Monday, January 19, 2009

Which Investment Is Riskier?

Imagine a perfect world where investment returns were 10% every year and you could simply invest in anything and be confident of the future. The past year will have cured most people of that fantasy world. For those people with a slightly longer memory, so did the tech bubble of 2000-2002. For those among us who are over 40 and "real old" as my eight year old pointed out, you may also remember the last major recession we went through in the early 1990's. The real older crowd would no doubt remember the early 1980's recession or the 1973-1974 one.

It's all those past market corrections that remind us that there is no perfect world (see right) when it comes to investing. With pessimism running rampant nowadays, it's all too easy to forget another reality - that markets run in cycles. Unfortunately, we've gone from one extreme of putting too low a price on risk to the other extreme of putting too high a price on risk, and it's not easy to convince people today that markets will rally again. The media also plays a part in this - how may people out there realize that most markets are up 15%-20% from their lows. Of course not. Bad news sells and good news gets buried.

So what did I mean about which investment is riskier (in the title)? Even long term investors have a breaking point and more and more I have heard the phrase "move it all into GIC's". One of the worst things anyone could do at this time would be to follow this strategy. Why you may ask? It's actually simple and will be explained in greater detail in coming blogs. Here's the basics:

When interest rates drop to historic lows, so do the rates that institutions pay on GIC's. Currently, a five year GIC pays somewhere in the range of 3.5 to 4% per year. Assume you invested $100,000 in the market at it's height and it was now worth $70,000. You pull the money out and invest it in a 5 year GIC at 4%. Five years from now where are you? Up to $85,166. Assume you renew at the same rates. In 10 years, you have $103,617. In other words it took between 8-10 years to recover and get back to zero. Now we come to the bad news.

When governments print money to stave off an economic collapse, eventually it will come full circle in the form of higher inflation. So my GIC would look good wouldn't it? Not necessarily. Picture this - two years into a 5 year GIC at 4% we see inflation jump to 5%. Your investment is actually declining in purchasing power each year you have it invested. If it's invested outside an RRSP or TFSA, then you pay taxes on the growth and your purchasing power is further diminished.

Historically stock markets have gone up and down on a year over year basis. In a previous blog I showed two charts that demonstrated the predictability of markets.

You don't need to be able to read the numbers to see what follows. The first chart represents annual stock returns for US large stocks per year. If you had to ride that roller coaster, I wouldn't recommend eating anything that would upset your stomach.

The second chart - the rolling 20 year history of the EXACT SAME US LARGE CAP STOCKS. If you averaged the returns over a period of twenty years for US Large Cap stocks from 1930 to 1950 and then presented a percentage, it would be 7%. This figure is in spite of the depression. Since 1950, the 20 year average never fell below 7% (the high point came from 1941 to 1961 at 17%).

Apparently we have discovered something incredible. If you look at investments over a 20 to 30 year historical reference, markets go up and down year over year but always go up in the long term. Maybe we should keep this little secret to ourselves - if the general public ever found out that investing patterns repeat, and that the current market downturn is offering one of the all-time greatest sales opportunities ever, more people would rush out to invest. That would push markets up and the deals wouldn't be nearly as good.

Does anyone know they way to success? I don't mind taking a slightly longer route - I don't need to get there for quite a few years...

No comments: