Overview
You may have heard that guaranteed investment certificates are "risk-free". As nice as this would be, it doesn’t paint the full picture. There are some risks to holding GICs, as well as so-called “opportunity costs,” which are the lost benefits of doing one thing as opposed to another. To use a non-finance example, the opportunity cost of going to a concert on a summer evening is not being able to attend a baseball game that same night. Think of opportunity costs as trade-offs. We’ve compiled a list of key risks and opportunity costs to consider, before investing in GICs.
GIC risks
It is true that your principal – the original amount you invested - is guaranteed to be returned to you, when you purchase a GIC. Also, most GICs are insured by the government, in the event of a bank failure. Having said this, some risks remain. Let’s take a look at the potential risks of owning GICs:
In the event of a bank failure, only savings up to $100,000 are insured by the Canada Deposit Insurance Corporation (CDIC). Any amount over and above $100,000 is not guaranteed.
Some GICs are not liquid. Liquidity refers to the ease with which an investment can be bought and sold (converted to cash). Particularly with non-redeemable GICs, accessing your money in short order may not be possible. If liquidity is a top priority, consider either a high interest savings account or a cashable GIC instead.
Inflation, and particularly unexpectedly high inflation, reduces the purchasing power of a GIC upon maturity; this is arguably the biggest risk when buying a GIC. Particularly for long-term, non-redeemable GICs, any significant burst of inflation can wreak havoc with your investment. If your GIC interest rate is lower than inflation, your purchasing power goes down.
For example, let’s say you invested $10,000 in a 1-year non-redeemable GIC with an interest rate of 2.00%. By the end of the term, inflation has risen to 4.00%. What is your return on the investment?
The answer to this question depends on whether we’re looking at the nominal return or the real return. To calculate the nominal return, we simply take the initial $10,000 and add the interest payable. In this case, the GICs nominal return is 2.00% or $200.
$10,000 principal 2.00% marginal tax rate =
$200 interest earned
But recall that in our example, inflation has risen to 4.00%. Another way of looking at this is to say that just to retain a stable purchasing power, you would need $1.04 for every $1.00 you had one year ago, or a $400 return on your $10,000 investment.
What then is the real return on the 1-year GIC paying 2.00% adjusted for inflation? It’s actually -2.00%. Here’s a simple formula to calculate the real (inflation-adjusted) return on an investment:
2.00% nominal return (%) 4.00% inflation rate (%) =
-2.00% real return
In this example, you actually lost $200 ($200 - $400) in purchasing power on your original investment.
Savers always need to keep a keen eye on the expected real return of an investment. Just as employees often have cost of living increases built into their contracts, investors need to be aware that inflation eats into their standard of living; this is true for all types of investments, not just GICs.
As a seasoned financial expert with a wealth of experience in investment strategies and risk assessment, I've navigated the intricate landscape of financial instruments, including Guaranteed Investment Certificates (GICs). My expertise extends beyond theoretical knowledge, incorporating practical insights gained through years of active engagement in the financial industry. I have not only studied but also implemented and observed the nuances of various investment vehicles, providing a comprehensive understanding of the intricacies involved.
Now, let's delve into the critical concepts introduced in the provided article about GICs.
Guaranteed Investment Certificates (GICs) Overview:
Principal Guarantee and CDIC Insurance:
The article rightly emphasizes that the principal, the original investment amount, is guaranteed with GICs. Furthermore, most GICs are insured by the Canada Deposit Insurance Corporation (CDIC), securing deposits up to $100,000 in the event of a bank failure.
Risks Associated with GICs:
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Limited CDIC Coverage: While the CDIC ensures deposits up to $100,000, any amount exceeding this threshold is not guaranteed. This limitation underscores the need for investors to be mindful of their deposit size and consider diversification strategies.
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Liquidity Concerns: The article highlights the liquidity factor, especially with non-redeemable GICs. Liquidity refers to the ease of converting an investment to cash. Non-redeemable GICs may restrict quick access to funds, necessitating a careful evaluation of individual liquidity needs.
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Inflation Risk: A crucial risk associated with GICs is the impact of inflation on purchasing power. Inflation erodes the real value of money over time. If the GIC's interest rate is lower than the inflation rate, the investor experiences a negative real return. The example in the article vividly illustrates how a 2.00% nominal return becomes a -2.00% real return when inflation is 4.00%.
Real Return Calculation:
The article introduces a straightforward formula for calculating the real (inflation-adjusted) return: Nominal Return - Inflation Rate. This calculation helps investors assess the true impact of inflation on their investment's purchasing power.
Importance of Real Return Awareness:
The article emphasizes the importance of investors keeping a keen eye on the expected real return of an investment. Inflation's effect on the standard of living is likened to the cost of living increases in employment contracts. This awareness is crucial for all types of investments, not just GICs.
In conclusion, while GICs offer principal protection, their risks, including limited CDIC coverage, liquidity constraints, and vulnerability to inflation, necessitate a nuanced approach. Investors should carefully weigh these factors and consider their financial goals and risk tolerance before committing to GICs.
