Wednesday, August 24, 2011

Investment Manifesto Appendix I: The GIC Approach

This is a followup to my previous post. I mentioned there that the clients in question were so distraught with the failure of their money to grow in the market that they wanted to move everything to GICs. It just so happens that someone else has thought of this already. His name is David Trahair, and he wrote an intriguing book called Enough Bull, that highlights just such an approach. Trahair, disgusted with the financial industry and the impact on investors of the Lost Decade (as 2000-2010 is now being called in financial circles), outlines, as the subtitle states, How to Retire Well without the Stock Market, Mutual Funds, or Even an Investment Advisor.

He introduces the concept of a GIC ladder and there is beauty in its simplicity. Let's say you have $100 000 to invest in 2003, like our fictional Mr. & Mrs. Smith. You take $20000 and buy 5 GICs, each maturing 1 year after the other. So you buy a 1-year, 2-year, 3-year, 4-year and 5-year GIC. For those who don't know, GICs are Guaranteed Investment Certificates, which, as they say, are guaranteed to pay you the stated interest rate each year for the term of the GIC. Typically, the longer the term, the higher the interest rate. The catch is you can't redeem it without penalty until the end of the term, but the bank rewards you for your delayed gratification by sweetening the interest rate.

Now, when the 1-year GIC matures, you sell it and purchase a 5-year with it. You do the same for the 2-, 3-, 4- and 5-years when they mature. Eventually you have five 5-year GICs. And every year, one of them matures. You sell it and purchase another 5-year GIC every year. This way, each year you are locking in a portion of your portfolio at the prevailing interest rates for that year.

How would such an approach work for Mr. & Mrs. Smith? I found the historical GIC rates from 1970-2011 and backtested such an approach. Of course the results are slightly boosted by the heady interest days of the 80s. But I don't imagine anyone was celebrating 17% GICs when they were paying 20% on their mortgages.

Again, I tested a $100 000 lump sum investment and compared it to a theoretical conservative index portfolio started in the same year. The results were rather surprising.

The index portfolio gained an impressive 9.6% per year, turning $100 000 into $4.3 million in 41 years. The GIC approach fared nicely as well though, coming in at 8.31% per year. While this may seem like a small difference, the magic of compounding ensures that the final result is drastically different. The final portfolio is valued at $2.6 million. Thus, the couple forgoes $1.7m in gains. Some might consider this a small price to pay for sleeping soundly for 41 years. And in case you're wondering, the GIC portfolio outpaced inflation which clocked in at 4.4% per annum.

What if this approach was taken by our fictional couple in 2003? No crazy interest rate spikes to rely on in this period. Did it still produce respectable results? Indeed it did.

$100 000 invested in 2003 in such an approach would net roughly 2.92% per annum, versus about 5% in a conservative index portfolio. They forgo about $25000 in gains. But they still beat inflation, although barely, at 2.05% per annum.

So if you are interested in GICs, I recommend reading Mr. Trahair's book...and treading cautiously. In the markets, nothing is never free. And that goes for risk and safety as well. With risk you pay with volatility. With safety you typically pay in the form of unrealized gains. But it all comes down to what you can live with. Just don't sell yourself short and follow two VERY important rules.

Rule #1: DO NOT buy GICs from the big banks. Their rates are AWFUL. Use INGDirect, Ally, or Achieva Financial. TDs current 5-year non-cashable GIC rate is 1.65%. Achieva is offering 3.5%, Ally 2.75%.

Rule #2: Don't run scared to GICs. Do it because it makes sense for you. If you still think investing in a broad-based portfolio of stocks and bonds is the way to investment success, then d it. Don't put your money in a GIC mattress because your adviser screwed you. Fire your adviser.

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