In 2020, the share price of Zoom Technologies Inc. (ZTNO) rose to $20.90 on March 20 from $1.10 on Jan. 1. On Nov. 12 of that same year, the price dropped to a mere 16 cents per share. Investors who bought the stock and pushed the price higher probably thought they were buying the video conferencing platform that became notoriously popular for virtual meetings during the Covid-19 pandemic. ZTNO investors relied on representativeness, assuming the name coupled with the price explosion confirmed they were investing in the right business. However, Zoom Video Communications Inc. (ZM) and ZTNO are entirely different entities.

It’s easy to be overconfident in our ability to beat the market. Overconfidence is the common experience of overestimating our understanding and skill, and underestimating potentially adverse outcomes.

However, studies repeatedly demonstrate that most active investors, including professionals, fail to outperform the broad index over long periods. Yet, we are beguiled by stories of wild success and quick profits, as well as our innate enthusiasm for the investment decision we are about to launch.

Behavioural biases influence financial choices more than you may expect. We often rely on familiarity or recent experiences more heavily than we would like to believe. For example, plausible news reports in this morning’s social media feed may set the tone for trades you make that day. And after experiencing a loss, you may be unwilling to invest in similar investments, even when they provide an excellent opportunity in the future or advantageous diversification within your investment portfolio.

You may also find you favour certain stocks because of past performance, familiarity with those businesses, the countries where they are listed, or because they sell products you regularly use. And a company’s surprise earnings report or an extended period of stock market volatility influences investors to think that more of the same lies ahead.

Each of these common reactions interacts to push your choices toward an outcome that may not be arrived at as independently as you think. The ultimate effect of this interference is a suboptimal return on investment.

In fact, about half of all investors experience below-average performance. That’s a mathematical reality. If your investment experience falls in this category, you could quickly remedy poor performance by investing in the broad market or ETFs that track the returns of a specific index, such as the S&P 500 in the United States or the S&P/TSX composite in Canada. Yet, many investors are reluctant to reap the long-term benefits of passive investing because of the fear of missing out and other behavioural influences, even when a passive strategy eliminates the risk of underperformance and lowers the stress associated with active investment management.

While a passive strategy can reduce the impact of behavioural biases, it’s not without challenges. One of the most significant tests is overcoming the temptation to deviate from index investing when faced with short-term market volatility or the fear of missing out on greater gains.

When market values decline, passive investors may feel regret, compelling them to act — often deviating from a sound investment strategy at the wrong time. Conversely, when the market is performing well and you’re bombarded with stories from friends and media about quick profits and excessive gains, you may be tempted to switch to active strategies, jumping into security selection to replicate the excitement of fast money. Too often, investors are enticed to select stocks or strategies that other speculators have already driven up in price. The higher the price, the lower the potential profit and the greater the risk.

More commonly, after a prolonged period of broad market growth, passive investors may become overconfident in their ability to beat the market, especially if they have followed certain stocks that have risen more than the index. This phenomenon is related to hindsight bias, where you are left with feelings of regret about past decisions, and it often leads to making changes after the event has happened.

Despite these challenges, passive investing has a proven long-term track record. It provides broad diversification among various companies, reducing the risk associated with individual positions. Diversification reduces the volatility of holding only a few stocks or having limited exposure.

Every year, SPIVA (S&P Indices Versus Active) compiles data on the performance of actively managed investment funds. Most equity funds underperform the S&P/TSX composite and the S&P 500, and over five-year periods, more than 95% of funds fail to meet index returns every calendar year. Over the long run, passive investing more consistently outperforms active strategies.

With lower fees, more consistent outcomes, less required time and lower stress, passive investing is a compelling alternative. The trick is to stick to it. Implementing a passive investment strategy requires discipline and a long-term perspective. It’s essential to stay focused on your goals, educate yourself about the benefits, and seek professional advice when needed. By doing so, you can overcome the challenges posed by behavioural biases and achieve your financial goals.

Volatility is more than a temporary decline in value. It can play a critical role in the investment decisions you make, resulting in lower overall returns due to compounding.

Negative performance will hurt your overall expected returns because of the asymmetric performance of compounded returns. Simply put, after a negative return, you have less money invested.

When your investments drop by 1%, you’ll need to earn more than 1% to return to where you started because you’re working with a smaller investment.

Consider the following example of the effects of compounded returns. Imagine earning 10% for three years, then losing 10% for two years. Using quick assumptions, you may anticipate gaining roughly 10% overall. However, a precise calculation based on an initial $100,000 results in only $107,811 at the end of the five years, almost 22% less than anticipated. Even if the poor performance happens early in the investment cycle, the three positive years still don’t push the final value to the expected 10% return.  

The second impact of volatility affects our decision processes due to naturally occurring biases — or shortcuts we rely on — including recency or availability bias, and hindsight bias.

A gambler will typically take a bet when the award is about twice as much as the wager. Similarly, investors are as unhappy about losing $5,000 as they are happy about gaining $10,000. We take losses much harder on the chin, dollar for dollar — a heuristic called loss aversion.

In addition, we tend to overweight current and emotional details in our decisions. Details that are most easily recalled — such as a dramatic or recent loss — will disproportionately contribute to your choice outcomes. For example, you’ll be more likely to contribute to your investment plan if your portfolio performed well last year than if it had lost value. Most people would not consider that, by investing after a loss, you’re buying units of your investment at a lower cost, but instead focus on the overall loss as a sign of heightened risk.

We tend to think more simply and rely on rules of thumb and quick decision processes. If the investment rises, we think in broad categories such as “successful” or “unsuccessful” and are cued to invest more or withdraw based on those conclusions. Of course, you can slow this process down and consider more details, but the natural starting point is the broad experience that influences our choices.

Compounding this effect is the natural disappointment of losing value. It’s common to blame our earlier decision to invest, pointing to poor timing or manufacturing some other regret, in hindsight bias. These feelings of remorse can produce a reluctance to contribute to a well-crafted savings plan after your investment value drops, sometimes making it unpalatable to remain invested at all.

Fortunately, the solution to the mathematical problem of compound negative returns and the key strategy to thwart the biases, heuristics and rules of thumb that interfere with your investment plans are aligned.

If you are easily unnerved by market volatility — marked by a reluctance to continue investing — reduce your exposure to the ups and downs of market oscillations by selecting investments with more predictable patterns. You can also limit volatility by combining asset classes that behave differently during various market conditions to smooth out your return variability. When one asset drops and the other rises, your overall investment steadies.

The net behavioural benefit is the increased likelihood you will stick with your investment contribution strategy by creating a tolerable investment environment.

Limiting exposure to downside risk (volatility) will also produce higher long-term returns because you have less to compensate for when you lose less. Compare an investor whose performance alternates between a positive 12% return and a 12% loss annually for six years, with an investor who oscillates between a 5% return and a 5% loss over the same period. The first investor would have turned his initial $100,000 to $97,030, while the more conservative investor is left with $99,252.

Finding a comfortable level of portfolio volatility will enhance your long-term performance. You’ll know when you have found your volatility “sweet spot” because you will be comfortable contributing to your plan even after an adverse event. When you contribute new funds to the portfolio after a market decline, you buy more units at a lower price. Also, as you reconstitute the portfolio value, you contribute to a better overall return after a decline.

Matching your appetite for variable returns with the level of stability in your portfolio will create a more predictable environment to invest in and improve your overall returns. You’ll limit the impact of negative compound returns and enhance performance by reconstituting your investment after a decline.

RRSP loans might be a tempting option for Canadians looking to top up their retirement savings this year, but financial experts urge caution for those thinking about borrowing to invest.

Kimberley Tran, an economist and advisor with McAuley Financial Services, said an RRSP loan should be the “rare exception and not the rule” for Canadians looking to save for retirement.

“An RRSP loan is not for everyone,” she said.

If an investor has the contribution room and is short on cash, the idea of a larger tax refund than they would otherwise receive if they didn’t take out a loan does sound enticing.

But Tran says those considering taking on debt to invest need to look at more than the potential size of a tax refund.

An investor’s tax bracket, cash flow and savings priority should also be considered, she says.

Even investors who have used an RRSP loan successfully in the past will want to consider the higher interest rates charged on loans this year.

Gabriel Lalonde, a certified financial planner, said RRSP loans were more attractive when interest rates were lower. He said the pitch used to be that you could earn more on the investments than you would have to pay in interest on the loan.

“Well, now it’s not really the case. I mean, at 8%, you know, on the loan, it’s pretty tough to beat that safely in the market,” said Lalonde, who is president of MDL Financial Group.

And while interest payments on loans taken out for investing purposes can sometimes be tax-deductible, this is not the case for RRSP loans.

There are a few circumstances where a loan might be worth considering.

Lalonde said seasonal workers or commission-based sales people who have uneven income throughout the year may find an RRSP useful if they don’t have the cash right now to make a contribution, but know they will have the money later to repay the debt.

He also said if an investor is in a high tax bracket today, but knows they will be in a lower tax bracket in a few years, it might make sense to use up their RRSP contribution room now when the tax benefit of making a contribution is bigger.

“You definitely have to have an appetite for risk when you’re using somebody else’s money to invest,” Lalonde said.

Janet Gray, an advice-only certified financial planner with Money Coaches Canada, said if an investor is expecting a large tax bill this year, an RRSP loan and large contribution might make sense to help offset the bill.

But, she cautioned, there is risk associated with borrowing to invest.

“There’s no guarantee on your return,” she said.

“You could take a … $10,000 loan and be paying on it and then that $10,000 investment that you purchased could go down in value to $8,000.”

Gray said like any loan, you shouldn’t borrow more than you can afford to repay even with the help of a larger tax refund. And while a larger tax refund is nice to have, that extra cash should be used to repay the loan that the investor took out to help generate it.

“Don’t let the carrot blind you to the fact that you will have repayments to make,” she said.

Gray said investors also need to remember that an RRSP loan is adding debt, and it could impact your credit score and affect other borrowing.

“It’s a loan, and you still have to do all the qualifications around it and then all the ramifications of it afterwards.”

The yield on the 10-year Treasury has reached 5% for the first time since 2007. That matters for everyone, not just Wall Street.

Treasury yields have been climbing rapidly, with the 10-year yield rallying from less than 3.50% during the spring and from just 0.50% early in the pandemic. Monday morning, the yield on the 10-year Treasury was at 4.96% after hitting 5.02% earlier. The jump means the U.S. government must pay more to borrow money from investors to cover its spending.

It also directly affects people around the world, because the 10-year Treasury yield is the centerpiece of the global financial system and helps set prices for all kinds of other loans and investments. Besides making it more expensive for U.S. homebuyers to buy a house with a mortgage, higher yields also put downward pressure on prices for everything from stocks to cryptocurrencies. Eventually, they could help cause companies to lay off more workers.

Higher yields mark a sharp turnaround for a generation of consumers and investors who have known pretty much just low yields, as central banks kept benchmark interest rates pinned at nearly zero. Such low rates let people borrow money more easily, which helped economies to strengthen following the 2008 financial crisis, the European debt crisis and other maladies including, most recently, the Covid-19 pandemic.

The low rates led to rising prices for houses, stocks and other investments, but they may also have encouraged too much risk-taking and spurred investment bubbles.

Now, central banks are more concerned with getting high inflation under control. To do that, they raise interest rates and hope the higher costs to borrow will starve inflation of its fuel by bringing down spending.

The Fed’s main interest rate affects extremely short-term loans, those that banks charge overnight. The Fed has already pulled its federal funds rate to the highest level since 2001, and it’s debating whether to hike it one more time. Either way, it’s signaled plans to keep rates high for a while to successfully suffocate inflation.

The 10-year Treasury yield has been catching up to the Fed’s main interest rate after a string of reports has shown the U.S. economy remains remarkably resilient. While that calms worries about a possible recession caused by high rates, it could also keep upward pressure on inflation and shorter-term rates.

Federal Reserve Chair Jerome Powell said Thursday that many other factors could be contributing to the swift rise in the 10-year Treasury yield. They include the U.S. government’s big deficits, which require more federal borrowing, and the Fed’s ongoing efforts to reduce its trove of bond investments built earlier to keep yields low.

On the wonkier side, bond prices have also been falling in tandem with stock prices more often than they used to. That’s unnerving for investors who usually see bonds as the safer part of their portfolios, and it could be pushing them to demand higher yields to own them.

The rise in the 10-year Treasury yield most directly means the U.S. government has to pay more to borrow money for 10 years. But because the 10-year yield is the reference point for financial markets, it also quickly filters out into all kinds of loans.

Even for companies with the best credit ratings, the interest rates they borrow at are set by adding some extra on top of whatever the U.S. government is paying for its Treasurys. Borrowers with worse credit ratings have to pay more extra than those seen as good bets to repay their debts.

More expensive borrowing keep U.S. households from spending as much and companies from expanding as much, which should eventually hit overall U.S. economic activity.

More immediately, because a 10-year Treasury is seen as one of the safest possible investments on the planet, its yield swiftly sways prices for all kinds of investments.

When a super-safe Treasury is paying much more in interest, investors feel less need to pay high prices for a Big Tech stocks, cryptocurrency or other investment that carries more risk. It’s a big reason the S&P 500 has seen its gain for the year so far tumble from 19.5% at the end of July to 10% as of Friday.

Higher U.S. yields also attract more investments from abroad, which means investors are increasingly swapping their currencies for U.S. dollars. Since the end of July, the U.S. dollar has climbed roughly 4% against the euro, 5% against the British pound and 6% against the Australian dollar.

While a stronger dollar helps U.S. tourists buy more stuff when they’re abroad, it can also add financial pressure and heighten inflation for other countries, particularly in the developing world.

Even for U.S. bond investors, the swift rise in bond yields has brought losses of their own. When new bonds are paying higher yields, it makes the older, lower-yielding bonds already sitting in investors’ portfolios or mutual funds less attractive and knocks down their price.

The largest U.S. bond mutual fund has lost roughly 3% so far in 2023 and is on track for a third straight yearly loss. That’s never happened since its birth in 1987.

KEY TAKEAWAYS

• Stock performance this year has been driven by a small group of companies
• One way to examine market breadth is by comparing the performance of a broad, market cap-weighted index with its equal-weight version
• The economy can impact market breadth, as less-cyclical businesses, such as big tech companies, can grow earnings in a weak economic environment
• Narrow markets are often considered more fragile than broader markets, but shouldn’t necessarily be seen as a bad omen

After a dismal 2022, stock markets have roared back this year. The Nasdaq composite index had its best first half in 40 years, posting a 31.7% return for the year to June 30. The S&P 500 was up 15.9% over the first six months. What’s not to like?

One concern investors have raised during this year’s rally is that the gains for both indexes are being driven by a small group of companies. Owing to enthusiasm about artificial intelligence, the outlook for interest rates, and other factors, the so-called “Magnificent Seven” — Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla — have rebounded faster than other stocks. This has led to talk of a “narrow market.”

What does that mean?

One way to examine a market’s breadth is by comparing the performance of a broad, market cap-weighted index, such as the S&P 500 (in which each company’s weight in the index is based on its overall market size) with its equal-weight version (in which each of the 500 companies makes up an equal share of the index).

For example: Apple, the largest company by market capitalization, makes up more than 7% of the S&P 500; in the equal-weight version, Apple’s allocation is 0.2% — the same as the other 499 companies. That means when Apple (and a handful of other big tech stocks) perform well, the main, market cap-weighted index gets a much bigger boost.

A report from AGF Investments published at the end of May noted that the S&P 500’s year-to-date returns were around 10% higher than the equal-weight index — the largest spread at any time this century.

“Moreover, the better these large caps perform in relation to the rest of the S&P cap-weighted index, the greater their weighting becomes, leading to an even greater disparity of returns versus the equal-weighted index,” the AGF report stated.

The spread narrowed slightly over the summer, as more companies contributed positive returns, but widened again in September as bond yields rose.

Another way to examine breadth is to look at the percentage of S&P 500 companies trading above their respective 50-day moving average. A report from Purpose Investments showed that during the very narrow market at the end of May, fewer than 30% of companies were trading above their 50-day moving average. By the end of July, it was closer to 90%.

“This has been helping the equal-weighted index catch up a bit to the more popular market cap-weighted index,” the Purpose report said.

The market’s breadth this year (or lack thereof) has been related to the likelihood of a “soft landing,” or central banks’ ability to bring inflation down to their target range without triggering a recession, wrote Brian Levitt, Invesco’s global market strategist, in a July report. When a soft landing has appeared to be likely, more companies have contributed to market returns; when markets have anticipated a hard landing, requiring more rate hikes from central banks, the number of companies driving returns has narrowed.

“The strong economic data in early 2023 increased the likelihood of additional interest rate hikes and the potential for a recession,” Levitt wrote.

That meant less-cyclical businesses, such as big tech companies that can grow earnings in a weak economic environment, surged ahead.

Lower inflation data and renewed optimism over a soft landing may have contributed to a broadening of the market during the summer.

Are narrow markets a bad thing?

Narrow markets are often considered more fragile than broader markets. This makes sense, as performance hinges on a small number of players.

Levitt noted that markets became more concentrated before recessions in 1991, 2001 and 2008, and before growth slowdowns in 2011 and 2018. He also noted that markets are more concentrated now than they were in 2000, during the height of the dot-com bubble. However, the top 10 companies are more profitable today and have stronger fundamentals, Levitt said.

Brian Belski, chief investment strategist with BMO Capital Markets, wrote in a report earlier this year that, based on previous periods of narrow outperformance, broader markets often hold up well after that outperformance subsides.

“Narrow market breadth in general does not represent a bad omen for S&P 500 performance,” Belski wrote, “despite the contrary narrative being pushed by many investors.”

During down or flat markets, covered-call products tend to gain in popularity. Assets in options-based ETFs grew by $4.4 billion last year, according to National Bank, with covered-call strategies making up the majority.

The reason for the increase? Covered-call strategies work well in periods of market volatility, said Chris Heakes, director, portfolio manager of equity, derivatives-based and multi-asset portfolios at BMO Global Asset Management.

“Covered calls make [volatility] work for investors because they can get more premium or more attractive options trades with it,” he said.

Here’s how the strategy works.

“A covered-call fund essentially invests in a basket of underlying securities and writes call options on that basket of stocks,” said Jaron Liu, director, ETF strategy at CI Global Asset Management.

There are funds in Canada using covered calls on broad market indexes as well as on companies within specific sectors such as banking and energy.

“A call option is a contract that gives the buyer the right, but not necessarily the obligation, to buy a stock at some predetermined price,” Liu said. “In exchange, the seller of that option receives an option premium. Investors can generate higher income from those option premiums.”

If the market is down or flat, Liu said, a covered-call strategy can potentially outperform a similar strategy that doesn’t have call options written on it because “those option premiums that the seller gets provide additional income and can help offset some of the stocks’ decline.”

For instance, let’s say a basket of securities is trading at $115. The manager writes a covered-call option for someone to buy those securities in a month at $120 with a $1 option premium. If the value of the basket of securities declines or stays the same, the buyer decides not to exercise their option and the seller keeps the securities and the premium. For the options seller, the decline in the portfolio’s value is partly cushioned by the premium.

In exchange for these benefits, investors give up the potential for upside if stocks rally. 

“When there’s strong upward movement in stocks, that increases the likelihood that the call options end up in the money, which means that the underlying stocks will be called away,” Liu said. “So investors lose out on some of that growth potential.”

Let’s return to our example of a basket of securities trading at $115. If the basket goes up to $123, the options seller only nets the $120 strike price plus the $1 premium, leaving the rest of the gains on the table.

“So the further the strike price is written from the actual stock price can affect the yield and the performance of these strategies,” Liu said.

Aside from the ability to generate potentially higher income than the market, covered calls are also tax efficient, Heakes said. That’s because the income from option premiums is taxed as capital gains (50% taxable) rather than interest (100% taxable).

Finally, it’s important that investors understand the underlying investments within the covered-call strategy, as well as what percentage of the portfolio has call options.

“It could be 25%, 33%, 50% or more,” said Vernon Roberts, options strategist at Horizons ETFs Management (Canada) Inc. “This way, investors know how much of the upside they’re actually participating in, as well as the risk of the underlying assets so that they are comfortable.”

Writing calls on a smaller percentage of holdings allows more room for upside, while writing covered calls on 100% of a portfolio would eliminate all potential upside.

Unlike mutual funds, ETFs trade throughout the day. This activity requires intermediaries, known as market-makers, who adjust bid and ask prices ato reflect the value of the ETF’s underlying securities.

A market-maker’s day usually begins between 6 a.m. and 7 a.m.

The previous night, after markets closed, ETF providers calculated each fund’s net asset value (NAV) and compiled a portfolio composition file (PCF). The file contains the creation and redemption baskets, showing market-makers exactly which securities and the quantity of each that’s needed to create or redeem a unit of the ETF, said Prerna Mathews, vice-president of ETF product strategy with Mackenzie Investments in Toronto.

Market-makers will use the PCF when the market opens to estimate a bid and an ask price for ETF investors. They spend the pre-trading hours reviewing the PCFs and inputting the information into their trading algorithms, Mathews said. They’re also digesting what happened overnight, such as macro events, as they try to determine how markets may look at the open.

Opening bell

Market-makers take the opening 15 minutes of every trading day to ensure an ETF’s underlying assets are accurately priced. Mathews said investors should avoid trading while this process plays out. “Let the markets settle,” she said.

Keeping an ETF’s bid-ask spread up to date and facilitating trades between buyers and sellers is the market-maker’s primary task during the trading day. Trading screens show what the buyer is willing to pay and what the seller is demanding. The difference is the bid-ask spread.

As the ETF’s underlying securities move up and down in value, the market-maker rolls the bid-ask for those individual securities into the bid-ask for the ETF. Market-makers earn money on the spread: because a security’s value could drop between the time they purchase it and sell it, they’re compensated for the risk of holding the asset and creating liquidity.

Competition between market-makers at different firms helps ensure prices are fair, Mathews said: another market-maker will undercut you “if they see a price on screen is not reflective of the value of the underlying exposure.”

Market-makers create ETF units by delivering a basket of underlying securities to the ETF provider in exchange for a block of units, usually 50,000. To process a redemption, the market-maker returns the ETF units in exchange for the securities.

A few factors can affect the bid-ask spread. One is the liquidity of the underlying holdings. Large, frequently traded stocks tend to have narrower bid-asks, so an S&P 500 ETF will have a narrower spread than a small-cap fund. ETFs holding a smaller basket of securities also may have wider spreads because price movements are more pronounced across fewer holdings.

Funds that use hedging require more complex trading (and therefore costly) strategies from market-makers, which may translate into wider spreads. And bonds, which are sold over the counter, often have less transparent prices, also contributing to wider spreads.

Finally, funds holding international securities are more difficult to price since markets are closed for part or all of the Canadian ETF’s trading day. “Market-makers are using a lot of different proxies to value those underlying emerging market securities,” Mathews said. Those proxies include foreign exchange markets, futures markets and macro news.

An exceptional day

Spreads can widen for any ETF when the liquidity that market makers provide becomes more expensive. The widening can be moderate and short-lived, as sometimes happens around Federal Reserve announcements, or it can be more severe and enduring, as it was in March 2020 during the onset of the Covid-19 pandemic and after Russia invaded Ukraine last year.

“[Markets] don’t know what’s coming next, so you will immediately see risk priced in,” Mathews said, which widens bid-ask spreads.

Macro events tend to affect ETFs that depend on more volatile foreign currencies, Mathews said.

In times of uncertainty, investors who want low risk along with capital preservation may turn to low-volatility investments. Securities considered to be low-volatility do not fluctuate in value as much as other investments.

“If you think about why someone would buy a low-volatility investment, they [have] a desire for risk reduction,” says Sam Febbraro, executive vice-president at Investment Planning Counsel. But there’s a trade-off. “It’s hard to have risk reduction and have the performance shoot to the moon. As a result, these investments may sometimes underperform in a rising market. But in theory they should be less volatile on the downside.”

A low-volatility investing strategy focuses on reducing volatility or risk compared to the stock market index, says Jeet Dhillon, vice-president and senior portfolio manager at TD Wealth Private Investment Counsel. “Low-volatility strategies use risk as the primary measure to determine if particular stocks will be included or excluded, and what the optimal weighting of the included stocks will be in a portfolio.”

Types of low-volatility investments

Many people think of cash, GICs and bonds when they think of low-volatility investments, but stocks and ETFs can also fall into this category.

Dhillon adds that utilities and consumer staples are examples of low-risk stocks because the demand for the goods and services from these companies is less cyclical. These stocks therefore provide some stability from swings in the economy.

Cash and GICs are low-volatility because there is no risk of losing the amount originally invested (known as the principal).

Bond agreements, also known as covenants, also promise that the principal will be paid back when the bond matures. Bondholders also typically receive interest payments, known as coupons, at regular intervals.

During periods of high volatility, bond values don’t fluctuate as much as the value of equities. That’s because fixed-income returns are affected by longer-term trends such as interest rate changes.

You can also invest in a low-volatility ETF. Such ETFs may comprise companies that are considered to be low-volatility, such as consumer staples, real estate income trusts (REITs) and utility companies, says Craig Basinger, chief investment officer at Richardson GMP.

Risks of low-volatility investments

Stocks

Dhillon warns that low-volatility equities don’t always outperform the stock market. They tend to underperform during strong bull markets and outperform during severe bear markets. “In other words, the lower level of volatility dampens both the highs and lows of returns,” Dhillon says.

ETFs

Low-volatility ETFs may be risky during periods with rising bond yields, warns Basinger—particularly ETFs that favour REITs and utilities. REITs and utilities tend to hold a lot of debt and are therefore sensitive to increases in interest rates: rising rates make servicing debt more expensive, so returns are dampened. More importantly, explains Basinger, if government bond yields rise, then the dividend yields of these REITs and utility stocks (called “quasi-bond proxies”) look less attractive and fall in price. “The government bonds are a competing asset class to the bond proxies,” he says. (Note that Basinger’s warnings also apply to the underlying REITs and utilities if they were purchased directly or in a mutual fund.)

Bonds

Bonds have an inverse relationship with interest rates, tending to fall when rates rise. Investors could then lose money if they sell a bond for less than what they paid for it.

Inflation also poses a risk to bondholders. Investors who hold bonds to maturity get their principal back, but if inflation has increased since purchase, the principal would be worth less in present-day dollars.

Buying bonds from unstable governments or companies is another risk, known as credit risk or default risk. Such issuers may not be able to pay the interest payments or the principal of the bond at maturity.

GICs

Since GICs are guaranteed, they tend to pay lower interest rates than riskier instruments. Most GICs also fix their rates for the entire term. This is a risk because the interest rate may not keep up with inflation.

Other ways to reduce volatility

Creating a balanced portfolio with stocks and bonds is a good way to reduce volatility, says Basinger. Diversifying a portfolio geographically and across asset classes will also help.

Basinger’s firm also uses what’s called a risk on, risk off investment strategy. This strategy tilts the asset allocation toward equities when the stock market goes up. Conversely, the strategy will favour bonds when the market falls.

“It’s not designed to be a full portfolio, but designed to complement a portfolio and provide a tactical component,” he says.

Whether it’s building infrastructure, growing a business or investing in equipment, governments and corporations often need to raise funds for their operations. Issuing bonds is a common way to raise the money they need.

What is a bond? It’s an IOU from a corporation or government to an investor. Issuing bonds means that the face value of the bond (known as the principal) must be repaid on a due date (maturity). Investors will also earn interest on the bond, otherwise known as the coupon. The coupon is calculated annually as a percentage of the bond’s face value.

People choose to invest in bonds for “a perceived predictability in future cash flow,” says Shailesh Kshatriya, director of investment strategies for Russell Investments Canada. “If the bond is paying 5%, 10% or whatever the coupon rate is, your belief is that there is a high degree of predictability and certainty that you will get that cash flow over time.”

There are four major types of bonds, each of which have their own market:

• corporate bonds, which can be used to finance operations or business growth;
• government bonds, which repay the face value of the bond on the maturity date with periodic interest payments;
• municipal bonds, which are issued by local governments to fund projects; and
• mortgage bonds, which refer to pooled mortgages on real estate properties.

Though bonds are often thought of as safe investments, bond prices can fluctuate for several reasons. We look at each.

Interest rates

A rise in interest rates generally means bond prices will fall and vice-versa, otherwise known as an inverse relationship.

Interest rates play a role in determining the coupon rate—what Kshatriya calls “the predictable cash flow”—and future bond prices. He says it’s important to consider current interest rates and where they may head in future. Forecasting interest rates includes looking at where they are in relation to the business cycle.

“Are we in the early stages of a business cycle, the middle stages or in the late stages?” asks Kshatriya. In an early stage, interest rates have typically been reduced to help the economy grow again. Rates tend to be steady during the middle stage. The late stage means rates are rising to prevent inflation during an economic recovery.

Changes in interest rates affect the market value of the bond you hold.

For example, “if interest rates rise to 4%, the bond with a 3% coupon is no longer going to be attractive because participants could just go get a bond with a 4% coupon,” says Catherine Heath, vice-president, portfolio manager and fixed income analyst at Leith Wheeler.

That would decrease the demand for such bonds, leading to a price drop in the secondary market: you would get a lower price for it if you wanted to sell it instead of holding it to maturity.

“The bond with a 3% coupon is going to be discounted by the market because of its lower interest rate,” sums up Heath.

Inflation

The inflation rate also has an inverse relationship with the price of bonds. Any rise in inflation means the return you’ll earn on your bond will be worth less in current dollars when the bond matures.

“Inflation is the enemy for bond investors because it erodes purchasing power,” says Kshatriya.

Economic reports

These reports include the monthly numbers for employment, inflation and GDP growth.

“You have economists forecasting what those numbers are going to be, so the big thing that moves the bond market is when those numbers are reported,” says Joey Mack, director of fixed income at GMP Securities. “If those numbers are a lot different than what economists were expecting it to be, you’ll get a move in the market.”

Positive economic news, such as stronger employment data, will generally cause bond prices to fall, while negative news, such as lower housing starts, will generally cause bond prices to rise. That’s because investors often turn to bonds during times of uncertainty, increasing demand when economic indicators are poor.

Bumpy financial markets can be unpleasant, especially when headlines are forecasting doom and gloom. It’s even less pleasant when you don’t understand the reasons for the ups and downs.

To help you cut through the noise, we’ve prepared a series of explainer articles to detail the reasons behind market moves–both negative and positive. And for those who can’t stomach volatility, we define low-volatility investments.

As a bonus, we’ve also included our Economics 101 series, which looks at the forces shaping our everyday financial lives.

Investing

Reality of stock markets includes volatility

It would be nice if share prices only went up. Since that’s not the case, we look at why there are ups and downs. (If you’d like a comprehensive explanation of a stock, read this article.)

Why bond markets go up and down

These so-called safer investments are still vulnerable to swings. This piece explains the relevant factors. (If you’d like a comprehensive explanation of a bond, read this article.)

What is a low-volatility investment?

We look at what low volatility really means and how these investments work. (If you’d like a comprehensive explanation of volatility, read this article.)

Economics 101

As you’ll see, economic forces are a big part of why markets move. Need a crash course in economics? Give these articles a read:

• Supply and demand: Why do you care?
• Central banks and why they exist
• Monetary policy and how it affects you
• What is fiscal policy?