Four common investment misconceptions

One of the biggest misconceptions I come across in the financial advice industry is that as you get older you need to reduce your equity allocation. While this philosophy may be based on some truth, it oversimplifies reality. Many people unnecessarily choose an asset allocation that they believe is safe, but which could actually jeopardize their future goals.

The foundation of this argument is based on the principle of the investment time horizon. The simplified thought is this: as we age and have fewer years to live, our time horizon must shorten. Although we all have an expiration date, our assets do not. When it comes to investment assets, time horizon and life expectancy are not necessarily the same thing. And even when they are, many continue to misallocate assets based on an erroneous assessment of risk.

Here are four common investment misconceptions.

Age equals time horizon

The time horizon should be the most important determining factor in choosing the percentage of stocks, bonds (or CDs) and cash that make up your investment portfolio. Rather than relying on the adage “your age should equal your bond allocation,” investors should look at their likely future cash needs in tranches.

• First bucket: immediate needs. This includes withdrawals that are expected to occur within the next 12-18 months. These assets should be invested in money market accounts or current (chequing/savings) accounts with little or no market volatility.

• Bucket two: intermediate needs. Money that you expect to withdraw in more than two years, but in less than eight to ten years. Funds for tuition, vehicles and major home repairs are examples. The timing of these expenditures is reasonably foreseeable. These funds should be invested in higher-yielding, time-limited investments, such as high-quality bonds or bank CDs. The maturity date should roughly coincide with the scheduled withdrawal date.

• Bucket three: Long-term needs. You don’t expect to need this money in the next eight to ten years. These funds should be invested in stocks and other risky assets. These assets have higher expected returns, but they come with greater short-term volatility.

The stock market is very risky

When we talk about risk in financial terms, we usually refer to volatility, or how much an investment can gain or lose value. From quarter to quarter or year to year, the value of stocks can go up and down dramatically. However, if we look at returns over longer holding periods – like five and 10 years – the volatility drops dramatically. This happens because stocks historically tend to sell off dramatically, recover over time, and eventually reach new highs before the cycle repeats itself. Historically, these cycles take seven to ten years to fully unfold.

• Diversification is important here because a stock is a small piece of ownership in a company. Some companies never recover, and the stock price reflects that; but as an economy recovers, the market not only participates, but generally leads the way.

• Long-term equity returns are nearly double those of bonds. According to the NYU Stern Database, the S&P 500 stock index has an average annualized return of around 10%, dating back to when the index had only 90 stocks in 1928. US Treasuries have yielded a just under 5% over the same period.

Government bonds are less risky than stocks

Unlike stock returns, bond returns are limited by mathematics. A bond is simply a $1,000 chunk of a much larger loan. Once the loan is created, the terms of the loan do not change. The “total return” of a bond comes from the interest paid (the coupon payment), plus or minus any change in price. The price of a bond will change as prevailing interest rates change. When rates fall, the bond becomes more valuable because it has to pay a higher coupon than the prevailing market interest rate. Therefore, as prevailing interest rates fall, existing bonds gain in value; as rates rise, existing bonds lose value.

• Bonds cannot repeat their historical performance. Over the past 50 years, bonds have experienced a prolonged period of systemic decline in interest rates. Interest on a US Treasury bill fell from 16.3% in May 1981 to 0.03% in December 2008. During this period, US Treasury bills earned an annualized return of 9.77%. Most of this performance can be attributed to the steady decline in market interest rates.

• With current market interest rates at zero, historical yields are no longer relevant to future return expectations — if we assume that rates cannot fall well below zero. This means that as the Fed raises rates to fight inflation, the prices of existing bonds will fall, crippling future bond yields and virtually guaranteeing that they will struggle to keep up with inflation.

You cannot lose cash

With the rise of cryptocurrency and alternative assets, we need to rethink our definition of money. Technically, money is simply a store of the value of our labor. It has taken many forms throughout history, but its purpose has always remained the same. We earn it when we work and keep it until we want to exchange it for something of value.

• If the storage unit of our currency decreases in value, it will take more units to buy the goods we want in the future. It’s inflation. In 2021, the consumer price index increased by 7%. This means that the work we did in early January 2021 bought 7% less goods by the end of the year. If we assume a working year of 250 days, that means we lost 17.5 working days due to inflation. Holding cash can and does lead to loss of money.

Ah, making decisions…

Armed with this knowledge of important misconceptions, what decisions should investors make? Here are three suggestions:

• Invest for your needs, not for your age.

• Think carefully about your projected expenses and use the “bucket” methodology. This should be the basis for the award decision.

• Resist changing your allocations based on market conditions. Market timing is incredibly difficult because it requires two perfectly synchronized decisions: when to exit and when to return.

The information provided here is not investment, tax or financial advice. You should consult a licensed professional for advice regarding your specific situation.

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