By Richard Yasinski CFP
I write this the morning after the Brexit vote – the referendum in which Brits voted to exit the European Economic Union. The late polls suggested they would vote “stay” and the equity markets were rising. Then the “leave” vote won and markets declined, at least temporarily.
The media has been presenting this drama as a significant risk to the stock market and there is little doubt that markets swing daily on any new information. But at this point it’s hardly a major panic as declines go. I’m surprised the markets have not declined further.
I just heard of an investor who went to cash, sold all her equity portfolio to wait out the vote. As the leave side won, to benefit from this strategy she must immediately reinvest all of her cash into the equity market – but statistics and history suggests she will wait for “a more certain direction.” Just as those investors did who stayed in cash after the crash of 2008 and remained in cash as the S&P doubled over five years. I know many did this because I’ve met them – they are still in cash.
But haven’t we seen this movie a dozen or more times before? The Russian ruble crisis of 1998, Y2K, the tech bubble, 9/11, the Gulf War, mortgage crisis, SARS, Ebola, fiscal cliff – etc. The 20-year average annual return of global markets ending in 2015, which covers all of these “end of world” events, is in the order of nine per cent. (you can look it up!) All through this time there was never certainty. Those investors who participated in the growth of equities during this time simply had to have faith the market would eventually grow. Based on historical probability, given the last 100 years of reliable data, we can expect the markets to continue with their volatility along a constantly rising trend line of let’s say around seven to nine per cent. So what is the real risk?
There are a few and I will describe them in order of importance with the most important first.
The greatest real risk is our own ability to make decisions about our spending and investments. Much has been written about behaviour finance which covers all aspects of how we make financial decisions. Humans are prone to making emotional decisions based on a small sampling of data – especially when it comes to something as important as money. Note the examples above. The only way to resolve this is knowledge and if you cannot spend enough time gaining the knowledge, or don’t have the stomach for the volatility, get the support of a good advisor.
The second most significant risk is inflation and taxes. I grouped these because they impact our real return – the money we get to spend. Although we have experienced low inflation over the last decade, don’t underestimate the impact of even a two per cent rate of inflation and don’t assume it will stay that low. The 50-year average rate is three per cent so we need to consider the reality of rates of inflation higher than two per cent over the next decade if we are to average to three per cent over two to three decades. A three per cent rate of inflation means our cost of living doubles over a 25-year retirement. Consider how much you spend now to cover living costs and expect it to be twice that in 25 years.
With government debt at all-time highs, we can assume taxes will play a bigger part in paying down that debt (or paying the rising interest) and tax planning a bigger role in our financial planning and security. Taxation and inflation mean we need growth in our portfolios beyond the low interest rates of fixed income investments.
Lastly is our life span. My grandfather lived to about age 73. My mother lived to age 91 and has remained relatively healthy other than the last year or so. Since I take very good care of myself, and live in an age of greater prosperity and access to good food and care, I can expect to live longer – 95 or later. As I’m not retiring until age 70 I will still need to plan for a 25 to 30-year retirement. With inflation and rising healthcare costs, I will need to plan for growth in my portfolio.
The only way to achieve that growth is a higher allocation to equities.
So the real risks are not Brexit, ISIL, epidemics, government debt, or the latest media crisis of the day. The real risk is our own ability to allocate enough of our portfolio to growth investments, believing they will provide the return we need.
The real risk is achieving enough growth over inflation and taxes. The real risk is outliving our money.
Richard Yasinski is a Certified Financial Planner (CFP) and an independent financial planner practising since 1996. Watch his video, www.financiallysound.ca.