Is it beneficial to pay a pro to actively manage your investments, or does passive investing have a bigger pay-off? Should you make regular payments to your TFSA or RRSP or is it better to invest a lump sum all at once? Is socially responsible investing just a gimmick or is it backed by real deal results?
These are all reasonable queries, and here at Young and Thrifty, we recently compiled an extensively researched white paper that provides answers to these real-life questions. Using peer-reviewed research, government statistics and reports, and privately commissioned studies, our team of financial experts looked at the latest research on investing and what variables or factors can impact successful outcomes. Here’s a summary of Young & Thrifty’s evidence-based guide to investing like a pro.
Which Investing Approach Wins in the Long Run?
Passive investing is about removing your judgement from the investing process by purchasing a mutual fund or exchange-traded fund (ETF) that tracks a particular index (like the S&P 500). The fund “passively” follows the index, which means its returns closely mirror the results of that benchmark. This approach avoids trying to pick winning stocks and instead owns the market as a whole in order to collect the equity risk premium.
In contrast, active investing is about adding your judgement to the investing process. You (or a fund manager) choose which stocks or ETFs to purchase and when to purchase them (otherwise known as timing the market). Active investors (like day traders) believe it’s possible to beat the market and that share prices are not always representative of their fair market value.
In a nutshell, 70+ years of research supports that passive investing outperforms active investing.
A risk-appropriate portfolio of low-cost, globally diversified, index funds or ETFs is the best and most reliable way to achieve long-term investment returns.
While active investing can outperform the market over shorter periods of time, it is impossible to do with any long-term consistency and reliability.
Is It Better to Invest a Lump Sum or Space Out Your Contributions?
Let’s say you got a big tax refund or bonus, and you want to invest that money into a TFSA or RRSP. Is it better to deposit the whole shebang into your investing account all at once, or make small payments over the course of the year? It’s a question many investors face: whether to take a lump sum investing or dollar-cost averaging approach.
The evidence supports that it’s best to invest a lump sum immediately. A 2012 Vanguard study found that immediate lump-sum investing beat dollar-cost averaging about two-thirds of the time.
That’s because markets historically increase about two-thirds of the time (or two out of every three days). Staying invested for a longer time improves the likelihood of capturing positive market returns. Investors will gain exposure to markets as soon as possible.
Stock returns exceed the returns of cash (the equity risk premium) and putting your lump sum to work in the market right away takes advantage of this growth opportunity.
The bottom line: invest a lump sum of money immediately rather than dollar cost averaging over time.
However, if fear of loss and regret is too strong to bring yourself to invest the entire amount at once, design a systematic approach to invest smaller portions at regular intervals, or more preferably, adjust your asset allocation towards a more conservative portfolio before taking the plunge.
Just don’t rely on your emotions to dictate when it’s best to invest.
Should You Invest When Markets Are At An All-Time High?
Investors get nervous when stocks reach new all-time highs. Record high stock prices are often seen as a precursor to a market correction or crash. But the evidence shows why investing at all-time highs isn’t as frightening as it seems.
Stocks reach all-time highs more often than we realize. In 2020 alone, U.S. stocks reached 30 new all-time highs. Since the great financial crisis in 2008-09, the S&P 500 has seen more than 270 all-time highs. That’s about 14% of all trading days where stock prices closed at an all-time high.
Stock prices increase over time and rise more frequently than they fall. Bull markets also last longer than bear markets, and prices rise much higher in bull markets than they fall in bear markets.
Research from JP Morgan found that if you invested in the S&P 500 on any random day since the start of 1988 and reinvested all dividends, your investment made money over the next year 83% of the time. On average, your one-year total return was 11.7%.
Looking at the research, investing when stocks are at an all-time high led to better outcomes than investing on a random day. It reinforces the notion that time in the market is better than timing the market.
Investors with a long-time horizon should confidently ignore market conditions and stick to their investment plan.
The best approach is to invest for the long-term in a risk-appropriate portfolio. Stay invested and contribute regularly, regardless of market conditions (such as new highs or lows).
Could Borrowing to Invest be a Good Idea?
You may have seen advertisements for RRSP loans and thought about borrowing to invest. But is it a high-stakes game?
The idea of using leverage to generate higher returns is nothing new. Most homeowners used leverage to buy their home, contributing 5% – 20% from their own savings and financing the remainder with a mortgage. While borrowing to purchase a house is widely accepted, borrowing to invest in stocks is less palatable.
However, the same concept can apply to investing. What if young investors used leverage to gain more exposure to stocks and take advantage of their long time horizon? When we’re young, we have a long time-horizon but less money to invest. When we’re older, we have more money, but less time for compounding to work its magic.
So, what does the evidence say? Is borrowing to invest a good or bad idea?
Borrowing to invest can be beneficial. In a 2010 paper, Yale professors Ian Ayres and Barry Nalebuff assumed a 44-year investing cycle (from 21 to 65) where investors use 2:1 leverage in their early years before slowly deleveraging over time.
The authors suggest that young investors should also allocate 100% of their portfolio to stocks until their target level of equity investment is achieved. The results showed that if people had followed this advice, historically, they would have retired with portfolios worth 21% more on average when compared with investing 100% in stocks with no leverage.
Young investors in their 20s and 30s should consider using 2:1 leverage (e.g. invest $20,000 total by using $10,000 of your own money and $10,000 from a loan) to increase their stock exposure until a target level of investment is achieved. This approach uses time diversification to enhance retirement savings outcomes with less risk.
Young investors should also increase their stock allocation to 100% to take advantage of the equity premium. This strategy comes with a major caveat: leveraged investing can lead to substantial losses. Deploy it with eyes wide-open to the possible risks.
Should You Stick with Canadian Stocks or Go For Global Investments?
Canadian investors have a serious home country bias when it comes to their investments. On average, the equity component of a Canadian investor’s portfolio contains 60% Canadian stocks. Home bias is not uncommon. Investors in most countries prefer their domestic stocks over foreign stocks. Chalk it up to buying what you know.
In large, diverse markets like the United States, home bias is not a big deal. But in a country like Canada, which makes up just 4% of global equity markets, a strong home bias can lead to a significantly less diversified portfolio.
So, what’s the best way to proceed?
Diversifying your investments across the globe is important, but some home country bias is reasonable because it actually reduces volatility, fees, and taxes.
Allocating 20-30% of your equity portfolio to Canadian stocks is ideal for lowering overall portfolio volatility, lowering fees and taxes, and feeling good about your portfolio when Canadian stocks are performing well.
What’s the Optimal Asset “Location”?
The concept of asset location is to figure out which assets to hold in each account. We do this because the returns from capital gains, interest, and dividends are all taxed in different ways. Also, each of your accounts (RRSP, TFSA, non-registered) has different tax rules which may align more favourably to certain asset classes.
Advisors look for ways to optimize their clients’ investment portfolios to take advantage of or reduce the disadvantage of these different tax treatments. They accomplish this by placing certain assets in either a tax-deferred, tax-free, or taxable account. To summarize:
- Bonds, GICs, high-interest savings – RRSP or TFSA
- Canadian stocks and preferred shares – Non-registered (taxable) account
- U.S. and foreign dividend-paying stocks – RRSP
- REITs – RRSP or TFSA
Optimal asset location does lead to higher after-tax returns. In a 2013 paper, Morningstar found that optimal asset location of investments led to a 0.23% per year increase in after-tax returns (compared to holding the same asset mix across all accounts).
Optimal asset location does indeed enhance returns, but at what cost? What looks optimal on a spreadsheet becomes unwieldy for investors to manage in real life. Complicating matters further is the concept of pre-tax versus after-tax asset allocation.
All of the money invested inside your RRSP does not belong to you. A portion belongs to the government, which will collect taxes when you start withdrawing from the account in retirement. If let’s say, 30% of the RRSP value does not belong to you, should that change your asset mix?
Investors should intentionally hold the same asset mix across all of their account types.
It’s intuitive to want to place certain asset classes inside certain account types to optimize your asset location and strive for higher after-tax returns. But this approach unnecessarily complicates portfolios and leaves too much room for error and unknown risks.
A better approach is to hold the same risk-appropriate asset mix across all accounts. For example, a medium-risk investor with a balanced 60/40 portfolio could hold Vanguard’s VBAL or iShares’ XBAL in their RRSP, TFSA, and non-registered (taxable) account.
Back in the day, “responsible investing” was mostly a niche area for investing. But today, it makes up a big chunk of Canada’s investment industry, with RI assets accounting for 50.6% of all Canadian assets under management. It’s an investment area that’s gaining traction among all age groups, but millennial investors are 65% more likely than Boomers to consider ESG factors when making investment decisions. But is socially responsible investing better than traditional investing? Will it yield better returns, or will your conscious portfolio be eaten up by higher fees?
On the positive side, responsible investments have shown to perform just as well or even better than traditional investments. It’s partly because the act of considering ESG factors helps minimize exposure to risks not visible within corporate financial statements, leading to improved long-term financial performance. Case in point: a 2015 Carleton University study showed that RI equity mutual funds in Canada outperformed their respective benchmarks 63% of the time.
There are downsides to consider. Socially responsible funds often have higher fees, which can eat into your returns. The reason is that the market is narrower and fund managers have to be more actively involved in the process. However, robo advisors are starting to make SRI portfolios less costly to investors.
The second tricky thing about SRIs is trying to match your values with the right portfolio. It’s a flawed process: guns and gas may not be in your portfolio, but how do you feel about fast food and soda? It may seem harmless, but these industries are contributors to climate change and health conditions (such as diabetes). There’s no perfect portfolio that’s 100% “woke” and it’s going to take some research and soul-searching to strike a balance.
Whether to go with SRI or traditional investments largely depends on your personal preference. It really comes down to trade-offs. Investing with your conscience first means accepting a less diverse portfolio and slightly higher fees. Investing with your wallet first means accepting that your dollars are supporting both good and bad companies across the globe.
If responsible investing is important to you, start by researching the assets and corporations involved to ensure that they are adhering to the SRI guidelines as outlined by the various indexes.
It’s easy for a company to say they’re socially responsible, but if you do decide to follow an ESG or SRI investment strategy, do your research before trading. Then, just buy SRI funds using an online brokerage, or you can pay a robo advisor that offers SRIs to do the work instead.
If you prefer a traditional investing approach, make sure to diversify broadly across the globe in a risk-appropriate portfolio of index funds or ETFs (on your own with an online brokerage or through a robo advisor).
Investing has been democratized for millions of investors around the world. We no longer need expensive advisors to buy stocks or flashy market timing gimmicks to access the global markets. Today, we have online brokers and robo advisors where investors can build a low-cost, globally diversified, and risk-appropriate portfolio of investments that beat the pants off of traditional active investing strategies. There are even investment apps!
At the same time, the behavioural challenges that come with investing haven’t got any easier. Investors still struggle to control their emotions. They struggle with loss aversion and FOMO. They struggle with analysis paralysis because of all the tools and investment options at their fingertips.
That’s why we look to the evidence to help guide us through the decisions that every investor is going to face throughout their investing journey.
Decisions like whether to capture the market returns through low-cost index funds and ETFs or to try to beat the market with a more active approach. Decisions like what to do with a lump sum of money, and whether to invest it all at once or dollar cost average over time. How much home country bias is appropriate? Should I use leverage? And, where the heck should I put my bonds?
A significant amount of academic and empirical evidence exists to help guide our decisions and make the best investments. The key is to sort through the bafflegab (marketing speak from the investment industry) and look for the evidence.
We hope you find that here with this evidence-based guide to successful investing. The next step is easy: just get started investing!