Whenever I have an investment idea, I remind myself that millions of other people are probably having the same thought as me.
I often see the pattern play out among my clients. Questions about a topic arrive in bunches as people come to similar conclusions about developments in the markets. I invariably advise them to take a deeper look before making a decision.
Currently, I’m fielding a lot of questions about higher interest rates now available from short-term investments such as GICs and high-yield funds. Why risk money in the stock market when you can earn over 5% from these relatively safe investments? Here again, the answer for a long-term investor is not as obvious as it may seem.
One reason to pause before taking action is that the stock market may continue to do significantly better than short-term investments or the bond market.
You only have to think back to this time last year when a similar situation occurred. Yields surged to over 5% last fall and many investors were tempted to switch from stocks to short-term fixed income investments.
The attraction of low-risk investments with a generous yield was understandable after a dismal 2022 in the markets and many years of rock-bottom returns from fixed income securities. In hindsight, it would have been the wrong call.
If you had bailed on equities last year to lock in a safe 5% return, you would have missed out on substantial gains in the stock market. This year, the U.S. market returned 17.8%1 to the end of August in Canadian dollar terms while the Canadian market returned 6.9%1.
A second argument in favour of caution is interest rates may go even higher. Many forecasters currently expect rates to come down in the coming months, but as I noted in July, there are no guarantees. If economic growth and/or inflation come in stronger than expected rates may increase and stay higher for longer than pundits expect today. Higher rates would penalize those who locked in now and would also send bond prices lower.
These issues point to more fundamental, historical reasons for long-term investors to resist the temptation to switch from stocks to safe short-term investments. While safety may feel good in the short run, these investments offer lower and more unpredictable long-term expected returns than stocks.
Reporting on a study of historical returns in 35 countries since 1900, the Credit Suisse Global Investment Returns Yearbook shows that stocks outperformed all other asset classes. But to earn equity returns, you have to be ready to put up with the kind of volatility we saw in 2022.
The threat of volatility is why you earn a risk premium over a safe investment for holding stocks and, to a lesser degree, bonds. As interest rates rise, the risk premium should also increase. In other words, returns from risky assets should increase along with interest rates, and this is what we see in an analysis of the question in the Credit Suisse Yearbook.
What’s more, your long-term returns from stocks are more likely to keep up with inflation than the returns from safe investments.
For more detail on these points, please see a video by our PWL Capital colleague Ben Felix.
The bottom line is that higher interest rates have not changed our basic asset allocation philosophy. If you have five or so years of spending needs available in shorter duration bonds, then you can withstand drops in the stock market and there’s no compelling reason to change your asset mix.
The yields currently available from GICs and other short-term investments may be alluring but, as is so often the case, making long-term portfolio decisions on the basis of short-term market moves can lead to unfortunate results.
1 Source: Dimensional