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.

8 replies on “The Danger Of Being Too Conservative”

Good post. In the investment & economic climate right now both fixed income and equity investment is going to make conservative investors uneasy. There’s a lot of volatility everywhere and all signs point to interest rates heading down even as inflation is creeping up, particularly in food & energy–the stuff we all use everyday.

There is risk with fixed income investing; it’s just different and not as apparently volatile as equity investing. As you point out, fixed income is affected primarily by interest rate fluctuations & inflation–this may not seem to be a big deal because you don’t notice but it can still run you over: more like a glacier than a Mack truck (equities). Next thing you know your capital is eroded just as much as if your holding of JNJ (Johnson & Johnson) took a hit. While the couch potato portfolio or a proxy of it using something like TD’s e-series funds (disclaimer: no affiliation with TD) is a good way to dip your toe into the market, I’ve learned that you have to know yourself when investing. If a person is comforted to see a GIC roll over and drop the amount invested plus interest in their lap (even though it no longer has the same buying power), then they’ll be awake nights everytime the stock market hiccups. Historically recessions last about 11 months, so if we’re in one now, look to next year for a recovery.

The impact of inflation & taxes on buying power is tough for some people to wrap their mind around–think that every dollar you spend is actually $1.50 (before taxes & inflation). That latte from Starbucks isn’t $3.00, it’s actually $4.50. If you have a $1,000 debt, it’s actually going to cost $1,500 of your gross earnings to pay off, before you even add in usurious interest penalties.

My wife is kind of like this. She wants GUARANTEED returns with NO risk. No matter how many times I have to repeat “no risk, no reward”, it doesn’t really sink in.

I’ve got her investments in Index funds which is about as risk tolerant as she gets.

I can understand those with less than 10 years until retirement being ultra-conservative in their investing. It would be hard to stomach working all those years to save, and suddenly see your nest egg drop 40% over a short time period. However, I know people in their early thirties who are just as conservative. To each his own I guess, but I want a “real” return on the money I invest, not just preservation of today’s spending power.

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