Richard Morin
Update :
15
April
2020
Update :
April 15, 2020
With the sudden drop in the stock market and the anxiety it is causing many investors, many financial institutions are currently focusing on their guaranteed investment certificates (GICs) or deposit bills that offer a return linked to that of the stock market (or a "reference portfolio" made up of blue chips or bank shares, for example), but with a guarantee that you will get your capital back at maturity. It's like having your cake and eating it too!
Obviously, the concept is very attractive, but do these products deliver on their promise? Is it an attractive investment?
No return without risk
In order to answer these questions, we must first recall certain cardinal rules of the financial markets, of which the most important is probably the following: there is no return without risk. Even those good old non-redeemable GICs are not risk-free. If you have to liquidate it before maturity, you risk losing the interest you've earned.
The reason that GICs that are linked to the performance of the stock market offer a higher return than regular GICs is that they also carry a higher risk. First, if you liquidate your investment before maturity and the markets fall, your loss would be even greater than the market decline. Even if you hold to maturity, you run the risk of receiving no interest on your investment. If the annual inflation is 2% over the 5 year term, you will have lost more than 10% of your purchasing power. Not exactly a recipe for a comfortable retirement.
So how much return can you expect from stock market-linked GICs, and does the principal guarantee they offer really help?
It's all in the details
Another cardinal rule of investing is that you shouldn't invest in a product you don't understand. Well, frankly, some of these GICs are so complex that it's hard to understand them without a financial background! Complex or not though, they all share certain characteristics that are important to know.
The first important detail is that these products do not offer the return of the stock market but rather a return "linked" to the stock market. What does this mean? First of all, the return on these GICs is generally linked to the evolution of stock prices, but excludes dividends. This is a fundamental difference since dividends and their reinvestment typically make up more than 40% of the stock market return over a 5-year period. Over 20 years, 60% of the return comes from dividends (the result of compounding).
If, like most investors, you have an investment horizon of more than 5 years, you are sacrificing 40% to 60% of your potential return. In addition, the return on these GICs is generally capped. That's a lot of lost return to enjoy the capital guarantee that these GICs offer.
Incidentally, what is this "guarantee" worth?
Maturity guarantee only
Another important detail is that these GICs only guarantee the principal at maturity. What happens if you need money and want to withdraw your principal before maturity? The issuing institution will generally agree to redeem the GIC at a price that it determines in its sole discretion based on market conditions. This price will, however, be less than the value of the reference portfolio (this is explained in detail in the disclosure documents for these GICs which, unfortunately, no one reads). In other words, if you have to liquidate due to a market downturn, not only will you not receive your original principal, but your loss could be greater than if you were to invest in the stock market.
Unnecessary protection
If you're saving for retirement, your investment horizon - the period of time you'll hold stocks and bonds in your portfolio - is several decades. In fact, even if you're 75 years old and you're gradually depleting your capital, your investment horizon is still 20 years since your life expectancy is over 95 years! What matters to you is that the stocks and bonds in your portfolio continue to pay dividends and interest and that the value of your assets grows over the long term (and the long term is 10 or 20 years, not 3 to 5 years). Short-term fluctuations don't affect you. On the contrary, they are excellent opportunities to buy stocks at a discount.
What are the chances that the value of a balanced portfolio of stocks and bonds will decline over a long period of time, say 10 years or more? The answer is simple: it has never happened in the modern history of financial markets! Even the unluckiest investor - who invested just before the crash of 1929 - still made an annual return of 1.80% over the next 10 years[2] with his balanced portfolio. The only 2 episodes of negative returns over 5 years occurred during the Great Depression of the 1930s.
It's going to be okay
Despite the decline in the stock market, the balanced portfolio has posted an annual return of nearly 3.5% over the past five years. In comparison, the GIC linked to a balanced portfolio of a large financial institution has returned only 0.8% over the same period. For an initial investment of $10,000, the balanced portfolio would be worth $11,840 today, while the GIC would be worth only $10,400. For the next 5 years, the difference could be even greater since stocks are currently less expensive.
Your financial advisor has structured your portfolio to help you achieve your long-term goals, despite market fluctuations such as the one we are currently experiencing. The investment policy you have agreed upon is your "strategic plan". Stick to this plan and you can achieve your financial goals. If you give in to the marketing of financial institutions and take refuge in GICs (market-linked or not) during stormy times, you will inevitably miss the upswing that will bring your capital back to its original level.
Your diversified portfolio of stocks and bonds is the best way to preserve and grow your capital. Don't worry, you'll be fine.
[1] Advisor Perspective, Dividends' True Contribution to Total Return May Surprise You, March 2016
2] Portfolio composed of 60% S&P500 index and 40% long term US government bonds
3] Continuous periods of 5, 10 and 20 years respectively