Everyone with any money – whether gained from savings or inheritance – faces the same question. What should I do with it? Fear of loss is natural, and even necessary. It makes us cautious. But a greater danger is to do nothing, in the face of uncertainties and doubts. Over a typical investment career, the net real profits on stocks are likely to be 100 times greater than cash deposits. Conclusion: we should all own at least some stocks.
Cash is low risk in the short run, but high risk in the long run. A portfolio of stocks is precisely the opposite. It’s riskier in the short run, but low risk in the long run.
That’s a bold statement, so I’d better explain what I mean.
Saving and investing is about delayed gratification. Instead of spending money today, you’re putting it away to spend in future. You could be saving to buy a home within a few years. You could be investing to make sure you have a comfortable retirement…or to fund school or college fees for the kids…or even just to leave a decent inheritance for someone.
However you got the money in the first place, the most important thing is that you don’t lose it again. OfWealth aims to help you with that mission.
Specifically, you need to stay ahead of the rising cost of goods and services. You need to preserve purchasing power.
This means the first aim of investing is to make sure your net returns at least match inflation, after you’ve paid any taxes due.
Without this, you’re effectively losing money every year. Inflation steadily chips away at the value of your money. You don’t notice it over a few years, but the long-term effect can be huge.
For example, imagine you had all your financial wealth in the form of a big stack of physical cash. There’s no risk of the price going up or down, since a dollar is a dollar, a euro is a euro, a pound is a pound. That’s why cash is low risk in the short run.
But physical cash pays you zero interest income. That means, if consumer price inflation (CPI) is just 2% a year, you lose about 2% a year in purchasing power.
Due to compounding, you’d effectively lose a quarter of your money in 14 years. To lose half of the value would take 35 years. This is clearly a big deal for any long-term money. By that, I mean the kind that you don’t plan to dip into for decades, such as retirement funds. (Even if you’re already close to or even in retirement, you could still have decades ahead of you.)
You could try to make up for this erosion of value by converting that physical cash into bank deposits, which are loans to the bank. In return, the bank pays you interest, but also usually charges fees, in return for payment services.
Unfortunately, we still live in a low interest rate world. For example, the best rate I could find for current US dollar certificates of deposit (CDs) was 3.1% a year. But that’s likely a teaser rate for a limited time, or limited amount. In any case, it means locking the money up for five years, presumably with penalties if you change your mind later.
But let’s say you could get 3% on your bank deposits. And let’s say CPI averages 2% over time, in line with the Federal Reserve’s target. You’d make 1% above inflation, so all’s okay, right? Except you’d probably have to pay income taxes on the whole 3%.
Personal income taxes are complex, and vary by country and US state. But let’s assume you have to pay about 30% on interest income. The net interest would come to 2.1% a year, or just 0.1% above inflation. At that rate, you’d only add 1% to purchasing power over a decade. It would take 95 years to add a measly 10%, which means you’d be out of luck. Doubling your money, in terms of what it would buy, would take your descendants a staggering 695 years to achieve.
This is what I mean when I say cash, or bank deposits, are high risk in the long run. You surely won’t make more than minuscule profits, and you may even lose meaningful purchasing power over time.
Put another way, large cash deposits are only suitable for money that you plan to use relatively soon, meaning within a few years. You need to find a more profitable home for anything that you don’t plan to use within, say, five years. Above 10 years and there’s no question: cash is a waste of both time and profit opportunity.
That’s not to say that you shouldn’t have a large cash allocation within your investments from time to time. Such as after a long bull market in stocks, when good value is thin on the ground. That’s why I currently recommend a 35% allocation to cash (mainly meaning deposits or very short-term bonds such as treasury bills).
This cash allocation has a dual role. In the event of a sharp fall in stock markets, it acts as “ballast”, limiting losses and steadying the portfolio ship. In the aftermath, it can be deployed as “ammo”, aimed at the inevitable deep-value bargains, and making big profits as markets recover.
Of course, there are other investments such as gold, bonds and real estate. But I’ll skip over those today. I want to focus on the difference between cash and stocks.
A stock represents part ownership of a business. No more, no less. But, unlike owning your own business, the management is entrusted to others.
Overall, business profits go up over time, which makes stocks more valuable. At the same time, companies distribute cash in the form of dividends and stock buybacks. The former provides an income to investors, which can be reinvested. The latter leaves the remaining stocks relatively more valuable (since the business value is divided between fewer of them).
Since 1900, US stocks (“equities” in the following chart) made 9.6% a year, on average. That’s 6.5% above inflation, known as the real return. The chart below makes it clear how stocks left bonds and bills (similar to cash) way behind, over the long run. (Note it has a logarithmic vertical scale, which means the same percentage gains or losses always look the same size on the vertical axis.)
Source: Credit Suisse Investment Returns Yearbook
Of course, that 9.6% gross return was before taxes and investment costs (fees and commissions paid to the financial industry). But, let’s say an investment in the S&P 500 makes 8% a year pre-tax in future, over 10 years or more.
Individual circumstances vary. But let’s also say taxes average 20% over time, across both capital gains and dividend income. That would leave 6.4% a year, after taxes but before inflation. If inflation averages 2% a year in future, that would mean 4.4% net, real return.
At that rate, the purchasing power of the stock index investment would double in 16 years and quadruple in 32 years. With life expectancy above 80 years, most investors should be thinking at least that long term, and much longer in many cases.
So…let’s see. You could simply invest in the stock index and make +300% over 32 years – after taxes, fees and loss of purchasing power (inflation). Or you could sit on the best cash deposits for the same time and make 3.3% net, real return…in total.
Put another way: the net, real returns on stocks are likely to beat cash by around 100 times…over the typical, three-decade timespan when an investor has the most funds to deploy. Over even longer time frames the difference is even greater.
So why doesn’t everyone buys stocks, if it’s so obvious that the profits are superior? I believe it’s primarily due to a major misunderstanding of the real risks involved. This is perpetuated by academic theories taught to students of finance, and then practiced by the investment industry (whose members usually went to those schools).
Why stock investments, done right, aren’t as risky as people think
So let’s get back to my opening statements, where I said that stocks are riskier in the short run, but low risk in the long run. Therein lies the rub.
Stock markets can swing in any direction in the short run. Individual stock prices even more so. That makes stocks risky in the short run. Which makes them unsuitable places to park money that may be needed in the near future, since you may have to sell them at a bad price.
Professional investors and finance professors are obsessed with this short-term risk. Portfolio managers get bonuses based on annual results, not assessed over decades (they don’t want to wait that long). And finance professors like complicated statistical models that rarely prove more than the square root of…not much.
As an example of short-termism in action, corporate pension funds must not fall too much in a short time. Otherwise the sponsoring companies have to cough up extra cash to plug the funding gap (even if it’s only temporary). Insurance company reserves have to be stable, since industry regulations set minimum amounts relative to potential liabilities (claims). Hedge fund managers often run leveraged portfolios, meaning if market prices fall then margin loans are called in, making them forced sellers. Hence they try to avoid too much price volatility at all costs.
This means most professional investors are incentivised to think short term. As a consequence, they must hedge their stock positions against price falls, or suffer the repercussions.
But you’re not one of them. Private investors have the luxury of taking a longer-term view. If you’re investing for 10 years, what matters ultimately is the end result, not the short-term price swings in between.
That said, I get it. No one likes to see the reported value of their portfolio fall on their brokerage statement, including myself.
But the key is to focus on the horizon and not gaze at your feet. The goal is arriving at the desirable but distant destination, not worrying whether the next step will be easy or hard.
Owning stocks is crucial if you want to put your money to work over the long term. Currently, I recommend a 40% allocation to stocks. That reflects the relative scarcity of good value, cheap stocks after a long bull market. One day, that could increase as high as 80%, if there’s a significant stock market fall.
Below is a summary of the recommended asset allocations, which are unchanged since August 2017. These are not meant to be hard and fast rules. Instead they are meant to show you how I feel about different asset classes at the current time. I fully realise that what you actually do will depend on your personal preferences and circumstances.
These recommended allocations are not an attempt to time the market. No one can do that, and never believe anyone who tells you that they can. I’m not predicting a market crash in the near future, although it’s possible (at which point the cash “ammo” can be deployed).
My portfolio recommendations are based on value. It’s about the abundance or lack of decent opportunities to buy stocks cheaply. When there’s a lot of good value about, I want to own more stocks. When there’s relatively less of it, I’ll put less into stocks. The latter is where we are today.
That said, there is good value around, if you look in the right places. Assuming the stocks owned are bought right, they’ll work out well over time, on average. That’s irrespective of short-term, macro market moves (both up or down). By being selective with individual stocks, you can make superior returns over time (see here for access to my current recommendations, based on in-depth analysis).
Even just buying the S&P 500 index in October 2007, just before it crashed due to the global financial crisis, you’d still have made a decent profit after 10 years.
The GFC was the biggest economic and financial crisis since the 1930s. So this is an amazing result. It’s also testament to the power and profitability of patient stock investing.
Do I think we’re in for another GFC anytime soon? No. Which is even more reason to own at least some, carefully-selected stock investments.
More to come…
Stay tuned OfWealthers,