Risk, Return and Moral Hazard

Reuters reported on Tuesday that the Bank of Montreal (BMO) missed their profit target in the third quarter due to reduced trading revenue. (Click here for article). Banks earn revenue from the interest spread between deposits and loans, fees, advisory services, trading revenue and investment banking.

Today in the Globe and Mail, Murray Leith, vice president and director of research at Odlum Brown Ltd. tries to convince investors that they should get out of their bond holdings and return to equity investments. (Click here for article). Mr. Leith's argument is:

“With Canadian 10-year government bonds and high-quality corporate bonds currently yielding less than 3 per cent and 4 per cent respectively, it’s a mathematical certainty that the average Canadian bond fund will not achieve a compound annual return of 5 per cent over the next 10 years.”

It's hard to argue this point. A drop in interest rates below the current 0.75 percent overnight rate would be required. Not impossible, but highly unlikely. Mr. Leith's next point is also not debatable:

"The returns for stocks, on the other hand, should be much higher in the next decade than they were over the previous 10 years."

Notice the choice of words in the two quotes. When talking about bonds, Mr. Leitch uses "will not" but when discussing equities, he says "should be". The first implies certainty, the second implies risk. A 4% Government bond held to maturity is guaranteed to pay 4% annually. A share in any company over the same time period has an uncertain return. Most investors are not stupid, they are risk averse, prefering a guaranteed rate of return to a risky one.

Bonds trade in the OTC market where prices are not transparent. Most individual investors do not "trade" bonds, they buy and hold. Firms like BMO and Odlum Brown earn income by trading securities on behalf of their clients. The commissions on bonds are very small and are only earned once if held to maturity. Commissions on stocks can be up to 2% to buy and 2% to sell.

We do not mean to imply that investors should not hold equities, but they should do so as part of a well balanced portfolio designed by a qualified advisor, preferably a fee-based one, and fully understand the risk and return associated with the portfolio. There is a moral hazard problem with commission based advisors. They must sell you something to get paid.