Too many investors fear longevity too little – and market volatility too much

Editor's Note

This article was sponsored by RBC Dominion Securities.

In 1993, the cost to mail a letter in Canada was 43 cents. Today (assuming anyone were to actually want to mail a letter) it would cost $1.07. That’s an increase of just over two and a half times, and it’s pretty close to the average inflation in the price of consumer goods over the last three decades.

The stock market, on the other hand, is another story entirely. Over the same 30-year period, the S&P 500 has increased nearly nine-fold in value, from 451 points in 1993 to 4,027 as I write this article. That increase is almost four times the rise in the cost of our humble little postage stamp, and it doesn’t even factor in the dividend yield, which currently sits at about 1.69 per cent. If you had reinvested those dividends over the same 30 years, the total increase would be much higher.

What does all this mean for the average investor who might be looking for a little perspective in these challenging times?

Right now, we’re in the midst of a modest market decline. Since the start of 2022, the S&P 500 has dropped by about 16 per cent. As far as bear markets go, this one is fairly tame. In 2000, for example, the S&P 500 experienced a drop of 51 per cent. In 2009, the decline was 50 per cent. Of course, the fact that the current decline isn’t as bad as others we’ve been through before is small consolation if you’re counting on your hard-earned investments to see you through your retirement years. Whether you’re already retired, getting close to it, or just starting out, if your portfolio is declining, it’s always a stressful time.

But as our stamp comparison tells us, if we look beyond short-term market fluctuations towards the long-term view, equities are still one of the most reliable ways to not only keep up with inflation, but beat it resoundingly. The typical retirement these days lasts about 30 years – roughly the same amount of time as in our example above. Looking at the numbers from a 30-year perspective, it’s not hard to conclude that an asset that can increase nine times in value is a great hedge against inflationary forces that could reduce your buying power by a factor of 2.5.

The math, therefore, is pretty clear. So why are so many investors so much more concerned with inflation and short-term market volatility, than they are with the long-range longevity of their investments?

The reason, I think, can be found in the old adage about boiling a frog in a pot of water. As the saying goes, if you put a frog in a pot of boiling water, it will immediately jump out. But if you put it in a pot of cool water and then slowly bring the temperature up to a boil, the frog won’t perceive the danger it’s in until it’s too late, and it will end up being boiled alive.

The same is true for inflation. Unlike stock market declines, which are usually big, sudden and dramatic affairs, inflation normally happens so gradually that it flies almost entirely under the radar. Sure, it makes the news when there’s a big jump, like we’ve seen over the last few months. And we all get annoyed whenever prices go up at the gas pump. But a jump of 30 cents a litre for gas is still a whole lot easier to swallow than the gut punch delivered by a $150,000 decline in a $1-million stock portfolio.

As a result, investors tend to fear bear markets way more than they do inflation – regardless of the fact that market declines are temporary, whereas consumer prices almost never go down again once they’ve gone up. Most investors don’t want to see their portfolios decline by so much as a single dollar, especially when prices are rising around us. So when a steep decline suddenly happens, our fears and anxiety start telling us that it might be time to cash out, sit on the sidelines, and wait for the jitters to pass.

And cashing out is indeed exactly what’s happening right now. The only reason the markets go down is because some nervous investors have decided to sell, and are willing to accept a lower value on their investment as the price for certainty. By some estimates, there’s currently more cash sitting on the sidelines than there was in the financial crisis of 2009.

The problem with this approach is that most of those investors who are heading for the hills have some kind of target in mind for when they’ll be willing to put their money back into the market. Several people I’ve spoken to lately have told me they think the S&P will bottom out at around 3,200. How they come up with 3,200 is anyone’s guess, but something about this number seems to be popular. And there’s no question that this could very well happen.

But there’s also no question that it might not. That 3,200 number is a pure guess, and we could hit it tomorrow, next month, next year – or never. What is certain, however, is that one day the S&P 500 will reach 6,200. And 8,200. And 10,000. Maybe not in the next year or two, but soon enough. Do you really want to take the chance of missing out on that kind of long-term, inflation-beating increase, all because you were sitting on your money, waiting for a bottom that might never come?

And have no doubt: that increase will eventually happen. There’s a risk premium built into stocks that means they have to pay more over the long run than guaranteed investments like GICs or savings accounts. It’s not wishful thinking. It’s the law of the jungle.

No one would own stocks if they didn’t pay more than less-volatile options. Why would any investor endure all those anxious ups and downs unless they came with a premium return? But the only way to get that premium is to take on some risk. Not a fake risk, where you somehow get out at exactly the right time and then back in at the precise moment before things turn around. Real risk, where you have to endure periods of anxious volatility in order to harvest the rewards that come with it.

I know, I know, easier said than done, right? Maybe. Maybe not. For me, the best way to deal with the conundrum of fearing market volatility more than inflation – a fear that can cause even the wisest of investors to lose their cool and take their money out of the only asset class that’s been proven to beat decades of rising costs – is a sound financial plan.

A good plan will make the risks of inflation clear and real. A good plan will show you the truly devastating effect inflation can have over the course of a lifetime if your portfolio isn’t equipped to outstrip it. A good plan will also make sure you have enough funds separate from the markets, so you aren’t forced to dip into your long-term investments at the wrong time.

So now that we’re here in a depressed market, what’s the first step forward? I would suggest, if you don’t already have a financial plan, now would be a great time to get one.

This article is supplied by Alan MacDonald, an investment advisor with RBC Dominion Securities Inc. Member–Canadian Investor Protection Fund.