Rewards of Saving versus Investing
There is, of course, a big difference between the returns to be expected from saving versus investing. In a related article I have provided my definition of what constitutes saving as opposed to investing.
This article looks at the returns available from saving and looks at the estimated long-term returns to be expected from equity investing.
First let’s take a look at the (rather scant) rewards currently available to fixed income savers and investors.
The following table is meant to be indicative of current interest rates or returns as of November 30, 2014. It’s meant to show the relationship between rates. It’s not intended to show the very best rates available in the market, rather it shows more typical rates available.
| Interest Rate or return | Potential for loss in dollar terms | Nominal dollar value of $1000 after 30 years at this rate, before taxes | Real value of $1000 after 30 years, at this rate, before taxes, but after 2.0% inflation | |
| A typical bank account | approximately zero | none | $1000 | $545 |
| “High” interest savings Account | 1.25% | none | $1452 | $798 |
| Five year GIC | 2.22% (Average across banks according to Financial Post) | none | $1921 | $1068 |
| Five year Canadian government bond | 1.43% | modest and temporary only | $1531 | $842 |
| Five year A rated corporate bond | 2.33% Telus and Enbridge per TD direct investing | modest and temporary only | $1996 | $1104 |
| Five year rate reset preferred share | 3.8% to 4.4% for higher quality issuers | modest and likely temporary only | $3061 to $3639 | $1708 to $2037 |
| Perpetual and highly rated preferred share | 4.4% to 5.0% per a CIBC report | potential for permanent value loss with higher interest rates | $3639 to $4322 | $2037 to $2473 |
| Ten year Canadian government bond | 1.9% | potential for temporary market value losses | $1759 | $970 |
| Ten year A rated Corporate bond | 3.6% Manitoba Tel per TD direct investing | potential for temporary market value losses | $2889 | $1610 |
| 30-year government bond | 2.45% | potential for temporary market value losses | $2067 | $1144 |
| 30 year A rated corporate bond | 3.77% Enbridge Gas Distribution 4.45% Telus |
potential for temporary market value losses | $3035 $3692 |
$1693 $2067 |
| 30- year government Real return Bond | 0.63% plus inflation compensation | there is a risk of temporary value loss if real interest rates rise but the bond will mature at full purchasing power in the end | $2179 assuming 2% inflation | $1000 |
Most of the above returns available for savers are fully taxable unless invested in tax sheltered plans. Only the preferred shares would be subject to lower tax rates. In terms of availability of cash if needed, bank accounts are instantly accessible, GICs are locked in for the term and the remaining items can be sold on the market at any time.
None of the above investments seem very attractive at all. For money that is being saved for use within a year I would use a regular or a “high interest” bank account. The return is very low but the bank account offers safety and instant access to the money including the ability to spend it or send it to someone else instantly by electronic means.
For cash that will be used after about one year or cash that is essentially being parked in case attractive investments arise (such as would arise during a material stock market decline), I would favor the use of five year rate reset shares of high quality issuers. Due to the rate reset feature and due to the high quality of the company these can be expected to trade at about par value at the time of the rate reset in five years. Meanwhile they offer a better return than most of the alternative fixed income choices. And they won’t likely decline too much below par value even if interest rates rise. And if they do decline one can wait for the rate reset in five years.
When it comes to investing for longer periods such as 10 to 30 years, I find the available returns from fixed income to be unappealing. If inflation rises substantially, then these will turn out to have been terrible investments. If inflation and interest rates stay very low then they will still not be great investments. Possibly, the perpetual preferred shares at over 5% would be a reasonable investment. Bonds in the range of 4% will not turn out to be reasonable long term investments unless inflation averages less than about 1%.
Next, we can take a look at the potential returns from investing in common stocks. In the short term, the returns from investing in stocks are extremely unpredictable. In any given year a loss of 30% is not particularly unusual nor is a gain of 30%. And, that’s on a broad index of stocks. When it comes to individual stocks the range of annual returns in the short term is from minus 100% to gains of hundreds of percent. And the long-term average annual return range on an individual stock is from minus 100% to perhaps positive 25%. In the following table we use a range from 4% to 12%. Measured over the long-term (such as 30 years) it seems unlikely that the return from stock market indexes will be outside that range, although it is possible.
| Assumed long-term average annual return | Potential for loss in dollar terms | Nominal dollar value of $1000 after 30 years at this rate, before taxes | Real value of $1000 after 30 years, at this rate, before taxes, but after 2.0% /b>inflation | |
| Stock Index | 4% | high potential for temporary losses, little potential for permanent losses | $3,243 | $1,811 |
| Stock Index | 6% | high potential for temporary losses, little potential for permanent losses | 5,743 | $3,243 |
| Stock Index | 8% | high potential for temporary losses, little potential for permanent losses | $10,063 | $5,743 |
| Stock Index | 10% | high potential for temporary losses, little potential for permanent losses | $17,449 | $10,063 |
| Stock Index | 12% | high potential for temporary losses, little potential for permanent losses | $29,960 | $17,449 |
If stocks turn out to deliver at least 4% annually in the long run, then stocks are going are going to do better than almost any of the fixed income choices listed above. And if stocks end up delivering 8% or more, then stocks purchased or held now are going to dramatically outperform high quality fixed income investments purchased or held now. And if one can manage to earn 12% or more — unlikely for the stock index, but possible for some stock portfolios — then the out performance becomes truly staggering.
On top of that, stocks in taxable accounts face considerably lower income tax rates. Taxes on capital gains are deferred until the sale of the stocks and then taxed at half the rate of regular income and dividend income is also taxed favorably.
When it comes to investing for longer periods such as 10 to 30 years, stocks appear to to me to be the clear choice. As far as an allocation to fixed income, I see no reason for an allocation to longer term fixed income investments returning less than 4%. I would allocate some funds to cash and to short-term fixed income including five year rate reset preferred shares. I would do that, not as a permanent allocation but with a view to having funds available in the case of a material stock market decline to pick up bargains.
I would warn, however, that conventional wisdom is to always use a balanced portfolio approach and always maintain an allocation to fixed income. I don’t follow that wisdom. I have always said that I do not give advice on asset allocation because it is specific to each person’s circumstances. Above, I present the figures and offer my own conclusions. Ultimately, we all invest at our own risks and need to be comfortable with our own decisions.
END
Shawn Allen, CFA, CMA, MBA, P.Eng.
November 30, 2014