Bonds are Risky, Stocks are Riskier, but is Cash the Riskiest Long-Term Asset?
In stock market selloffs the daily accumulation of losses can keep you awake at night.
Fixed income investing in a bond portfolio is less stressful, but in times of rising interest rates one can feel like the interest earned is not worth the risk, as the capital value of the bonds decline.
With these concerns you may wonder, is it even worth risking your hard-earned wealth? Wouldn’t cash be the answer to protecting wealth without anxiety?
These concerns are not unfounded. When markets perform well these concerns can fade, but then leap out again in times of stress.
Owning stocks has been uncomfortable so far in 2022, with the S&P having the worst four month start to a year, since 1938.
Stock market volatility has been high in recent months as recorded by VIX. The VIX index acts as a gauge to measure the expectations of future market volatility and can, it times of calm markets, reside well below its historical norms. Unfortunately it’s not uncommon for this number to double or triple. These spikes in implied volatility are often accompanied by rapidly declining markets. Corrections in excess of -40% are not unheard of in this past decade. We have recently observed a significantly higher VIX level as both the equity and bond markets have sold off.
Poor risk/reward offered from fixed income investing, following a multi decade bull market caused by declining interest rates
Where do we go from here? With rates now rising from generational lows, a logical expectation would be that rates will inevitably rise further (beware, logical and reasoned forecasts have a habit of not occurring as predicted).
What happens to bonds when interest rates rise? They fall in market value to adjust their yield to reflect current market demands.
While buying bonds in a laddered strategy will mitigate some of this interest rate shock (near term bonds mature and the proceeds are invested into longer dated maturities), depending on the magnitude of interest rate increases, this can still lead to account statements reflecting a loss in value.
Hiding in cash is not the answer
If these two fears are forcing you to park your wealth in cash, are you aware of the loss of purchasing power inflation will be responsible for?
The Bank of Canada has a mandate to target an inflation range of 1% to 3%, with a 2% target midpoint (target may be adjusted upwards). In my view a 2% level of long-term inflation seems optimistic, in light of current inflation trends. In the following example one can see the loss in purchasing power, if an investor earns 1.5% after tax and inflation averages 3.5% (for a net annual loss of 2%).
This means a -2% decline in purchasing power each year should you sit in cash. Losing 2% of your wealth may not feel like a substantial loss, but keep in mind this number grows to be extremely significant over multiple years of negative compounding. Over 25 years of 2% inflation, a -40% loss of your wealth’s purchasing power is realized. This is certainly not wealth preservation in practice.
With all these concerns to investing causing anxiety, and sitting in cash not being a viable option over the long term, what options are there that will provide a greater return than cash and still not cause undue anxiety?
In my experience a balanced portfolio of stock indexes, diversified bond holdings (public and private debt), short term funds for cash flow needs, is the best opportunity set.
Take measured risks where you can estimate what your potential downside loss might be before entering into the investment. Perhaps you want to take a position in the S&P 500. Reflect on this index’s 12% sell off in the first four months of 2022 (a frequent occurrence), and recognize that historical corrections of up to 50% have occurred in the past.
Perhaps a 25% portfolio weight in this index makes sense. This 25% weight could result in an overall portfolio loss of 12.5%, if the S&P 500 declines by 50%. Investors have very different levels of comfort with loss. You need to measure your ability to take risk, both emotionally and financially. With an estimate of the capital risk in the S&P 500 you can move forward with building out a balanced portfolio of additional holdings.
Be patient, be diversified, understand the level of risk that you are comfortable in taking.
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