A key element of your return on investments like stocks, mutual funds/index funds, or real estate is likely to be capital gains or capital losses. Put another way, because your initial capital isn’t guaranteed, it will fluctuate so you’ll end up with more or less than you started with. However, GICs have different risks and rewards.
When you buy a GIC, your capital is protected. First, it’s guaranteed by the bank that issued it; so as long as it’s solvent, the bank has to pay you back. And in the event that the bank fails, your money is insured subject to specified limits by either the CDIC or a provincial credit union insurance body. As long as you stay within the CDIC/credit union insurance limits, your money is safe.
But there’s something else to consider: inflation. Let’s say you lend a friend $1,000. Your friend isn’t great about paying you back on time, and so repayment only happens three years after the initial loan. During this time, inflation has averaged 2% annually.
So did your friend fully pay you back? There are two answers to this question. Nominally, the answer is yes. He or she borrowed $1,000 and paid back $1,000. But in what economists call “real terms,” that is, keeping purchasing power constant, you really didn’t get paid back what you loaned out. The reason for this is that inflation over the years erodes the value of money. The $1,000 you get back after three years doesn’t buy what it did when you made the loan. The tendency to think only in terms of nominal values is sometimes referred to as the “money illusion.”
How does this apply to GICs? When you buy one, you’ll receive your capital at the end of the term plus a prescribed rate of interest. But inflation will eat into your “real” return. For example, say you buy a five-year GIC at 2.5% (currently the best GIC rate on Ratehub.ca). If inflation ends up being 4% for most of the term, you’ll actually lose money after accounting for the loss in purchasing power. On the other hand, you’ll make money in real terms so long as inflation stays under 2.5%.
A helpful, simple formula to figure out your real return is the following:
Nominal return minus rate of inflation = real return
(2.5% – 2% = 0.5%)
So if you’re earning 2.5% on a GIC and inflation is 2%, your real return is 0.5%. But if you’re earning 2.5% in interest and inflation is 4%, you’re losing 1.5% annually. Needless to say, you always want to do your best to ensure you’re at least keeping track with the rate of inflation. (Incidentally, that’s why unions insist on cost of living adjustments in their collective bargaining agreements).
There’s a flipside to this. While inflation is a primary risk to your GIC investment, deflation actually does the opposite: it helps you. For instance, if you buy the five-year GIC paying 2.5%, and consumer prices start falling, you’ll actually be making more than 2.5% in real terms. Money will effectively be worth more so you will have greater purchasing power.
To use an example for our handy formula, let’s assume that prices are falling by 0.5% a year. In this case, we take the nominal return on the GIC, 2.5%, and subtract negative 0.5%, for a real return of 3%. Granted, deflation is a much rarer occurrence than inflation for various reasons, but it can happen.
Importantly, the effect of inflation and deflation on your investments is not limited to GICs. A significant reason to have some exposure to the stock market isn’t just the potential for capital gains, but to own a “real” asset that offers some protection against the effects of inflation.
We’re used to thinking in nominal terms. But when it comes to GICs and other investments, the way to protect your purchasing power is to focus on keeping it “real.”
Flickr: Pictures of Money