Building on my evidence based investing guide, this article further explores why we invest. When we think of investing it’s only natural to dream about discovering the next Microsoft or Amazon stock or about becoming a world-class investor like Warren Buffett. But why invest in the first place? Is it the thrill of building wealth? Bragging rights at cocktail parties? Or is there a more practical reason to invest?
The truth is most of us invest our money to build a nest egg for when we retire. Our human capital (years of earning paycheques) has been depleted and so we need to replace it with financial capital (savings and investments) to fund our spending in retirement.
Another key reason to invest is because of the silent wealth destroyer known as inflation. If inflation didn’t exist, we could literally stuff our savings under the mattress and use it to fund future expenses. But inflation increases the cost of living, typically by 2-3% each year (yeah, I know). That means something that costs $100 today will cost $300 in 40 years from now.
By investing our money, we hope to earn a rate of return that exceeds inflation (hopefully by a lot) so that we can maintain the same purchasing power over time.
Why Invest Early?
There’s a world of investing options from which to choose, including stocks, bonds, real estate, gold, cryptocurrency, and more. Stocks have been the best and most reliable performing asset class over the long term. Here’s a look at annual stock and bond returns since 1935:
- U.S. stocks – 11.69% per year
- Canadian stocks – 9.74% per year
- Balanced portfolio* – 8.87% per year
- International stocks – 8.29% per year
- Government bonds – 6.00% per year
- Treasury bills – 4.27% per year
- Inflation – 3.41% per year
*A balanced portfolio contains 50% stocks and 50% bonds
Do you see why investing is so important? Let’s say you have $5,000 to invest today and you plan to add $5,000 per year for the next 30 years. How much would you have in your retirement portfolio?
Assuming your investments returned 8.87%* per year for 30 years you would have a retirement portfolio worth more than $729,000. Think about that for a minute. You only contributed $155,000 of your own savings (your initial $5,000 plus 30 years of $5,000 contributions) but because of the magic of compounding investment returns you will have a retirement portfolio worth nearly five times that amount.
That’s the awesome power of investing and also why it’s so important to start investing early.
*We should probably lower our expectations for future returns. Bonds can’t repeat their historical performance with interest rates so low today, and stocks haven’t seen a meaningful correction (yet) since 2008-09. That combination should reduce the expected future returns of stocks to ~6% and for bonds to ~2.5%, which would mean an expected return of 4.25% for a 50/50 balanced portfolio. With that in mind, we should also aim to save and invest more to make up for lower returns.
Risk and Return
The link between risk and return is one of the most important lessons for investors to learn.
Stocks may have the highest expected returns of any asset class over the long term. But in the short-term stocks can be highly volatile. That means stocks have the potential to lose money in the short term. Indeed, any investment made in an individual stock comes with the risk of losing all of your money if the company goes out of business. This happens fairly regularly as strong companies survive, and weaker companies fail.
The lowest average annual returns come from treasury bills, but this asset class has never lost money in a single year. It’s the definition of a risk-free return. Only the most conservative investors who simply cannot handle the ups and downs of the stock market would invest in treasury bills, although retirees may hold a higher percentage of cash in their portfolio to help meet their spending needs.
Bonds are considered to be a safe and secure asset class but in its worst single year bonds lost 5.9% in value (although bonds have never lost money over a five-year period). Bonds are crucial building blocks for your investments and indeed most investors should have some bonds to help reduce the volatility in their portfolio and for rebalancing when stocks fall in value.
To highlight this, a balanced portfolio of 50% stocks and 50% bonds saw a single largest one-year decline of 14.5% and has never lost money over a five-year period. When stocks have fallen, a balanced portfolio has always declined less than a portfolio made up of 100% stocks.
Meanwhile, U.S. stocks have the highest annual average returns over the long term and as you might guess also have the largest single-year decline in value (losing 35.9%). Even the worst five-year period for U.S. stocks saw declines of 5.6% per year, suggesting that stock investors truly need to be invested for the long-term to enjoy higher expected returns.
It’s also important to note that only a small number of stocks drive the vast majority of stock market returns. This is not a new phenomenon, but something that has persisted throughout history. Since 1926, four out of every seven U.S. stocks have lifetime buy-and-hold returns less than one-month treasury bills. That means more than half of U.S. stocks failed to beat the returns you could get just by holding cash.
The “risk-free” rate of return is what you can expect to earn from a guaranteed investment like a GIC. Today that’s about 1.8% on a 1-year GIC.
By definition, any investment that offers higher expected returns must come with some degree of risk. There are simply no guarantees beyond the risk-free rate of return, and if anyone tries to sell you on a high guaranteed rate of return, turn around and run the other way!
Finally, there’s also a measure of risk within each respective asset class. For example, small stocks are more volatile than large stocks but also come with higher expected returns. International stocks come with special risks such as fluctuations in currency, foreign taxes, political and liquidity risks. Corporate bonds are riskier than Canadian government bonds, which are backed by the full faith and credit of the federal government.
Again, risk and return are joined at the hip. In general, the riskiest investments may also come with the highest expected returns. But an investor needs to carefully manage their own risk tolerance to build a sensible portfolio. It wouldn’t make sense for 100% of your retirement portfolio to be invested in the riskiest and most speculative asset class. The goal should be to balance risk and reward as sensibly as you can to achieve your desired rate of return.
Final Thoughts
Investing in sensible portfolio of stocks and bonds has proven to build wealth over the long-term, which can fund your retirement spending and allow you to maintain your purchasing power over a long period of time. Stuffing your money under the mattress isn’t an option. You need to invest to beat inflation.
At the same time, you need to understand the trade-off between risk and reward. The riskiest investments can be highly lucrative but also may cause stomach churning anxiety in the short-term (you may be feeling this right now). On the other hand, the safest investments might not keep up with inflation, so you need to find a careful balance that fits your risk tolerance.
I write a lot about investing. My goal is to help you build your knowledge base so you can decide an appropriate asset allocation, which investments make the most sense for you, and exactly the type of investor you want to be so you can build a portfolio that achieves your retirement goals. That’s why you invest.
