No matter how carefully and scientifically a portfolio is constructed, inevitably it will be affected—at least in the short term—by periods of market turbulence and macro-economic uncertainty. Equally inevitably, investors will suffer anxiety and be tempted to veer off their long-range plan. However, you will not necessarily find a safe haven in guaranteed investments.
Would you refuse to have children unless you had a firm guarantee that there would be no risk of serious illnesses and other difficult challenges due to unforeseen circumstances? Of course not. Naturally, we all hope for a smooth passage for our children, but we know that periods of great anxiety are inevitable. We also know that these periods will be offset by the joys and deep satisfaction of family life, and so we are prepared to take the risk and endure the rocky ride.
Long-term investing requires similar fortitude, pragmatism and perseverance. The returns you need to meet your financial targets over the course of your life do not come without risk; in fact, your returns are a compensation for taking well-considered risks. No matter how carefully and scientifically a portfolio is constructed, inevitably it will be affected—at least in the short term—by periods of market turbulence and macro-economic uncertainty. Equally inevitably, investors will suffer anxiety and be tempted to veer off their long-range plan.
Some investors will say they do not have the stomach for this kind of risk and retreat to the safety of “guaranteed” investments, like Treasury bills. Unfortunately, in investing as in life, an “all or nothing” approach seldom brings the desired outcome. History shows that guaranteed investments are not necessarily the safe haven that investors are seeking.
Between 1900 and 2010, inflation in Canada has run at 3%. Over that same time period, Treasury bills (as a proxy for guaranteed investments) have experienced a return of 4.7%, which is 1.7% over inflation. Stocks have experienced a rate of return of 9.1% or 6.1% over inflation. If you needed a return of more than 1.7% to meet your financial goals, you can see that Treasury bills would have guaranteed that you had less money than you needed. The safer route would have been to invest in stocks with their 6.1% rate of return over inflation.
Let’s look at it from another angle, the time periods when each performed the worst. The period of greatest loss for Treasury bills was 1934–1951, when the loss against inflation was –44%; for stocks, the worst period was 1929–1932, with a –55% loss against inflation. Although the gross loss was greater for stocks, before you jump to the conclusion that they were the riskier investment, let’s look at their recovery times. Treasury bills dropped 44% over 18 years and took 34 years to recover. Equities dropped 55% over four years but took only three years to recover.
Seen in this light, Treasury bills with their lower risk of volatility nevertheless pack a different kind of risk—that is, the risk of loss of earning power or the erosion of the value of your money against inflation. Stocks, with their greater risk of volatility, offer greater protection against the risks posed by inflation.
Emotionally, inflation does not deliver the kind of gut-wrenching punch as market volatility, but it is a slow, wealth-draining hemorrhage. Say you bought your home 34 years ago, when the average cost of a new home was $54,000 and the average family income was $13,000. Savings kept in a guaranteed investment over that period of time would have resulted in a significant erosion of your purchasing power against today's costs.
Safety in investing is typically measured in terms of volatility. However, this approach fails to take into account other threats to a successful investing outcome. In building the portfolio that will provide for you in retirement, you need to find a balance between holding guaranteed investments with their low volatility and stocks with their power to protect against the erosion of your purchasing power.
1. Data extracted from the Dimson Marsh Staunton (DMS) Global Returns Database
This article by Daryn Form was published in the September 2012 edition of Sask Business Magazine.
Daryn Form is a Senior Financial Advisor with Assante Capital Management Ltd. providing wealth management services to principals of family-owned and privately held companies. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada. The information mentioned in this article is for general information only. Please contact him to discuss your particular circumstances prior to acting on the information above. The opinions expressed are those of the author and not necessarily those of Assante Capital Management Ltd. Rates are not guaranteed and are subject to change at any time without notice.