How to Easily Outperform Investment Advisors & Robo-Advisors
Investment advisors and robo-advisors have a massive disadvantage – they are short-term thinkers. You can easily outperform them by learning the skill of long-term thinking.
Short-term thinking leads them to select suboptimal investments and focus on the wrong risk.
You can clearly see this because nearly all investment advisors and robo-advisors do the “4 Performance Drags” that drag down their long-term performance. Just avoid the “4 Performance Drags” and you can easily outperform them.
How easily? It’s like a race from Halifax to Vancouver. All the investment advisors and robo-advisors take various combinations of flying, driving and biking for different parts of the trip. They all debate about how much driving and how much biking. Meanwhile, you take a non-stop flight. Who gets there first? That easily.
Prefer an overview? Like videos? Check out our whiteboard video, or read the full post below!
The truth is that investment advisors and robo-advisors are not even trying for the maximum reliable long-term total return.
In this post, I will explain:
- How short-term thinking reduces long-term returns
- What are the 4 Performance Drags?
- How to Use the 4 Performance Drags to compare popular investment strategies
- The skill of long-term thinking. Why long-term thinkers easily outperform and how you can learn to think long-term.
- The secrets to outperforming with stock market investing.
Learn to think long-term. Avoid the 4 Performance Drags. Learn the secrets to outperforming with stock market investing.
Then you can easily outperform investment advisors and robo-advisors.
A. How Short-term Thinking Reduces Long-term Returns
First, Let’s understand how short-term thinking leads to selecting suboptimal investments and focusing on the wrong risk.
1. Suboptimal Investments
Investment advisors and robo-advisors tend to focus on what might happen next week or next year, which asset class will outperform, and reducing short-term volatility.
It is “compliance advice” – their advice for you must fit the rules of their compliance officer even if that means it is not what is optimal for you. “Compliance advice” forces them to focus on short-term volatility.
This is why they use conventional asset allocation by allocating portfolios between stocks, bonds and cash.
Long-term thinkers consider this to be “de-worsification”. Effective diversification is a variety of high-return investments, such as investing in many sectors or all over the world (global equities). De-worsification is a mix of good and bad investments, or high-return and low-return investments.
Conventional asset allocation and de-worsification is probably how most people should invest – but you can learn to think long-term and use effective asset allocation instead.
Most investors are short-term thinkers focused on what might happen this week or this year, and whether the market will go down short-term. They look for a reasonable return with less risk, so they probably need conventional asset allocation, even though it will reduce their long-term returns.
Long-term thinkers focus on the maximum reliable long-term total return on their investments to achieve their life goals. The asset class with the highest reliable long-term return is the stock market. Over the long-term, stocks have outperformed bonds and cash 100% of the time. (Details in section D.) This is especially true in periods like today with very low interest rates.
You can learn to be a long-term thinker. Don’t worry about anything that may or may not happen in the next few days, weeks, months or years. Adjust your binoculars and look 20-30 years into the future. What investments are likely to reliably outperform over the next 20-30 years? Almost definitely equities (stocks).
(We usually use the term “equities” for the stock market, since it means you own equity in a variety of large companies.)
To invest effectively, long-term thinkers tend to invest 100% (or close to it) in equities (stocks).
2. Focusing on the Wrong Risk
Short-term thinkers focus on short-term risk, such as:
- Will there be a crash next month?
- What is happening in the economy?
- Will a politician do something negative for investors?
- How can we reduce short-term volatility?
Their goal is to reduce short-term volatility. When the market goes down, they want to minimize the decline. They define risk as either low standard deviation (a measure of volatility or uncertainty) or drawdown (how much investments go down in a decline).
For short-term thinkers, risk is short-term volatility (ups and downs).
Investment advisors will talk with you about your “risk tolerance”. They will require you to fill out a “risk tolerance questionnaire” and use it to determine your investments. However, risk tolerance is a learned skill.
You can learn to have a high risk tolerance.
When I first flew on airplanes, I panicked every time there was turbulence. I had a low “turbulence tolerance”. I have now flown many times and talked with many experienced flyers. I no longer worry about turbulence. It happens, it’s short-term and it’s part of flying.
Turbulence with equities is the same. It happens, it’s short-term and it’s part of effective investing. The stock market has reliably recovered from 100% of past declines with a little time, and still has outperformed bonds and cash 100% of the time over 30-year periods.
Long-term investors look for the maximum reliable long-term total returns. They typically have a long-term goal, usually retirement or financial independence or “FIRE” (financial independence retire early), so they define risk as getting a long-term return too low to achieve their life goals.
Long-term risk is a long-term rate of return too low to achieve your life goals.
For example, if your retirement goal is based on a long-term return of 8%/year, the risk in your life is not whether there is a crash next month – but whether your investments have a 30-year return less than 8%/year. If the markets go down, they will bounce back on their own with time. But if you get too low of a long-term return, you don’t get the comfortable retirement you want.
To get a 30-year return of 8%/year or more, bonds and cash make your portfolio more risky. Their long-term return will almost definitely be far lower than you need.
It’s critical to understand this. Stocks are volatile short-term, but have had reliable long-term returns in history. Bonds have low short-term volatility, but high long-term risk.
The worst 25-year calendar return of the S&P500 in the last 90 years is a strong 7.9%/year. Bonds made zero after inflation for 80 years from 1900-1982. Bonds lost nearly 50% after inflation for 40 years from 1940-1980. (Details in section D.)
This chart illustrates short-term risk and long-term risk. Which investment is more risky? Short-term volatility of equities or long-term steady losses after inflation that often happen with bonds and cash?
Long-term investors have a long-term life goal, so they only own investments they are confident should reliably make the long-term return they need. Bonds and cash will make less, so they add long-term risk. Only equities (stocks) are likely to make 8%/year long-term.
Focus on long-term risk, not short-term ups and downs.
Thinking long-term and having a high risk tolerance are skills you can learn.
To minimize long-term risk, long-term thinkers tend to invest 100% (or close to it) in equities (stocks).
B. The 4 Performance Drags
In the graph starting this article, “Total Return Investing” is just the global stock market (MSCI World Index). Notice that it easily outperformed the other strategies by between 3.9%/year and 7.6%/year for the last decade.
Investment advisors and robo-advisors tend to use the other strategies on the graph, all of which have had far lower returns because of the “4 Performance Drags”.
Let’s look at the 4 performance drags, how you can use them to compare investment strategies, and how avoiding them allows you to easily outperform investment advisors and robo-advisors.
1. FBI – Forced Bond Investing
Nearly all investment advisors and robo-advisors will try to force you to buy bonds (FBI). The classic 60/40 portfolio has 40% in bonds. Normally, the minimum they will allow is 20% in bonds.
The 30-year yield on the Canadian bond index today is 1%/year. Inflation is expected to average 2%/year. That means if you invest in the bond index for 30 years, you can expect to lose 30% of your purchasing power over 30 years. If you are lucky, you might keep up with inflation. Bonds may or may not keep up with inflation the next 30 years. Even though you collect the interest, you lose purchasing power. Your money buys 30% less 30 years from now than it does today.
That’s the optimistic view! Bonds will be lucky to make zero after inflation over the next 30 years.
What happens if interest rates rise during the next 30 years? Bonds lose value when interest rates rise, so bonds will lose money – not just purchasing power.
Bond investing today is like flipping a coin. Heads you make zero. Tails you lose money. How many times do you want to flip that coin? Do you want this coin to be 40% of your investments?
Why would anybody buy such a horrible investment?
This is why Warren Buffett describes bonds today as “return-free risk”. In the past, many considered them to be “risk-free return”, but today they are “return-free risk”.
Bond returns have been decent the last few decades. We had a super-weird “bond bubble” from 1982-2020 when interest rates fell from 20% to 1%. Bond returns are okay when interest rates fall, because declining interest rates make bonds rise in value. However, when interest rates are flat or rising, bonds tend to make zero after inflation or actually lose money long-term.
Bonds in Canada, the US and globally made zero after inflation from 1900-1980. That is 80 years with a zero return! This is the normal return of bonds. The returns during the “bond bubble” are super-weird and abnormal – and unlike anything we are likely to see in the future. From today’s very low interest rates, the next few decades are likely to be like the first 80 years of the last century – and nothing like the last 40 years.
I talked with a guy in 2000 that showed me that stocks have made 25%/year. That was the return of the S&P500 during the 5 years from 1995-1999 during the “tech bubble”. I told him, “You can’t look only at the bubble period and expect that to be a normal return.”
Similarly, you can’t look at bond returns only during the “bond bubble” from 1982-2020 and expect that to be the normal return.
Investment advisors and robo-advisors will show you charts with bonds or balanced portfolios (half bonds) having performed well, but will only show you returns during the “bond bubble”. All these charts are irrelevant. They only show bonds during the “bond bubble”. Ask them to show you what the returns on their portfolio will be when bonds make zero after inflation for the next 30 years.
How much are bonds likely to reduce your returns? Many investors have become aware of how fees can reduce returns, but not about how bonds can reduce returns. To make a comparison, the “Asset Allocation Loss Ratio” (AALR) can affect your returns like a “management expense ratio” or MER:
Asset Allocation Loss Ratio (AALR)
25% bonds = 1.5% MER
In other words, 25% in bonds is likely to reduce your long-term returns by 1.5%/year.
I have talked with quite a few investors that left a high-fee advisor who wasn’t giving them much real advice to go to a robo-advisor or “couch potato” portfolio – but ended up with a higher allocation to bonds. In the end, their returns were not any higher.
Jon’s story: Jon is a millennial age 30 with a high risk tolerance and knowledgeable about investing. He told me he knows how to “game” the risk tolerance questionnaires and answered every question from 3 different robo-advisors for the maximum risk. The recommended portfolio always had 20% bonds. He phoned the office to talk with a portfolio manager and told him he did not want bonds. The portfolio manager said he can make an exception and force him to buy only 10% in bonds. Jon called me and asked, “Why are they forcing me to buy bonds??”
Investment advisors and robo-advisors almost always try to force you to buy bonds. Its “forced bond investing” (FBI).
The bond portion of their portfolio will obviously drag down their long-term return. Read more here: The High Risk of Bonds.
2. Home Country Bias
In every country in the world, investors invest mainly in their home country. It’s dumb in every country (except possibly the US).
In 2008, the stock market in Iceland plunged 93% in 2 weeks in their financial crisis in which all 3 of their big banks defaulted. Investors in Iceland were decimated because they had 80% of their investments in Iceland stocks. When I read this, my first thought was, “What stocks are in Iceland?” I couldn’t name one. Why would they invest 80% only in their own tiny country??
In Canada, the story is the same. Canadian investors tend to have 25-80% of their investments in Canada, even though Canada is only 3% of the world’s stock market.
Stock market returns have been much lower in Canada than the rest of the world – and that will likely continue. In the decade ended 2019, returns of the Canadian stock market index TSX60 were 4.6%/year, while the US index S&P500 made 14.3%/year and the global MSCI World Index made 10.9%/year.
Canada normally lags, but not normally by 6.3%/year for a decade. The TSX60 outperformed in the decade from 2000-9 when oil shot up to $150/barrel, but lagged hugely from 2010-19 while oil plunged to $20/barrel (and lower for Western Canada Select oil).
This drag is likely to be more in the future than in the past, because we are in an age of climate change. Canada is primarily an oil country. Oil and gas are our main export. Our dollar fluctuates mainly based on the price of oil and interest rates. Our stock market tends to perform well when the price of oil is high and lag when it is low. To a significant degree, investing in Canada is primarily a bet on oil.
The global stock market MSCI World Index is well-diversified over the 14 main industry sectors and has many large, growing companies. Canada’s TSX60 is not at all diversified. 75% of it is resource and financial stocks. We call it “rocks, trees and banks”. Most of the other 11 industry sectors are only 1-2% of the index.
Bottom line: Canada’s stock market TSX60 index should not be a core holding for ANYONE. It is a resource and financial sector fund – not a core holding.
Home country bias will almost definitely drag down your long-term return.
3. “Riding the Brake” – Focusing on Short-term Risk
In a recent investment seminar, the speaker’s “wise” insight was that: “Every investment advisor is looking for reasonable returns with less risk”.
Note the goal is NOT the maximum reliable long-term total returns.
They are all “riding the brake.”
Normally when an investment advisor says “with less risk”, it is code for FBI – Forced Bond Investing. They will recommend bonds or a bond fund, or other investments that are partly bonds (such as income funds, balanced funds, or asset allocation), or some other type of income investing.
“With less risk” can also mean a variety of creative investment methods that focus on reducing risk, instead of maximizing returns.
It is critical to understand that investing for lower risk almost always means lower returns, as well. Investment advisors and robo-advisors will argue against this, but if they were investing for the maximum reliable long-term total returns, they would own investments with more growth.
Some recent trendy ways of “riding the brake” are “smart Beta” and “low volatility” funds. These are marketing attempts to persuade you that you can invest for lower risk and not reduce your long-term returns.
Investment advisors that use these methods will point to certain periods when they outperformed, especially when investors were pessimistic. But longer-term returns tell the truth. The highest return low volatility ETF returns were 4.6%/year the last decade when the MSCI World Index returned 13.4%/year. The highest return global “smart beta” fund has a 3-year return of 5.7%/year when the MSCI World Index returned 9.0%/year.
Almost all investment advisors and robo-advisors “ride the brake”. They focus on short-term risk, not long-term risk, which leads to them suboptimal investments that will likely have lower long-term growth.
“Riding the brake” by focusing on short-term risk will almost definitely reduce your long-term returns.
4. One-Idea Investing – “Honey, I shrunk the universe”
There are many great ideas in investing, but there is no silver bullet. You can’t find all the best stocks in the world if you have only one idea.
The biggest problem with “one-idea investing” methods is that they artificially reduce your investment universe. Instead of looking all over the world for the best long-term investments, they limit you to one subset.
“One-idea investing” includes some methods we have already discussed, such as home country bias, low volatility and smart beta, but it also includes sector funds and dividend investing.
The most popular sector funds recently have been the sectors in bubbles – crypto currencies and pot stocks. Investors in both learned the risks of ignoring fundamentals.
Many investors like dividend investing and it is not a bad idea – but there are many other good ideas. You get paid regularly with dividends and dividend stocks tend to be less volatile, but they have shrunk their universe to exclude most of the fastest growing companies and some great companies (such as Warren Buffett’s Berkshire Hathaway). These growth stocks reinvest their profits for more growth, instead of paying out dividends. Dividend investing is still investing in stocks, but many of the highest return stocks do not pay dividends.
The problem with dividend investing is that it is a type of income investing. It focuses on the dividend – instead of the total return. With total return investing, you can own dividend stocks and non-dividend stocks.
Once you focus on the dividend, it’s hard not to look for stocks with higher dividends – instead of the best total return stocks. Dividend investors often brag about how high their dividends are. High dividend stocks are the big drag, because they tend to be in slow-growth “bond proxy” sectors. Stocks with high dividends tend to be in only 3 or 4 sectors, such as energy, utilities and financials, and you miss large important parts of the market.
With dividend investing, you are always tempted to “ride the brake” of income investing by looking for higher dividends, instead of the maximum reliable long-term total returns.
There are 4 problem with dividend investing:
- Shrinking your investment universe.
- Forgetting about the growth. Today, you miss the big growth leaders in the stock market, such as 4 of the 5 FAANG stocks. The total return of stocks includes both dividends and growth. It’s “one idea investing” only focusing on the dividends.
- You often end up mainly in Canada (home country bias) because of familiarity with the companies and the lower tax on Canadian dividends (dividend tax credit).
- You are taxed on the dividends now and create a “tax drag”. You can defer tax paying it years from now by focusing on deferred capital gains. Hold solid equity investments for many years and just let them grow with little or no tax. Deferred capital gains are the lowest taxed type of investment income. After you retire, you can use “self-made dividends” by selling a bit of your equity investments every month. “Self-made dividends” are better than ordinary dividends in every way.
It is the maximum reliable long-term total return that we want. It does not really matter whether that return is in the dividend or the growth. The dividend is one of 100 details to consider when you invest in stocks.
For example, which of these 3 stocks would you rather own:
Stock A: 10%/year total return with 0% dividend and 10%/year growth.
Stock B: 9%/year total return with 2%/year dividend and 7%/year growth.
Stock C: 7%/year total return with 5%/year dividend and 2%/year growth.
When you think about it clearly, it is only the total return that matters. The dividend is only a detail.
Shrinking your investment universe with “one-idea investing” will most likely reduce your long-term total return.
Summary: Think Long-term and avoid the “4 Performance Drags”
Thinking long-term is a skill you can learn. Having a high risk tolerance is a skill you can learn. Avoid the “4 Performance Drags”. Invest for the maximum reliable long-term total returns.
If you do, you will probably invest with a high equity allocation (possibly 100%) with a diversified global equity portfolio and you will almost definitely easily outperform investment advisors and robo-advisors over time.
C. Comparing Investment Strategies
Now that we know about the “4 Performance Drags”, we can use them to understand investment methods. When you compare various investment strategies, the main difference is usually based on the “4 Performance Drags”.
Let’s look at the current popular investment styles:
1. Long-term Total Return Investing vs. Investment Advisors and Robo-advisors
Long-term total return investing is simply 100% global equity investing.
- Winner: Long-term total return investing. Easily. Investment advisors and robo-advisors nearly always have 20-40% in bonds (FBI), 20-80% in Canada (home country bias), and tend to focus on lower short-term risk with investments like income investing, higher dividends, smart beta or low volatility (“riding the brake”).
2. Dividend Investing vs. Index Investing
These are 2 of the most popular investing styles recently. There are hundreds of blogs focused on both of these methods. Which is more likely to give you the higher return?
- Winner: Dividend investing (normally). Dividend investing is 100% equities, while index investing usually has 20-50% in bonds (FBI). Bond holdings are the main difference.
- Index investing that is 100% equities will probably outperform dividend investing over time. Dividend investing tends to have 50-100% in Canada (home country bias) vs. 25-50% Canada for index investing. Home country bias would be the main difference.
3. Robo-Advisors vs. “Couch Potato” Investing
Index investors often debate between these 2 methods.
Winner: Robo-advisor (by a nose) (normally). Both are index investing and robo-advisors add a fee (typically .5%), but the winner is usually the one with less in bonds (FBI) and Canada (home country bias). Having 10% more in bonds or Canada is probably a bigger effect than the .5% fee. Remember the AALR: 25% bonds = 1.5% MER, so 8% bonds = .5% MER.
- I compared a large robo-advisor to the couch potato portfolios with their most aggressive portfolios. Both had 20% in bonds, but the robo-advisor had 23% in Canada while the Couch Potato portfolio had 30%. Home country bias is often the main difference.
- Robo-advisors normally just invest in broad indexes, but sometimes have underperformed when they include “one-idea investing”, such as smart beta, low volatility, or dividend funds.
D. The Skill of Long-term Thinking
Financial Planners have a huge investing advantage over investment advisors. Investment advisors think short-term about what will happen next with investments. Financial Planners think long-term about your life goals.
Learn to think like a Financial Planner – long-term.
I learned this writing 1,000 professional Financial Plans. Achieving the desired retirement is impossible for most people using a balance portfolio with a 5%/year return, but is usually achievable with an equity portfolio with an 8%/year return. It led us to focus on how to reliably get a higher long-term return.
The main reason investment advisors and robo-advisors use the “4 Performance Drags” is because they think short-term.
Adjust your binoculars to 20-30 years from now. Learning to think long-term is the first critical step. Thinking long-term can have a profound effect on your financial freedom.
The chart below puts it all in perspective. It shows the 200-year “real” (after inflation) returns of different investments. Note that stock market returns have been both many times higher and much more reliable than bonds or other investments. You can see this because the return is close to the trend line for the entire 200 years.
People sometimes worry that something bad will happen in the economy or politics that will make the stock market lose money long-term. Today’s problems are small compared to history. This chart goes through the Revolutionary War, the 2 World Wars, the Great Depression and the last pandemic (the Spanish Flu). Through all this, stock market returns were always close to the long-term trend line.
Bond returns vary far more from its trend line. Note how bonds lost money steadily from 1940-1980 during the “Bond Collapse” and then shot up from 1982-2020 during the “Bond Bubble”. Bonds in Canada lost almost 50% of their purchasing power after 40 years during the “Bond Collapse”.
The reason stock market returns have been so reliable long-term is because it is an investment in large companies with managements. Whatever happens in the economy, the management adjusts to try to bring the company profits back up. Bonds don’t have managements.
Stock market returns are not as smooth as they look on this chart, because this is decades it is ahead or behind the trend and this is an exponential growth chart.
However, it puts it all in perspective. It clearly shows that stocks provide the maximum reliable long-term total returns.
“With less risk” always refers to short-term risk – not-long term risk. The investment industry is focused on potential short-term market declines. They measure risk with a statistic called “standard deviation” (a measure of volatility or uncertainty) and they focus on the 3-year standard deviation (for some reason).
The truth, however, is that risk depends completely on the time period. In the classic “Stocks for the Long Run”, Professor Jeremy Siegel studied investment risks after inflation for a 200-year period. You can see in the chart below that stocks are riskier than bonds and cash for 1-year, 2-year and 5-year periods. However, stocks are lower risk and have more consistent returns than bonds or cash (T-bills) for periods longer than 20 years:
For retirees, the conventional wisdom is that they should invest mostly in bonds. However, history shows that stocks have been more reliable than bonds in providing a reliable retirement income rising by inflation for 30-40 years. The “4% Rule” that many advisors use to determine how much you can reliably withdraw from your investments every year has only ben reliable in history if you invest with 70%-100% in stocks.
Long-term risk for bonds is higher than long-term risk for stocks.
Thinking long-term is a skill you can learn. Having a high risk tolerance is a skill you can learn.
If you do, you will probably invest with a high equity allocation (possibly 100%) with a diversified global equity portfolio. Then focus on identifying investments where you are confident the long-term return over the next 20-30 years should be equal to or above the world stock market index (MSCI World Index).
The stock market has reliably provided solid long-term returns in history. When you focus long-term, you can be confident in the stock market.
Long-term investors look for the long-term security of the stock market, instead of the short-term safety of bonds. Is your money safe OR secure?
Don’t worry about short-term volatility. Look for the maximum reliable long-term total returns. Then you can easily outperform investment advisors and robo-advisors over time.
E. Learn the Secrets to Outperforming with Stock Market Investing
There are secrets to outperforming with equity investments. Here they are! (Drum roll…)
1. Get all of the return of bull markets. Don’t waste your energy trying to guess when the next market downturn will happen, because it will lead you to miss the growth. The stock market is rising (bull market) most of the time. Focus on getting 100% or more of the growth during bull markets.
From 2009-19, we had the longest bull market in history. Nearly every day in that decade, there were articles recommending to get ready for the next recession or market crash. Most investors missed much of the growth because they focused on short-term risk by trying to guess when the bull market would end. During bull markets, keep your foot on the gas all the time.
2. Buy more when stocks are on sale. Every now and then, stocks go on sale. Short-term thinkers call this a “bear market” or market crash, but long-term thinkers see that stocks are on sale. Buy more if you can, whenever the markets drop by 20% or more.
Market declines are always buying opportunities. All it takes to beat the index long-term is to match the index returns and buy more whenever stocks are on sale. This reduces your average cost and increases your long-term return.
This means your brain needs to take over and not listen to your gut. The human gut has evolved to be efficient for fight or flight, but not for complex decisions like effective investing. People that have a human gut tend to be bad at market timing. Ignore your gut and always try to buy more when stocks are on sale.
Having a high risk tolerance is a skill you can learn. It is your brain taking over from your gut when the markets are down. Remind yourself that stocks have the maximum reliable long-term total returns and your retirement is based on a return of 8%/year (or whatever is in your Financial Plan).
3. Invest 100% in global equities. Have the highest allocation to equities you can tolerate and diversify effectively globally. This gives you 0% in bonds, 0% in cash and 3% or less in Canada. Avoid the “4 Performance Drags”.
4. Always be confident in the long-term growth. Adjust your binoculars to 20-30 years from now. Thinking long-term is a skill you can learn. Invest for the maximum reliable long-term total returns.
Most investors, investment advisors and robo-advisors are short-term thinkers and probably should invest the conventional way. But you don’t have to.
Learn to think long-term. Learn to have a high risk tolerance. Avoid the 4 Performance Drags. Learn the secrets to outperforming with stock market investing.
Then you can easily outperform investment advisors and robo-advisors.
Planning With Ed
Ed Rempel has helped thousands of Canadians become financially secure. He is a fee-for-service financial planner, tax accountant, expert in many tax & investment strategies, and a popular and passionate blogger.
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Another terrific article!
I am about 85% in equities with my Robo advisor and and again questioning myself, “why?”
I retired a couple years ago and have been moving toward more equities since then. Now may be a great time to go to 100%.
Keep up the great advice on your blog. Excellent and FREE advice!
My article on the Smith Manoeuvre is the most in-depth anywhere and explains how it works and all the issues: https://edrempel.com/smith-manoeuvre/ .
For a retired person, the Smith Manoeuvre can help you use equity in your home to give you a more comfortable retirement.
We often meet people we call “Millionaires in Poverty”. These are people with a net worth of more than $1 million in their home that are living below the poverty line on $20-25,000/year before tax. They live on nothing so their kids can get a million dollar windfall after they die. They need a way to access their home equity to live more comfortably.
Their options are:
1. Sell their home & rent.
2. Borrow against their home to spend.
3. Borrow against their home to invest.
Some do reverse mortgages out of desparation.
The Smith Maneouvre is far more effective. You can borrow against your home and invest to provide a more comfortable retirement income. The loan is paid off whenever you sell your home in the future and investment withdrawals can pay the interest plus more income. You get a nice tax benefit, which can help you qualify for more government benefits.
It is not for everyone. You need to be able to stay invested when your investments go down. You have to be confident in your investments over the long-term.
We have seen the Smith Manoeuvre dramatically improve the lifestyle of retired people.
We don’t create dividend portfolios, because we are focused on minimzing tax, not paying tax every year.
In the end, it is the total long-term return after tax that matters. Dividends from companies outside of Canada can have foreign tax withholding (typically 15% of the dividend) in an RRSP and are taxed fully in non-registered portfolios. However, the drag from lower returns in Canada and home country bias can generally be more than the tax difference.
Tax is one factor in investing, but not the main factor. Long-term growth is. The wisdom is: “Never let the ‘tax tail’ wag the ‘investment dog'”.
The most in-depth article on the Smith Manoeuvre anywhere is here: https://edrempel.com/smith-manoeuvre/ .
It needs to be a long-term strategy, so most people start before retiring. The Smith Manoeuvre is a strategy to invest from your home equity to increase your retirement lifestyle. Over time, the return on equity investments is far higher than the interest cost. The interest is tax-deductible. If you invest tax-efficiently (generally NOT in dividend stocks), you can get tax refunds most years, as well.
You need to have the risk tolerence for it, but you risk tolerance is a learned skill.
I often see what I call “millionaires in poverty” – rich people living below the poverty line. Million-dollar home paid off. Hardly any investments. Living off $20,000/year before tax. They need a method to create retirement cash flow from their home equity.
They can either sell & invest the proceeds & then rent, borrow to spend, or borrow to invest and get cash flow from the investments. Often they plan to sell their home in 10 or 20 years. Borrowing against it is essentially an advance on the future proceeds.
Some people do the Smith Manoeuvre with dividend stocks, but that is not optimal. They end up with all their investments in Canada, which is a resource & financial sector fund, not a properly diversified portfolio. The dividends are taxable every year. The goal with the Smith Manoeuvre is to invest tax-efficiently and try to have minimal taxable income from your investments, in order to maximize your tax refunds.
The rest is in the article: https://edrempel.com/smith-manoeuvre/
Okay, I’ll bite. What is the Smith Manoeuvre mortgage and how would it benefit a retired person?
If you are a Canadian and want to create a dividend portfolio primarily from a non-registered account, wouldn’t you want 100% Canadian equities? Or at least heavily weighted to that in order to avoid the foreign withholding tax?
You are right that I used CPI in my study of the 4% Rule (https://edrempel.com/reliably-maximize-retirement-income-4-rule-safe/ ). I used actual returns of stock & bonds and actual CPI for 150 years.
Inflation is a major factor over a 30-year retirement. A portfolio of 100% equities only ran out of money after 30 years 6 times in the last 150 years – 5 of which resulted from inflation. (Only once was a major market decline a problem.) If you actually want to increase your retirement cash flow by 8%/year when CPI is 2%, it would be a big challenge. I have not done the math on this, but the failure rate would be much lower for all asset allocation amounts – especially those with more bonds.
Different people experience inflation differently. The 4% Rule applies mainly to seniors (and FIRE people). Seniors tend to spend and experience differently than the “average Canadian”. Their biggest expenses are usually house costs (property tax & utilities), groceries, gas, entertainment, travel and health care costs. Most of these may rise faster than CPI inflation.
Some of the biggest of these expenses are quite discretionary. For example, if your retirement plan includes $15,000/year for travel and that’s all you can afford, then you keep your travel costs around $15,000. Over a couple decades, you may actually be downgrading your travel while keeping your travel costs the same. You may increase it by CPI inflation, since that may be what you can afford.
There isn’t a good measure for this. Everyone experiences it differently.
Why do you think actual inflation is around 8%, Mark?
It is not what most of our clients experience. For our clients that have jobs where they just get CPI inflation increases each year, their incomes generally rise faster than their expenses. Over the years, they tend to have more cash left each year (assuming they can avoid lifestyle creep). The main reason is because their largest expense is usually their mortgage, which does not rise by inflation.
There are many things that don’t rise by inflation, especially things we buy (because of global free trade) and our technology (because of progress). Out TVs are about 80% cheaper than 30 years plus being thousands of times higher quality.
Most seniors don’t have a mortgage and don’t spend large amounts on purchasing stuff or technology, so they may experience higher inflation.
Quite a few of our retired clients don’t experience higher inflation, because they may maintain their tax-deductible Smith Manoeuvre mortgage into retirement. This gives them a large portfolio to provide higher income. Plus the tax-deductible mortgage cost does not rise with inflation.
Does this answer your question, Mark?
I have zero in crypto-currencies. I look for investments that I expect to reliably give me huge long-term growth.
For example, the stock market is highly likely to be between 7 and 17 times today’s value in 25 years (based on the last 90 years of S&P500). In this period with the modern stock market, it has always provided huge growth over 25-year periods. Then I find exceptional All Star Fund Managers that I am confident should continue to outperform their index.
Crypto-currencies do not have an intrinsic value. There is no way to know whether they are over-valued or under-valued. It is entirely speculative. In 25 years, it could rise to the moon or it could go to zero.
In short, there are no underlying fundamentals to support it. Plunging to zero is possible.
There may be a lot of potential, but they are highly hyped now, which is usually negative. The biggest uses of crypto-currencies, other than speculation, are crime and tax evasion. They are likely to become regulated, which could be their downfall.
[…] doing some reading, notably Ed Rempel‘s blog, I decided to reevaluate my home country bias, i.e. being too widely exposed to […]
In regard to my last question on inflation rates I don’t think I was clear. I am asking how you would figure the 4% withdrawal rate with so much disparity in inflation rates. If you just use the CPI it would be much lower than real rates of inflation which are estimated to be closer to 8%. You would need some solid long term investments to sustain that level.
I really appreciate all the time and effort you put on this site.
Ed I like to know what do you think about crypto currency and would or do you have any money in it?
My article is about global equity investing and how it beats fixed income and Canadian equity. If inflation is higher, this should work even better.
Higher inflation tends to devalue fixed income and the Canadian dollar. Equities tend to adjust to higher inflation over time, because the companies you invest in tend to raise their prices by inflation.
I’m not a believer in non-growth investments like gold or silver. Businesses have profits that grow over time and can be forecast. Gold & silver produce nothing and are mainly speculative. I agree with Warren Buffett and have 100% in equities.
We invest globally, so a devalued Canadian dollar is a direct gain for us. It means our global equities are worth more in Canadian dollars. A spendthrift Canadian government can be good for our investments.
If there are periods where the Canadian dollar may go up, we can just hedge the dollar.
That happened this year. Our portfolio manager hedged the dollar in March when the dollar fell to $.69. It ended the year about $.78, which was an additional 9% gain for our clients – in addition to the equity growth.
[…] lectures, notamment le blogue d’Ed Rempel, m’ont amené à réfléchir au home country bias, c’est-à-dire d’être trop […]
Great question. I struggle with it too.
The S&P500 has signficantly outperformed the MSCI World Index. Since 1950, the S&P500 averaged 11.7%/year vs. 9.5%/year for the MSCI World Index.
Comparing different time periods is affected a lot by some bubbles and collapses. MSCI outperformed in the 80s and lagged in the 90s with the Japanese Bubble and collapse, which was several times larger than the US Tech Bubble. S&P outperformed in the 90s and lagged in the 2000s with the Tech Bubble and collapse.
Consistency and growth rates have changed over time. The MSCI used to be mostly many steady, but lower growth, European countries. Then it became more volatile as emerging markets became larger. Now China has increased the growth.
Looking at growth and consistency over time, you would end up with all or mostly US investments and very little globally. However, a lot of the world growth and most of the stocks are elsewhere in the world. We are investing based on future expectations, not past.
Home country bias is a dumb idea, but possibly not in the US. I don’t think it makes sense to be only in the US, though.
Our All Star Fund Manager portfolio manager is 75% global & 25% US equity now. Global growth, global value, global GARP & US equity. Makes sense. Is it the best allocation? This is open to debate.
In general, though, we don’t make top down allocation decisions. It’s all bottom up.
Our portfolio manager chooses his holdings based on finding the world’s best fund managers. The current allocation is based on the fund managers, not a choice between US & global.
Each of the fund managers is bottom-up, as well. Their allocation is based on the best stocks they find, not on a choice of geographic or sector allocation.
Top-down allocation tends to be wrong based on recent trends & belifs. Bottom-up allocation is much more reliable.
What do you think, Jason?
In your article you say that inflation is about 2% but I have read several articles which state it is closer to 8%. It might depend on what products are included in the data but I am wondering how an increase in the inflation rate would change your strategy.
Also, would gold or silver have a place in a portfolio to offset the devaluation in our Cad. dollar?
Thanks for a great article – a big heads up!
Thank you for the research and interesting investment theory. I see in the article you did a 10 year average return and the S&P500 beat global MSCI World Index by 3.4%/year. I was wondering if you did (or could do) a comparison of the total return investing for all world vs S&P for 30 years (or multiple 30 year sections over the history of the stock market)? Do you think there is some risk mitigation by limiting 100% exposure to one market, even if its is the US? The MSCI has less than 55% US exposure.
Ed, Thank you so very much for your reply. I have learned more on your site in the past week than reading many books on finance over the past year.
I realize I will need a professional plan.
I studied the “4% Rule” in depth. This rule suggests withdrawing 4% of your investments for retiremetn income when you retire and then increasing it by inflation for the rest of your life. It worked 97% of the time in the last 150 years for investors with 70-100% in equities. That is without managing it at all.
I looked at a wide range of strategies to manage it. Basically setting up measures of when to reduce the income and by how much. I found methods to have a 100% success rate in history with a 6%/year withdrawal – as long as you are willing to reduce your withdrawals in certain situations.
It’s usually better to keep your withdrawal rate lower at about 4%. Then effective management would never, or hardly ever, require any adjuestment to your withdrawal.
It’s hard to give you a definite answer, since I don’t know your situation. In general, if you are retiring at age 65, you have an expected life of 25-30 years. The equity markets have outperformed bonds 100% of the time over 25-30 year time periods.
The issue is your withdrawal strategy. I studied the 4% Rule in-depth over the last 150 years. Investors that had 70-100% equities were able to withdraw 4% of their portfolio and increase it by inflation reliably for 30 years with a 97% success rate the last 150 years. However, bond investors only had a 47% success rate.
You have to be able to tolerate the ups and downs, but if you stay invested in equities right through your retirement and invest effectively, you can have a more reliable inflation-adjusted retirement than with a bond or 60/40 portfolio.
The study is here: https://edrempel.com/reliably-maximize-retirement-income-4-rule-safe/ .
In the same study, I looked at a cash reserve to cover expenses for 1-year or 2-years. I found no benefit. In the last 150 years, the cash reserve never helped, but did occassionally result in running out of money sooner. Holding a cash reserve reduces the return of your portfolio, which might make it harder to support your retirement income.
Here is the concept. Retirement income should be rising by inflation. Inflation is small in 1 year, but huge over a 30-year retirement. Fixed income investments are not good at providing rising income for you. Equity investments are more reliable r at providing rising income over the long term.
[…] Canadian financial blogger, fee-for-service financial planner and tax accountant, recently examined how to easily outperform investment advisor & robo-advisor. In the article, he mentioned that it makes sense to have a portfolio consisting of all equities, […]
Hi Ed, Very interesting article! For withdrawals, do you use a strategy like the variable percentage withdrawal? With this approach, based on the client’s portfolio size (+/- based on returns), you can adjust withdrawals. With an initial 6 months withdrawal and then monthly to top up the reserves. If there is a hit to the portfolio then less will be withdrawn until there is a recovery. This would only work if the client has some room to cut back on spending.
Hi Ed, Thank you for your article. My head is spinning as I was sold on the 60/40 rule. Now I will rethink my entire strategy. My main concern is that I have very little in CPP or OAS so no fall back if I go full on equity and the market plummets for any length of time. Of course from what I have read, the bonds wouldn’t help either. My son is full on equity as he is young but for those of us entering retirement, with little OAS or CPP would you advise a cash reserve? Thank you for enlightening me! I have spent the past year reading many investment books and this is the first be of unconventional wisdom I have come across. Currently in analysis paralysis mode.
Hi Gus. Thanks for taking the time to share your kind words. I’m glad it was helpful.
Investing 100% equities is not for everyone, but it works for investors that are truly long-term and will stay invested during bear markets. Over a 30-year+ retirement, an extra 1.5%-3.0%/year return from not having bonds drag down your returns is huge!
[…] Canadian financial blogger, fee-for-service financial planner and tax accountant, recently examined how to easily outperform investment advisor & robo-advisor. In the article, he mentioned that it makes sense to have a portfolio consisting of all equities, […]
The 4% withdrawal is from the value of your investments. With equity investments, there is no such thing as principal.
Yes the total return we would expect from a quality equity portfolio over time should be 8-12%/year. However, to determine a safe withdrawal rate, you need to protect against bad periods of time.
With a 4% withdrawal, most retirees with equity portfolios would see them grow, so they can increase thier retirement income after a few years.
The question is: How sure do you want to be that you won’t run out of money during retirement? With a 4% withdrawal rate and 70-100% equity portfolio, it has been reliable 96-97% of the time in the last 150 years.
If you withdraw more, say 5%/year, then the success rate dropped to 80% or a bit less.
Note this is without managing your withdrawal. We have learned how to make a 6%/year withdrawal rate 100% reliable based on history by studying various ways to manage your withdrawal rate.
What an amazing article Ed! thank you so much for every word you wrote , I’m 50yo and have 30% of my portfolio in bonds after it was 40% at some point and I was so convinced after seeing the interest rates going down to nearly 0% that my bonds allocation is going to be a drag on my portfolio , reading your article today convinced me beyond any doubt that i should go into a 100% equity well diversified although i know it’s the truth that Canada is only 3% of global economy but the way i thought about it is supporting our great nation in my own way but at the end yes it’s unfortunate that our economy rely heavily on oil.
Again i just wanted to thank you for all your effort.
In your 4% withdrawal rate for retirees example of a million dollars are you taking the $40,000 from the principle amount or just the income generated from the million dollars. It would be easy to generate the 4% with dividends and capital gains and you are leaving a lot of money on the table if you don’t touch the principle amount. Good for the kids but not dad and mom!
That’s a great article, I appreciate your insights.
Thanks for the kind words!
Great question. Most retirees still have a long-term time horizon. For your question, let’s assume you are 60 and planning to retire at 65. In 50% of couples age 60, the one that lives ths longest lives until age 94. You should plan for your money to last past age 94, since running out of money at age 94 means there is a 50% chance you or your spouse is still alive and out of money.
When you graph a retirement withdrawal starting at age 65 that runs out at age 100, you still have most of the money invested until your late 80s. This means a 60-year-old probably has a time horizon of 25-30 years, which means most of their investments should be invested for 25-30 years.
I did an in-depth analysis for retirees with 150 years of actual data on stocks, bonds and inflation to test the “4% Rule”. This rule is used by many financial planners, but mostly badly. The 4% Rule states that you withdraw 4% of your investments per year and increase it by inflation and it should last at least 30 years. For example, if you retire with $1 million in investments, you withddraw $40,000 in year 1 and increase that by inflation every year.
I tested it to see if this had worked in history. The result is that it did work for investors that were 70-100% in equities, but failed most of the time for typcial retirees using the “Agee Rule” of investing their age in bonds. The study is here: https://edrempel.com/reliably-maximize-retirement-income-4-rule-safe/ .
Most seniors can’t tolerate the short-term volatility of equities, and should probably will need some fixed income to be comfortable. This will, however, mean they should retire on much less. I recommend 4% withdrwal for equity investors, 3% for balanced investors and 2.5% for fixed income investors.
The vast majority of our clients have remained 100% in equities after they retired. They are comfortable with the investments, familiar with the ups and downs, and understand how this helps them have a more comfortable retirement.
Thanks Court! Glad it was helpful. Yes, for people that like podcasts more than reading, I receommend the Explore FI podcast on this topic: https://exploreficanada.ca/podcast/029-outperform-advisors-ed-rempel/ .
Good to hear from you! Thanks for your comment.
Your question about RESPs is important and applies whenever your time horizon is shorter. The short answer is that the investments will most likely be up signficantly, but if the unlikely event of a signficant decline would be a huge problem for you, then perhaps you need to be cautious and forgo the likely gains.
RESP withdrawals have an additional issue because it’s harder to delay withdrawal until your investments recover.
Here is an example. Your kid is 16. You are going to withdraw the RESP entirely over 4 years from age 18-22. That means the average dollar will be invested for 4 years. Based on history, the stock market has been up 89% of the time in 4-year periods with the typical total gain of 40-50%. There has beeen an 11% chance of a loss after 4 years with the worst loss being 6.8%/year, or 25% in total.
It is very unlikely, but possible, that you have 25% less after 4 years. If that happens, how much of a problem is it for you? If it is a massive problem, then you may want to invest parly in fixed income or cash. That means you give up an 89% chance of a gain averaging 40-50%.
In practice for our clients, they don’t really know exactly what education will cost. Which program will they go into? Will they live at home or in residence? Most also expect their kids to pay part of the cost in order to learn some money skills. They can do this with a part-time job and a student loan.
There is some room to delay withdrawals. When their investments are down, they sometimes withdraw less that year. You need to withdraw everything from the RESP before your last child finishes university. However, you can withdraw from the RESP and buy similar investments in an “in trust for” (ITF) account for your child just until the markets recover.
Our clients have almost all stayed fully in equities right to the end. They are nearly always rewarded for this. If investments are down a lot, we would look for methods to stay invested until there is a recovery.
These types of situations have to be looked at uniquely for every client. For most, all equities is the best, but not for everybody.
Thanks. I don’t recommend individual linvestments. See my answer to Mary below, who asked a similar question.
Glad my article was helpful for you. Pensions are beginning to see the light. Most neeed a long-term return of 4-5.5%/year to meet their pensions oblgations. If 40% of their investments make only 1%/year, they are expecting horoic returns from the other 60%. Here is a pension industry article about this: https://www.benefitscanada.com/investments/fixed-income/is-it-time-for-pension-funds-to-rethink-their-fixed-income-allocations-83340 .
Good insight to look for a global equity investment. Sorry, but I am the financial planner, not the investment guy. I don’t recommend specific investments. There are lots of people that can recommend an ETF for you.
In fact, I don’t even choose specific investments. My skill in investing is identifying investors with skill. 100% of my personal investments are with the elite portfolio managers I recommend for clients: https://edrempel.com/become-a-client/ . I look for “above index returns” – portfolio managers that I expect to make long-term above index returns returns after fees.
Thanks for your comment. I’m glad it was helpful for you.
Nice article Ed thanks!
Does your strategy make sense for those nearing retirement? Let’s say an individual who will need access to those funds in 5 years. Too much risk?
Great post Ed. It reads very similar to what you said on the Explore FI Canada podcast episode you were on. I totally agree with everything written here.
Great article Ed, very insightful stuff. 🙂
For investments like RESP where the timeline is typically shorter, would you recommend investing 100% in stocks then shift toward more bond allocation as the kid gets closer to post secondary education age? Or would you simply stay 100% in stocks?
Awesome article. Would an ETF like XAW be something that fits your recommendation?
Thank you for teaching us the truth about investing. In addition to your analysis, it is important to note that pension plans are heavily invested in bonds (60/40) for ‘safety’. Other pensions like the American Social Security is forced to buy bonds at 100% allocation. This means that one day these pensions could fail. Thank you for your wisdom.
So do you have a Global MSCI ETF you’d recommend?
Glad you found it useful!
Thanks for this incredible article, Ed. Your commentary on bonds and the importance of diversifying globally is eye opening. I think my portfolio is close to 20% invested in Canada, which represents a pretty significant home bias. I’ll be looking to make some changes over the coming months.. Cheers.