Every day the Canadian stock market extends its recent rally helps hide an uncomfortable fact about investing.
Even after 10 years, investing in stocks can seem futile. On an after-inflation basis, the S&P/TSX composite index lost money over the past decade. The index averaged a gain of 1.1 per cent annually for the 10 years to late-October, while inflation averaged 1.6 per cent. And, yes, that includes Friday's record-high close on the TSX.
One of the investing world's main messages is that patient, long-term investing in stocks is a path to building wealth. But what, exactly is long term? It's not five years or less – that's basic. Now, it seems that 10 years may not be enough, either, in some cases.
The point of investing in stocks is to get better returns than safer investments such as bonds or GICs. You run more risk of losing money with stocks, but you also have the potential of making substantially more. Sad to say, a 10-year Government of Canada bond purchased 10 years ago would have locked in a pretty much risk-free annual return of 4.3 per cent.
You could have done even better than that with provincial or corporate bonds.
The past 10 years include the global financial crisis and a long detox period that continues today in some ways. Stocks plunged in late 2008-09, rebounded sharply and then entered a land of peaks and valleys. The latest surge started in September and has brought us to a point where we can look back at those 1.1-per-cent annual gains over the past decade and realize it could have been worse.
The experience of the past 10 years on the TSX tells us nothing about what to expect in the decade ahead, but it does offer an important caveat. You can spend 10 years in the stock market without much to show for it. To manage this risk, consider these three rules.
1. Dividends matter
If we look at the S&P/TSX total return index, where dividends are added to changes in share price, then the annualized 10-year gain is 4 per cent. As ever, dividends make up a large part of the returns from stock-market investing.
Investors are intensely interested in dividend stocks these days because 1) they've done very well in the past decade, and 2) yields are often higher than they are for bonds and GICs. But the investing world too often fails to consider dividends when measuring how stocks are doing.
We hear constantly about how the S&P/TSX composite index is doing, while the numbers for the total return index are less available. For returns of more than a year, the total return index is the one that matters for assessing stock-market results (on Globeinvestor.com, you can get quotes for the total return index by typing tsxt-i into the search box).
2. Global diversification matters
The Canadian stock market is 30-per-cent weighted to resource stocks, which have struggled for the most part in the past 10 years. Add financials such as banks and insurance companies and you have two-thirds of the Canadian market accounted for. This is the poorly diversified mix that produced those weak 10-year returns.
Meanwhile, the tech-heavy, resource-light S&P 500 index has averaged 7.4 per cent annually over the 10 years to Sept. 30, including dividends. Convert that return to Canadian dollars and you get 9.9 per cent. International markets outside North America have been comparable to Canada over the past decade, but much stronger lately.
Ironically, the focus on dividend stocks may undermine global diversification. Investors gravitate to Canadian stocks for dividends because of their familiarity and the availability of the dividend tax credit in non-registered accounts. Views on diversification vary a lot, but one thought is to divide your stock-market holdings into equal portions of Canadian, U.S. and international content.
3. Patience matters
Generally, 10 years should be long enough to invest in stocks with a good outcome. To guard against disappointments such as the past decade, remember the importance of dividends, diversify globally and stay patient.
Must you have a multidecade time frame? No, but it sure helps. The 20- and 30-year annualized returns for the S&P/TSX total return index to the end of last month were 6.6 per cent and 7.5 per cent, respectively.