Do not listen to the Siren Song of short-term guarantees. In the realm of investments and financial decisions, the age-old debate between short-term guaranteed returns and long-term potential returns is perennial. The promise of secure gains tempts many individuals, but in this episode, we will explore why choosing long-term potential returns over short-term guarantees may be the wiser choice.
Short-Term Guaranteed Returns: A Tempting Proposition
Short-term guaranteed returns are like a siren’s song for investors. They offer the allure of immediate profits and a sense of security that can be hard to resist. However, there are essential factors to consider when opting for short-term gains at the expense of long-term potential returns.
The main drawback of short-term guaranteed returns is that they often provide limited room for growth. These investments may offer consistent but modest profits, which can fail to keep pace with inflation and increasing living expenses. Over time, the real value of these returns may decline, leading to a gradual erosion of your purchasing power.
By favoring short-term guarantees, investors may overlook opportunities that offer significantly higher long-term potential returns. Many successful investments require time to mature, and the best chances for substantial gains may require riding out short-term market fluctuations. If your money is tied up in CDs or annuities, you may be unable to capitalize on better opportunities.
Long-Term Potential Returns: The Road Less Traveled
Choosing to invest for long-term potential returns may require patience, a higher tolerance for volatility, and a willingness to weather market ups and downs. However, the benefits can be significant and far-reaching.
Higher Growth Potential
Long-term investments in equities—co-ownership of the best businesses in the world—will provide more substantial growth potential over time. While they may experience short-term volatility, they historically yield higher returns when held for extended periods.
By allowing your investments to grow over the long term, you can accumulate wealth that surpasses what is achievable with short-term guaranteed returns. This accumulation can help secure your financial future, fund major life goals, and provide a comfortable retirement.
2023: A Case Study
The value of the S&P 500, a collection of the 500 largest U.S. companies of which you can be co-owners, peaked at the end of 2021 at about 4,800. Then we had 2022.
What Happened in 2022-2023?
Rising interest rates, the logical and effective chemotherapy to the cancer of inflation, coupled with Russia’s invasion of Ukraine, caused many to flee to the “safety” of cash and new CDs. The reduced demand for equity ownership in the best businesses in the world caused their value to fall temporarily.
The value of the S&P 500 declined from 4,800 to just under 3,500 for a moment on October 13th, 2022. This was about a 25% decline in 10 months. A routine bear market. It’s been climbing back up through 2023 with fits and starts.
Meanwhile, the Fed raised interest rates consistently from the spring of 2022 and finally eased off in the fall of 2023. It’s now commonplace to find CDs and even Money Market funds giving 5.25% interest.
The Siren Song of 5% Interest
Far too many people are getting seduced by 5% guaranteed interest. I’m not talking about short-term money for short-term expenditures, like an emergency fund or saving for that down payment next year. People are taking their long-term wealth- and retirement-building money out of the market in favor of 5% guarantees.
Is that the best place to build wealth? Even over the next few years? If you think so, consider this.
Decline Vs. Recovery
As I’m writing this (a few weeks before it aires), the value of the S&P 500 was 13% down from its all-time high. That means it will take a 15% gain to recover. How’s that? We covered it in Episode 67, Bear Markets Aren’t Bad, but here’s a refresh.
If $100 declines 13% in value, you have $87. If you get 13% back, that’s only $11, and you get $98. Thus, it takes a 15% recovery to get back to $100.
People often lament that it takes a larger recovery to make up for a decline. For example:
- It takes a 25% gain to make up for a 20% decline.
- It takes a 33% gain to make up for a 25% decline.
- It takes a 43% gain to make up for a 30% decline.
And while we may lament it at the top, once we have experienced the decline, the recovery is actually a beautiful thing! Now that we are already 13% down, it means we will get not just a 13% recovery but a 15% one. That’s 2% extra!
Do The Math
When, not if, the S&P 500 recovers, those who were co-owners of those profitable companies will see a 15% increase in the value of their shares.
If you invest in 5% CDs, it will take you three years to earn 15%. You would only choose this because you believe it will take the S&P 500 longer than three years to recover.
Will it? Who knows. The longest bear market was the Global Financial Crisis of 2007-2012. That was about five years from peak to trough to recovered peak (shorter if you reinvested dividends).
We are nearly two years into this current bear market. Do you think our current situation is as bad as the Great Recession? If you do, you either watch too much news or don’t get my quarterly update by email or magazine.
I don’t know when it will recover. Neither does anyone else. But I doubt it will take that long. At least, I wouldn’t bet on it.
“But Freeman,” you might say, “Interest compounds. So a 5.25% CD compounded over three years will give more than 15%.”
Indeed. If it compounds monthly, it will come out to about 17%. And the best businesses in the world pay dividends. So, you must add 1.5-2% to your annual return in the S&P 500.
If it does take three years for the price of the S&P 500 to recover, you’ll need to add another 4-6% on that, resulting in 19-21% total return in the S&P vs. 17% in CDs.
And there is a chance that the value of equities will recover in the next two years. If that happens, you will get a 7.5% average annual price return (plus dividends of 1.5-2%, resulting in a 9%+ annualized return).
There’s also a chance it will recover in the next 12 months. If that happens, you will get a 15% annual price return, 16%+ with dividends.
Yes, you can listen to the Siren Song of guaranteed interest rates. You can invest in CDs and get 5% returns.
Or you could be a co-owner of the best businesses in the world. In doing so, you may get the same return over the next three years. This assumes this bear market would be as long as the Global Financial Crisis.
Of course, you may get twice the return of CDs over the next two years. Or you may get thrice the return over the next 12 months.
Which do you choose if your time horizon is there years? A guaranteed 5% average annual return? Or a variable 5-17%?
While the temptation of guaranteed returns may be alluring, choosing potential returns is often the more rewarding and financially sound strategy. By focusing on investments that have the capacity to grow significantly, you can achieve higher financial stability, build substantial wealth, and achieve your long-term financial goals. Check with your Fee-only Fiduciary Certified Financial Planner for recommendations on your specific plan.