Investing: What Really Matters
Marksman’s investment philosophy is based on a core set of beliefs, supported by decades of academic research.
Fact: The vast majority of investors underperform the market benchmarks such as the S&P 500 in the US, and TSX/S&P Composite in Canada, over time [1]. For the 10-year period ending December 2018, 97% of funds managing US equity failed to match the S&P 500 total return. It is not much better for mangers of Canadian assets. Over the last 10 years, 91% of funds managing Canadian equity failed to match the S&P/TSX Composite total return. Results are similar over previous decades.
Given these and other daunting statistics, clearly it is very unlikely that any individual investor should expect to be able to select managers that will outperform an index strategy over the long-term. Instead, individual investors should focus on what really matters:
- Diversification. In the investing world, diversification is the only free lunch. It doesn’t cost more to be diversified and it spreads your risk around. It is important to maintain diversified exposure to not only Canadian equity and bonds, but US equity and bonds, as well as other international markets.
- Time horizon. This is the number of years before you will likely need to withdraw a significant portion of your portfolio. Generally, the longer your time-horizon, the more risk you can afford to take to achieve growth in your portfolio. For example, if you do not expect to begin drawing down your portfolio in the next ten or so years, a growth-oriented portfolio is probably appropriate. However, if you are already retired and you will need your entire portfolio to sustain you for the rest of your life, then a lower risk and income-oriented portfolio would be appropriate. Time is your friend when investing; and the more of it you have, the more risk you can tolerate.
- Fees and expenses. Mutual fund fees in Canada (typically 1.5%-2.5%) per year are among the highest in the world. They cannot be justified based on performance results. Higher fee mutual funds tend to have lower returns to investors. Trading costs, including broker commissions, spreads and custody cost eat into returns. All else being equal, less trading is better than more trading.
- Taxes. Taxes have a huge negative impact on the long-term term performance of Canadian investor portfolios. Taxable portfolios are subject to tax on capital gains, dividends and interest, annually. Tax-exempt portfolios (RRSPs, LIRAs etc) are subject to your marginal tax rate upon withdrawal.
Generally, Canadian investors should:
Defer taxes as long as possible by maximizing RRSP contributions, especially during peak-earning years by reducing gains and income in taxable portfolios.
Reduce assets in taxable portfolios by maximizing contributions to TFSAs. Choose TFSA over RRSP early in career or when taxable income is low.
Make sure your portfolios are managed holistically in regards to tax. Generally, bonds should be allocated to tax-sheltered vehicles. Dividend-paying US equity should be allocated to your RRSP or LIRA. From a tax perspective, Canadian equity is appropriate in any vehicle; however, if you have a taxable portfolio, then Canadian equity and Canadian preferred shares belong here, to maximize the tax-advantage.
Use exchange traded funds (ETFs) to get exposure to the various markets. From a tax perspective, ETFs are particularly beneficial for taxable portfolios, as their structure and how they are managed, make them highly tax-efficient. Portfolio turnover (trading) is typically very low; thus, for long-term investors, capital gains are often deferred indefinitely.
- Discipline. Most investors perform poorly, even relative to the mutual funds in which they invest. How is that possible? It’s because of a lack of discipline and poor advice from their advisors. They follow the herd and invest on emotion; buying into mutual funds after good performance and selling after poor performance (buy high, sell low). They act on tips; they try to time the market. Both have been shown to be losing strategies. They often behave irrationally and not in their own interests. Successful investors invest with discipline, logic and reason.
- Manager-selection. Picking stocks is a formidable task. Picking good fund managers who pick winners in just as difficult. Advisors typically rely on past performance when making recommendations. They look to the past to explain the future because it’s easy to rationalize. The problem is that there is no correlation between past and future performance. It’s a roll of the dice. Choose a manager who you know will act in your best interests; a manager who focuses on what really matters.