What does a safe investment mean to you? What makes it safe?
One of the common responses I get from women is, “Anything that provides a guaranteed interest rate is safe.”
We tend to feel all warm and fuzzy when we know that our principal – that is, the amount of money we invested – is safe from loss. And, what a bonus when we also know exactly how much we’ll earn from the investment.
In Canada, Guaranteed Investment Certificates (GICs) are a good example of such an investment. If you put $5,000 in, you know you will get $5,000 out plus interest. The interest rates aren’t very high, but at least the return is guaranteed, which makes it predictable and, here’s that word again, safe.
All good, right?
It depends on your definition of “safe”.
Your so-called safe investment could be expensive and problematic in the end.
Let’s look at the hidden risks behind guaranteed returns.
Margaret and Ann: A tale of two widows
Years ago, when I was doing research to understand the inner workings of investments, I interviewed a number of financial advisors. One of them, Alan MacDonald, told me a story I’ll never forget, to illustrate the danger of so-called safe investments.
Alan told me the story of Margaret and Ann (not their real names), two widows who had long since passed away. They had both become widows at roughly the same age, in the 1950s. On top of that, they both had investments worth approximately $300,000, which was a lot of money back then. The women were in good shape financially.
That’s where their similarities ended, though.
Margaret, whose investments consisted mostly of blue-chip stocks, decided that she wouldn’t make any changes to the portfolio. The stocks were doing well and she saw no reason to sell them.
Ann, on the other hand, was much more conservative. She did not understand stocks and was concerned that they could lose value if something happened to the market. She transferred her holdings to GICs, which she felt were much safer.
At the end of her life, Margaret’s portfolio had grown to seven figures. She lived the last of her days in comfort.
Ann, unfortunately, was living in poverty at the end of her days.
How is that possible?
How could it be that two women who were relatively wealthy when they became widows, could end up in such different circumstances at the end of their lives?
More specifically, how is it that the woman who played it safe ended up having to scrape by in old age, while the woman who left her holdings in riskier investments, enjoyed a wealthy retirement?
The answer is that one portfolio was inflation- and taxation-proof; the other was not.
What is inflation?
Investopedia gives the following definition of inflation:
Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed a a percentage means that a unit of currency effectively buys less than it did in prior periods.
Basically, inflation is the increase in the cost of goods, which means that one dollar today buys less than it did ten years ago.
We’ve all experienced inflation, regardless of our age. For fun, look at the value of your parents’ house. How much did they pay for it decades ago? How much would they get for it today?
My parents just sold the family farm not that long ago after owning it for many decades. They got more than 20 times what they paid for it!
If I rolled back the clock and spoke to my parents when they first bought the farm and told them that according to my crystal ball, they would sell it for more than 20 times that price decades down the road, I suspect they’d have trouble believing it.
We all know that prices go up, but it’s hard to imagine them going up that much.
But they do.
And that’s what caused Ann grief: Her money didn’t keep pace with inflation.
The trouble with “safe” investments
One of the first things you learn when you start studying investing is that the higher the risk, the higher the projected return.
I say “projected” because there are few guarantees with investments.
And that’s the problem with products like GICs. Safety comes at a cost. In order to guarantee the principal and the rate of return, you get very little for your money.
At the time of writing this, the inflation rate in Canada is hovering around 1%, whereas a 5-year GIC will get you anywhere from 1.4% to 1.85% in interest.
There are two things to note here. First, that’s a very low rate of inflation. Our central bank is targeting 2%.
Second, those are low interest rates for GICs, too. Here’s the thing: Once you lock in, your rate is fixed, whereas the rate of inflation varies. No one has a crystal ball, but it wouldn’t take much movement up in the inflation rate to surpass the interest rate from the GICs.
Do you see the problem here?
That’s not all.
Then there’s taxation
The rising cost of goods relative to the low interest rates from GICs is one thing, but there is also taxation to consider.
If your GICs aren’t in tax-sheltered accounts, such as Registered Retirement Savings Plans (RRSPs) or Tax-Free Sheltered Accounts (TFSAs), the interest is taxable at your marginal tax rate.
Any interest you earn in an unregistered account is like adding income to your tax return: 100% of it is taxable at your marginal tax rate.
So, to use the best case scenario from above, assume you have a GIC earning 1.85% per year. Take away the impact of inflation and what are you left with?
Now, add to that by taking away the taxes, and the amount you’re left with dwindles even more.
By the time everything is said and done, the buying power of your “safe” investment might not keep pace with the increasing cost of goods.
And that’s where you lose buying power.
Looking at your principal is misleading
This is where a lot of people get fooled: They only look at the principal balance and think, “Oh good, it’s safe! It’s all there.”
The number may be the same as it was when they first invested, but the purchasing power is not.
That’s what happened to Ann. She felt secure because the principal balance never went down and every year it grew by a small amount of interest. What she didn’t realize is that there was a metaphorical hole in her finances caused by inflation and taxes, both of which were emptying her financial bucket faster than the small rate of interest was filling it.
You need a plan
This is why it’s so important to understand investing and to sort out the place for products like GICs.
They can be useful in the right place and for the right reason, but not as an overall investing strategy.
And it’s important to understand a key concept: risk.
GICs, in the way that Ann used them, were terribly risky. They cost her wealth and a secure retirement.
If you’re tempted to pass judgement on Ann, it’s worth remembering what the research tells us: Most women would feel more comfortable with this approach – the “safe” route – and most would also not be aware of the risks.
The wealth gap between the sexes exists for a reason, and Ann’s story demonstrates a small part of that story.
It’s time every woman learned to invest and to harness risk appropriately to build wealth.
Our future depends on it.
If you want to learn more, I’ve just opened the registration doors to my Invest With Confidence 3.0 Course. You can get more information here.