A big part of investing is balancing the main trade-offs of risk versus return.
In general, investments that carry more risk of loss tend to give you higher returns. Usually, this includes equities like stocks and mutual funds.
Whereas fixed-income investments, like bonds and Guaranteed Investment Certificates (GICs), tend to preserve your capital but offer lower returns.
Most types of securities can be held in a variety of accounts, from registered retirement savings plans (RRSPs) to tax-free savings accounts (TFSAs), among other types of accounts.
Most financial advisors suggest holding a mix of assets in different ratios, depending on your age and savings goals. Especially during these uncertain times, investing in fixed-income securities can give you some peace of mind by smoothing out the risk in your savings plan.
What are GICs?
Within the lower-risk category of fixed-income investments, there are still differences in the amount of risk you are taking on. Generally, GICs are considered to be a safe option because your initial investment is secure. You lend your money to a financial institution and agree to invest your funds for a specific amount of time in exchange for interest payments.
GICs have a set term – the amount of time you must hold them without cashing out – with a set interest rate for that time. Terms can be as short as a month or as long as 10 years and you are guaranteed your principal – the money you put in – as long as the institution doesn’t default and is a member of the Canada Deposit Insurance Corporation.
Besides adding a lower-risk component to your portfolio, GICs can also be a safe way to save money for a shorter-term goal than retirement, such as a wedding, a car or a down payment for a home.
Are GIC’s truly risk-free investments?
While your principal is generally guaranteed, there are a few things to consider with GICs:
Because you buy a GIC for a specified amount of time, you may be stuck if you suddenly need the money, say for an emergency expense or income after an unexpected job loss.
With interest rates low, you risk your returns being lower than inflation (the amount you can buy in future dollars being less than in current-day dollars). While this is a low risk in Canada right now, the Bank of Canada does expect inflation to return eventually to its target 2% as the economy recovers.
Interest earned on GICs is fully taxable at your marginal tax rate. You can lessen your tax burden by holding GICs inside your TFSA or RRSP.
Investing in GICs during COVID
Of course, the COVID-19 pandemic has thrown a wrench into the investing climate in several ways.
With businesses shut down, unemployed consumers spending less, and the global nature of the pandemic affecting our exports, the country’s economy has entered a recession (when a country’s economy declines for more than two fiscal quarters). With no clear end in sight to the pandemic, many economists predict a bumpy recovery to pre-COVID levels.
The stock markets
While you would expect stock markets to mirror the sliding economy, markets have been bouncing all over the place, plunging in March, then rebounding, then dropping again with fears of a second wave of infections. This means high volatility or high risk for those investing in equities. For instance, the CBOE Volatility Index (VIX) — a measure of expected volatility on the S&P 500 — spiked last month amidst the COVID-19 cases in the United States.
On the other hand, central banks have been keeping interest rates low to encourage businesses and individuals to spend. Canada’s central bank is keeping its benchmark interest rate at 0.25%. Interest rates are likely to stay low for the foreseeable future. The effect of low interest rates on fixed-income investments like bonds and GICs is that you get a low return on your investment.
So what to do?
Most advisors caution against both panicking and trying to time the market. If you are worried about markets dropping and sell your stocks, you will be locking in losses. If you believe stocks are going to rise and load up your portfolio with them and the market ends up dropping, you can also see nerve-jangling losses.
So, stick to a longer-outlook, balanced savings strategy, with some of your money in higher-return equities and some in safer fixed-income products. A commonly cited rule of thumb is to hold a percentage of stocks equal to 100 (or 110 to account for longer average lifespans) minus your age. So, for a typical 60-year-old, 40% of their holdings could be equities – preferably diversified, low-cost, quality balanced or conservative funds or stocks – and the rest would be in safer assets, such as GICs.
You may also use GICs to buy stocks or equity funds if the market dips when your GIC comes due, paying less to own a greater number of shares or fund units.
But one of the drawbacks of GICs is having to hold them until they come due, which results in potential problems, such as:
- If you need the money, you may be forced to cash it in early, potentially losing all interest earned up to that point.
- If interest rates rise, you are locked in at a lower rate until the GIC matures.
- If rates fall, when your GIC comes due and if you want to invest in another GIC, you will renew all your money at a lower rate.
A strategy to maximize your GIC returns without locking in all of your money for a longer-term is to ladder, or stagger, the amount of money you want to invest across different time frames. This also helps reduce the influence of interest rate changes on the investment.
How to build a GIC ladder
There are many types of GICs from fixed-rate to variable-rate, which carry terms from one year to upwards of 10 years. Usually, the longer the term, the higher the interest rate.
These details allow you to build a GIC laddering strategy.
How to ladder:
- Decide how much you want to invest in GICs.
- Divide the amount into the number of individual investments you want to make into different time frames, for example, one to five years.
- Look for the best rate.
- Reinvest each investment into 5-year GICs as your original investment comes due.
Let’s say you had a total investment of $10,000. Dividing this by five gives you five investments of $2,000.
Here is an example of how laddering might work, with assumed interest rates (your situation may be different).
Amounts are reinvested with interest earned at maturity, using the Royal Bank of Canada’s GIC laddering calculator:
Balancing risk versus returns
If you are concerned about market volatility but worried about low interest rates on safer fixed-income products, a diversified approach to your investments can give you some peace of mind. If you use GICs as part of your fixed-income assets, consider a laddering strategy to maximize interest rates and also the flexibility to be able to withdraw money when you need it.