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moneysense.ca, 24/09/09
Emotions affects fixed income investors too
In a recent discussion with the Globe and Mail, Enough Bull (read my review here) author David Trahair once again made a case for investing exclusively in GICs. Unfortunately, I don’t think it is a persuasive case. First, he compares TSX total returns with GICs over various time periods and despite a premium from stocks ranging from 2% to 6%, he says “GIC returns seem to be competitive”. Michael James showed that even modest premiums when compounded over time result in a huge difference in the ending value.
Mr. Trahair then says that expenses and emotions take a toll on the equity premiums:
The last point is emotions – were you able to hold on when your equities lost almost 50% of their value from June 18, 2008 to March 6, 2009?
It is a fair point — something that, hopefully, won’t come as a surprise to regular readers. But is it valid to assume that fixed income investors are not prey to emotions? Does the low volatility of fixed income help investors to stay invested? Let’s turn to the DALBAR study of investor behaviour for some answers.
The DALBAR study found that investors in both stocks and bonds experienced much lower returns than the comparable indices. Over a 20-year period ending in 2008, stock investors underperformed the index by 6.48%. Bond investors didn’t do much better — they underperformed by 6.66%. Interestingly, stocks performed poorly over the 5- and 10-year period ending in 2008 but stock investors didn’t do much worse. But, bond investors once again underperformed by 6% over the same time period.
As bonds have much lower volatility than stocks, it is likely that bond investors are hurt by greed rather than panic. It is hard not to chase the latest ‘it’ investment when everyone else is piling into it.
moneysense.ca, 24/09/09
It would be interesting to know whether GIC investors stray from their chosen path as much as bond investors do. I might be inclined to think that they stick to GICs through thick and thin better than bond and stock investors, but it’s hard to say for sure. A few years back, I was surprised to learn that one of my older relatives who is adamant about investing only in GICs took a flyer on mutual funds back in the early 70s and got crushed. So, it seems that even GIC investors manage to underperform their “index”. How much they underperform as a group I don’t know.
Michael: I’m not aware of any studies of GIC investors. But I wouldn’t be surprised if the results are consistent. Like you note, GIC investors probably are tempted to chase other asset classes. It is hard to resist piling in when you hear about a friend making a killing investing in the latest high-flier.
A big point that doesn’t seem to be addressed in David Trahair’s thesis is tax efficiency. With that in mind, GIC real returns are going to be dramatically lower than the returns from stocks, which are very tax efficient. Index ETFs are even more tax efficient, I think.
TEMPLE
His advice makes sense to people that don’t want to take risk in the stock market with their savings. Even though returns are much smaller than stocks, there is no risk involved. There is no guarantee that stocks will outperform bonds in the future as past is not an indicator of future performance. Because this is a matter of the level of risk tolerance I think there is no point in arguing and trying to point out how over long run stocks outperformed the bonds. It sounds like ideological argumentation. In the end it is a matter of the level of risk tolerance not empirical evidence. Economy is not physics and not everybody should accept to risk life safings with a market collapse we witnessed last fall.
I think the comparison between stocks and fixed income go much deeper than just evaluating the returns. In my opinion, the philosophical purpose of a fixed income product is NOT an investment – it is a method of capital preservation, a way to “park your cash” while you are waiting for something to transpire.
In the case of a 25-yr bond, it would be there waiting for your retirement – if you are 25 yrs away from retirement. In the case of a 5-yr GIC, it could be money set aside to buy a new car if you have, say, 5 or 6 yrs of life expectancy remaining in your current vehicle. Or, it could be the down payment on a house if you set a goal of 5 yrs to save enough money to buy a house. Or really any major capital purchase. A boat, a round-the-world vacation, whatever. A high-interest savings account is used for emergency funds because it isn’t “locked in” for some term like a GIC.
The problem with buying stocks is that you’re not guaranteed to have that cash 25 yrs from now at retirement. Or in 5 yrs to buy that new car or put the down payment on a house. While the POTENTIAL is there to outpace the investment return of a bond or GIC, it’s not guaranteed to be there WHEN YOU NEED IT.
Of course, when I say “fixed income”, I’m referring to government bonds and CDIC backed GICs. As we’ve seen with corporate bonds and commercial paper, they can be as volatile as stocks and they may not be there when you need it! I also exclude bond FUNDS, which I would never advocate anybody to buy – I’m referring to actual bonds which have a maturity date and you’re guaranteed the return of your principal.
If you’re into buying corporate bonds, then I actually put it in the same category as buying stocks in terms of risk. The main difference is that you know what your investment return will be if the company survives to your maturity date! And, of course, there is more money in the pot available for you than a common shareholder if the company goes bust.
@TEMPLE: DT assumes that GICs are held in tax-deferred accounts such as RRSPs and TFSAs. In taxable accounts, you are right. The tax treatment makes a huge difference to after-tax returns.
@Basil2: Personally, I don’t think a 100% stock portfolio is suitable for most people. In the same vein, I don’t think a 100% fixed income portfolio is suitable either. Most people cannot afford to avoid stocks altogether. The lower returns from fixed income means they have to plan to save much more right from the beginning. The best way to manage risk is to hold a suitable mix of both — not avoid one entirely in favour of another.
@Phil: I agree with characterizing bonds as wealth preservers. But there is risks in bonds also — the risk that they won’t keep up with inflation. Bonds, after all, are a promise to return the nominal face value. Inflation could eat up that value. Today, we have real-return bonds. But they aren’t risk-free either. A person’s personal experience of inflation may not be comparable to the Government’s definition at all. The point is there are risks with every asset classes — nothing is truly risk free.
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“CC said: The lower returns from fixed income means they have to plan to save much more right from the beginning”
Agreed.
“CC said: Bonds, after all, are a promise to return the nominal face value. Inflation could eat up that value”
Longer duration bond returns should reflect expectations about inflation. One way to take care about inflation risk is to buy for example 5 yr bond every year and sell a 5 yr bond that matured that year. That way you will keep your overall returns somewhat in line with inflation.
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