Stock markets like we have today make financial planning so quick and easy.
Invest or pay down debt? Invest, of course. Didn’t exchange-traded funds tracking the tech-heavy Nasdaq 100 index make more than 65 per cent in the past 12 months in U.S. dollars? What’s the rate on home equity lines of credit these days – 3 per cent or something similarly trivial?
Stressed about finding more money to save for retirement? Why bother when an investment in the S&P 500 index made 55 per cent in the past 12 months in U.S. dollars and even the S&P/TSX Composite made a bit over 44 per cent. That’s enough to more than offset those past years of half-hearted saving, right?
What’s happening with stocks these days is a marvel. You can hardly do anything wrong as an investor if you ignore the struggling bond market and do-nothing cash. If stocks keep it up, wealth-building will be simple.
A prediction: Stocks will fall at some point, and wealth-building will present the same challenge it always has over the long term, which means 10-plus years. There will be wins and losses, with overall gains coming in at levels that seem modest by early 2021 standards, but still better than bonds or cash.
Try to keep this in mind as you look at the returns posted by exchange-traded funds, mutual funds and individual stocks in your portfolio for the 12 months to March 31. Think of them as tutorials on the ways investors can let themselves be fooled by numbers.
One of the most important lessons is to pay close attention to end-date bias, which refers to the way the end period for measuring returns from an investment can have a huge impact on results. The bottom of the 2020 stock market crash came in mid-March, which means returns measured with the end of that month as the starting date reflect almost the full extent of the stock market surge of the past year.
It could take close to another year to flush end-date bias out of one-year investment returns. A way to bring yourself back to reality is to look at how longer-term returns have fared in the most recent data. Even after the great gains of the past year, the S&P/TSX Composite index generated a return of 6 per cent on an average annual basis over the 10 years to March 31.
That’s not a bad starting point for estimating average annual total returns – share price changes plus dividends – for the stocks and equity funds you’ve owned for 10-plus years, before fees. It’s true that the S&P 500 averaged 13 per cent over the past 10 years in U.S. dollars, but that’s unusual. Over the past 20 years, the annualized S&P return is close to 6 per cent.
Another way numbers fool investors is through what people in the field of behavioural investing call recency bias, which means expecting the future to look like the recent past, rather than historic norms. Wait, this sounds a bit patronizing. Let’s accept that investors are enjoying the heck out of the stock market rally, but they realize the good times won’t roll indefinitely.
Even so, recency bias can negatively affect your thinking about money. Are you weighing whether to invest your 2020 tax refund or pay down debt? It’s hard to get excited about paying off a line of credit or loan when you look at recent investment returns.
Likewise, it can seem like the biggest blunder ever to have money sitting in a high-interest savings account earning 1 per cent to 1.55 per cent at best when stocks have month by month flung themselves ever higher over the past year. You can always pull emergency funds out of your line of credit, right?
Cast your mind back to March, 2020, for an answer to that question. At times of great financial stress, cash safely parked in a Plan B fund offers true peace of mind. Money you made in stocks can melt away in days if the markets crash.
The COVID-19 pandemic has brought us what could very likely be the best investing conditions we’ll see in our lifetime. Count your gains and plan for leaner times ahead.
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