My last post outlined the semi-dull (really dull?) fundamentals of investment and savings vehicles available to Canadians. This material can be dry, especially to those not interested in risk, yield, investing, finance, etc. But I urge Canadians to do their homework on it as it is important to, at the very least, have a basic understanding of stocks versus bonds, and know where to hold these various investments.
“So how do I actually create an investment strategy I’m comfortable with?”
Well it all boils down to personal taste. Try not to dwell on it to death though, or you’ll end up like Skeletor in the picture above.
To begin with, it’s probably best to talk about the traditional approach to investing for retirement and creating your nest egg. It is this nest egg upon which you will feast to survive in your golden years. It goes something like this…
- When you’re young, you have time on your side before you take a crack at retirement. If you’re 25 or 30, and you’re not supposed to retire until 60, 65 or 70, you could have up to 45 years to accumulate a nest egg!
- So you have a long investment horizon and you would invest heavily in stocks, and very little in bonds; maybe a 95%/5% split. Why? Because experts feel that people could better manage the volatility of stocks over a long term and could then reap the rewards of better average annual returns.
- As we get closer to age 65, this mixture slides less in favour of stocks, maybe to a 60%/40% split. The point of this is to reduce volatility & increase predictability – the only issue is you get predictably lower yield, since bonds provide lower yield (If you remember from my last post).
- Most humans aren’t very good with the behavioural psychology aspect of money:
- If Mr.Panic sees the stock market dip and lose 20%, he might think “I don’t want to lose more! I’ll just take this 20% loss and wait till the market is finished it’s downward spiral and get back in.“
- Then the market corrects itself gaining 25%. However, Mr. Panic hesitates at first not knowing if this is the real deal or not, he isn’t mentally prepared so he invests a few months late and only gets a 15% gain. Well he lost out didn’t he?
- Volatility means nothing until you cash out and realize those gains/losses.
- The fact is, Bull Markets last much longer than Bear Markets. While it’s from 2014, I like this infographic from Business Insider illustrating this trend nicely.
- So while Bear Markets can be a scary thing when you lose 20% or more, they statistically last only 367 days on average (using data from 1900-2014).
- From there, you could enter a Bull Market that can last 5 to 10 years with much more potential upside. In addition, it is the first year or two of a Bull Market where you’ll pare the losses of the prior Bear Market (i.e. getting out during a Bear and trying to time your way back in on the upswing of a Bull is generally poor planning).
- A Bear Market is defined as a drop of 20% or more. If I look at data after the Great Depression, I see 4 years with a drop of 20% or more with an average drop of 30.2%. BUT, looking at the return the following 2 years, provides an average return of 30.9% in the first and 12.3% in the second. This means that every dollar you had in the market BEFORE the 30% drop, would be worth $1.03 after the third year. Not a great annualized return but you’re net positive. Even better news is that from here, you ride out another 3 to 8 years of a Bull Market ensuring some nice returns!
- Those in favour of this traditional approach will say that is exactly what they’re trying to avoid, a big market crash close to their retirement date. Could you imagine closing in on say a $1.0M nest egg and then all of a sudden you’re down 30% to $700K? That would sting, but if you’re able to remain flexible and continue working the next TWO years, not only will you be putting additional savings into the market at discounted prices, but your original nest egg, using historical averages, would grow to $1.03M. If you were able to put away an extra $50K/year over those 2 years, you’d get your nice initial Bull Market returns of 30.9% and 12.3%, boosting your nest egg by $120K. Now you’re at $1.15M, congrats you hit your target and then some by incorporating some flexibility!
My problem with the traditional mixture of stocks and bonds is that, sure, stocks do have more volatility, but as I said earlier, Bear Markets are much shorter than Bull Markets. So during that big bad Bear, you cut out your expensive Summer travel plan and replace it with a staycation / local camping for a Summer or two. If you’re close to retirement, work an extra year or find some part-time work that you enjoy to supplement. To me, it’s significantly better to take on the volatility of the stock market for greater returns than shift to bonds.
A caveat to this is some folks will adjust before a market crash. They may increase their bonds/cash and reduce stocks off a gut feeling / expert opinions / self-analysis of Global GDP Growth-to-Market Capitalization Growth or CAPE, etc. This is certainly doable and can be advantageous if you’re lucky enough to reduce your exposure right before the market drop. But if the market drop has already occurred…ride it out! I wouldn’t suggest trying to time the market – the old saying is “time in the market is better than timing the market.” If you’re not a super savvy investor, a passive approach like this works wonders.
For those who like the traditional approach, I would look into Target Date Funds. Target Date Funds are mutual funds that make those adjustment from stocks to bonds based on a target retirement date. So the fund will rebalance over time as you approach the target. Target Date Funds are usually accessible in any RRSP / DCPP plans.
My personal approach is more aggressive, as I’m comfortable with 100% stocks. I’d say for those looking to retire early, you’ll also likely benefit from this as taking on more safety with bonds reduces your portfolio returns, and it will naturally take more years to compound to your desired nest egg. You could opt to hold individual stocks but to do this, you need to spend an adequate amount of time understanding the company, their cash flow, position in the market, competitive advantages, and many many more aspects. For the majority of us, and this is not news as you can find it on many personal finance blogs, is to use Index Funds.
Index Funds track broad indices such as the S&P 500, NASDAQ, Total Market, etc. You can find Index Funds tracking anything these days. The beauty of this approach is you own parts of each company (bad and good) – this requires little research and overall, the good companies will outperform the badness of the bad ones. Index Funds can be bought in any investment account. I personally like Vanguard funds which are seen as some of the best options for very low fees. Have a look at the link and explore some funds! You can read up on any of those funds by clicking on the Fact Sheet.