Jordan has agreed to help out the crack writing staff here at Four Pillars by contributing the occasional post. He is a young guy living and working from home in Vancouver with his wife and 2 young kids. Jordan is a computer geek at heart and last year discovered he also had a hidden passion for personal finance with the goal of “early financial retirement”. He will write about various financial ideas and situations that he comes across and share resources and useful tools.
When is it ok to invest your house down payment in the stock market? I’ve always understood that a house down payment shouldn’t be invested in the stock market. Actually the rule probably is if the time horizon of your money is less than 5 years, it shouldn’t be in the stock market. In fact if someone asked me for my advice I would say exactly the same thing. But I wanted to explore and research the idea for myself, so here is a new page in the Amateur Investor’s Manifesto.
Stock markets are volatile
The logic behind this rule is that the stock market is very volatile over short periods of time. As we clearly saw last year someone fully invested in the market could have easily lost 50%. Over the long term it’s much easier to predict a positive outcome. As you’ll often hear – “the market always goes up” and “there has never been a 10 year period on the S&P 500 that went down”. Unfortunately after last year that is no longer true.
So the alternative is to invest in a GIC or high interest savings account which is protected up to $100,000 per account / per bank or $200,000 for couples. The chance of a bank failure seems extremely low in Canada, the more real risk is high inflation eating away your money’s buying power.
Adding equities to your house down payment
What about a short term diversified portfolio? Shouldn’t it be possible to increase the return by taking on a small amount of risk? Let’s see what would have happened to an 80% GIC / 20% stock portfolio that’s invested for just one year. The asset allocation is the ultra conservative portfolio recommended in “The Smartest Investment Book You’ll Ever Read”. In my test scenarios I’ll be using a $100,000 down payment.
* 80% / $80,000 ING Direct 1 Year GIC
* 10% / $10,000 iShares S&P 500 Index (XSP)
* 8% / $8,000 iShares MSCI EAFE Index (XIN)
* 2% / $2,000 iShares Canadian Index (XIC)
·
|
Year |
GIC |
Stocks |
Inflation |
80/20 Return |
80/20 Result |
Safe Return |
Safe Result |
Diff |
|
2008 |
4.10% |
-37.50% |
-2.00% |
(6,220) |
93,780 |
2,100 |
102,100 |
-8.1% |
|
2007 |
3.50% |
4.00% |
-1.97% |
1,630 |
101,630 |
1,530 |
101,530 |
0.1% |
|
2006 |
2.75% |
14.90% |
-2.47% |
2,710 |
102,710 |
280 |
100,280 |
2.4% |
|
2005 |
2.50% |
9.10% |
-1.39% |
2,430 |
102,430 |
1,110 |
101,110 |
1.3% |
|
2004 |
2.50% |
6.30% |
-1.99% |
1,270 |
101,270 |
510 |
100,510 |
0.8% |
|
2003 |
2.75% |
7.60% |
-2.42% |
1,300 |
101,300 |
330 |
100,330 |
1.0% |
|
2002 |
2.75% |
-21.80% |
-1.58% |
(3,740) |
96,260 |
1,170 |
101,170 |
-4.9% |
Inflation is the Core CPI from the Bank of Canada which actually excludes inflation of housing prices, but it does show the buying power of your savings goes down over time.
I wasn’t able to look up the GIC rates for 2002-2006 so I used ING’s historic high interest savings account rate for the beginning of each year which is usually just a bit lower then a GIC.
Oout of the 7 years tested the worst result was underperformance of $8,320, or 8.1%. The best result was $2,430 of overperformance in 2006. So a slight loss isn’t much fun but not the end of the world. The gains aren’t huge, but they do help a bit. I think with careful consideration to exactly what your goal is and your risk tolerance it is possible to invest for short term goals because on average the market goes up.
Dealing with a short fall
You basically have 4 options if you come up short, which is very likely for short term investing:
- You will need to adjust your goal such as delaying when you buy a house or looking for a lower cost house.
- Make up the short fall with income cash flow by redirecting savings before the absolute last moment possible or paying for expenses (ie tuition) as they come up
- Borrowing the short fall from another savings account such as a non-RRSP retirement account.
- Borrow more money on the mortgage or open up a line of credit.
Can you fully invest your down payment in the stock market?
Yes, in certain situations I believe so. If you have enough savings outside of your short term savings goal to replenish it if there is a catastrophic loss then you should be able to be fully invested. If you realize the worst annual return possible is -50%, and your short term goal is $100,000 then you need to have an additional 52% ($52,000) in guaranteed savings to cover the loss & estimated inflation. If that other money is also fully invested then you would need to have 104% more ($104,000). This will help you ensure you would end up with $100,000 after a 50% drop.
It definitely wouldn’t be much fun seeing $100,000 of retirement savings vanish just so you could afford your $100,000 down payment, but it’s not really any more risky if you would have been fully invested anyways. The flip side is if you are lucky and there is a bull market, you will either have a larger down payment or you can add the extra money into your already larger retirement account. If you had been invested in 2006 you would have had your $100,000 down payment and your retirement account would have risen to $124,860 (+24%) instead of $112,430.
It’s worth repeating: I would still not recommend investing a house down payment in the stock market. It’s just not a good idea for most people. If you do decide to do it then: know your risks, be conservative, make sure you can fully cover a short fall and hang on for a bumpy ride.