“The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation,” said Vladimir Lenin. Given the turmoil of the stock markets in the past year, we should apply some basic principles to our retirement planning if we want to avoid Lenin’s trap. Retirement planning is complex because of the number of unknowns – years to retirement, life expectancy, rates of inflation, rates of after-tax return, health, and desired lifestyle. How do we balance our portfolios to account for these factors?
Conventional financial wisdom is that commodities are riskier than stocks; stocks are riskier than bonds; and bonds are riskier than fixed term deposits. Reliable studies, however, show that over a long period – for example, 30 years – stocks are no riskier than bonds and have a much higher real rate of return.
The probability of negative returns decreases over time regardless of the asset mix of the particular portfolio. Indeed, the probability of negative return for all classes of assets falls to zero over ten years. For the long-term portion of our portfolio, it may be entirely prudent to put a substantial portion of investments into stocks in order to earn the higher rates of return.
There are other factors to consider in retirement planning: inflation, tax rates, and tax deferral. Inflation eats into real investment returns. Some secure asset classes – such as government bonds, GICs, and Treasury bills – lose value over time, and the tax bite is immediate.
The tax bite for each class of assets also varies considerably. For example, the tax rate on interest income is about 46 per cent versus only 23 per cent on capital gains. Assuming inflation of 3 per cent, a bond paying 5 per cent interest has a return of minus .3 per cent annually.
To be sure, inflation erodes nominal investment returns and taxes reduce our income. However, as we learned in 2007, one must be able to withstand the fluctuations of equity investments in the short term. Academic studies showing long-term measures of risk for stocks, bonds, and commodities do not help if you cannot sleep at night. But to elude Lenin’s trap, we need to plan for the long-term.
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