Retirement: shares or bonds?
By Marcel Côté
Imagine that your registered retirement savings plan (RRSP) offers two investment options. In both cases, the investment horizon is 10 years. The first guarantees a 6% return. The second will yield 12% but with a slight risk — a one-in-50 chance the return will cap at 5%. Say you are 40 years old; which would you choose?
Chances are many of you would opt for the second investment despite the small risk of a lower return. Because at the end of 20 years, $1,000 at 12% will be worth $9,650; but at 6% it will only be worth $3,200. Even with that one-in-50 chance of getting only 5%, the second investment is much more attractive.
So why do pension fund managers and investment advisers, almost unanimously, recommend splitting your retirement fund between the first type of fund, the one with a lower return, and the second, which after 20 years is worth three times as much? Can’t they do the math?
They can, but perhaps they just like the short term and prefer active portfolio management. Maybe they also like to make themselves look useful by exaggerating the risk of long-term equity investments.
The second investment consists of equities; the first of bonds. The indicated returns reflect the historical returns of bonds and shares on the US market over 20 years. If your portfolio consisted of diversified US stocks in 1984 and you held onto it until 2004, your return before fees would have been 13.1% a year, as opposed to 8.6% for a comparable portfolio of US bonds. Factoring in annual fees of 0.5%, a $10,000 equity investment in 1984 would have been worth $107,800 in 2004, while a bond investment would have been worth only half as much at $52,300. In the US, based on the average return over the past 75 years, a diversified equity portfolio is worth US$94,755 after 20 years, while a bond portfolio amounts to only US$28,380. (Annual fees of 0.5% have been subtracted in each case.) So why load up on bonds in RRSPs and pension funds?
To achieve these results, you must hang on to your investments for a long period, say 20 years. Over shorter periods, the return gap doesn’t shrink but the risks increase. Since 1948, the only time bonds have outperformed shares in a diversified portfolio held for 10 years was during a four-year period in the 1970s, and in all four scenarios the difference was minor. Equity portfolios held for 10 years that were built up in the 1990s and survived the bursting of the stock market bubble in 2001 still yield more than bond portfolios. It is only when the investment horizon shrinks to less than five years that equity portfolios become relatively more volatile. Higher risk shares are always superior if portfolios are held for a significant length of time (at least 10 years).
Moreover, you must have a diversified equity portfolio, as individual securities are much more volatile than the market. More importantly, active stock investments demand management, e.g., buy and sell, which drives costs up considerably. Fortunately, over the past 10 years, a broad range of index funds has been developed. They mirror the behaviour of the market or market sectors, making it much easier to diversify portfolios. The best-known are linked to market indices such as the TSX 60, TSX 300 and S&P 500. Such a diversified portfolio, if kept for more than 10 years, will have a much higher return than a more bond-weighted portfolio while the level of risk will be similar.
But diversified all-stock port- folios are not always recommended for retirement funds, nor are they found in most pension funds, even though the latter have investment horizons of more than 20 years. Fund managers’ preference for bonds is hard to explain. But their preference for active management (buying and selling based on their perception of market trends), as opposed to index funds, is understandable. They derive revenue from each transaction. Yet, market theory and experience show most fund managers consistently underperform the market and index funds that mirror market trends. But it is in their interest to keep busy and beat the market, even if half of them will not manage to do it this year. (Next year, another group of managers will be the winning half, so do not place any faith in historical performance.)
If you are 45 or younger and plan to retire at 65, streamline the management of your RRSP. Make sure it is self-directed and invested in diversified index funds. Do not sell anything until you reach age 65. You will reduce your fees, get a better risk/return ratio and you will come out the winner.
Marcel Côté is a partner at SECOR Inc. in Montreal |
