I’ll agree. People don’t like risk. The thought of losing a dollar is intolerable. Even more importantly, your mom told you to never play with stocks. Though you never listened to her when she told you not to go out with that chain smoking douchebag. What the heck! Mom’s right. Buy some GICs in my bank account and make sure I don’t spend it all. What can really go wrong?
We don’t do things because of fear. Most of the time we fear failure, but without failure you will never learn. But what if I told you there was a way to invest without losing a single dollar? Does that sound too good to be true? Well there is some truth to that. Without risk, it’s hard to earn anything on your investments. The definition of gaining a return on your investment is essentially risk. However, there are many ways to mitigate that risk, at the cost of higher returns.
If you’ve read this far, you’re probably wondering what kind of voodoo magic I have up my sleeve. Or perhaps I’m trying to sell you on some kind of illegal money making scheme. The truth is, there are many ways to eliminate a lot of risk when investing. One way to do so is to create a market linked GIC. Yeah, these are things that you’ve seen at your local banking branch. What the bank doesn’t tell you is that your gains are limited and they’re taking a small fee for doing such a transaction for you. This means that if you buy the banks offering you are limiting your potential gains. If you think you got that 30% gain last year from the markets. Think again.
By purchasing GICs, you are essentially guaranteeing your principal. This kind of investment vehicle is for the people who are too afraid to lose money. The downside to using a market linked GIC is that you are completely limiting your upside because the amount of money actually put into the market is extremely small compared to the actual capital you are committing to the investment. So here’s how it works:
- Determine how much you want to invest. In this example we use $10 000.
- Determine the number of years you want to invest and the interest rate that the GIC will pay for that term. For us we’re going to use a 5 year 3% GIC.
- Figure out how much you have to invest in the GIC so that after 5 years you will get your original principal back.Amount invested in GIC = Principal / (1 + interest rate) ^ years invested
- So we end up investing $8626.09 into our GIC
- The remaining amount from our principal we can invest in equities. $1373.91
The end result of doing an investment like this is that you guarantee your original $10 000 after 5 years. Whatever you make on the $1373.91 over the 5 year period could be considered your interest for that original $10 000. So how does this benefit you? Easy, if you can beat the return of 3% interest that the GIC will give you, then you’ll be ahead. Don’t beat it and then you’ll be behind what the GIC would pay you if you just put the whole amount into the GIC. Somehow, like a fool, if you lose all the $1373.91 then you will still have your original $10 000 that you started with.
The question is why go with a strategy like this when you could potentially gain more from just investing in the markets. Quite simply, I hear a lot of people talk about losing money. This puts hesitation into the minds of people about investing in equity. When people fear equities they look for other secure alternatives. This other alternative is to do nothing. If you are doing nothing with your money and making nothing, then it defeats the purpose of saving. Trying to achieve financial independence requires you to put your money to work for you. If you ever want to dream about retiring, you’ll want your money to work for you. Otherwise, you’ll always fear running out. Creating your own market linked GIC means that you will at least guarantee your principal. It’s also a valuable tool to be able to help you learn how to invest your money.
This plan is also good for those that have a short term horizon, or saving for a short term purchase but want to get a potentially larger return than what a GIC will offer you. With GICs paying such paltry interest, it’s not hard to beat the return of a GIC. Take this other fact as well. If you are investing outside of a registered account, which means that you are paying taxes on your interest, then GICs are even worse off. Taxes paid on interest income are at your marginal tax rate. At least capital gains from equities are taxed at half the gains.
Let’s take a look at a few possible scenarios.
Assuming all gains from equities to be capital gains, it’s not hard to see that a manageable 7% from a market linked GIC would outpace the regular GIC by a significant margin. Not only would you end up with over $300 more after 5 years but you’d only pay an addition ~$60 more in taxes for your gains. This is the advantage of capital gains. They are taxed at a lower rate than regular interest income. Paying tax is not always a bad thing, that just means you are making money. At the end of the day a dollar more is a dollar more regardless of how much tax you pay. Just remember that.
The real question of using a market linked GIC is whether it’s worth all the trouble. Well that really depends on whether you are trying to make money, or if you are trying to learn about investing in something other than a GIC. As I’ve said, using this method guarantees your original principal. It’s like being a bird tied to a pole with a cord, and jumping off a cliff. Sure it might fall, but it won’t fall all the way. But maybe it’ll learn to fly? Who knows.
Personally, this way of investing is extremely conservative. With almost 90% invested in a GIC, the rate of return can’t possibly be overly achieving. It’s certainly something that might be considered for part of your portfolio if you have a short term goal and you don’t want to risk your principal, but as a long term investment strategy, a market linked GIC is not diverse enough. It is certainly a strategy that wouldn’t grow your money over a long period of time.
If you want to get your feet wet with equities and you want the training wheels to go with it, try making your own market linked GIC. Just be wary that you can’t expect much on returns. At least you’ll have the peace of mind that you aren’t losing anything from trying to invest in equities.