|The risks of 'risk-free' investments
Wednesday January 25, 2012
A new RRSP season is upon us, and before long we will get inundated
with advertisements telling us to invest in GICs or park our
money in money market funds as an antidote to recent market
volatility and a decade or so of muted returns from equity markets.
We will read (and hear) more about negative news from the U.S.
and Europe as they attempt to re-start the economic growth machine.
It would be very tempting to “go safe” and put new money into
these so called risk-free investments. But are they really all
that risk free?
Much has been said and written about the many risks of equity
investing, and most are true. Most equity investments, regardless
of geographica area, have not performed well in the last decade,
but is that a good enough reason to ditch them or not consider
them this year? I personally don’t think so.
I am a firm believer in the line of thinking (which history
proves over and over) that equities perform better than fixed
income over time. We need fixed income in our portfolios for
a smoother ride and to avoid the 35% to 40% corrections that
hurt from both the monetary and psychological aspect. No matter
how well you understand long-term investing and volatility,
a 40% haircut hurts and takes time to recover from.
My feeling is that we know the last decade has been rough for
equity investors (with exceptions in certain sectors like precious
metals and resources). We know the prices are low because of
this. We know that sectors that perform poorly in one time period
are often the best performers over the next time period.
Putting what we know together tells me that it is still vitally
important to buy equities. They are priced well, and we are
living longer than ever, which means we need more than the returns
offered by GICs from our money. Living longer can be great,
but it means you need more money or need to get better returns
from your nest egg.
GIC/money market risks
When equities perform poorly, some investors move to “safe”
investments like GICs and don’t think there are any risks by
making that decision. But there are in fact some risks associated
with GICs and money market funds.
Opportunity risk. What else could your money
be doing? The GIC is safe, but also has no potential to do well.
We never know when stock markets will take off.
Inflation risk. About half of the time from
1982 to 2008, after 40% marginal tax rate and inflation, GICs
lost money. To me that is pretty risky. We can’t ignore taxes
and inflation, because they are part of investment reality.
Sometimes a very big part, if you have a high income and are
in a high tax bracket.
Incidentally, over that same 26-year period, the return on
the S&P/TSX Composite Index was between three and four times
higher than the return on risk-free investments.
I do believe GICs and money market funds have a place in one’s
portfolio. They can be used for short-term purchases, emergency
funds, and holidays. They can be used for tactical investment
decisions. They can be used to save for something like a house,
where you don’t want to risk losing 25% a year or more of your
capital before you make the purchase.
For potentially better investment performance, there are many
other fixed-income vehicles that let you slide up the risk scale
a bit to target returns that are likely to be better than the
“risk-free” variety. Ask your financial advisor to lay out a
few options before settling for the riskiness of risk-free returns.
Generic Mutual Fund Disclaimer
Commissions, trailing commissions, management fees and expenses
all may be associated with mutual fund investments. Please read the
simplified prospectus before investing. Mutual funds are not
guaranteed and are not covered by the Canada Deposit Insurance
Corporation or by any other government deposit insurer. There can be
no assurances that the fund will be able to maintain its net asset
value per security at a constant amount or that the full amount of
your investment in the fund will be returned to you. Fund values
change frequently and past performance may not be repeated.
Personal Opinions & Recommendations Disclaimer
The foregoing is for general information purposes only and is the
opinion of the writer. This information is not intended to provide
specific personalized advice including, without limitation,
investment, financial, legal, accounting or tax advice. However,
please call the author to discuss your particular circumstances.