Why invest in stocks when I can get 5% “guaranteed”? | Science of Wealth

‍The original version of this article first appeared in The Business Times.

Dinner conversations have changed quite a bit this year. Friends that, two years ago, would not stop talking about hot stocks, coins, and NFTs, are now talking about the amazingly high “guaranteed” fixed deposit rates they are getting at their banks. 

Indeed fixed deposit rates are high - higher than they have been for a while - but just because they are high does that mean we should park our money accordingly? 

2023 year-to-date, global equities are up 18% (represented by the MSCI World Index in USD as of November 30, 2023). Those sitting in fixed deposits have been comfortable but have missed out, and history does not paint too different a picture.

How stocks have done during high interest rates in the past

When interest rates have been around or higher than 5% in the past, global equities consistently performed better by a significant margin. 

From 1973 to 1991, interest rates were above 5% and reached 15%, as the US battled with inflation in the teens, an oil embargo, and a great recession. In that time, stocks endured much volatility including Black Monday where US stocks dropped by over 20% in a single day. 

Yes, fixed deposits in this period would have shielded you from this volatility and earned you a healthy return. US Treasury Bills, an asset the market considers to be “risk free” and a good gauge for where fixed deposits would have been, returned 326%. Despite the high rates, you would have left a lot of money on the table with equities returning 579% in the same period.

History certainly does rhyme, and the same concept can be observed from 1995 to 2000, 2006 to 2007, and what we are experiencing in 2023.

To understand this phenomenon, we need to remember the fundamental mechanics of how markets work. 

The equity risk premium: why a portfolio of diversified stocks goes up relatively more than fixed deposits, with enough time

The risks associated with owning or benefiting from something is relative to everything else, and prices are determined on this basis. It applies to owning one car versus another, buying fruit from one stall versus another, or staying in one hotel versus another. 

The same concept applies to stocks, bonds and fixed deposits. When fixed deposits become more attractive with higher rates, stocks and bonds get beaten down to a price where their expected returns are still worthwhile relative to fixed deposits. The finance industry calls this re-rating, and we witnessed this during 2022 as interest rates were rising, and stocks and bonds went down to a price where the market believed they provided the appropriate relative higher expected returns.

If your investment goal has time before you need to use the money you are investing, patience to harvest the equity risk premium, discipline in staying diversified and managing your cost, and the stomach to tolerate more volatility, you will be rewarded. Since 1970, global equities went up over 9,000%, during which a risk free return went up just over 900%. 

When fixed deposits may make sense

Fixed deposits may have a place in your portfolio, but my opinion is that they should only be used for a clear goal in the short-term, and with money that can be locked up by your bank. 

For short-term goals or emergency money, you can also explore safe and smart cash management options like money market funds, which should have similar yields to fixed deposits, be more diversified, accrue interest daily, and be redeemable without penalty for many platforms. 

Foreigners and citizens should take advantage of SRS, and the long-term compounding of the equity risk premium

A gentle reminder that the deadline to top up your Supplementary Retirement Scheme (SRS) is around the corner. SRS is a gem that everyone should look into, helping all of us save for tomorrow, and save on tax today. 

Singaporeans & permanent residents can save up to $3,366 in taxes by contributing up to $15,300 to SRS.

Foreigners can save up to $7,854 in taxes, by contributing up to $35,700 to SRS. 

The deadline to contribute is December 31 for this tax year, and the beauty is that once you top up, you can take advantage of the equity risk premium to build your long-term savings well above what is “guaranteed”.