The trade-off

By Brad Steiman | October 16, 2012 | Last updated on October 16, 2012
4 min read

Successful investing requires careful consideration and balancing the trade-offs from competing demands.

For example, one investment trade-off is found in the risk-return decision. The competing demands within this decision are protecting capital versus preserving purchasing power.

Some investors consider risk to be volatility. They have difficulty stomaching the daily ups and downs with investing in asset classes that have significant price fluctuations, such as equities, because declining prices are often accompanied by negative headlines.

These investors extrapolate the recent past into the future and see the bad news as an indicator of what’s to come. These investors want short-term preservation of capital.

Other investors may define risk as a diminishing standard of living. They have long-term financial obligations, such as spending during their retirement, and their primary goal is building wealth to meet those future expenses. They recognize that, while the effects of inflation are sometimes slow or undetectable in real time, inflation can be the silent killer of a financial plan. These investors desire long-term preservation of purchasing power.

You can guarantee the preservation of capital by investing in Treasury bills, as long as you accept the potential for the loss of purchasing power.

Meanwhile, you can preserve purchasing power by investing in asset classes with expected returns exceeding inflation, providing you accept price fluctuations that can impair your capital.

Unfortunately, in practice, investing isn’t that simple. Investors rarely have such clear objectives, or well-defined definitions of risk. Some expect long-term preservation of purchasing power and short-term preservation of capital. Advisors can get clients to focus on the trade-offs between growth-oriented assets and assets that stabilize the portfolio and reduce its fluctuations.

So if an investor is fearful and more focused on capital preservation, it’s time to reframe the trade-offs by emphasizing why growth assets were in the portfolio to begin with and how the so-called riskless asset (i.e. bills) can be extremely risky in the long run. History offers a valuable lesson.

A century of market returns

Table 1 contains annualized returns from Canada and the U.S. from 1900 to 2010. These returns are calculated from the Dimson Marsh Staunton (DMS) Global Returns Database and are in local currency.

In nominal terms, bills only slightly beat inflation before tax. But this small return can easily disappear on an after-tax basis. Still, the table demonstrates that equities have delivered returns exceeding bills and inflation by a wide margin, even when accounting for taxes.

However, the trade-off for pursuing higher expected returns of equities is accepting the risk of substantial declines compared to the relative stability of bills.

Table 1: annualized nominal returns (1900-2010)

Country Inflation Bills Equities
Canada 3.0%. 4.7% 9.1%
U.S. 3.0% 3.9% 9.4%

Table 2 shows that during their worst performing periods, Canadian and U.S. equity values have dropped 64% and 69%, respectively, whereas bills have always been flat (if you consider minus 2 basis points a rounding error) or slightly better.

The risk-and-return relationship from a preservation of capital perspective is apparent in these nominal returns, but the picture is a bit different after considering the impact of inflation. From a standpoint of preserving purchasing power, the riskless asset looks far from risk-free.

Table 2: worst performing periods for equities and bills nominal returns (1900-2010)

Equities Bills
Country Period Total Returns Period Total Returns
Canada 1929-1934 -64% 1945 0.37%
U.S. 1929-1932 -69% 1938 -0.02%

Table 3 contains the biggest peak-to-trough declines, in real terms, for equities over the same time period. It’s no surprise the magnitude of real declines is substantial, with stock prices dropping 55% and 60% after inflation.

However, the three-year and four-year duration of the declines of both countries’ equity markets is still relatively short, as are the years to break even. After the decline, the Canadian market recovered in three years and the U.S. in four.

Table 3: Worst performing periods for equities real returns (1900-2010)

Peak-to-Trough decline Recovery
Country Period Total Returns Years Years
Canada 1929-1932 -55% 4 3
U.S. 1929-1931 -60% 3 4

In contrast, the data in Table 4 for bills, or the riskless asset, is revealing. The biggest peak-to-trough declines after inflation are 44% and 47% — a similar order of magnitude to equities. Further, the duration of the declines extends to 18 and 19 years, with investors in bills waiting an astounding 34 years to recover in Canada and 48 years to recover in the U.S.

Table 4: worst performing periods for bills real returns (1900-2010)

Peak-to-Trough decline Recovery
Country Period Total Returns Years Years
Canada 1934-1951 -44% 18 34
U.S. 1933-1951 -47% 19 48

Source: Dimson Marsh Staunton (DMS) Global Returns Database. In local currency.

Performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.

Comparisons like these are needed when discussing the trade-off of preserving capital versus preserving purchasing power. Investors feel the risk of equities in real time. Volatility is immediate and apparent as investors can track their portfolio values.

Conversely, the risk of investing in bills and other low-volatility assets is less discernible and may take time to detect because it shows up when investors open their wallets many years later.

Brad Steiman is Director, Head of Canadian Financial Advisor Services, and Vice President of Dimensional Fund Advisors Canada ULC.

Brad Steiman