Asset allocation for a Canadian 10 years into the past

Hanging out with friends. Inas and Daniel

If you have been reading my blog for awhile, you will know that my favorite asset allocation for Canadians is ⅓ Canadian stock, ⅓ US stocks, and ⅓ International stocks.

Let’s say that you met me 10 years ago (October 2007) and you asked me how to invest your money. And let’s say that I gave you the same advice that I give out today. Would you have been a happy investor? Let’s find out.

If you invested on October 2007, you were in for a wild ride. The national and international markets where about to tumble due to the financial crisis of 2008. You would have been looking at your portfolio and calling me a complete idiot, cursing yourself for ever talking to me.

I often say that if you are going to invest in the stock market, you have to have a 10 years outlook and that at the end, if you are well diversified, you should come out fine. That prediction turned out to correct.

The financial products which I use to do my investing are as follows:

  • Canada: The XIU. This represents the 60 biggest Canadian Companies
  • US: VTI. This represents the whole US. Market
  • International: XIN. This represents big size companies from all over the world.

As you can see in the graphs, on 2008 everything dropped. The Toronto and US market lost about 50% of their value while the international index lost about 40% of its value. At this time, many retail investors without a financial adviser would have bailed out.

Let’s say you endured the pain. Where would you be today?

  • Your International exposure would still be negative by 14.7%
  • Your Canadian exposure would be positive by a mere 5.04%
  • But your US exposure would be positive by 67%

Your average of these three investments would be 19.15%.

Divided by 10 years, this will give you about 1.9% per year.

These are not great returns, considering the amount of risk involved. The amount of pain related to seeing your investment dropping by over 50%.

There is a problem with my calculations. I don’t know how to add the dividends earned during these past 10 years. Let’s say that on average you earned 1.5% in dividends. Now your total return per year is 2.4%. This is less bad, but It’s still very poor return. Consider the psychological stress, I would have preferred to lose out to inflation and have my money in cash.

What are the alternatives?

During the same period, bonds have gone down the the less that 1% territory. You might as well keep your money under the mattress.

And real estate, also had a big drop in the States. Since then it has recuperated as well, but let’s be honest, real estate is not a real passive investment. I invest in real estate and believe me, it gives me plenty of headaches.

In conclusion, in spite of a 50% in the stock market. Stocks are still the best place to put your passive money. However, the faith that I once had on the stock market, it has been badly bruised. I feel that 2.4% is not enough compensation for putting my money in harm’s way. I am still investing in the stock market, but I feel a lot less enthusiastic and optimistic than when I first started writing this article.

Currency diversification for Canadians

Here is a 10 year graph of the same investment, the S&P 500, being held in Canadian dollars and being held in US dollars.

Because of the cost of hedging, the investments in Canadian dollars under performs the investment in US dollar by a whooping 15.60%, that’s a lot of moolah.

Long ago I suggested that the ideal portfolio for a Canadian would be composed of ⅓ Canadian index stocks, ⅓ US index stocks, and ⅓ international Index stocks.

Now the question is: In which currency should you hold  those investments which are not in Canadian dollars?

Filming “A closer Look” with my friend Elijah.

The way I have decided to do it is by investing my ⅓ of US index in US dollars.

I would have considered investing the ⅓ of international in foreign currency but it is just too complicated. I would have to deal with Euros, Yens, Yuans, and all the other currencies of the emerging market. My portfolio in not big enough to burden myself with all those details.

On the other hand, my US investment is ⅓ of my portfolio, that is quite substantial. So the question is valid. Should I invest my US portion in Canadian dollars or in US dollars.

Many of you may be unaware that there is such an option.

When we buy the most popular US index, the S&P 500, we have the option to buy it with US dollars or  in Canadian dollars. The S&P in Canadian dollars is protected against the currency fluctuation of the Canadian dollar vs. the US dollar. But that protection comes at a price. It is like paying for home insurance, it’s not for free. This hedging cost is about 0.15% of your US assets. Not a lot, but it’s just another erosion of your capital.

If you are investing for a short term period, you should not be investing in the stock market.

If you are investing for a long term goal, then you are further diversifying your portfolio not only by investing in the US market but also investing in the US dollar.

As Canadians, we have to be aware that our currency fluctuates a lot with the price of oil. We think that Canada is an advanced economy, but we are nothing more than a big gas station for the rest of the world. If oil prices go up, our currency goes up, If oil prices go down our currency goes down. Our currency is in fact too volatile and the US dollar is the more stable currency; their economy is more diverse.

Looking it from that point of view it makes sense to have some of our money in US.

In regards to cost, how does it compare.

When I keep my US investment in Canadian dollar I have to pay the hedging cost every year, this hedging erodes my returns over time.

When I keep my US investment in US Dollar, since I earn in Canadian dollar, I have to pay the conversion cost from Canadian to US and then when I retire, from US to Canadian.

In the long run, I feel that keeping my US investments in US dollars is less expensive and I feel more diversified.

At what point should you start adding bonds to your portfolio

Preparing for winter

I advocate not to have bonds in a portfolio, but the conventional wisdom is to have a portfolio of stocks and bonds.

Let’s clarify a few points:

  1. Stock are not more risky than bond in any 10-20 years time period, they are just more volatile.
  2. Stocks produce a higher return than bonds.

If stocks are not more risky than bonds and if they give higher return than bonds, why should anyone own bonds? Because they reduce volatility, because with smaller ups and downs an investor is better able to withstand the changes of the market.

Let’s assume a portfolio of 50-50 stocks and bonds. Let’s assume that the expected return of stocks is 8% and the the expected return of bonds is 2%. The expected return of your portfolio is 5%.

What I suggest is to put 100% of your portfolio in stocks. then draw a line that goes up at the rate of 5% per year. This means that if you start your portfolio with $100,000, by the end of the year you should have $105,000.

Here is an example the Toronto Stock Exchange vs. a 6% growth line.

In this example, I overlap the real returns with the 6% growth line. If the returns are in excess of the 6% line, they are not to be considered are part of your assets, they are meant to be considered as insurance money, or protection against a downturn. Just like you don’t consider the money that you pay in insurance as part of your assets.

If the returns are less than the 6% line, then you just have to be patient and have faith that eventually the returns will catch up.

All that being said, you think  you should own some bonds. At what stage should you add bonds to your portfolio?

Most financial advisers suggest adding bonds as percentage of your assets as you grow older. They will say that if you are 60 years old, you should have (for example sake) 60% of your portfolio in bonds, and the older you get, the biggest the percentage of bonds you should have.

But let’s be realistic. If you only have $100,000 at age 60, you don’t have much money to protect and therefore, you should be more concerned with growing your portfolio than protecting it. On the other hand, if you have $5,000,000. You don’t care about making more money, you care about protecting your assets and you could easily be 100% in bonds.

Actual amount of money matter more than percentages.

So here is the question again: At what stage should you add bonds to your portfolio?

Answer: When you have reached your capital objective.

Let’s say that you believe that to retire you want to have $500,000 in your bank account. After years of hard work you have reached the amount of $500,000. Then, the next step should be to start protecting your asset.

Let’s say that your portfolio of $500,000 grew 8% in one year. That would be $40,000. You would sell about $40,000 worth of stocks and buy some bonds. And do that for every year thereafter until you reach a level of dampen volatility which will make you feel good at night.

Disclaimer: Of course, this is my way of thinking which fits my risk profile. I am not saying you should do the same or that you should follow my example. You may have different risk tolerance or time frame.

The way that I think about it is that first you want to make your money and then you want to protect it. As you grow your assets you should keep in mind that there is an strategy to make your money, and there is another strategy to conserve your money. You don’t want to be too conservative if you have very little to protect and you don’t want to take risks if you don’t have to.

There is no solution for income inequality

There are two seasons in Canada: Winter and July.

Social inequality is nothing new, it has existed since the beginning of civilization. Some people like to focus on building wealth and some people focus in other activities other than building wealth.

Here is a short excerpt for Plutarch in the year 594: “the disparity of fortune between the rich and the poor had reached its height, so that the city seemed to be in a dangerous condition, and no other means for freeing it from disturbances… seemed possible but despotic power.”

No only has income inequality existed for thousands of years, but it has existed in all the geographical areas of the globe. In short, income inequality is just one more trait of humankind.

And why wouldn’t it exist? Business people who like to accumulate capital practice their craft with the same tenacity that a pianist practice his scales, or a painter practice his techniques. If a musician gets better with each practice session, shouldn’t a capital accumulator get better with each business deal? Imagine that we tell a guitarist who practice 8 hours per day, that he has to give half of his skills to someone who only practice 30 minutes per week. It doesn’t make sense, but we don’t think twice to tax a business person more that 50% of his income to re-distribute his wealth.

We live in North America, a land full of opportunities and choices.

You present two college students with two career options. One career pays $80K per year and the other pays $35K per year. One student picks the career which is better paid and the other picks the career which is less well paid. These are choices these students took out of their own free will. One student is going to earn more than the other one. Why should we penalize him/her by taking some of his earnings away?

Two consumers are presented with two smart phones, an iPhone and an Android. One cost almost $1,000 and the other one cost about $100. Both of the phone do phone calls, text, Facebook and YouTube just the same. One buys the iPhone and the other buys the Android and invest the savings. For sure, after 10 years, the one who invested the money will be better off. Why should that person be penalized.

There are two apartment renters, each one renting a two-bedroom apartment. One uses the extra bedroom as an office/storage room. The other one uses the extra room to rent it to a friend. One is going to accumulate more money that the other one every month. Why should we penalize his money making decision?

Income inequality will never go away. We should not penalize a person for making a decision which will benefit him/her financially. Instead, we should educate people to become more savvy consumer, better informed investors. We should teach people about the magic of compound interest, about  investments, about how to become better consumers and don’t waste money on brands.

Once we do a better job educating people about the investments opportunity presented at their feet every day, then we will have a better chance of reducing income inequality.

Investing in commodities is worse that dead money

Smoking shisha with friends

Most financial advisers recommend capital diversification between two asset classes: stocks and bonds. But every now and then I see some financial advisers recommending two additional asset classes: real estate and commodities.

A common portfolio including those additional would look like this:

  • Stocks: X%
  • Bonds: X%
  • Real estate: X%
  • Commodities: X%

In previous articles I have explained why I don’t like investing in bonds. I think the opportunity cost is too high. In the long run stocks outperform bonds and stocks are NOT more risky than bonds, they are just a more volatile.

In previous articles I have also mentioned that I invest in real estate. In particular, I own a condo in the coolest neighborhood of Montreal. Obviously, I like real state as an investment. As long as the tenants pay the rent on time and don’t destroy your property, it’s a sweet business.

One asset class which I dislike worse that bonds is commodities.

what are commodities?

Commodities are standardized raw materials or products such as wheat, sugar, corn, coffee, cocoa, oil, gold, copper, etc.

How do people make money with commodities?

Investors speculate on whether the prices of any one of those commodities will go up or down. If they think the price of of corn will go up they buy corn. If they think they price of corn will go down they sell corn. If their speculation works out, they make a ton of money. If their speculation doesn’t work out, they lose a ton of money.

Why I don’t like commodities as a long term part of your portfolio?

Commodities is a zero sum game. For every trade there is a winner and a loser. If we add commissions into the equation, on the long run, investing in commodities is a losing game.

When you invest in stocks, you get dividends or the price of your stock goes up as the company retains earnings. See article on what kind of return to expect from the stock market.

When you invest in bonds, you get paid interest.

When you invest in real estate you get rent.

When you invest in commodities you get nothing.

Let’s say you buy a bar or gold. You hide it under your bed. 10 years later, you look under the bed and you see the same bar of god. You don’t see a bar and a half, you don’t see two bars, none of that… Your bar of gold has remained the same. You check  the price of gold and most likely your bar of gold has increased in value at the same rate as inflation. Nothing more, nothing less. If your investment is going to grow at the rate of inflation, you might as well buy government bonds.

See article on why investing in gold is a bad idea.

There are similar scenarios for all kind of commodities. They have violent swings up or down, but if you look at any long term chart, on a 20 year period or longer, the value doesn’t go up higher than inflation.


My ultimate recommendation is to continue piling up your money in real estate and stocks. You will continue getting dividends checks or rent checks. Let the money continue working for you. 🙂


How to chose a mutual fund

With my friend at the military academy

Mutual funds is one of the most flexible and available financial products for new investors. They are within the reach of practically any one. With as little a $25/month, anyone can get started.

See my previous article about what are mutual funds.

Let’s say that you decide to get started investing in mutual funds. Open your browser, type “mutual funds” and you will be presented with myriad of options. There are more mutual funds than stocks in the stock market.

The first step is to ignore all the mutual funds which are advertised. The reason is  that these funds take money from the pocket of investors to buy advertisement. Not only the fund pays for advertising, but they also pay handsome yearly commissions to the financial advisers (financial product pushers) who sells it to you. These commission are often called trailer fees and they about 1% per year.

How much are you paying in management fees

Most mutual funds in Canada have management fees of between 2% to 3%. You should avoid those at all cost. Canadian mutual fund companies should be ashamed to charge such ridiculous high prices.Those generous commission are coming out of the pocket of the investor year after year.

Unfortunately, those are the mutual funds which most financial advisers (financial product pushers) will recommend to the public, the reason is that those are the products which will pay the highest commission.

Here is a rule of thumb. If the management fee is more that 0.5%, run away. Don’t even consider it.

Actively managed funds under perform index funds by a lot

By this time I have read hundreds of reports claiming that most actively managed funds do not beat the index. Some reports say that 75% of actively managed funds under perform, other reports say that 90% of actively managers under perform. It doesn’t matter… The conclusion is that the investor is better off investing in index funds than on actively managed funds.

Steps to invest in Index funds

All major Canadian banks are catching up with the index fund reality. Most of the time they will not promote their index funds, they rather promote their actively managed funds. But all of them have their own version of index funds, you just have to ask for it. Look or ask for funds with this keywords: “Canadian Index,” “US index,” and so on.

Some banks offer index funds with expense ratio of more than 0.5%, simply ignore those funds and go with the bank who is offering index funds that cost 0.5% or less. Remember, the more you pay the bank, the less that it’s left over for you.

What are Mutual Funds

Giving a speech at local Toastmaster club

One of the best financial instruments to get started as an investor are mutual funds.

How a mutual fund operates

An investment company solicits investments from many investors. Those investments can be  as small as $25 per month. This is what makes mutual fund so appealing, that it is within the reach of practically anyone who can put together a small amount of money.

The money collected is is used to make investments, generally of stocks, but also bonds and other securities. A professional mutual fund manager is the person in charge of making daily investments decisions.

Having a large pool of money allows the money manager to diversify into many investments. Small investors generally don’t have the capital to invest in hundreds of different companies. Also, small investors don’t have the time nor expertise to research hundreds of companies.

Different focus of mutual funds

Many mutual funds companies have different focus of interest. For example, some funds may invest in technology companies, other funds may invest in dividend paying stocks, other may invest is small stock. It is up to the investor to decide which of those investments philosophies he/she prefers and then buy the mutual fund which reflects that philosophy.

Advantages of mutual funds

One of the big advantages of mutual funds is the elimination or reduction of single stock risk. Those who once owned Nortel, Enron, or Blackberry are well aware of the single stock risk. Single stock risk exist when an investor can lose a significant amount of money because the single stock they own, has a big decline in price. By having hundreds of stocks, the single stock risk is greatly diminished.

Disadvantages of Mutual funds

However, mutual funds are risky and many of them could do so bad that they could be closed down. It is quite possible to lose 50% or more of your money when investing in mutual funds.

Another big disadvantage of owning mutual funds is their high fees. Canada has one of the highest mutual funds fees in the world. While you, the investor, are putting your money at risk, the mutual fund company could easily eat away more than 50% of your profit. It’s very important to make sure your fees are low. Most Canadian mutual fund charge between 2% to 3% in fees. This is outrageous, they should be ashamed of themselves, but is it also, the generally public faults.

Side note: I have a friend, who continues investing in expensive mutual funds because the mutual fund salesperson invited him to a nice steak dinner.

Look for low fee index funds

If you are interested in mutual funds, make sure you don’t pay more than 1% in management fees. There are many alternatives out there.

It has been proven over time that most active managers don’t beat the benchmark to which their funds are compared. For example, a Canadian mutual fund may be compared to the Canadian stock market index. Most mutual fund don’t beat their benchmark because of their high fees or because of many other mutual funds inefficiencies.

The solution to diversify your investment and pay a low fee is to invest in a mutual fund which follow the national index. For example, in Canada, I would invest in a mutual fund which follows the the Toronto Stock Exchange 300. In the US, I would invest in a mutual funds which follows the S&P 500. The fee for this kind of funds is generally 0.10% or less.

Historically the US market and Canadian market have grown at the rate of over 8% per year. If you subtract the index fund expense of 0.10% then you will be left over with a profit of 7.9% or more. This is a more interesting scenario than paying 2 to 3% in fees to a mutual fund a mutual fund manager.

Large-Caps, Mid-Caps or Small-Caps?

Teaching tango at University of Montreal

What the academics say

Ever since I have been reading finance books, I have been reading that Small-Cap stocks are more risky but they perform better. I see graphs and charts backing up these studies, so I decided to double-check. Is it true that Small-Cap perform better than Big-Caps?

I went to my favorite ETF provider and I looked for Big-Caps (VOO), Mid-Caps (VO), and Small-Cap (VB).

What my findings say

My findings did not corroborate the results of the academics. In fact, my findings contradict the research of the academics. Maybe the academics had different set of data, but I have to work with the data that is available to little investors like myself.

Here is a 5 year graph which showcases Large-Caps, Mid-Caps and Small-Caps.

I was not able to find a longer term comparison.

In the graph we can see:

  • Big-Caps going up 19.95,
  • Medium-Caps 15.81
  • Small-Caps 9.51

You might say that 5 years is not a long enough time frame to make a decision, and I agree with you, but the time frame in which an investor gets in and gets out is often random, dictated by his life circumstances, most of the time outside of his control. In any other 5 year period, the results could have been different. What the next 5 years will do, no one knows.

My conclusion

Maybe the academics are right, but I am not an academic, I am real person with real money. I have to go with the information and the tools which are available to me at the moment.

We don’t know which sector is going to do better or worse, we don’t know whether small or large caps will perform better. If we assume that in the long run, stocks are going to go up, then let’s buy a little bit of all of them. Let’s buy Large, Mid, and Small caps. When we retire, when we begin to withdraw money to sustain our lifestyle, then we can take a look and determine which on performed better.

Trends in the US Economy

Differences between the Canadian and US economy

I rather focus my attention on the US economy than on the Canadian economy.

I see the Canadian economy as huge gas station for the US and a huge ATM machine. The biggest drivers of the Canadian economy are the oil companies and the banks. You take those two sectors from the index and there is no Canadian economy.

Any Canadian investing his money in the Canadian index may think that he’s diversified but he’s not, he’s invested in two sectors: Financials and Energy.

The US economy is more diversified

On the other hand, the US economy is more diverse.

Generally, the easier way to invest in the US is to buy the S&P 500 index, this index represents the 500 largest companies of the US. This is one of the best set-it-and-forget-it strategies. Over the last 10 years, the S&P 500 index has increased in value 68 %. This time period includes the financial crisis of 2008 in which the US economy tumbled almost 50%.

If we look closer into the S&P index, we will discover that it is composed of many industries, all of them well represented in the index. Those industries are:

At a birthday party.
  • Discretionary
  • Staples
  • Energy
  • Financials
  • Health Care
  • Industrial
  • Materials
  • Real Estate
  • Technology
  • Utilities

But as you can imagine, not all of those industries grow at the same rate. Some go up, others go down and others stagnate.

The US economy is constantly changing. 200 years ago 90% of the economy was based around farming. Nowadays no one thinks of farming. 200 years ago, we didn’t have a technology sector, now we can not live without technology.

Who is the leader and who is the lagger

I went back and looked at the Spider Industry Sectors for the past 10 years to see which industries have been producing most of the gains for the S&P and which industries have been a drag. Here are the returns:

  • Discretionary + 145%
  • Health Care +133%
  • Technology +120%
  • Staples + 105%
  • Industrial + 73%
  • Materials + 42%
  • Utilities + 36%
  • Real Estate + 5% (This is a new sector, there is only 1 year of data)
  • Energy – 5%
  • Financials – 8 %

Here is a graphs which represents all those returns.

What narrative could we build from these numbers?

Reversion to the mean

There is the reversion to the mean theory which suggest that prices return to a mean average. If we believe this theory, Discretionary, Healthcare, and Technology, will either slow down or retrace. And Financials, Energy and Utilities will increase in value. People who follow this theory have a tendency to re balance their portfolio once a year, selling their winners and buying the losers.

I have news for these people: Agriculture will never be a major part of the economy. That time is long gone. Hunting whales to extract their oil to light lamps will never be a major player of the economy. Moby Dick is dead.

Following the trend

On the other hand, I see technology becoming a bigger player in our economy. I see healthcare growing as well. Medicine continues to advance, our life expectancy continues to grow, which means we will need more medicines, more doctors, more everything.

What to do???

It’s dangerous to predict the future. You never know which industry will go up and which industry will go down, that’s why we buy the index, to protect us from our incapacity to pick sectors. But if I had a little bit more money to play around, I would buy a bit more Healthcare and a bit more Technology.

If you had extra money to play with, which sector would you pick?



Global diversification, not always a panacea

Hanging out with friends

For years I have been promoting the advantages of global diversification.

My recommended portfolio

Generally, I recommend a portfolio of ⅓ Canadian, ⅓ US, and ⅓ international stocks. I claim that  different countries run at different economic cycles, this means that as some countries’ economies are growing other countries’ economies are shrinking.

Avoiding home bias

The advantages of having a diversified portfolio of different geographical areas is that we can reduce home bias ( the tendency to buy stocks from your home country). For example the Canadian economy is only 2% of the global economy, it makes no sense to have a portfolio of only Canadian companies.

Does it work?

It is believed that having investments from different countries, decreases overall risk and increases long term returns. But is this true?

It has been my observation that in time of crisis, most markets are highly correlated, they behave in unison, thus rendering diversification useless. At the exact moment when you need that benefits of diversification the most, it’s the moment when you can’t have it. At any other time, global diversification in a nice academic theory.

It doesn’t work when you need it the most

Two examples come to mind. The time when the Greek government almost defaulted on their debt. At that time all the international markets were moving in unison, they were tanking. The other example was the financial crisis of 2008. All the international markets went down at the same time.

This is the Canadian and US market. As you can see, at the time of the financial crisis of 2008, all markets when down, then all markets started to recuperate at the same time, then each country went about their own business.

Global investing is an idea that it’s nice in the textbooks but almost useless in real life. Yes, as the textbooks tells us. If we invest over a 20 year period or longer, our investments line are smoother when we are properly diversified. But as investors, will we have the stomach to see all our national and international investments tumble at the same time?

Lack of better ideas

In spite of all of its shortcomings, I will still champion my ⅓, ⅓, ⅓ portfolio of Canadian, US, and International ETFs. Not because I am a strong believer, but because I lack any better ideas.