things. I think it's really important to remember, and I think this goes back to your comments earlier, Dan, about how people say like, “Yeah, I've got a really high-risk tolerance,” even though they may not actually have it, people get excited about taking risk. But risk is risk. It's risk for a reason.

Risk premiums don't always pay off over all time periods. I mentioned small cap value stocks. If you've been in US small cap value stocks for the last 20 years, good luck. It's been a pretty rough period. Leverage amplifies both good and bad outcomes. It's not like you just lever up and off to retirement. It's completely possible, but taking more risk leads to worse outcomes, rather than better. Risk is multidimensional. Your psychological constitution and your financial situation are constraints on how much risk you can take. Even if you can handle a lot of risks psychologically and financially, you may want to dial it back if you don't need to take a lot of risks to meet your goals.

I think it is important to just be aware of the fact that the nature of risk changes at long horizons. We saw that from the CFA study. Even a conservative long-term investor should likely have an allocation to stocks. In that paper, it said a 50% allocation to stocks, instead of a 20% on a one-year horizon, lots of subjectivity around that, but the point is, if you can meet your goals with the expected return of bonds, I don't know if it means you should be 100% in bonds. At least not nominal bonds. Long-term investors concerned with their inflation-adjusted wealth may find that a higher allocation to stocks is contrary to popular wisdom, safer than a more bond-heavy portfolio, with a caveat that it doesn't cause behavioural problems, which as we've talked about is super important. The last thing to summarize is that investors who want to take more risk should consider taking compensated risks, rather than speculative ones.

Dan Bortolotti: That's a super important point right there. When you said a minute ago that sometimes riskier portfolios will result in worse outcomes, if you take poor, uncompensated risks, that's the most likely scenario. That's not just a fringe possible outcome. That's what's most likely going to happen. If you take compensated risks, obviously, your probability goes up dramatically.

Ben Felix: Totally. Anything else out of this topic?

Dan Bortolotti: I wanted to ask you a quick question about how you guys feel about, let's call it perceived risk. The context here is Justin Bender and I did a piece in the Globe and Mail, I think it was probably a year and a half ago or so, where we were comparing bond ETFs versus GIC ladders. Just as an example, we would say, compare a short-term bond ETF that holds bonds from one to five years, versus a ladder of GICs with maturities one to five years and you roll them over every year. Our argument was that the GIC ladder is likely to deliver slightly higher return over time, because you're compensated for the illiquidity.

Not only that, we made the comment that a GIC ladder has no volatility. A lot of people took issue with that and said, well, that's a ridiculous statement. If interest rates go up or down, the value of those GICs changes and if they were mark to market every day, they would go up and down in a similar way to bonds, which is 100% true. But it misses the point, because most investors do not think of GICs in that way. If they buy a GIC for $50,000 and every day they look at it, it's $50,000 plus accrued interest. In their mind, that's zero volatility. Now, is it an illusion? Of course. But if the whole point of adding fixed income to a balance portfolio is to reduce volatility in order to regulate your behaviour, then it's done its job. It doesn't matter if it's an illusion.

If you want to look at the economic theory of it and say, well, a GIC is worth less if interest rates go up, you're correct. But in practice, that doesn't mean anything. It has no impact on an investor's behaviour. I'm throwing that out to see what you guys feel about that as at risk versus a perceived risk.

Mark McGrath: Can I introduce you to private credit?

Dan Bortolotti: Please do.

Mark McGrath: That's the whole argument. I have friends who use a lot of alternatives in their portfolio. This is the exact argument. Even if it's volatility laundering, I know GICs aren't really the same from that perspective.

Dan Bortolotti: Yeah, because they're guaranteed. Private credit is not. That's the difference.

Mark McGrath: Yeah, absolutely. Private equity and private real estate funds, but these funds are products that are not mark to market and are valued infrequently. The advisors themselves that I speak with know the real value of this has gone down, but the clients are going to see that. If that improves their outcome over time, let's discard the high fees and everything else. If that improves the outcome over time from a behavioural perspective, do I have a duty to that client to at least consider these things as part of the recommendation? It's a really, really interesting question and not one I’ve got a great answer to.

I do agree with you, Dan, that psychologically, that lack of volatility can be a good thing. Absolutely. As we discussed earlier, if you can meet your objectives with less risk, why not consider it?

Dan Bortolotti: With the private credit thing, I mean, the issues there are probably the costs and the credit risk. It's not the illiquidity. I would look at this in the same way I would look at when someone buys a house, for example, they say, well, it's not a volatile asset. Real estate goes up and down every day in value theoretically. But for all intents and purposes, nobody has a ticker on their house that lists the exact value of their home at this moment. If they did, they would probably have a lot of stress as a result. The fact that it is not marked to market every day and isn't always in your face, allows you to hold that asset with a little more equanimity than you would a truly volatile asset. I think sometimes, you can harvest a little bit of that behavioural bias and use it to help a client, not to deceive them.

Ben Felix: I think we've talked with this for asset allocation, too. If you shovel all of your fixed income into the RRSP account, that effectively increases your allocation to equities on an after-tax basis, which is what actually matters to your future consumption. I've got a riskier portfolio objectively, but it looks like it's less risky, because you've got what you see in your accounts is this big chunk of fixed income in your RRSP account. Similar idea. There's a pretty strong behavioural argument to look at it like that. For the GICs, I think it makes sense that it would help people feel better.

I know that analogy to private equity and private credit is not great, because they're not guaranteed like a GIC is. But conceptually, it's similar where people have demand for the smoothing effect of illiquid assets, regardless of what the underlying is, because it makes their portfolio look less risky. Even if that's not true at all economically, it makes it look less risky and that makes people feel better. Interesting thing there on the illiquidity premium, Antti Ilmanen has written about this, about how if there's so much demand for that smoothing effect, it could actually flip the illiquidity premium negative, because people are so willing to pay for the smoothing effect in their portfolio, I have no idea if that would show up in the GIC market, but it is interesting.

Dan Bortolotti: You can easily compare that just by looking at GICs compared to government of Canada bonds of the same maturity and there's a premium. But that's a good point. People value it so much. In theory, it could drive the price up and take it away. I think as long as it's an illusion, and it is, why not harness that, rather than arguing that it's nonsense and that you're fooling yourself saying, “Okay, maybe I'm fooling myself.” But you always have to start from the position that you're not adding bonds and GICs to a portfolio to boost the expected return. You're adding them to lower volatility and make you a more disciplined investor. If you can accomplish that goal with an illusion, you've still accomplished the goal. Maybe you're doing the right thing for the wrong reasons, but that's okay.

Ben Felix: That's interesting. Yeah. It's a behavioural argument anyway, so why not continue to push the behavioural argument?

Dan Bortolotti: Exactly.

Mark McGrath: The type of people that might benefit from that are likely not the type of people who understand mark-to-market pricing and fixed-income pricing mechanics in the first place. The people are complaining about your article, Dan, and saying, “Well, no. If you marked to GICs.” Those are not the people that, because of their financial knowledge, obviously, they probably have a high enough risk tolerance that they don't need to fool themselves into the illusion of that smoothing effect of GICs anyway.

Dan Bortolotti: I think that's fair.

Ben Felix: I like that argument, though, for GICs.

Dan Bortolotti: Well, we certainly saw it in 2022. We had people who loved holding GICs in their portfolio and despised holding bonds. If you're going to argue that they're the same and the economic impact of rising interest rates is the same, you're theoretically correct, but it doesn't really mean very much to the end investor who's living through it.

Ben Felix: It's a great argument.

Mark McGrath: There's also cashable GICs, too, which I find to be quite compelling, where if you hold it for 30 or 90 days, your interest rate is guaranteed for the full year. But now they're liquid after that 30 to 90-day period. I think those are really interesting middle ground, too. You've got the guarantee if rates don't change, or if rates have gone down, then you can hold it. If rates have gone up, then you've benefited and you can cash it out and reinvest.

Ben Felix: GICs are equivalent to CDs for our American listeners. Short-term guaranteed deposits that are locked in for a period of time and they have pretty good returns relative to government bonds, for example. All right. Should we head into the after show?

Dan Bortolotti: Let's go.

***

Ben Felix: I want to talk about the AMA controversy. I tell it at my notes, but it wasn't really controversy. It's just a lively discussion in the Rational Reminder community based on a comment that both Dan and I made. Some people in the community really dislike the notion that not needing something to achieve your goals is a good reason not to use it. I think there was a disconnect between what we meant when we said that and how it was perceived. It was perceived as us saying that return stacking, which is what we were talking about then, might have some really attractive alpha, but we're just going to choose to ignore it because our clients are going to achieve their goals anyway. That's not what we meant.

I have one quote from the person who kicked this discussion off. K-L-A-N-H. I don’t know how you pronounce that, in the community. They say, “During the episode, there was this notion of I've never met anyone who failed to meet their financial goals because of not optimizing their portfolio. It felt quite hand-wavy to me and I started wondering how much of that is because of recent fantastic asset returns and/or reality of who their clients are. People with a relatively high net worth, would they feel differently if the last decade offered only say, 2% returns for a broad market index?”

There's one other comment that kicked off this whole discussion. They agreed with K-L-A-N-H. Flight8 said, “I suspect that most people in this community already know to hold a low-cost globally diversified portfolio of equities. They landed here for the evidence-based academic leaning focus of the podcast and discussion,” to then say, “Well, none of that really matters and the grand scheme of things can come across a bit disappointing. At the end of the day, we listen, debate and analyze the arguments not purely as an intellectual exercise, but in large part to decide whether to implement the evidence in our portfolio in some fashion.”

I think there's a lot to unpack here. When I said this, and I think, Dan, you'd agree, I did not mean that we are wilfully giving up on expected returns that we know were there, because our clients are so well off that it doesn't matter, or because we just, for whatever reason, don't want these extra returns. What I meant when I said that is that I don't have confidence that there's enough there in return stacking, in that case, to change our client's ability to meet their goals, especially when you trade off the risk costs, tracking error, which is a behavioural risk of that type of investment. I don't know, Dan. You said the same thing. What are your thoughts?

Dan Bortolotti: That's exactly right. I mean, I would really have to stress that. I mean, that would be a deeply insulting thing to say to any of our clients, this idea that, oh, we're not really going to try very hard, because your portfolios are big enough. I mean, we can't really add any value. I would never be that flippant. I think it's really important to say here, first of all, I mean, to address the idea, I suspect most people in the community already know to hold a low-cost globally diversified portfolio of equities. I'm sure that's true. That is not true of the greater population. Not even close.

The first thing when I've been writing about this for years, my thing I always try to stress is number one, get that part correct. Once you've got that part correct and you execute that low-cost globally diversified portfolio with discipline, it is really, really hard to do better. It's hard to do that. But if you can do that, what are you, 97%, 98% of the way there? You can work very, very hard trying to get that additional 2%. By that, I mean, market-beating returns is basically what we're talking about here. This idea that if you work harder at it, you have a very good chance of beating the market over time. I'm sorry, I don't believe that. I think the evidence bears it out. The whole active management bears it out. It's possible, absolutely. Is it likely? I don't think so.

If it's something that you enjoy on an intellectual level and you want to try to implement those ideas in your portfolio, I encourage you to do it. But don't be dismissive of people who say, “I'm going to have a merely an outstanding portfolio, instead of an optimal one.” The best parallel here I would make is with nutrition. There's a lot of research into nutrition. But just because you read the most up-to-date studies and you follow some of that empirical advice, doesn't guarantee you're going to get a higher outcome, or a better outcome. You do everything you can to get an excellent outcome, but let go of the idea that there's optimal, because the next time another study comes out, optimal just changed. You're always behind the curve. Strive for that if it's what you want, but I think be very careful to acknowledge that it's extremely hard to do better.

Mark McGrath: The type of people who spend their time in the RR community are obviously the types that are trying to optimize that last mile, as you guys pointed out. There's always trade-offs for that. To your point, Dan, optimal is only really knowable in hindsight anyway. For a lot of our clients, it's those trade-offs that could be really, really important and optimizing the last mile based on outcomes that we can't guarantee in the first place. If you've solved 97%, 98% of it, then there's a decision to be made about whether you want to attempt to optimize that last mile, knowing that there's going to be some trade-off somewhere. For many of our clients, I think maybe that's not exactly a good use of their time, our resources and everything else. I generally agree with both your comments otherwise.

Ben Felix: It's even more extreme. People who comment in the Rational Reminder community, there's the 100 or whatever people that comment actively, and then there's the remaining 10,000 that just read stuff. The people that are commenting, they tend to be the nerdiest people. I adore them and I spend a ton of time interacting with them in the community. It's not that we see an opportunity in whatever thing, and we're intentionally not taking advantage of. I agree, Dan, that would be insulting to our clients is that we just don't see that compelling of an opportunity given its trade-offs. Don't think that it's going to change anyone's ability to meet their goals. It's not that we see some amazing thing and we're just like, “Yeah. You know what? We're not going to do that.”

Dan Bortolotti: Took a lot of work.

Ben Felix: On Flight8's comment about it being disappointing, I do believe that to a large extent, that optimization, it doesn't really matter. You just explained this really well, Dan. I think evidence-based investing as just a concept has become a bit of a buzzword. But as we've seen, just on this podcast with so many people sharing different and often conflicting perspectives from a research perspective, there's evidence to support pretty much anything you want to do within reason. You can find a paper in the Journal of Finance to support, I don't know, probably hundreds, if not more, of investment strategies. Take these three papers. Look, they support this thing. I'm going to build an ETF. You could do that and call it evidence-based. But should people be chasing every basis point based on that? I mean, it's not practical. I like your analogy, Dan. If it's nutrition, you're changing your diet every week. The same thing with portfolios.

We express that in the way that we invest, you too an even greater extent, Dan, because you guys are mostly market cap weighted, but we're using Dimensional funds. It's not like we're 100% small cap value with leverage or whatever. We're pretty close to the market with pretty gentle factor tails, because we don't have a ton of conviction that this stuff's going to beat the market over the long term. We've got enough that we've got some tilts, but I truly believe that when Flight8 says that it's disappointing, I agree. I wish there was cooler stuff we could do and be confident it's going to add value, but I just don't think that's the case.

Dan Bortolotti: To circle back to the original comment, the listener said something, would they feel differently if the last decade offered only say, 2% unrealistic but not impossible annualized real returns for a broad market index? Again, we're looking backwards here. The absolute returns don't really make any difference to the strategy. For example, if over the last decade, a broadly diversified equity portfolio really did have a 2% real return, that's probably the best the vast majority of us would have been able to get. This idea that if absolute returns are low, there's somehow a greater opportunity to outperform the market. I just don't think that's true. I don't know how it could be theoretically true, let alone in practice.

Mark McGrath: I've written an article about this in Seeking Alpha yesterday. Somebody sent it to me. I don't know if either of you guys saw it, but it was called XEQT, a poor way for Canadians to invest. You'll be really familiar with both of you with XEQT, but it's the iShare’s, can’t remember the specific name. You probably know it, Dan, with the iShares Global Equity portfolio, all in one solution for 20 basis points. Just a magnificent piece of financial market engineering. I'm a huge, huge fan. I often comment XEQT and chill. I just think it's a great, great product. This article is basically the same, because of high US valuations. XEQT is a bad product, and it's going to underperform over the next decade, and active management will shine.

Dan Bortolotti: Underperform what?

Mark McGrath: There's absolutely nothing to support that. My friend Cam commented, “You made a really good point.” By definition, it's not ever going to be a bottom quartile fund, because active and passive are effectively equal before fees. Because of its low fees, it's unlikely that this is going to underperform active management in aggregate. It's always going to be a median, or top one or two quartiles than of fees, so it's never really a poor way for people to invest in these types of strategies.

Dan Bortolotti: Well, and I’d argue over a period of 10 years or more, funds like that typically are in the 5th to 10th percentiles. They're not just in the top half. They're much higher up.

Ben Felix: If people want to check that discussion out there, we’re at 119 comments. That was the first AMA episode that we did before the end of the year, I think. I want to talk about the OneDigital reaction. There was a lot of reaction. There were four types of reactions, if I were to summarize them down. For anyone that missed what I'm talking about here, PWL as a firm has been fully acquired by another firm called OneDigital.

There were a lot of congratulatory and excited reactions, which was nice. That was from a lot of clients, a lot of industry peers, and other professional contacts. They were generally pretty excited. There was a lot of cautious and sceptical optimism, and that was from some people in the Rational Reminder community and some clients. It was a pretty common reaction. They had the view that they trust us to have made a good decision, but based on anecdotal or personal experience, they're just a bit nervous about anything that involves private equity.

One digital has private equity investors, but it is not itself a private equity fund. That's probably the most fair reaction that I observed, given the relative lack of information that people had if they weren't part of making the deal happen. There was a lot of pessimism, a lot of that in the Rational Reminder community, and a lot of that in comments on YouTube. There were predictions that the podcast is going to end, that the community is going to be shut down, and that PWL, as we know it, is never going to be the same. I don't think any of that's going to happen. We're all staying at PWL. Cameron is staying at PWL. The podcast is sticking around. The community is not going anywhere.

The last one, which was less fun to interact with, was blind rage and disdain. That was mostly from anonymous commenters on our content, some of whom apparently did not previously realize that the Rational Reminder podcast was a PWL podcast. Someone was like, “Wait. What? This podcast is sponsored by a financial firm? I'm not listening anymore.” I was like, “What?”

Mark McGrath: Where have you been? You literally open every single podcast by saying your title, at PWL Capital. Did you think we just happened to all get together and happened to work at the same firm?

Ben Felix: I think some people might have actually thought that. I don't pass any judgment on people's reaction to the news. It was a big news. It was a big change. Nobody has anywhere close to the information that me, Cameron, and the PWL leadership team that made the decision. Nobody has anywhere close to that. I think people have a tendency to be pessimistic, or assume negative stuff. I do have some comments, though. We did not make this decision lightly. We had professional investment banking advisory help from people with specific expertise in wealth management M&A, looking at everything. Not just financials, but looking at the fit and the long-term prospects of the partnership and all that stuff.

We talked to practitioners who we know and trust, not just random practitioners, but people who have been on both sides of acquisitions, both people who have been acquired and done acquisitions. Talked to many of them. We talked to other firms that had been acquired by OneDigital specifically. We spent countless hours with the OneDigital team. We had professional legal advice from our long-time law firm, which, again, has specific M&A expertise, and they gave us lots of counsel along the way.

It's not like we just did the thing one day, because we felt like it. We put a huge amount of time and effort into making what we think is a good decision. On the other side of the deal, now that we have been sold, we're not cutting costs. We're not laying off staff. We're not reducing our services to clients to increase our profitability. PWL was already a well-run independent business. We built our current costs and service offering and profitability and everything into the deal. We're not going to get squeezed for more profit. They knew exactly what they were getting. We are continuing to invest in our client experience. We have some big infrastructure projects going on for things like online account opening, which makes everybody's lives easier. Also, online account updates.

We've just invested in improved financial planning software. It's a better software period. It's also got open APIs, which has allowed us to connect our client information from our data lake into the financial planning software, which makes our advisors work a lot easier for updating financial plans. It's got open APIs as well. We connect the custom planning models that Braden builds right into the planning software. We're continuing to build and release free financial planning tools that are available to the public. He's working on one right now that it's basically a bare-bones full financial planning tool, but it helps you optimize which accounts your contribution should be going into and which accounts you should be withdrawing from in which order when you're retired. This is super cool. It shows you how much better off you are if you’re doing it in the optimal order versus something else. All that stuff is continuing. It's not going to go away.

We could have done all that without OneDigital, though. Why did we do this deal? There are a lot of reasons, but I've got a few that I think are important that I want to mention. OneDigital as a firm has invested heavily in technology specifically designed to improve their client experience, and their expertise and resources are going to be super valuable to us as we work on doing the same, which is an important undertaking for us. They have, I think, 52 software developers and a head of product who has built a ton of really cool FinTech products in the past, and now he's working at OneDigital, to us is exciting. We think it's going to improve our client experience.

It also helps us grow through the acquisition of philosophically aligned Canadian advisors and also, to manage the growth that we're already seeing. People might say, well, why is growth matter for your clients? I think growth is good for everybody. It's good for clients and employees. Yes, it's good for shareholders, too. Growth allows a company to retain and continue to hire top talent, which is not something that's easy to do. The scale that comes with growth also facilitates investment back into the business and into the client experience.

Another one worth mentioning is that PWL was financially healthy. We were fine. I mean, we were doing really, really well from a stability perspective, but we were still a small business and we still had 100% of our revenues derived from investment management fees. Now, when your revenue is 100% derived from investment management fees, what happens when the market drops by 30% and stays there? But bounces back like it did in COVID, you're fine. But if it stays there, that's a 30% drop in your revenue, at least on an annualized basis.

During COVID, we came out of it fine, but that was really scary as a small business that doesn't have insane profit margins. Market drops 30% to 40% and it's like, oh, well, this isn't very good. OneDigital is a much larger business. They've got more diversified revenue sources than investment management fees. We're just on a much more stable platform than we were before.

Then the last piece that I'll mention is that this solves succession. What does that mean? Any successful private business has this problem, where founders typically hold most of the equity and the second generation just doesn't have the capital to buy the business from them. We were there. We had started allowing employees to buy shares in PWL. We had a great program in place. It was working well. There's lots of uptake from employees. The business was growing at this crazy pace and it just wasn't realistic to have a successful transition to the second generation.

At some point, we were going to need to raise external capital to solve that problem. There are lots of ways we could have done that. We did explore a lot of different avenues. When we met these guys, we just felt like we'd found the right partner that, among all the other things, was going to solve that problem once and for all. That's it. You guys have anything to add on the OneDigital?

Mark McGrath: No, I don't think anything that hasn't been covered already. I tried to hop into the Reddit thread and tame some of the stuff. It was not all super negative, or anything. A lot of people thought it was interesting. My clients, I've only talked to a couple of them. A couple of them were just like, “Great. Good for you.” The biggest question I've got from clients is, “How do you feel about that, Mark?” I think that's just such a great litmus test and a great question to ask as a client. Because our clients trust us and my clients trust me. They ask me, “Are you feeling good about this?” If I'm feeling good about it, they're like, okay, great. Let's carry on.

I think you explained it well, Ben. I think a lot of the reasoning and the due diligence and the process that went into this has already been well explained online and in previous episodes. I don't think I need to go much further into it.

Dan Bortolotti: The reaction has been mixed, I think, with clients that I've spoken to. I mean, some are sceptical, which I think is totally appropriate. Any change should be met with scepticism, not cynicism. For me, it always comes back to the same thing, which is, OneDigital was not interested in PWL because we were a distressed asset that they wanted to come in, burn it down, and then rebuild it. They came in because they like what we do, and they wanted to scale it up and bring that level of service to more people. If that ends up being the result, well, then it's pretty hard to argue with that.

Ben Felix: That falls into the sceptically optimistic, or cautiously optimistic. I think, that's how I would describe that reaction, Dan. There's a lot of that, and a lot of clients have said stuff like, “I'm nervous about this, but let's see how the next 12 months go.” I do think that we have, pressure is not the right word, but we're going to have to continue doing what we have been doing for the last 20, whatever years for the next few years to show that nothing has, in fact, changed for the worst.

Dan Bortolotti: One of the interesting things about this, I thought, is all of our clients are Canadian, of course, worried whether the fact that OneDigital is a US company might be an issue. I said this when we were talking about the acquisition is that in many ways, I think it could be a positive, because I think we would all agree that the US financial industry is in many ways years ahead of what we're doing in Canada as a rule. Our approach focusing on, let's call it index investing, passive evidence-based investing, whatever you want to call it, with integrated financial planning is more common in the US model than it is here. I would be, I think, a lot more worried if we were acquired by a Canadian firm who wanted to turn us into a mutual fund house. I think the cultural fit and in terms of the suite of services that we offer makes a lot more sense, frankly, with the US firm than it would with most Canadian counterparts.

Ben Felix: I agree with that. We looked at a lot of potential partners for this decision, some of them being in Canada, and to your point, Dan, there were some really interesting opportunities, but the fit here was just different, which is why we did it. I did want to mention something about my own health. You'll notice next week that Cameron is doing a rare solo interview of a guest that hasn't happened many times. That happened, because a week ago to the day that we're recording today, I had to have a surgery to remove a potentially cancerous testicle, and that guest was booked for the next day for the Friday. I thought, maybe I could still do it, but then there was no chance. Wasn't feeling too good after having a testicle removed.

Now, I don't have a diagnosis yet, but the testicle had to be removed due to a strong suspicion of cancer, is the language they used. They can't diagnose it though, until it's gone through pathology. I'll know more about that in mid-February. It might seem like a weird thing to talk about in a podcast about financial decision-making, but I thought it was important to share for a couple of reasons. One of the AMA questions had asked about profound experiences that changed how we give advice to our clients. I had mentioned my mom having had breast cancer, and my friend dropping like a rocket basketball due to his heart stopping is shaping my perspective.

It hits a lot harder when it's yourself. We had all this exciting stuff happening with OneDigital, and we announced it actually the same day that I was having surgery. I obviously knew about what was happening way before that. Yes, as a PWL shareholder, there was a financial windfall from the deal for me personally. I did roll the majority of my PWL equity into OneDigital equity. So, it was nothing too crazy. There was something there. Then I found out that I might have cancer, and it just puts everything in perspective.

Money is a tool that lets you do the stuff that you want to do. It lets you have control of your time. Let’s you express yourself. But if you don't have your health, what does it actually do for you? The other thing I want to say about this is that while I don't have a diagnosis yet, it's possible that it's not cancer. The doctors involved seem to think that whatever it is, we caught it really early. It feels weird talking about my testicles. I keep saying testicle. About a year ago, my testicle just didn't feel quite right. I've been playing basketball and got hit in the nuts, which happens sometimes. It hurt too much. I told my wife and she booked an appointment. Really pushed me like, “You're going to the doctor.” I went and got it checked out.

They sent me to get an ultrasound. There's a little thing on my testicle. Man, that feels so weird to keep saying. Then, so then this is too small to worry about now, but we're going to keep an eye on it. Then, I went for these routine ultrasounds. It seemed like we're just monitoring this thing that wasn't changing much and it probably wasn't a big deal. Then the last one I did at the end of last year, the results came back after the holidays. You're all just like, yeah, this needs to come out and now. Booked the surgery for six days later. It's crazy.

Anyway, so I guess my point of sharing that piece is listen to your body, I guess, I don't know. Because you're all just said that if this does end up being cancer, the fact that I caught it when I did and it came out when it did, it was likely lifesaving, as opposed to potentially spreading to other parts of the body and stuff like that. That's that. Hopefully, my pathology comes back with positive news, but we'll see.

Dan Bortolotti: I think, I speak for everyone, Ben. Wish you all the best on that. Thanks for sharing it too, because I think it's important to share that message. We appreciate the vulnerability and the fact that you shared this with the audience as well.

Ben Felix: Thanks, Dan. All right, one review. We do have some other recent contacts, but I think we can kick those forward to the next episode. This review is pretty funny. It's very fitting for the content of the episode. The title of the review is 666 reviews with a shocked face emoji. They give us five stars. They say, “Podcast still gets a five-star review from me, but can't help but notice after the episode announcing the buyout by a large US private equity backed company. They are sitting at 666 reviews. Coincidence? Well, now they have 667. Hoping the pit in my gut about their latest announcement is unfounded. Please be the exception to the rule and don't let this be the beginning of the end of something great.” From Mountain Men on iTunes and Canada.

Mark McGrath: The number of the beast has been surpassed. We're safe.

Ben Felix: Anything else from you guys?

Dan Bortolotti: No. I think that's all I've got.

Ben Felix: All right. We've got a guest episode next week, and then we'll do an AMA the week after that. That's it for this one. Thanks for listening.

Dan Bortolotti: Thanks.

Mark McGrath: Thanks, guys.

Is there an error in the transcript? Let us know! Email us at info@rationalreminder.ca.

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Participate in our Community Discussion about this Episode:

https://community.rationalreminder.ca/t/episode-343-how-to-choose-an-asset-allocation-episode-discussion/34745

Papers From Today’s Episode: 

'The Grable and Lytton risk-tolerance scale: a 15-year retrospective’ — https://static.arnaudsylvain.fr/2017/03/The-Grable-and-Lytton-risk-tolerance-scale-15-year-retrospective.pdf

Links From Today’s Episode: 

Meet with PWL Capital: https://calendly.com/d/3vm-t2j-h3p

Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.

Rational Reminder Website — https://rationalreminder.ca/ 

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/

Rational Reminder Email — info@rationalreminder.ca

Benjamin Felix — https://pwlcapital.com/our-team/

Benjamin on X — https://x.com/benjaminwfelix

Benjamin on LinkedIn — https://www.linkedin.com/in/benjaminwfelix/

Cameron Passmore — https://pwlcapital.com/our-team/

Cameron on X — https://x.com/CameronPassmore

Cameron on LinkedIn — https://www.linkedin.com/in/cameronpassmore/

Mark McGrath on LinkedIn — https://www.linkedin.com/in/markmcgrathcfp/

Mark McGrath on X — https://x.com/MarkMcGrathCFP

Dan Bortolotti — https://pwlcapital.com/our-team/

Dan Bortolotti on LinkedIn — https://www.linkedin.com/in/dan-bortolotti-8a482310/

Canadian Couch Potato Blog — https://canadiancouchpotato.com/

Canadian Couch Potato Podcast — https://canadiancouchpotato.com/podcast/