With high market valuations and an ever-lasting bull market, one might get scared to invest in equities (stocks) and stay on the sidelines. We are not and continue to hold an aggressive portfolio of low-fee index funds (see our actual holdings). Over the long-term, the market has historically greatly rewarded equity investors but there is a balance to be found. With the help of the efficient market theory, we try to build a diversified portfolio which will support us throughout our journey.
How to balance between stocks and bonds?
Gathering data from 1928 to 2017, Aswath Damodaran from the Leonard N. Stern School of Business tallied that the average return of the S&P 500, which closely represents the American stock market, summed up to 11.42% per year before inflation.
Over the same period, 10-year Treasury Bonds averaged 5.18%. The short-term 3-month Treasury Bills averaged a return of 3.46% before inflation.
With this said, wanting higher returns and holding a large portion of your portfolio in stocks like we do is risky. By risky, we mean volatile. You will never lose a dime if you do not sell, but it will be a bumpy ride. One way we use to get a smoother ride is by holding an efficiently diversified portfolio.
The modern portfolio theory to the rescue
The modern portfolio theory developed by Harry Markowitz in 1952 states that it is insufficient to take a single investment approach or single asset class approach, but rather take a mixed-asset approach.
Better returns and less risk can be achieved with a combination of investments or an “efficiently diversified portfolio”. Having different asset classes does not mean to hold shares of Coke and Pepsi but rather holding investments that are not perfectly correlated or are, ideally, negatively correlated.
You can diversify your portfolio by investing in U.S. stocks, international stocks, bonds, real estate investment trusts (REITs), or emerging markets for example. You can get a free portfolio analysis with a customized efficient frontier chart with Personal Capital.
Source: Morningstar
Worldwide diversification
Holding a balanced portfolio can potentially increase your returns while greatly diminishing risk. We do not hold many bonds in our portfolio but we are greatly diversified across continents and asset classes.
To get into numbers, using asset class return statistics from the S&P TSX Composite Index returns, the DEX Long-Term Bond Index returns, and the S&P 500 Index returns from 1970 to 2009 provided by Standard & Poor’s Index Services Group, we can see in the table below how diversification can increase the average yearly returns while greatly diminishing the risk, or volatility, of your portfolio.
Holding a globally diversified portfolio with 40% bonds, for example, historically reduced risk by 41.64% while increasing returns by 0.64% per year over a Canadian stock-only portfolio. Over the whole period (from 1970 to 2009) this slight edge adds up to a 28.25% higher end balance.
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|
Asset Class |
Average Yearly Return |
Standard Deviation (Risk) |
Risk Reduction |
|
Canadian Stocks |
9.7% |
16.57% |
— |
|
Balanced Portfolio |
10% |
11.49% |
30% |
|
Globally Diversified Portfolio |
10.34% |
9.67% |
40% |
Source: The Index House
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We do not expect history to repeat itself but the basic concept still holds; investing in different asset classes around the world and benefiting from the non-correlation of the markets over the long-term.
Over the past decade, the correlation between markets has generally been on the rise. This makes proper diversification harder but still possible. In the chart below, absolute correlation is represented by 1.00.
Source: Charles Schwab
It makes sense when you look at today’s economy. Most American companies have now expanded across the globe and now operate everywhere from Texas to Rio de Janeiro.
Not only does most major company now depend on emerging markets for growth but another major factor is the ease of information the internet has brought us. Information now spreads quickly across markets and anyone can now have access to the same information only large institutional investors used to get.
Controlling your fees
Going forward, we cannot predict returns nor can we guess which asset class will perform best. The one thing we can know and control is the fees associated with our portfolio.
We keep our fees low by holding index funds from Vanguard and using Questrade to trade for free.
The following graph clearly shows the impact of fees on your portfolio over the long-term. Over an investment lifetime (here results are shown since 1974) management fees can diminish total returns over threefolds.
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Source: Germak
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At the very bottom, the blue line represents the historical returns of $10,000 invested in the S&P 500 after a 2.5% management fee commonly charged by Canadian mutual funds.
With almost twice as much total returns, the gray line illustrates the returns after a 1% fee and further up. The yellow line shows the potential after a 0.42% annual fee such as the average fee of TD e-Series funds.
Lastly, the blue line shows the historical returns after a 0.15% management fee charged by most ETF providers such as Vanguard and the green line represents the S&P total returns over this period.
It is astonishing to see how the simple fee structure of exchange-traded funds has tripled the returns of investors when compared to highly-priced mutual funds. We suggest you try out Personal Capital’s Fee Analyser for free to see exactly how much your portfolio is costing you.
If all of this sounds too complicated, we suggest Wealthsimple.
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