The Three Basic Ways to Invest
The three basic ways of investing open to all people are: treasury bills, bonds, and common stocks. Numerous investment strategies have been derived from these three basic assets.
In this primer, Tralucent has provided the last 92 years of US history (1926 – 2018) as an example to discuss what an investor may learn from studying historical returns.
Treasury bills (T-Bills) are debt securities issued by provincial and federal governments.
They are created as a way for governments to fund various public projects.
When an investor purchases a T-Bill, they are effectively lending money to the government.
T-bills are considered a safe and conservative investment since the government backs them.
A corporate bond (bond) is a debt security issued by a corporation and sold to investors.
Bonds are a form of debt financing and can be a major source of capital for many businesses.
When an investor purchases a bond, they are effectively lending money to the company.
With bonds, investors ONLY earn interest.
If a company goes into bankruptcy, it pays its bondholders along with other creditors before its stockholders, making bonds arguably 'safer' than stocks.
Common stock (stock) represents ownership of a corporation.
When an investor purchases stocks, they are buying a piece of the company.
The value of a stock rises and falls with the value of the company, allowing the investors to realize profits or potentially losses.
If a company goes into bankruptcy, stockholders have rights to a company's assets only after bondholders, preferred shareholders and other debt-holders are paid in full. This makes stock arguably 'riskier' than debt or preferred shares.
However, stocks usually outperform bonds and preferred shares in the long run.
Treasury bill investors lend money to the Government for less than a year and the Government gives them a return. At the end of the period, the lender turns around and lends it again at the new going rate. This rate may not be the same as the last one, and so is the source of some fluctuation. Some other forms of investments that are derived from treasury bills are GIC’s, Bank term deposits, and the like.
History shows that the rates vary from year to year and that even these relatively safe investments can have varied returns. Indeed, they have varied from near zero during the depression, to 14% during the 80’s inflation, and back to near zero in 2011. Though it is worth pointing out – there has never been a negative year.
What $1 invested in 1926 Treasury Bills grows to:
If our great-grandfathers had started a trust account for their great-grandchildren then that account would have grown every year, though not always at the same rate. This trust account, starting with $1 in 1926 would have grown to $21.17 by the end of 2018. In 1926, the average salary was $1313. Now, assuming $1313 had been set aside for us, that salary would have grown to $27,796. There is never a down year and with a compounded annual return of 3.37%, the money grows quite steadily.
Here investors lend money to governments, corporations, municipalities and the like for terms longer than a year. They are paid a certain amount (interest) every six months and then the entire principal is returned at the end of the term. This interest varies from time to time and that causes fluctuations in returns. Nonetheless, over the 92 year period corporate bonds have provided a compounded annual return of 6.01%, with 19 years where the return was negative, proving that there is nothing fixed about fixed income. Out of these 19 negative years, the highest negative return was 8%. Bonds are very useful for situations where low volatility is desired, but a steady return can not be assumed.
What $1 invested in 1926 Corporate Bonds grows to:
Back to that same trust account started by our great-grandfather: that account would have grown most years, though not always at the same rate. One dollar invested in 1926 would have grown to $214.28 by the end of 2018. Again, assuming he has set aside one year’s salary of $1313, had it been only invested in bonds, the current value would be $281,350.
With the exception of a few periods where your family would be scratching their heads as to why the returns were negative when they are supposed to be positively fixed, your money would grow quite steadily with a compounded annual return of 6.01%.
With this, you could afford a decent down payment for a house in Toronto.
Investors buy shares in companies trading in recognized stock exchanges. Some stocks pay dividends, and some do not. Their prices fluctuate widely which creates huge variations in returns.
Some years are extremely painful, with stocks having gone down by 30 or even 40 percent. In some cases they even go down some more the next year, causing extreme anxiety. Then, there are some years they go up by 50% to be followed by another year or two (or three) of very strong returns. Another fairly common scenario is where there is year that markets are up by 50%, to be followed by near zero return, followed by large declines such that there is a five year period where there was no progress to speak of.
Yet, it is unthinkable that a diversified portfolio will become ZERO.
A compounded annual return of 10.11% - but the huge variation from year to year makes a mockery of the term average. Approximately 25 of the 92 years shown have been negative, and some quite severely.
All these ups and downs makes one wonder – is it a stock market or a soap opera?!?
What $1 invested in 1926 stocks grows to:
Back to that trusty trust account, if our great-grandfather had invested only $1 in 1926, then that account would have grown and shrunk over the years, but growing more than shrinking overall.
This measly $1 would have grown to $7029.83 by the end of 2018! Assuming instead it was the one year salary of $1313 he had set aside for us, the same money would have grown to $9,230,167! Granted, this growth would have been full of drama, anxiety and pain; yet it would allow us to buy at least a nice vacation property in Cayman Islands, if not more.
Perhaps such experiences are best captured by the phrase – no pain, no gain.
Long term returns, the drama, pain, and joy: Over long periods of time, the Stock Market with a return of about 10% has been the best performing asset classes (I refer of course to the information above – where we present its history and how it has outclassed other asset classes). However, the stock market is packed with drama, theatrics, pain and joy. Below we have outlined how stock markets move so you may get a better feel for what happens.
The Pain AND Joy in the stock market
Level 1 Corrections: 7 to 10% declines happen just about once a year. It is almost a routine. Please expect them.
Market returns are lumpy. This means that in many cases returns occur in a relatively short period while the market then goes sideways or even down creating zero returns over months and quarters. You may consider this as sort of Level 1 Corrections as well.
Level 2 Corrections: Even 10-20% declines happen just about every 18 months and may happen swiftly within months. Every time something like this happens, it may wipe out months of gains and even years.
The math is simple. Imagine the market over a two year period has risen 20% and then in months it declines 20%. Net result is that two years gains are gone. Please do not be astonished when such a thing happens and in fact expect them every now and then. Similar math and sequence of events will then even result in one year gains to dissipate. Again, please do not expect yearly gains or gains every twelve months either.
Level 3 Corrections: Declines greater than 20% take place on average every four to five years as well. They wipe out years of gains sometimes even making four and five year returns as zero. We guarantee, something like this will happen again as well. Please expect such declines and do not expect gains even every four years either.
Level 4 Corrections: Even 50% declines from top to bottom take place every ten to 15 years leaving even a decade long return to zero. Please bear even this aspect in mind.
The purpose of the above is not to discourage you or to frighten you but to explain the nature of the stock market and to add to your knowledge. Now that you are aware of corrections and declines, You must then also realize that 7-10% up movements are also routine and far exceed the declines; stocks climb 20, 50 and even 100% in short periods. During these periods, the up movements far exceed the down. Which then produce 10% returns over long periods of time – Returns so stellar that they handily beat other asset classes and inflation.
Earlier we noted that every now and then even four year returns may be zero or nonexistent. However note that four year returns that handily beat anything else are even more routine – one only has to think long enough.
Every now and then even ten year returns may be near zero. The good news is that this is not frequent - only three periods in the last 92 years (1928-1940, 1965-1974, 1999-2010). In spite of these periods, the ten year stock returns on average beat other asset classes hands down.
Even more interesting is that such gains have come about through wars, recessions and depressions, political upheavals etc., etc. Obviously, declines were an opportunity to add to holdings and to be patient.
We repeat, one of our most favorite pictures - A Comparison of Various Asset (Investment) Types.
Please notice the long term returns from Large Cap US stocks. One glance at the picture below and you will also conclude that the observations discussed previously are quite correct: most one year and four and ten year returns are positive and something to celebrate.
Therefore one only needs to think long term and be patient.
Your Unanswered Questions
The above is a simple primer to get started thinking about investing in public markets. It does not answer numerous questions that most are likely to have such as:
1. How do these returns stack up against inflation?
2. How to look at volatility during the year?
3. How to handle volatility?
4. How should you look at markets if you were planning for your great-grandchildren?
5. How should you look at markets if you were planning for the next 3 or 5 or 10 years?
This is where you may call Tralucent for a discussion as to how we may be able to help.