Most people are afraid of the stock market. They see it as a casino that is rigged by billionaires.
In a 2018 Ontario Securities Commission survey, savers and investors were asked how much of their portfolio was in cash or Guaranteed Investment Certificates (GICs), and how much was in stocks, bonds, mutuals funds, ETFs and other investments. The responses below are arranged from most to least conservative (100% cash/GICs, 75% cash/GICs, 50% cash/GICs, 25% cash/GICs, 0% cash/GICs).
43% of respondents indicated that at least half of their portfolio was in cash or GICs. And the other category includes bonds and mutual funds and ETFs which could also have significant cash and bond holdings.
That’s a problem.
Because while stocks are risky short-term investments, cash, GICs and bonds are risky long-term investments.
To be clear, I’m talking about low-cost index funds (mutual funds or ETFs) of stocks. Investing in individual stocks is risky. Companies go out of business every day. The entire world does not.
The risks of stocks vs. bonds
The reason stocks are risky in the short term is that returns are volatile. In some years returns are highly positive, in others they are extremely negative. In contrast, bond returns tend to be consistently modestly positive and only rarely are they even slightly negative. You can see this in the chart below with annual returns of the US stock market in red and annual returns of the US bond market in blue.
The reason bonds are risky in the long run is that returns are so low that a portfolio of bonds may not generate the returns needed to meet your retirement goals. The graph below shows what $10,000 invested in 1987 in the US stock market (red) and bond market (blue) would be worth today. The stock portfolio would be worth over $300,000 while the bond portfolio would only be with $70,000.
You would have had to save over four times as much if you invested in bonds to end up with $300,000.
The world is different
And for much of that period, interest rates were far higher than they are today.
Look at what has happened to interest rates on 5-year GICs between 1980 and today:
But over this same period, stock market returns have continued to be relatively strong:
Going forward, expectations are that stock and bond returns will be lower than they have been in the past. Below you can see the return assumptions from the Financial Planner Canada Standards Council 2020 Projection Assumption Guidelines.
Expected returns here for short-term and long-term bonds are 2.4% and 2.9%, respectively. After subtracting expected inflation (2%), the expected real returns for short-term bonds are 0.4% and 0.9% respectively.
0.4 and 0.9 percent.
Rates of return this low essentially mean that every dollar you have invested in bonds or GICs should be expected to essentially just keep up with inflation.
If you are placing all of your retirement savings in these products, it means that you will have to save nearly every dollar that you intend to spend in retirement.
That’s not how retirement savings has worked in the past. Investment returns contributed significantly to retirement goals, even if you were invested in bonds and GICs.
But look at the expected returns for Canadian equities, foreign developed market equities, and emerging market equities: 6.1%, 6.4% and 7.1%. Subtracting inflation, those are real returns of 4.1%, 4.4% and 5.1%.
That’s way better than bonds. Your invested dollars would actually grow in real terms (after subtracting inflation): 1.5x after 10 years, 3x after 25 years, 6x after 40, 9x after 50, 13x after 60.
With real interest rates near zero, it would be incredibly difficult to save for retirement by investing entirely in cash, GICs and bonds. They essentially just keep pace with inflation.
Today, a long-term investment portfolio needs to include stocks.
Remember, stocks are risky in the short term, but bonds are risky in the long term.