Capitalism Redux
The Financialist • Issue 102 • July 2009
BY ALAIN QUENNEC BComm CFP FMA
The most recent gyrations of the equity markets have caused many investors to focus more and more on the short term. “How is The Market doing this morning?” they may ask themselves at 6:35 am, only 300 seconds into the trading day.
Try to think of the market the way we think about the weather. You may or may not like what you see when you look out the window, but it doesn’t help you figure out how much it will snow next winter.
While I can’t predict the weather next month or next winter, I can tell you it is highly likely to be colder in January than in July. That’s a safe bet, and not guaranteed, but one I’m willing to make consistently. It’s the same with the markets – they are bound to go up and down, and sometimes severely so, but the general trend is upwards, and for a reason.
HOW INVESTING WORKS (BASICALLY)
Some investors lend money to a bank, credit union or trust company and get back a GIC in return, representing the funds the financial institution must pay back to the investor, with interest. How will the financial institution do this?
Banks and others lend money to individuals and corporations at a rate of interest higher than they are paying the investor on the GICs.
I know why I pay interest on the money I borrow, but why does a corporation do so? The corporation can take that borrowed money, buy a machine that manufactures “widgets”, hire someone to run that machine, and sell the widgets at a price greater than the interest, wages and other costs, thus turning a profit. As an investor, I have three basic choices: 1. Lend money to a bank, credit union, etc. (invest in a GIC). 2. Lend money to a company to get higher interest (buy a corporate bond). 3. Buy a portion of the widget company to own the profits (buy stock).
The GIC is most secure, but offers the least return.
The bond is less secure, but offers better interest.
The stock is least secure, but potentially offers the best return of all.
The problem with the first two is that they don’t help investors keep up with inflation over time – only stocks do that. The problem is identifying which ones are the best ones. It’s a full-time job for a professional and that’s why, after planning and determining how much to have in stocks, we hire money managers.
Over time, GICs tend to return 2-3% more than inflation; stocks 6-8% more than inflation. After taxes, GICs barely keep up with inflation at the best of times (low inflation years), and they actually lose value in high inflation times. Stocks are very volatile and you often have to wait for them to perform to expectations, but that's why we often allocate some of the portfolio to safe investments — to allow you the ability to be patient and wait out financial storms like the one we are now living through.
Which of the three investment options should you choose?
In most cases, the answer is all three options. The proportion of investment capital dedicated to each option is a function of one’s personal risk tolerance, investment objectives, and financial planning.
A word of caution for those who don’t believe stocks have a future, and think GICs are the only reasonable investment. Stock prices are generally reflective of corporate ability to produce profits.
If stocks have no future, it is because there will be no profits.
If there are no profits, companies will not be able to repay their bank loans.
If banks are not being repaid, what is their ability to repay GIC interest or capital?
Deposit insurance provides a certain level of safety, but there is not enough insurance money to bail out every deposit-taking institution. Without the (eventual) profits of capitalism, our banks would fail in the end and our seemingly safe GICs would vanish along with them.
For more information, please contact your Rogers Group Financial advisor.