The Globe and Mail, Report on Business
Published May 4, 2007

Feeling richer?  But are you better off?

When Lori and I left Toronto to move west in 1991, we kept our summer cottage in the Haliburton.  Back then, we weren't tying up a lot of money - our cottage is strictly a 'plywood special'- and the friends, water skiing and corn were too good to leave behind.

We were back last weekend to see if the place was still standing and assess how good a winter the mice had.  As we talked to people, without a doubt the topic on everyone's mind was how much higher cottage prices are this spring.

These conversations reinforced to me just how much richer we're feeling because of higher real estate and stock prices.  The value of our homes and investment portfolios have surpassed what we ever thought was possible.
 
And for the most part, this prosperity has resulted in people being better off, although it isn't always the case.  Let me explain.

Asset inflation has been fueled by 25 years of declining interest rates.  If you invested in long-term assets (equities, real estate and/or long-term bonds), the rate decline has had a hugely positive effect on the value of your capital.  If you stuck to an investment plan and didn't panic when markets were weak, you are indeed better off.

But investors that tried to time the market and got it wrong, or were too conservative, that is they kept their money in savings products or just rolled over guaranteed investment certificates (GICs), are clearly worse off today.  They are experiencing the negative side of the rate declines - lower bond and dividend yields - without having fully benefited from the market appreciation. 

It doesn't seem to matter, however, if we are better or worse off.  We all want to achieve the returns we had in previous years.  But we shouldn't kid ourselves.  With the decline in rates behind us (or a majority of it anyway), we should expect real estate and financial assets to generate a lower return in the years ahead.  We can hope for more - and if we get lucky with a particular investment or strategy, we may be able to achieve more - but the math is hard to ignore.

Obviously, future returns are impossible to predict, but there is a very strong linkage between current yields and future returns.  The higher the yield, the higher the expected return.  Currently, however, we have low bond and dividend yields.

Specifically, the math looks like this.  The risk-free rate is now 4% (the yield on a Government of Canada bond).  In determining what future bond returns will be, the current yield is as good an indication as any.

Equities will generate higher returns, but it's hard to say how much.  We can debate the equity premium all day long, but it's fair to say that the extra return above the risk-free rate is likely to be in the range of 2 to 5%, not 10 to 12%.  Therefore, equity markets are likely to generate single-digit returns over the next 10-20 years.

The danger in pursuing yesterday's returns is that investors may take inappropriate or unintended risk.  A recent example of this occurred when investors sold their fixed income securities (bonds or GICs) and bought income trusts for the higher yield.  They substituted a secure investment with a fixed level of income for an equity security that had a higher, but more variable distributions.  Sometimes the strategy worked out.  Sometimes it didn't.  There are plenty of other examples of where investors have been lured into products that give them a chance of achieving a higher return, even though the potential returns being advertised (i.e. you can earn up to X%) is unlikely to happen.

To be clear, I think risk is a good thing in the context of long-term investing.  Trying to convince investors to subject themselves to more risk and to use short-term variability to their advantage has been a recurring theme in this column.  But if investors are stretching beyond their normal risk tolerance, then it can quickly turn into a bad thing.

There are lessons to be learned from all of this.

First, while most people have a higher net worth than they anticipated having at this point, they have to recognize that a by-product of good past returns is lower current yields.

Second, if you're young - my view of young changes every year, but let's say under 55 years of age - you should be investing, not saving.  That means having exposure to long-term risk assets and not trying to eliminate short-term volatility. 

Third, for people who are retired, or close to it, focusing on higher returns as their only means to a better lifestyle is not the way to go.  I'm not saying an investor shouldn't take prudent risk and structure their portfolio appropriately.  Both are positive steps.  But just moving up the risk curve is not the answer.  Spending less and/or saving more should also be part of the mix.

On the last point, there is a well worn saying that has always stuck with me.  "More people die stretching for yield than at the barrel of a gun."