As we continue to see some more attractive interest rates being offered on bank deposits, I often get the question of – “why should I take more risk and invest, when I can get 5% in a term deposit?”
It’s a good question, and we would always advocate for only taking the amount of risk you are willing to and need to take to achieve your goals, however when answering this question on ‘risk’ we need to look at both sides of the equation, not just the risk in investing.
Contrary to popular belief, there is no such thing as “no risk” when it comes to investing. Risk is a trade-off. When an investor seeks to avoid one type of risk, they are inevitably exposing themselves to a different risk.
For example, investors seeking to minimise short-term principal risk (temporary volatility) are, by default, accepting the long-term risk that their portfolio may not keep up with inflation. Rarely is this latter risk discussed.
Short-term market fluctuations always have and always will dominate the headlines. So, it’s no surprise that these all-too-normal fluctuations dominate the minds of investors as well. How can we avoid the next downturn? How can we make our portfolio less volatile?
Innocent questions, but are they the right questions to ask? The whole point of investing is to achieve our financial goals. But by seeking shelter from short-term market volatility, investors may materially decrease the probability of reaching those goals.
So, let’s take a closer look at this with a worked example, comparing a 5% return that you may see from term deposits or the 30-year average of bonds, compared to equity returns that have historically been about 10% per year.
Certainly, nothing is guaranteed, but let’s assume these long-term averages hold true.
Many may say to themselves, “If I can earn half the return of equities with a lot less stress, that sounds like a pretty good deal.”
As logical as this may sound, there’s a critical flaw in this argument that many people will miss. Of course, it’s a misunderstanding of how compound interest works. Because with compound interest—that is, earning interest on your interest—the difference in the long-term, in-your-pocket return is likely to be far greater than the 2:1 return that’s implied.
To explain what I mean, let’s look at this hypothetical:
Let’s say you invested $100,000, earning a 5% return versus a 10% return over various time periods. How much would the end-portfolio values differ at the end of each period?
As you can see in the visual, the difference in the end-portfolio values compounding at 5% vs. 10% over 30 years is not 2X as you might have guessed. It’s actually 4X!
And over 40 years, the difference grows to more than 6X!!
This means that, on the extreme end—by allocating 100% to term deposits/bonds vs equities—if historical returns hold, the potential cost of “volatility avoidance” is somewhere between 75%-80% of total dollar returns over 30 and 40 years, respectively! That’s pretty shocking, isn’t it?
Even if you consider less extreme examples than above, it’s easy to see that there is a very real cost to volatility avoidance that almost nobody talks about, and it has everything to do with misunderstanding the value of compounding.
While it’s obviously important to plan for your short-term cash flow needs, and an allocation to cash & bonds are necessary in retirement, I doubt so many investors would knowingly choose short-term comfort with their long-term assets if they knew how much they were giving up to get it.
My hope in sharing the math here today is to make it obvious why I constantly reiterate the long-term value of owning the world’s great companies—versus lending to them or to a bank —and why I encourage patience at every turn.
If you would like to know more about how we do this, or to discuss what else is involved in the Financial Planning process, please feel free to get in touch by replying to this email or directly to Harlen’s Certified Financial Planner and Partner, Tom Napier tnapier@harlen.au
And while we are on the topic of what’s involved with Financial Planning, please see below for a graphic of where some of the key value sits for those that do go through the Financial Planning process with Harlen
