Personal Finance

The Danger Of Being Too Conservative

For out non-Canadian readers, GIC stands for Guaranteed Investment Certificate, and its pretty well the same as an American CD. You put the money in for a fixed length of time at a fixed interest rate, then at the end of the term, you get your money back plus the interest (or you can get the interest paid out over the term of the loan). They’re guaranteed by the government, so are a very safe, very conservative investment. They’re typically referred to a “fixed income”.

Most of my family and friends are VERY conservative investors. We’re talking GICs, Canada Savings Bonds and savings accounts conservative investors. My mom won’t touch mutual funds because they’re too volatile and she wouldn’t be able to weather the market fluctuations. While I’m certainly sympathetic to taking a conservative position with investments, there’s a price and a danger when this is how you invest.

The price you’ll pay is that your return is going to be about equal to inflation, so you’ll lose whatever you make.

If you were getting 5% on your GIC, it may seem pretty good until you take away 40% for taxes (this puts you down to 3%), then take 3% away for inflation (this puts you down to 0%). In real terms, you’re just preserving your capital. This isn’t unnecessarily a BAD idea (your capital is VERY safe), but the problem is that your money isn’t working for you. All your savings will simply be what you’ve earned and stashed away: it won’t grow.

But Mr. Cheap” you protest, “what about times when there are high interest rates, like when it was 12% back in the 80’s?” Well, back in the 80’s when we had high interest rates inflation was very high as well. What fixed-income giveth, inflation taketh away.

Inflation isn’t too big of a worry, since with high inflation, interest rates will go up, so if you set up laddering (where different GICs come due at different times), you’ll get pretty close to the average interest rate. What inflation taketh away, fixed-income giveth.

The real danger with this is simply that you won’t be able to save enough money to live off of in retirement. Compounding won’t be working for you, so even if you’ve been saving since a young age, it will be hard to accumulate enough to be comfortable in retirement. Of course, if you put the money into a RRSP, you won’t be taking the tax hit mentioned above, but at 2% compounding it’s going to be quite meager. This can work if you live well below your means, and save aggressively, but I think there are better options.

When you allow a little more volatility in an investment (give up the absolute guarantee of GICs), the market rewards investors richly for taking on this risk. If you earn the average nominal return on equities, 10%, you’ll lose 4% to taxes (40%), and 3% to inflation, leaving you with 3% to compound (7% if its in your RRSP). Certainly better than treading water.

Something like the couch potato portfolio is an easy way to set up a very diversified equities portfolio. You don’t have to put all your savings into it (start small, maybe with 10 or 20% of your savings until you get your sea legs). If you can set it up, re-balance once a year and ignore it the rest of the time, you’ll do fine. The danger is if there’s a correction and you’re tempted to sell and flee back to GICs (don’t do this!). It may be a good idea to keep your investment small until you have gone through a real dip to make sure you have the stomach for it. Over time you’ll see that you’re getting a lot more growth from the equities compared to your fixed income (the GICs) and hopefully will become comfortable with the idea of exchanging a bit of volatility for dramatically higher returns.


Investment Recommendations For Friends

Everyone always loves to say “do your own research before purchase”, “make sure to do your own due diligence” or “this is just for informational purposes, not to recommendation to buy or sell” and garbage like that. People are clearly reading investing opinion pieces because they can’t reach their own conclusions, and are prepared to defer to someone they feel is more knowledgeable. The disclaimer is just a cop-out to avoid blame if things hit the fan.

With that in mind, I’ve been happy to write about pretty much anything on this blog, and am equally open with thoughts and ideas about investing to my real life friends and family.

After reading about Lending Club, my best friend and I went 50/50 on a $500 investment. We discussed all the available loans, would send back and forth loan options to fund, and after we’d loaned out the $500, all the loans were doing very well. We’d originally planned to re-invest the proceed, but instead we borrowed more from Lending Club to re-invest (leveraging my friend’s great credit rating since I didn’t have any American credit at the time). Another $2500 in and we were collecting loan proceeds to pay off our debt (and Mr. Cheap was feeling like a tycoon).

Then our first “post Christmas” crash hit, a bunch of our loans went into delinquency, and eventually bankruptcy. Our money has broke even (with the high interest loans JUST covering those who have been defaulting), and our hope is to break even or at least have a bit of our originally $500 left when we pay off the loan we took out.

More recently, in the middle of the sub-prime shakedown, Washington Mutual was yielding over 10%. I talked to my friend about how I love dividend stocks, how stable banks are, and how much they value investors’ long term confidence in their ability to pay dividends. Trusting my judgement, my friend bought in to WaMu at over $30. The stock prompt started nose diving. Partly because I wanted to share her pain, and partly because I honestly thought it was unwarranted pessimism, I bought it myself at $21, buying on margin (which wasn’t terribly smart since I’m not working right now and will have a very low income when I’m back at school). Neither of us invested more than we could lose, but it really sucked when they started saying they’re going to cut their dividend by 2/3rds (I can forgive a low stock price, but if you cut your dividend you’re dead to Mr. Cheap).

Recently when I was talking to my friend I expressed my amazement that she’d still listen to me babble about money since the only thing I seem to be able to do is lose it for her. “Experience is a great teacher but she’s a costly one” rings in my mind, and more and more I see the wisdom of not providing specific financial advice to people you care about. Talking about the thoughts and philosophies are fine, but making specific recommendations just sucks if they don’t work out (and there’s always a risk they won’t).

Of course, do your own due diligence and acquire your own experiences before following any of my advice ;-). A wussy, garbage cop-out, but perhaps a wise one.