The question of “Where do I put my savings?” has inspired the $11 trillion dollar mutual fund industry, countless magazines and articles, and even an entire workforce of financial planners and advisors. It is the most difficult question to solve in personal finance, because there are no certainties in investing. In taxes, insurance, mortgages, etc. – there are (for the most part) final, calculable answers; in investing, there are no ‘true’ answers, only opinions and estimates. It is therefore crucial to understand the theories behind portfolio allocation, so that you can understand how and where to put your savings, in order to give it the best chance at growing successfully.
This post is a bit theoretical and mathematical, but it explains 3 essential concepts to investing that all savers must know. If you don’t have the time (or stomach) to read through this, skip down to the bottom, where I summarized the 3 essential lessons. Next week I will get a bit more hands on, and actually show you how to invest your money.
What is the goal behind investing? It is to provide a return on your assets (or money). If you have $1,000 in cash that you wish to save, you’d want to invest it so that it grows over time. Why would you want to invest it? Because, contrary to the popular misconception, stashing your savings under your mattress is not the safest place to store your money. This is because of the concept of inflation, which erodes your money’s worth over time.
The return on your money is described in percentage values – for example, perhaps you want a 7% return on your $1,000 in savings – that will get you (1000*0.07) = $70 after the first year. If you invest your $1,000 a 7% for 2 years, will that get you (70*2) = $140 in interest? Nope! – In the 2nd year, you receive a 7% return on $1,070, which is equal to approximately $75, rather than $70. Your savings are now worth $1,145 (instead of $1,140). This concept is called compounding interest, where you earn interest on interest – and as will be explained later, is an extremely powerful tool.
For a typical portfolio, there are many places to put your money in, and the major categories include stocks, bonds, and treasuries (government bonds). Stocks are defined as a piece of ownership (or equity) in a public company, while bonds and treasuries are debt instruments – the corporation needs to borrow money, and you lend them that money with the purchase of their bonds. Here is a breakdown of the average yearly returns for each major category, since 1920:
Stocks = 11%
Bonds = 7%
Treasuries = 4%
If historical averages mean anything, stocks clearly provide the highest return for your money, on average. So then, if getting high returns is the goal of investing, why would anyone in the world buy bonds or treasuries instead of stocks?
Everyone understands the concepts of returns – the higher the return, the better. However, there is a second concept to investing (and even to all of finance), which is known as risk. Risk is defined as how volatile, or variable a return is. To illustrate, look at the 2 following scenarios:
Scenario 1:
Year 1 = 8% return
Year 2 = 6% return
Year 3 = 7% return
Average arithmetic return = (8+6+7)/3 = 7%
Scenario 2:
Year 1 = 53% return
Year 2 = 0% return
Year 3 = -32% return
Average arithmetic return = (53+0+-32)/3 = 7%
Both scenarios offer the exact same average return. However, which scenario is better? They’re both mathematically equal, yet most people are risk averse, and therefore consider Scenario #1 a lot more favourable. We are going to assume that you are risk averse – otherwise, you might as well take your savings to the casinos and try your luck there with investing. The aforementioned 2 scenarios illustrate the most crucial and elementary concept in finance – the risk/return tradeoff. In general, investments that are riskier provide higher potential returns, and vice versa. Interestingly, it is the risk that affects the return, and not the other way around. For projects and investments that are extremely risky, investors will only spend their money on it if the returns are high enough to offset that risk.
How can we measure risk? There are many ways, but the basic way uses a statistical value, called the standard deviation. Calculating the standard deviation is fairly simple.
Back to our question about stocks, bonds, and treasuries. Why would someone buy a bond over a stock if stocks provide higher returns? Because bonds have a lower standard deviation than stocks, and are therefore less volatile or risky. Are bonds therefore better than stocks? That is the million dollar question that every financial advisor will give you different opinions about. The theoretical answer is based again on the risk/return tradeoff. In other words, is the higher return on stocks enough to offset the higher risk of stocks? There is no true answer, but I can tell you what current financial theory does have to say about this question.
When I say that stocks are riskier, what I mean is that although you hope for an 11% return tomorrow, it could be that next year is a down year, and you actually lose money on your investment. However, over time, the long-term average of the stock is still 11%, and therefore, if you held the stocks for, let’s say, 50 years, you are practically guaranteed to end up with more money at the end of the 50 years than a bondholder. I can prove this to you statistically, but it’s mostly beyond the scope of this blog.
Therefore, the question of how much risk to take in your portfolio is related to the question of “when do you need the money?”
If you are 25 years old, and you are saving towards your retirement in 40 years, then I would advise you to engage in riskier investments, i.e. stocks. However, if you are saving for a down payment for a house mortgage, in, let’s say, 2 years down the road, it is probably a very bad idea to put all your money in stocks. Similarly, if you are 55 years old, you should put less money in risky investments, and more money in safer investments. The popular line goes that you should subtract your age from 110, and whatever that number is, that’s the percentage amount of your portfolio that should be allocated to stocks (regarding retirement savings).
Remember I briefly mentioned the power of compounding interest near the beginning of this post. Again, compounding interest means that you receive interest on interest already received in previous years. This may seem like a small amount at the beginning, but over a long period, compounding interest can provide exceptional returns.
For example, assume 2 scenarios, one with compounding interest, and one where you don’t receive compounding interest. Assume you have $100,000 in savings, and earn a 12% annual return compounded monthly (in other words, 1% per month), and that the investment period is 30 years.
Scenario #1 – No compounding interest: Essentially, you earn 100,000*0.12 or $12,000 each year, and multiplied by 30 years, you get $360,000 in interest earned, plus your initial investment of $100,000 = $460,000. Not bad - your investment grew from $100,000 to $460,000 in 30 years.
Scenario #2 – Compounding interest: How much money do you think you will have after 30 years? Care to guess? The answer is: $3,594,964.13. Your $100,000 investment grew to well over $3.5 million.
Another way to illustrate the immense power of compounding interest: If you put away $250 to your savings every month starting at age 35 up until the age of 65 (assuming a 12% monthly compounded return, and compounding interest), you would have $873,741 at age 65. But if you started putting that money away at age 25, then you would have $2,941,193 at age 65. What a difference 10 years makes!
The power of compounding interest grows larger and larger as the investment period gets longer. The difference between 30 and 40 years is comparatively way larger than the difference between 5 and 15 years. So remember, the earlier you start saving, the better!! If you start saving only $250/month starting at age 25, you will most likely be in a terrific financial situation near retirement. But if you only started saving in your 40’s, you’re going to have to make much larger sacrifices to end up with the same total portfolio value.
One last point. In this post, I kind of led you to believe that your portfolio can only consist of stocks or bonds. Nothing can be further from the truth! You can mix your portfolio with both bonds and stocks, or stocks and treasuries, or practically any other combination of investment vehicles. And here’s the real clincher: the more you mix, the better! You’ve probably heard about the concept of ‘diversification’. Mathematically, diversification allows you to earn the same return as an undiversified portfolio, with less volatility (or risk). Again, I can prove this to you mathematically, but it’s a bit beyond the scope of this blog.
Diversity is an extremely powerful factor, just like compounding interest is. If I told you that you should invest 50% of your portfolio in stocks, that doesn’t mean you should spend half your savings on RoyalBank stock. It means you should spend half your savings on a diversified holding of stocks, perhaps 100 stocks together. My own personal portfolio actually consists of many thousands of different stocks from different companies (I am being perfectly honest with you). Why would I do that? Because it lowers the total risk of my portfolio, without sacrificing any returns. How did I pull that off without being a billionaire? Wait until next blog, and I’ll show you!
Summary: That post was a bit theoretical, mathematical, and long (I know, I’m sorry). In summary, here are the 3 essential lessons that you should know about investing:
Lesson 1: Stocks provide higher returns than bonds, which in turn provide higher returns than treasuries. However, stocks are more volatile (or riskier). Therefore, the question of how much stocks you should invest in relative to bonds is really a question of when you need your money. The closer you are to needing the money (for example: you’re close to retiring, or are saving for a house purchase in the coming years), the less risky you should be with your money.
Lesson 2: Diversify, diversify, and diversify. Never put all your eggs in one basket, whether that means putting all your money in one stock, or all your money in the stock market in general. In fact, the more you diversify (i.e. the more different kinds of investments you purchase), the less risk your portfolio has, and the better off you are in the long run.
Lesson 3: Recognize the power of compounding interest over the long-run. Beginning to save and invest money at an earlier age has the advantage of utilizing the remarkable power of compounding interest. The later you wait to save, the more money you will need to put away to achieve your dream retirement living.
Stay tuned next week for more portfolio allocation essentials!
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Question about Lesson # 2 (Diversification). If I choose to invest all my savings in bonds or treasuries, what is the risk? I think they provide safe, guaranteed investment returns with no risk. What's wrong with this approach?
ReplyDeleteI think you're asking a few different questions here.
ReplyDeleteFirstly, in terms of risk:
Treasuries are generally considered to be the safest investments on the planet, so there isn’t really any (default) risk involved. In other words, the chances that the US or Canadian federal government will go bankrupt while you are holding their treasury is practically zero. This is why they offer the lowest returns of any investments - you are taking on very little (and perhaps no) risk. In fact, right now, the return on treasuries is almost 0%.
There is a bit of risk though - called interest rate risk. Basically, if you buy a treasury now for a 1% return, and then the interest rate rises tomorrow to 2%, the value of your treasury plummets, because who wants your treasury bill when they can get a better one in the markets for the same price? But the interest rate risk only applies if you plan to sell your treasury early. If you buy a 5 year treasury, and are certain that you will wait 5 years to cash out, then interest rate risk doesn’t matter, b/c you are going to get the money you signed up for anyways. Just if you want to sell it earlier than 5 years, you won’t get as much money for it as you paid for, should the interest rates rise. Conversely, if interest rates fall – then you make a lot more money, just right now, the rates are literally as low as they can go, and they can only go up at this point. This is why treasuries of longer terms (i.e. a 10 year bill vs. a 5 year bill) offer higher returns, because the longer the term, the more the interest rate risk.
Next, you mentioned bonds. Bonds definitely have default risk. If you own corporate bonds from General Motors, let’s say, and then GM goes bankrupt, you are in some trouble, and probably won’t get all your money back. This is why corporate bonds offer a higher return - because you are taking on the extra risk of default happening. As well, there is also interest rate risk (same as before). There are some other risks too, although these are the main ones.
So again, you said "I think they provide safe, guaranteed investment returns with no risk".
The consensus theory is that treasuries are guaranteed and safe, unless you plan to sell early. However, corporate bonds are never guaranteed. Bonds are usually rated on different scales, to determine the default risks involved. The basic rule is: the higher the return offered on the bond, the more risky it probably is. This makes sense - if I opened up a company tomorrow with no money and no track record, and I offered you some bonds - you'd want a big return to compensate for the big risk involved, b/c who knows what will happen with my company? In fact, there is a market called the ‘junk bond’ market – these are bonds offered by very risky companies, and they can sometimes offer sky-high returns on their short-term bonds, but the risk is comparatively very high.
Finally, to answer your final question: “What’s wrong with this approach?”
ReplyDeleteThere is nothing wrong with this approach – it’s up to you to decide how conservative or risky you want to be with your money, and bonds and treasuries are definitely less risky than stocks, real estate, commodities, etc. However, if you only invest in bonds and treasuries, know that you are giving up higher returns. For example, historical records show that you will only average between a 4% and a 7% return as opposed to 11% (Currently, those numbers would be different, but I’m just using the historical averages as an example). You’re not alone in your thinking – there is a opinion in finance today that in fact says you should only put your money in bonds and treasuries, because stocks are just too risky.
So again, there is nothing wrong with your approach. Personally, if you need your money soon (i.e. you are investing for the short-run), I would agree with you, and I would put almost all my money in bonds and treasuries or even Bank GIC’s (although make sure you can easily get the money back when you need it). However, over the longer term, most financial advisors would tell you that it’s good to put a little risk in your portfolio as well, because otherwise, your savings won’t grow as much as they could. But it’s all up to you, and how conservative a guy you are. If you are generally a safe kind of guy and don’t want to experience the roller-coaster returns of stocks, then debt instruments may be better for you. As I mentioned in the beginning of this post, there are no certainties in investing, only opinions and estimates.
As well, in terms of diversification:
ReplyDeleteDiversification gets less important as your investments get less risky. If you truly wanted to put all your money in only treasuries, I would still advise you to diversify in different types of government debt instruments, but it's not as important, b/c total risk is less to begin with.
If you are putting all your money in bonds - you should definitely still diversify. If you put all your money in one company's bond, and then that company goes bankrupt, you are in serious trouble. Better to spread out that risk across many companies, so in case one of them goes bankrupt, you won't lose as much.
In terms of only putting it in one class of investments (i.e. just bonds) - you can do that as well if you like. Personally, I wouldn't do that if its a long term investment, but as we said before, there are only opinions in this type of work. Your opinions is as good as mine (Im serious - I actually have an unbelievable story to prove this point, but you'll have to wait until next post!).
There is also one more factor involved - how much money do you need to retire? you can mathematically work out if your bond returns are going to be enough to get you to the place you want to be. If bond returns arent enough to get you there, I would put at least some of your money in stocks, to help you reach your goals. ALthough, if you are still young, this factor doesn't really come into play.
ANyways, I hope this answers your question. Feel free to ask anything else (I'll try not to publish a megillah next time).
Thanks. Much clearer now. I'm actually looking for short-term investments and that is why I was asking about diversity. Looking forward to your next post!
ReplyDelete