What's safe today will cost you tomorrow: The case for equities

In finance, what counts as safe depends on how long you hold it. Cash is the safest asset over one year and the costliest over several decades. Stocks are the reverse: volatile in any single year, and the most reliable builder of wealth over long periods.

In this post, "stocks" and "equities" generally refer to public equity unless stated otherwise. The arguments made apply to both public and private equity.

Why cash feels safe

Two psychological biases push people toward cash.

• Loss aversion. A loss hurts more than the positive feeling of a gain of the same size. (See prospect theory for further reading on this bias).

• A short-term view. People judge long-term savings on short-term results. Behavioral psychologists found that investors behave as if they review their portfolios about once a year, even when the money is for long-term goals. They called the combination myopic loss aversion.

Together these make cash feel safe and stocks feel risky:

• Cash feels safe because the number in the account never goes down.

• Stocks feel risky because the price moves every day, and the falls are remembered more than the rises.

There is a cost to this.

Equities and other assets produce returns over long periods.

Cash does not.

A saver who stayed in cash to avoid short-term falls finds out decades later that:

1) He missed out on growing his savings

2) The value of his cash savings only buys a fraction of what it could have decades ago.

The number in the bank may not go 'down', but its value does because everything else becomes more expensive.

This post is meant to give comfort about holding equities for the long-term.

The evidence (below) shows what holding stocks for many years has looked like, so that the decision rests on that record and not on how a bad month (or year) feels.

What 213 years of returns show

The chart below tracks what $1 placed in each US asset class in 1801 would be worth in 2014, after inflation. The vertical axis is a log scale, so each gridline is ten times the one below it.

Two lines matter most:

Cash. $1 kept as cash in 1801 bought about 5 cents of goods by 2014. That is a loss of 1.4% a year. The primary cause this inflation? Printing money. When the supply of money grows faster than the supply of goods, each unit of money buys less. The line is roughly flat for the first 130 years, so almost all of the fall came after the 1930s, when money printing became common.

Stocks. $1 in stocks grew to $1,033,487 in real terms. That is 6.7% a year after inflation, and more than a million times the starting amount. This is why compounding is considered the 8th wonder of the world. (Read my post on compounding wealth here).

The "Dollar" line is money that earns nothing, such as a current account with no return. Short-term government bills did better at 2.7% a year, and bonds returned 3.5%. But both finished far below stocks.

A 1.4% annual loss looks small, but compounding makes it large. The table shows what 100 of purchasing power becomes at each asset's long-run average real return.

These figures are long-term averages, and any decade can differ widely from the average.

People hold cash for decades to save for a house or retirement.

That is the riskier move when making financial decisions that spans years or decades.

At the historical rate, cash held for 30 years loses about a third of its value.

The loss to inflation is only part of the cost. The other part is the return given up by not holding stocks, and it is the larger part. This is called opportunity cost and represents the the opportunity forgone.

Loss from cash earning nothing. Over 30 years, 100 in cash becomes $66 and $100 in stocks becomes $700. The saver in cash lost $634 when factoring this opportunity cost.

 Opportunity cost of investing. A saver in Treasury bills keeps ahead of inflation, and $100 becomes $222. That saver still ends $478 short of the saver in stocks.

This is why holding cash for the long term is a loss even when his or her account balance looks the same.

What this means for savers

When it comes to short and medium term financial decisions, cash has a function.

Everyone should have a cushion for a rainy day. (Unemployment, medical costs and other emergencies). The cushion should cover what you would need in a difficult period.

Savings above that buffer is savings that you will not need for many years. Holding them in cash exposes them to inflation. People should consider investing them in other assets.

Stocks have produced the highest long-run return. However, the right mix of assets still depends on each person's needs, income and time horizon.

I am not recommending individual stocks. I am recommending exposure to the asset class as a whole, held for a long time. Investing in individual stocks exposes you to the specific risks associated with that company. This risk can be eliminated when invested in a broad basket of stocks.

An index fund or ETF is the simplest way to get that exposure. It holds a basket of companies, typically the largest publicly listed ones. Most of these funds are low-cost funds that charge less than 0.2% of the invested amount per year.

Other asset classes have a place too. I think it is prudent to hold some real estate and gold. I may cover those in another post.

Private equity is an option for some investors. Buying into private businesses can add diversification with a different return profile. Most people cannot access it, because funds require qualified investor status and large minimum cheque sizes.

Choosing a country to invest in

A stock is a fractional share of a business. Stocks rise over the long run because businesses produce more, or produce more efficiently, and shareholders own the value of that output.

The chart displayed earlier shows US data. The same result is not guaranteed in every country, so you need to be comfortable with the country you invest in:

1) Economic, demographic and social prospects should be healthy. A growing and productive population gives businesses more customers and more workers.

2)  Institutions should be strong. Businesses keep investing and improving only when property rights, contracts and regulation give the private sector a reason to do so.

Where those conditions hold, owning a small share of the largest businesses is what I argue is the safe bet over the long-term.

Stocks are volatile over shorter periods

Stock price movements follow the output of the economy over the long run.

In the short run, sentiment, interest rates, investor cash needs, and one-off events push prices above and below that trend. This is why stocks are more volatile than cash or bonds.

The table shows the real annual return on US stocks over different periods.

The table shows two things:

1)  Over periods of 55 years or more, the real return was between 6.4% and 6.7% in every case.

2) The annual returns in any of the 12 to 15 periods ranged from -0.4% to 13.6%.

1966 to 1981

Stocks lost 0.4% a year after inflation for 16 years. That is a total loss of about 6% of purchasing power. Several causes combined:

• The period began with stocks at high valuations, including the large 'hot' companies known as the Nifty Fifty.

• The 1973 oil embargo was followed by stagflation. US inflation peaked at 14.8% in March 1980.

• Interest rates rose to control inflation. The 30-year US Treasury yield closed at 15.21% on 26 October 1981.

The assets that looked safe did worse over the same 16 years:

• Cash. US consumer prices almost tripled. Cash that earned nothing lost about two-thirds of its purchasing power.

• Bonds. Rising interest rates push down the price of existing bonds. Siegel puts the real return on bonds for the period at -4.2% a year.

The next 18 years, 1982 to 1999, returned 13.6% a year in real terms. An investor who sold in 1981 took the loss and missed the recovery.

The probability of a loss falls with over time

The longer US stocks were held, the less often they lost money. On a single day stocks fell 46% of the time, almost the odds of a coin toss. Over 20 years they did not lose money in any period.

The point is that when it comes to equity, time works for you. With cash, time works against you.

The lesson

What is seen as safe or risky will flip with time.

• Keep what you need in cash. This covers unemployment, medical costs and other emergencies, God forbid.

• Invest the excess in other asset classes. People should hold equities, which can be done through low-cost index funds or ETFs. If they have the opportunity to add private equity investments to their portfolio's in a reasonable way, they should consider it.

• Expect volatility in any asset class, and be prepared to hold through it. A useful reference for equities is 1966 to 1981. Stocks lost 0.4% a year for 16 years, mostly because the period started at a market high and was followed by inflation and rising interest rates. The following 18 years returned 13.6% a year.

Cash loses money reliably and incrementally. Stocks build wealth with time, but erratically.

This post is a personal view and not investment advice.