Earlier this month, I wrote two articles on opportunity costs (see here and here). This article will be a continuation of the topic. I will be focusing on the effects of compounding, and how it effects our risk appetite.
Let’s consider two common asset classes that retail investors can easily access in Singapore: equities and bonds. Historically, equities have outperformed bonds over the long run, which is defined as a period of 10 years or more. For the sake of convenience, let us assume the following returns for equities and bonds over a 10-year period:
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1) Equities: Compound annual growth rate (CAGR) of 7%
2) Bonds: CAGR of 2%
Let us now consider investing $10,000 across three different holding periods:
It is clear that equities gives the highest return. Now what is wrong with the table above? Given our assumptions, we should solely invest in equities across different holding periods, but that is not what most of us (or any of us) do in real life.
Let us complete the picture by looking at three graphs across different time periods for a particular equity index.
You can probably guess that the top most graph shows the index’s movement across one year, the middle for five years, and the bottom for 10 years.
Over a one-year period, equities have an average return of $700 relative to $200 from bonds (assuming that $10,000 was invested). Yet the actual equity return can differ widely depending on when you bought and sold your stock. The opportunity cost of investing in an equity over a bond in a year is not measured solely by the $500 difference in returns – it also involves taking on the risk of a very volatile investment (stocks) compared to a risk-free bond. If I have a sum of money that I know for sure I’ll need in one year’s time, it is unlikely for me to risk investing it in stocks relative to a bond just to earn an extra $500.
Now what if I know I’ll need my money only after 10 years? The difference in return between equities and bonds has now widened to $7,500 for a $10,000 investment. Moreover, the price volatility for a 10-year holding period for stocks decreases significantly compared to a holding period of one-year. If I am investing with a time horizon of 10 years or more, I would very much prefer to bear the equity-risk to make an extra $7,500 compared to bonds.
What I’ve shared above illustrates perfectly how the opportunity cost of picking risk-free assets is compounded over the long run. Over a long time horizon, most investors should have a bigger risk appetite since they are able to ride out short term price volatility.
Perhaps another way of looking at this is a popular investment close to many Singaporeans’ hearts – buying your own property. It involves a 20-year to 30-year mortgage, and is a huge financial undertaking. Most Singaporeans do not look at buying a property and selling it within a year. With investing in stocks, the lesson stays the same.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.