“BIDLYS” – Are defensive investments killing your returns?

We are in the second biggest stock market boom in history – and the most hated bull market ever.

The world stock markets (MSCI World Index) have more than tripled – up 250% since it started in March 2009. However, most investors have made significantly less. The reason is “BIDLYS”. (No, not “bigly”. 😊)

Let me explain.

If you are a long-term, risk-tolerant investor, getting all of the gain of the stock market (or more) is the way to build financial freedom. The long-term returns are high and reliable. For example, in the last 80 years, the S&P500 has averaged 12%/year. The worst 25-year return was a solid 7.9%/year.

The financial crisis in 2008 was the largest stock market crash since the 1930s. It was quick and broad, affecting almost all equity investors. The S&P500 fell 37% in 2008. It scarred many investors.

Since then, investors have been constantly worried about when the next crash will happen. It is a “Chicken Little” bull market with constant predictions that the sky is falling.

It has been one “apocalypse du jour” after another. Reasons for predicting the next crash since 2009 have included:

• “Dead cat bounce”
• “Double-dip recession”
• Quantitative easing (“QE”). The market is only fueled by the Fed “printing money”.
• QE is ending. The start of quantitative tightening “QT”.
• Housing crash.
• Brexit.
• Trump.
• Interest rates starting to rise.
• After 8 years, it must end soon.

As a result, many investors have constantly invested defensively – missing much of this huge bull market. Even many investors that claim to be “growth-oriented” and many Millennials with very long time horizons are investing defensively.

The investment industry has provided a steady stream of creative investments marketing to this fear. Most have been marketed as “high returns with less risk”.

The truth, however, is that lower risk almost always means lower returns over time. You don’t find the investments with the best long-term returns by focusing on low risk.

I called them “BIDLYS”. All the defensive investments owned by people scared of the next market crash. If your investments have not more than tripled since 2009, it’s probably because of BIDLYS:

Bonds:                  Bonds reduce the volatility of your portfolio, but also the returns. In calculating your growth, remember this key equation: 15% in bonds = a 1% MER.

“Asset allocation” generally means adding bonds to your portfolio.

Interest rates are very low and expected to stay low a long time, or possibly rise. Getting a 2%/year return on your bonds is probably the optimistic view.

Bonds gain when rates drop and lose when rates rise. If rates rise, you will probably lose money on bonds. Most bond funds lost money in 2017.

Ignore long-term bond returns. We are at the end of a 35-year bull market in bonds from 1982-2017, while interest rates went from 20% to 2%. Bond returns have been only a bit less than stocks, because they included capital gains from declining interest rates.

The last time rates were this low was in the 1950s at the beginning of a 30-year bear market in bonds. Interest rates went from 2% to 20%, while bonds lost 50% of their value after inflation after 30 years. If you had enough money to buy 2 cars and put it into a 30-year government bond in 1950, you could only buy one car in 1980.

Income:               In addition to bonds and dividends, income-focused investments can include income trusts, REITS, rental properties, annuities and option selling strategies. Income-focused investments have been expensive for the last few years. They had a good run, but have mostly been lagging the last several years. Interest rates are low. Expect income investments to have only moderate returns long-term.

Dividends:           Dividend investing is a subset of stock market investing. Today, most large stocks pay a dividend, so it is not much different than the large-cap indexes. You miss some unprofitable companies that can’t pay a dividend, but you also miss many of the market-leading growth stocks. Fast-growing companies usually reinvest their cash and only pay dividends after they mature and growth slows.

Whether it is “dividend-payers” (which are “bond proxies”) or “dividend-growers, why exclude non-dividend companies that include market leaders like Alphabet (Google), eBay, Facebook, Netflix and Priceline (almost all of the “FAANG” stocks), and great companies like Berkshire Hathaway (Warren Buffett’s company)?

Dividend-investing is less tax-efficient because you are paying tax every year on the dividends. Tax-wise investors prefer to defer tax. The lowest-taxed investment income is deferred capital gains.

For some people, there can be very low tax on dividends – but only if you are low income, under age 65 and invest only in Canada. People over age 65 can be hit with various clawbacks calculated on the “grossed-up dividend”. For example, low income seniors that can qualify for the Guaranteed Income Supplement are taxed at 69% on Canadian dividends!

“Home country bias” is not proper diversification. This is especially true in resource countries, like Canada, where 75% of our stock market is in only 3 sectors. We have hardly any companies in the other 11 industry sectors. You can’t reasonably expect a portfolio of Canadian banks, oil companies and utilities to keep up with the world stock market long-term.

Low volatility:    Investing only in very steady companies is obviously not an effective growth strategy. “Low volatility” funds were marketed heavily a few years ago following a few years when these conservative stocks had a good run. This quirk in the market ended a couple years ago. The BMO S&PTSX Low Volatility Index has only made about 1/5 of the return of the TSX60 the last 2 years.

Yield:                     “Anything with a yield” has been popular with “GIC refugees” since 2009 with the investment industry creating various investments that have a regular monthly or quarterly payment. With interest rates so low, these “bond proxies” try to get a bit higher rates than GICs or bonds. They will likely get hurt when rates rise. Don’t expect yield-focused investments to keep up with the broad stock markets.

Smart Beta:        An investment style where the manager passively follows an index based on factors like volatility or dividends, instead of the largest companies. In the end, it usually means almost the same as “low volatility”.

 

Summary

If you invest conservatively, expect lower returns.

If you are a conservative investor, this makes sense for you. It is important to invest within your risk tolerance. Conservative investors should not expect to get the full gains of the stock market.

If you are a growth-oriented investor, don’t expect to get the full return of the stock market with BIDLYS.

Sure, a theme can be popular for a while, but that is not how to get the best returns long-term. Buying popular investments is the classic investment mistake – you are probably buying high.

 

What is more effective than “BIDLYS”?

The most reliable way to achieve financial freedom is to build a large equity-focused portfolio. The stock market has provided reliable high returns long-term and should be the core of your long-term growth investments. Having confidence in the stock market long-term allows you to focus on finding the best investments for long-term growth.

Forget “some growth and some downside protection”. Ask: “Which investments or All-Star Fund Managers should get the highest long-term return?”

This may sound simple, but if you want to get the best returns, focus on getting the best returns. 😊

Once you have that confidence in the stock market, you can let go of the scars of 2008. Next time the market crashes, buy more.

If you are a growth-oriented, risk-tolerant investor, avoid BIDLYS. Invest in a global, diversified equity portfolio for the long-term.

 

 

Ed