Invest in the Stock Market

Why Invest in the Stock Market?

With the current stock market gyrations, people may wonder why they should invest in the stock market at all since stocks are not guaranteed and their values can go up and down.  

To help frame it better, it may be useful to replace the words “stock market”  with the word “companies.” 

If you own a globally diversified portfolio, you can think of it as investing in some of the best companies around the world.

So, why invest in companies?

Many people need to grow their money over time to beat inflation and taxes.

The following excerpt from the Book – Preserving Wealth describes this in more detail. 

The rest of us laughed, but Sally had dollar signs in her eyes. “Are stocks guaranteed?”

“No way!” Mark answered.

“Well then, why would anyone buy them?”

Uncle Wayne took over. “It’s true that the stock market goes up and down, but over the long term, the trend has been up, just like the economy. I can show this to you in black and white. I took the lib­erty of asking Aunt Lorraine what year each of you were born so that I could chart the growth of the Toronto Stock Exchange Index in a way that isn’t skewed toward my point of view. Look at this,” he said as he pulled out a sheet of paper.

Mark (1955)                           TSE was   536.50

David (1968)                          TSE was 1062.88

Alice (1970)                           TSE was   947.54

Jack/Sandra (1978)               TSE was 1309.99

Sally (1983)                           TSE was 2552.35

“The Toronto Stock Exchange at the end of 2019 was at a whopping 17,063.43, so even with all the turbulence in the time since Mark was born, the stock market has increased dramatically. Gosh, think of everything that has happened in the last sixty-three years: the Korean War, the Cuban missile crisis, Vietnam, the separatist movement in Quebec, the advent of the information society and the global economy, not to mention the oil crisis of 1973, the market crash of ’87, the fall of Communism, the Gulf Wars, Bre-X, Nortel, the Dot Com boom-bust in 2000–2001, the Great Recession in 2008–2009, 9/11 …”

“Enough with the history,” Sandra said affec­tionately “Let’s get back to the economy. What I think you’re saying is that at any one point in time, there’s enough upheaval going on that you could feel skittish about risking an investment in stocks. However, the bottom line is that the market has always gone up over the long term.”

“I’m still not crazy about the risk factor,” Sally said. “Stocks may have gone up over time, but how have cash and bond investments done in comparison?”

“I thought someone might ask that,” Uncle Wayne replied, “so I came prepared. The informa­tion for this chart came from the 2018 Morningstar Andex Chart, and it shows the average performance of each over various time periods.”

Last Ten Years

AssetCompounded
Annual Return
Risk
T-bills (91 days)0.9%4.1%
5 Year GICs1.8%3.6%
US Large Stocks13.0%17.0%
World Stocks6.4%20.1%
Canadian Stocks4.2%16.5%
Long Bonds6.7%9.6%
Balanced Portfolio7.5%10.0%
CPI (Inflation)1.5% 

Last Twenty Years

AssetCompounded
Annual Return
Risk
T-bills (91 days)2.3%4.1%
5 Year GICs2.7%3.6%
US Large Stocks5.9%17.0%
World Stocks4.3%20.1%
Canadian Stocks6.6%16.5%
Long Bonds6.8%9.6%
Balanced Portfolio6.4%10.0%
CPI (Inflation)1.9% 

Since 1950

AssetCompounded
Annual Return
Risk
T-bills (91 days)5.2 %4.1%
5 Year GICs6.2%3.6%
US Large Stocks11.7%17.0%
Canadian Stocks9.8%16.5%
Long Bonds7.4%9.6%
Balanced Portfolio9.5%10.0%
CPI (Inflation)3.6% 

“What the heck does the risk percentage mean?” I asked as I studied my copy.

“Good question,” said our uncle, turning toward me. “Look at the last twenty years; the average return for Canadian stocks was 6.6%. The risk figure is 16.5 percentage points, which means that the returns in any one year could have been as high as 26.3%, or as low as -9.9%. The fluctuation figure tells us the extent of the range for returns on stocks.”

“I’m still not clear on this,” I admitted.

“Try thinking of it in terms of your golf score, Jack. On average, you shoot about 110 for eighteen holes, but your range is probably anywhere from about 102 to 118.”

“Hey, what about the time I shot 95?” I protest­ed.

“That’s a good point,” Uncle Wayne agreed. “Sometimes a result will be well outside of the range, but as you know from your golf game, that happens very rarely.”

“I see,” Sally said. “The fluctuation is the stan­dard deviation, which means that the result will be within the range two times out of three. However, there is always a possibility that a result will be outside the boundaries of the range, like what happened in 2008.”

We all stared at Sally.

“No big deal,” she shrugged. “Stats 101.”

“So,” I commented, “if the results will be within the range of fluctuation two out of three times, then investing in the stocks of good com­panies would be the best investment over the long term. However, since the result could be outside the range one out of three times, and that means higher or lower, you have to be emotionally and financial­ly prepared to handle the risk factor.”

“I understand this,” Sally said, “but I don’t want the headaches of worrying about ups and downs. I’m going to sink all of my money into bonds and GICs, and I’ll be fine.”

“Not so fast, Sally,” said Uncle Wayne. “You haven’t considered the other risk factors related to investment planning, namely inflation, taxes, and the very real worry that you might outlive your supply of money.”

Again, Uncle Wayne shuffled through his papers to fish out another chart for us.

“Let’s say that in 2019, you invested $100,000 for a twenty-year period in a GIC with an average return of 3.5% before taxes:

2019     $100,000 (investment)

2038     $198,979 (3.5% return, no taxes)

“But you do have to pay taxes, so let’s assume your tax rate is 40%. That would mean your after­ tax growth is 2.1%, so let’s add that factor to the list.

2019     $100,000 (investment)

2038     $198,797 (3.5% return, no taxes)

2038     $151,536 (2.1% return, after tax)

“Your investment doesn’t look so healthy anymore, and we’re not even finished. We must count inflation as another factor, so let’s use a long-term inflation average of 2% and add that to our list.

2019     $100,000 (investment)

2038     $198,797 (3.5% return, no taxes)

2038     $151,536 (2.1% return, after tax)

2038     $101,979 (0.1% return, after tax, after inflation of 2%)

“What looked like a good investment before taxes and inflation now appears to be pretty darn poor. Your $100,000 has only grown to $101,979 in today’s dollars after twenty long years.”

“Are you saying I should invest everything in stocks?” Sally asked.

“I don’t think that would be within your comfort zone, Sally,” he answered. “Could you stand see­ing your entire portfolio down by 50% in any one year, like 2008, if you invested only in US stocks?”

“Hardly,” she replied. “I think I’d flip right out.”

“Then perhaps the answer, for all of you, is something called ‘asset allocation.’ Essentially it means not putting all your eggs in one basket.

“Several studies have shown that the most important factor in determin­ing the success of investments is asset allocation. I won’t bore you with all the findings, but the high­lights are:

  1. the allocation between stocks, bonds, and cash can account for up to 85% to 95% of the difference in returns between various portfolios; and
  2. different asset allocations represent differ­ent risk levels but may end up providing the same level of returns. The key is to fig­ure out which mix will bring the returns you want while offering the lowest possible risk.”

As we tried to absorb this information, Uncle Wayne looked at us thoughtfully and continued.

“The money you’ve received has come by way of your parents’ hard work and sound planning. I believe it should not be gambled with, and you should try to protect the capital as much as possi­ble. However, since you’ll want to provide for your own retirement as well as leave some money behind for your children, you’re going to need some growth too.

“My best advice is to develop a globally diversified portfolio that invests both in bonds and stocks/equities, based on your risk level and specific goals.”

“What kind of mix do you recommend?” asked Alice.

“Before we get into that, Alice, let’s review what I mean by risk,” Uncle Wayne continued as he sat up straight in his chair. “There are basically two main types of risk: capital preservation risk and inflation risk.

“Capital preservation risk is the risk that your capital is not there when you need it. Let’s say you were going to buy a new boat in a year, and the cost was $25,000. To make sure you had the $25,000 in a year, you would have to invest in conservative investments, such as a high-interest savings account, so you’d have the $25,000. If you invested in equities/stocks, in a year you could have more than $25,000 or a lot less.

“Inflation risk is basically making sure that your money grows over time as items get more expensive each year. Even inflation of 2% over twenty years, as in the prior example, can lead to costs increasing dramatically.

“Even if you’re close to retirement, you still need some growth in your portfolio, because peo­ple today are living longer, and the longer you live, the greater the chance is that inflation will beat you. I’m sure you all want to live a long time, but you don’t want to outlive your supply of money, so your financial plans should be based on a project­ed life span to your mid-nineties. That means Sally needs her money for the next sixty years, and Mark for another forty-two!”

Mark looked surprised and took a sip of his drink. “Wow, that is a long time. I wonder if I’ll still be water skiing then!”

Sally started to laugh and said, “You can barely water ski now! You only go once a year after a few brown pops!”

Uncle Wayne coughed to get our attention and continued. “So you all will need growth or equities in your portfolio to keep up with inflation. A globally diversified portfolio is made up of both bonds and stocks/equities from countries around the world, and the breakdown is determined by both your goals and your risk, or sleep at night, factor.”

“What specifically do you mean by goals and sleep at night factor?” asked Sally.

“Let me try to answer that,” Alice went on. “For short-term goals, say when you will need the money in less than five years, you’ll want to use conservative or defensive investments like short term-bonds, GICs, or high-interest savings accounts, so that the money is there when you need it.

“Longer term goals can be more difficult to plan for. For example, if you can attain your retirement income goals based on only investing in GICs and/or bonds, then the risk of your portfolio will be low, and it will not fluctuate much. Since your money growth is more consistent, you’re better able to sleep at night, because you really don’t need to worry too much about your portfolio declining in value.

“However, for many people, us included, to achieve our retirement income goals, we need higher returns than what bonds or GICs can provide … so we must invest in stocks. This is where the sleep at night factor comes in. The greater the allocation to stocks or equities, the greater the fluctuation—daily, monthly, and annually—of the portfolio returns and portfolio. This fluctuation of returns is called your risk level, or sleep at night factor. If you can’t sleep at night because your portfolio value changes too much, you may need more capital preservation type of investments in your portfolio; however, if you do this, you may not generate the returns required to achieve your goals. So how did I do, Uncle Wayne?”

“Awesome, Alice, I couldn’t have said it any better!”

“So how do you actually develop a diversified portfolio?” asked Sally. “I understand the basics between bonds and equities, and clearly I haven’t been doing as much research and reading as Alice. How do we put it all together?”

“From my experience,” Uncle Wayne continued, “there are six key factors to developing a globally diversified portfolio, and they are:

  1. strategic asset allocation
  2. tactical asset allocation
  3. specific Investments and/or money managers
  4. risk management
  5. fees
  6. taxes

 

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Jack Lumsden, MBA, CFP®    Financial Advisor, Assante Financial Management Ltd.

This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please make sure to see me for individual financial advice based on your personal circumstances. The information provided is for illustrative purposes only. Commissions, trailing commissions, management fees and expenses, may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated. Please read the Fund Facts and consult your Assante Advisor before investing.

Insurance products are services provided through Assante Estate and Insurance Services Inc.

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