Say “No” to Absolute Safety
November 21, 2023
Image used with permission: Dilok Klaisataporn
Say “No” to Absolute Safety
My colleague Harsh Narsinghani and I were recently discussing how many of our clients were unnerved by geopolitical and economic worries and how it shortened their investment horizons. Harsh and I agree there is ample cause for worry, but it also occurred to us that, unfortunately, this is almost always the case.
2022 was a particularly brutal year in equity and bond markets, and the negative returns blended right in with many other real-world concerns, the most troubling of which was probably the onset of war in Ukraine. For people who care about the future, there has been little relief in 2023. There seems to be no end in sight to the Ukraine war, the Middle East is embroiled in conflict, relations between the global superpowers are badly strained, and our democratic political system is dividing people rather than bringing them together.
In addition to these geopolitical issues, experts overwhelmingly predict a looming global (and Canadian) economic slowdown. In Canada, we have a chronic problem of under-investment and, consequently, a dismal record of productivity growth. Our standard of living is in relative decline when compared to other OECD countries, and despite low rates of unemployment, household spending is funded by an ever-increasing amount of debt. Although well off its peak, inflation remains stubbornly high. Unfortunately, debate in the public realm laments high inflation, but paradoxically, it doesn’t have the stomach to take the medicine of higher interest rates and less fiscal extravagance. In the past, there was a form of settled consensus that free markets, education and hard work would deliver national prosperity. But these days it seems our culture would prefer to scratch a lottery ticket and snare a pair of Taylor Swift tickets on a buy now pay later plan for immediate gratification. Short-term thinking dominates long-term planning more often than ever it seems, as there is so much to worry about.
Everybody Loves GICs
The preceding screed might step outside the bounds of a typical Nexus blog. But it is meant to underscore that we understand why so many clients feel unsettled these days. Especially after last year’s dismal returns, we “get it” that many investors prize safety. In speaking with clients, we know that many view GICs with rates of 5% or so to be an effective way to hide out from the travails of the world and get a better sleep at night. Alas, tying capital up for many years in GICs, even at 5%, offers only the illusion of preparedness for the complex world we live in. For most of our clientele, the future returns of a 5% GIC on an after-tax basis will be no different than 2.5%. When expressed in inflation-adjusted, after-tax terms, the best one might expect from this approach is no return at all. Now, we want to be clear, if the money you stash in bank GICs is for spending in just a few years, that might be an appropriate strategy. But if the money you allocate to GICs is coming from your retirement capital, then you are implementing a timing mismatch, allocating cash to short-term investments that are going to be used to fund your spending requirements in the future. More succinctly, you are timing markets, a strategy that rarely results in success.
Evaluate GIC Returns and Stock Returns Over the Same Time Horizon
When investors lose focus on the long term, they get distracted by the news of the day, which skews overwhelmingly to the negative. As a result, investors who commit capital to fixed rate GICs for four or five years love the immediate feeling of safety they get. But if investors instead evaluated their returns from high-quality equities over a five-year horizon, what might the opportunity look like, and how much risk are you really assuming from being in equities rather than GICs? Harsh and I ran the numbers, and the answer might surprise you. Although the monthly fluctuations of stock returns are larger than the contractual returns of GICs, investors that use an investment horizon of five years can expect much better returns, and the risk they assume of a significant capital loss at the end of their holding period is negligible. Let’s look at the basis for such an assertion.
An investor who diligently invested in the Nexus North American Equity Fund (NNAEF) at the beginning of every month since its inception in August 1997 and held onto each purchase for the next five years, would have achieved a compounded annual return of more than 5%, about 75% of the time. The other 25% of the time, the under-5% returns certainly would have been disappointing, but hardly catastrophic. In many cases, on an after-tax basis, those returns may have been close to GIC returns, given that dividends and capital gains are more tax-efficient than interest income from GICs.
Over the same period, in only 4% of the cases would an investor have experienced modest negative returns. The risk of a “big mistake” seems low. Conversely, 40% of the time, the investor would have achieved double-digit returns, an opportunity they forfeit if locked into the absolute safety of a GIC. The odds of generating a compounded return of more than 5% are high, and the odds of losing money are low if one takes a long-term approach to investing in equities. The table below summarizes the five-year compounded annual return distribution of the NNAEF.
Now, if the comparison between GICs and an all-equity approach seems too extreme, what might be the expectation if the investor stayed with a balanced approach instead? In fact, such an example more closely approximates what we know is going on in the real world, where many investors (including even some of our clients!) are accumulating GICs instead of applying the funds to a balanced portfolio of stocks and bonds. Again, GIC investors are choosing the assured mediocrity of GICs over a likely far better return from staying with a balanced approach. Since its inception, the Nexus North American Balanced Fund’s (NNABF) five-year compounded return has never been negative and has exceeded 5% about 80% of the time. The table below summarizes the five-year compounded annual return distribution of the NNABF.
Say “Yes” to Long-term Thinking and Better Returns
Being worried at a time like this is understandable. But sometimes, investors over-emphasize short-term worries to the detriment of their long-term success. In our opinion, current GIC rates bind an investor to a mediocre investment return. If investors have a time horizon for their capital of five-years or more, they most assuredly will do better sticking with equities. Of course, it will be bumpier, but the financial benefits will be worth it.