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dan bortolotti

Dan Bortolotti, CFP, CIM, is an associate portfolio manager at PWL Capital in Toronto. He is the creator of Canadian Couch Potato, an award-winning blog about index investing.

Investors disagree on many things, but these days there seems to be at least one consensus: Everyone hates bonds.

It's easy to understand why. The yield on a 10-year Government of Canada bond now sits at about 1.5 per cent, right around the current inflation rate. That means if you buy a bond and hold it for 10 years (assuming inflation stays constant), all you do is maintain your purchasing power.

For investors in exchange-traded funds, the expected return on bonds is equally uninspiring. Index funds tracking the broad Canadian bond market – which includes both government and corporate bonds – have a yield to maturity of just under 2 per cent.

Meanwhile, Wednesday's trading action notwithstanding, stock markets around the world just keep chugging along. U.S. stocks returned over 20 per cent annually (in Canadian dollars) during the five years ended April 30, and international stocks grew by more than 14 per cent annually. Even Canadian stocks, the laggard over that period, compounded at more than 8 per cent a year. Is it any wonder so many investors can't bring themselves to buy bonds yielding less than 2 per cent when stocks keep climbing?

There are a few other reasons investors have come to hate bonds. One is a natural inclination to overestimate our risk tolerance. This is especially easy to do now, because it's been a long time since we've experienced a genuine bear market. The last time we saw a 20-per-cent peak-to-trough decline was in mid-2011. Bonds saved the day that year, as they usually do during a downturn, but humans have short memories. Now bond investors feel as though they've been lugging around an umbrella during six years of sunshine.

Younger investors may have the most distorted view of reality. If you started investing after 2009, that brief downturn in 2011 (which was followed by a speedy recovery) has been the only black cloud you've ever endured. When twentysomethings tell me they're comfortable with an all-equity portfolio, I try to remind them that's because they have never seen their hard-earned savings cut in half. As Fred Schwed wrote in his 1940 classic, Where Are the Customers' Yachts?: "There are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description that I might offer here even approximate what it feels like to lose a real chunk of money that you used to own."

Even experienced investors seem to underestimate the volatility of stock returns. Whenever our firm brings on a new client, we have a thorough discussion about return expectations and risk tolerance. This begins with a questionnaire about an investor's objectives and willingness to accept losses. It's very common for investors with balanced portfolios to say they are willing to accept a loss of no more than 10 per cent in any year. That's simply not a realistic expectation. During the worst 12 months of the 2008-09 financial crisis, even a traditional portfolio of 60-per-cent stocks and 40-per-cent bonds would have lost about 20 per cent of its value. How soon we forget. If you want to limit your losses to less than 10 per cent, you likely need a portfolio of 70-per-cent fixed income, and that's a tough sell these days, even for retirees.

Another problem is we fail to appreciate that long-term averages bear almost no resemblance to year-over-year returns. Over the last century or so, it has been reasonable to expect an annualized return of about 8 per cent from stocks, and over rolling 30-year periods the consistency of returns has been remarkable. But humans don't think in long time frames: It's hard to stick to an investment strategy for three years, let alone three decades. And over shorter periods, stock market returns can give any investor whiplash.

Let's start with that assumption that an average of 8-per-cent annually is reasonable for equity returns. Then let's assume the range of "normal" returns would fall within a range from 5 per cent to 11 per cent, or three percentage points higher or lower than that average.

How often would you estimate that a global stock portfolio – with equal amounts of Canadian, U.S. and international equities – would have delivered returns within that "normal" range?

It turns out that since 1970, annual equity returns fell within that range just seven times – and two of those years were 2015 and 2016. In other words, in 40 out the past 47 years – that's 85 per cent of the time – the returns of a global stock portfolio were either less than 5 per cent or higher than 11 per cent. "Normal annual returns are extreme," writes Ken Fisher in his book, Debunkery. "It is hard to get people to accept the degree to which that's true."

Which brings us back to bonds and the reason they still belong in your portfolio, even when yields are less than 2 per cent. The only way to reliably reduce the risk of large losses in an equity portfolio is to add a healthy dollop of high-quality bonds. (GICs and cash can lower volatility, too, but they won't rise in value during a bear market.) You don't have to love them now, but somewhere down the road you're going to be glad they were there.

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