Margaret Thatcher, the Iron Lady, popularized the phrase "there is no alternative" when referring to neoliberalism – free trade, free markets and capital globalization. Recently, some market pundits have suggested there is no alternative (TINA) to equities, and U.S. equities in particular, given that the Bloomberg World Sovereign Bond Index yields 0.46 per cent with some $10-trillion-plus (U.S.) of government bonds trading at negative yields. This index represents every developed market government bond in the world.
To illustrate, here's why: The Bloomberg Global Investment Grade Corporate Bond Index yields 2.09 per cent. When compared to my favourite global equity ETF, the Vanguard Total World ETF (VT) that yields 2.25 per cent, you can see why TINA might say equities are the place to be. What she always forgets to mention is that the volatility of bonds and stocks are like night and day. While the potential return on equities is certainly higher than bonds by most measures, the risks are substantially higher.
How much risk you should take has everything to do with your ability to sleep at night. There are no right or wrongs here. That's why, for advisers, one of the most important aspects of managing wealth is knowing your client. For those managing their own portfolio, your client is yourself and the people you report to – most often your spouse or significant other. When I say know your client, I don't mean knowing their birthdays or if they like to golf or are Leafs fans, I mean understanding how they think, feel and react when it affects their money. It's critical to understand that humans are typically emotional when it comes to financials decisions.
There will certainly be another major financial crisis in the coming years. The astronomical levels of debt in the world create a powder keg that makes us more vulnerable to economic shocks. No one can tell you exactly when or exactly how, but it's coming, because there is always another market crisis coming. Since 1928, the average correction of 5 per cent or more from a previous peak was 13.4 per cent, and the average correction that was more than 13.4 per cent was 24 per cent. When you are in your retirement years and have no current income other than your portfolio, your anxiety is by far the biggest cost to investing – the anxiety of selling out your portfolio when you cannot take the stress and worry any more, crystalizing losses when you should be buying. Most people can handle the 13 per cent average, but it's the 24 per cent type that happen, on average, every four years that trips the sleep-at-night anxiety wire. That's why understanding the risk of the investment is far more important than shooting for maximum gains – something all investors would do well to remember as some markets make all-time highs.
The most common way to measure volatility (risk) is a measurement of the day-to-day change in price called standard deviation. This statistic takes the daily price change and measures how much above or below the variance is compared to the average price change. When trying to determine what investment is suitable for your portfolio, you need to consider both return potential and the cost of that return. The cost of the return is not just the management expense ratio (MER) as many will lead you to believe, the more important cost is the risk (volatility) you must accept to get that expected average return. When looking at average returns, it's so critical to understand that if an investment has an annual return of, say, 7 per cent, there are likely years it lost more than 7 per cent and years where it gained more than that figure. Too often, investors chase past performance (because understanding the future is harder than looking at the past), and sell the investment in disgust (at a low point) when it doesn't return anything close to 7 per cent promptly in the year they buy it. The graphic below shows the 10-year return and standard deviation of some of the major asset classes that make up the world of ETF investing.
Far too often, investors only focus on historical returns and MER as a way to determine if the investment is suitable. There is a much better way to do it, but it requires a bit of work. To calculate standard deviation, you simply need to track the day to day or week to week change in price of the ETF, stock or bond that you are considering owning on a spreadsheet like Microsoft Excel. Using the standard deviation function to calculate the annualized volatility as we have done in the graphic. [Tip: to annualize the standard deviation of daily prices changes multiply the result by the square root of 252 trading days in the year]. There are, of course, software programs that can help you with this (takes the manual work out of it). I've been advocating publicly for years, and strongly support a proposal by the Canadian Securities Administrators, to require that investment products show historical risk – publishing the standard deviation of returns right next to the returns themselves.
The most important equity index in the world is the S&P 500 (SPY). It represents about 35 per cent of the capitalization of the world equity markets. The average return from 2005 to 2015 was about 7 per cent. I would be willing to bet that most investors did not see that kind of average annual return over that period. The cost of that average return was sticking with the SPY as we went through the worst bear market in modern history – not the MER. The standard deviation was over 20 per cent, which means that your annual return would be somewhere between 47 per cent and minus 33 per cent in 19 of 20 years. The maximum drawdown (unrealized loss) was over 56 per cent from peak to trough. It's those nasty big decline periods or years that is the real test of anxiety. Understanding that you need to look at return and risk when evaluating an investment is probably one of the most important lessons one can have while determining what is appropriate for your portfolio.
AGG is an ETF that represents the entire U.S. bond market of government, investment grade corporate, mortgages and agency bonds. The average total return (capital gains plus interest) was 4.25 per cent and the volatility was only one quarter of the SPY, meaning the worst year would likely be about minus 6 per cent. Going forward, the interest yield is under 2 per cent, so you cannot look at past returns and expect that in the future. The same logic applies for equities, too.
If I were to suggest that based on the current market valuation, the historical average return of the S&P 500 over the next 10 years would likely be about 3 per cent with a standard deviation of 17 per cent, would you want to own it? That means you are looking at a high probability that one or two of those years would see a 31-per-cent decline. You would likely get a slightly smaller return from a short-term corporate bond ETF such as BMO Short Corporate Bond Index ETF (ZCS) with an annual standard deviation of about 3 per cent. The answer would seem to me to be an easy one – and is the reason why my global balanced fund currently has very little exposure to equities and a healthy exposure to short-term corporate bonds and cash. In February, when markets looked horrible, our equity exposure was very high.
So when the valuation of U.S. equity markets are well above long-term averages, like they are now, with a laundry list of red economic flags, prudent risk management suggests that ZCS is a much better holding than SPY for now. When that next correction comes and others are panicking to sell SPY because they can't sleep at night, sell your ZCS and buy all the SPY they want to sell you.
Larry Berman is co-founder of ETF Capital Management. He is a Chartered Market Technician, a Chartered Financial Analyst charterholder and is a U.S.-registered Commodity Trading Advisor.