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Owning Stocks In Retirement Is Not As Risky As Some People Think

03/18/2016 05:19 EDT | Updated 03/19/2017 05:12 EDT
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Conventional wisdom dictates that owning stocks when you're retired is risky, but not owning stocks in retirement is significantly riskier.

Let's first examine this "conventional" wisdom.

According to supposed investment oracles, when you're 30 years old you should have 30 per cent of your investment portfolio in fixed income investments and 70 per cent in equity investments. When you're 70 years old you should have 70 per cent of your investments in fixed income and 30 per cent in equities. Why?

What I say is that investing in any fixed income investment, be it a term deposit or bond, is a strategy doomed to fail; here's why:

If you're retired and living off the interest you receive from your fixed income investments (regardless of what the interest rate is), your capital is dropping in value every day. This drop in value is not noticeable on your statement, but is certainly noticeable when spending your money.

Consider this example: you take $10,000 and buy a term deposit that pays three per cent. Each year, you spend the interest you earned ($300). Each month your statement tells you that you own a $10,000 term deposit. Now comes the question: how much money have you lost on your investment?

People with a wider view of the world will say the loss would be equal to the rate of inflation over the period of the investment. If the inflation rate is three per cent per year, then the loss of purchasing power is $300. So, even though you received $300 in interest (which you spent), the actual value of your initial $10,000 investment has dropped in value by $300.

Protecting your purchasing power is more important in retirement than protecting your capital. With "debt" investing (buying term deposits and bonds), it's impossible to do that.

Let's forget for a moment what everybody says and talk about probability. I'm going to give you two scenarios and you tell me which is a riskier strategy.

Suppose you have $100,000 in your RRIF (Registered Retirement Income Fund) and you're 73 years old. Your current minimum withdrawal amount is 5.53 per cent. If you invest in a five-year non-redeemable term deposit, the going interest rate is about 2.35 per cent. To make up the difference between your minimum withdrawal amount and the interest you're going to receive, you have to withdraw capital. So let's set up your portfolio so that you use $80,000 to buy the term deposit (that would generate $80,000 x 2.35 per cent = $1,880) while the other $20,000 remains in a savings account maybe earning 1.5 per cent (that would generate $20,000 x 1.5% = $300).

In this scenario you're required to withdraw $5,530 ($100,000 x 5.53 per cent) in the current year. Based on this safe investment strategy, the income generated is $2,180 ($1,880 + $300). In order to meet your minimum withdrawal requirement, you would have to withdraw $3,350 of capital, leaving you with $96,650 in your RRIF at the end of the year.

Now, before we go on to scenario #2, what would you really have available in your RRIF if inflation was two per cent? The answer (relative to purchasing power) would be $94,717. Even though your investment statement would say you still had $96,650 in your RRIF account, inflation would have reduced the purchasing power by $1,933, leaving you with $94,717.

In scenario two, we will take the same $100,000 and invest $80,000 in the stock market and leave $20,000 in cash. For simplicity, I'm only going to invest in one stock -- let's use Royal Bank common shares.

The current dividend yield on Royal Bank common shares is 4.3 per cent. Leaving the $20,000 in cash would generate the same $300 in interest and, when added to the dividends of $3,440 ($80,000 x 4.3 per cent), would equal $3,740 of cash flow. This would require you to withdraw only $2,090 of capital.

So if we assume the same two per cent inflation at the end of the first year, how much would the purchasing power of your portfolio be? The answer is we don't know, because it depends on the value of the Royal Bank common shares.

Obviously, so far, it looks like the term deposits are the safest investment method, but let's talk about what really matters -- probability. Pay attention to this question: what is the probability that after one year your term deposit is going to increase in value (remember you're spending the interest, so don't include that)? The answer is, of course, zero. As a matter of fact, due to inflation, the purchasing power has eroded.

Now, what would you say is the probability that the Royal Bank common shares will be worth more one year from now? Would it be five per cent? 25 per cent? Regardless of what you say, you can't say it's zero.

How about five years from now? What are the chances that Royal Bank common shares will be worth more than today? 10 years out? You can probably see where this is going. If you have a number of common shares that are generating dividends, probability says that those investments will increase in value over time as long as you're invested in sustainable businesses and you're in no rush to sell.

Now, naysayers will tell you that dividends are not guaranteed and that common shares can fall to nothing -- both are true; however, I'm talking about probability. If you're retired and may live for five -- 40 years, why would you willingly agree to invest all (or most) of your money using an investment strategy that is guaranteed to fail?

Regardless of how risky you think the stock market is, probability tells us that Royal Bank will probably not stop paying dividends and that five years from now Royal Bank common shares will likely be worth more. Neither dividends nor future values are guaranteed but, unlike term deposits (and bonds), at least well-chosen common shares of publicly traded companies are not 100 per cent guaranteed to fail.

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