One of the challenges about investing is deciding where to put your money. Everyone wants to get a decent return (usually without too much risk) but no one has a crystal ball. What complicates the dilemma, especially these days, is that there’s an abundance of choice. You can buy mutual funds, index funds, stocks, bonds, bond funds, and GICs. And this isn’t in any way exhaustive: from the boring but stable to the risky and exciting, the options are practically endless.
All this choice can be overwhelming, particularly if you’re a relatively new investor. You’ll find countless advisors and analysts who claim to know which investment is the one to own these days, but who’s to say which of these pundits will turn out to be right?
Like many things in life, it helps to simplify the issue in order to make a decision. On this note, let’s take a look at how two major asset classes stack up: stocks and GICs. When we refer to stocks, for the sake of argument we’ll assume they’re being purchased in the form of index funds. Index funds, as a reminder, are baskets of stocks that basically represent a specific market. For example, an index fund that tracks the S&P/TSX Composite Index would own all the major stocks on the exchange. As such, the performance of the index fund will closely track the ups and downs of the index.
Round 1: Returns
When you’re thinking about where to invest your savings, the question of “how much can I make?” is ever present. On this score, equities have GICs beat. Over the long term, one of the key factors of your returns from stocks is likely to be capital appreciation. In other words, the value of stocks tends to go up. In contrast, other than those of the equity-linked variety, GICs don’t offer the potential for capital gains.
Round 2: Risk
Of course, there’s a flipside to this. Stocks, unlike GICs, bring with them the potential for capital loss. In other words, you can invest $10,000 in an index fund, and it’s possible that two years from now, the stock market will tank and your investment will be worth $8,000. GICs don’t carry this risk. For one thing, they’re a legal liability of the bank who issued them. In addition, government deposit insurance protects most GICs in the event that the financial institution goes bust. So you’re protected on two fronts.
Round 3: Income
There are two ways to make money with an investment: capital appreciation and income. Having just looked at the potential for capital appreciation with regards to index funds and GICs, now let’s turn our attention to income.
Both index funds and GICs offer steady income. Index funds pay investors income in the form of dividends (that are received from the individual stocks owned by the fund). GICs pay interest income, which is usually specified at the beginning of the term and expressed as a percentage.
Index funds do offer higher annual income than GICs. Currently, an index fund which tracks the S&P/TSX has a distribution yield of slightly more than 3%. The top five-year GIC rate, on the other hand, is 2.15% at the moment. It’s also worth mentioning that Canadian dividends receive more favourable taxation than regular interest income.
That said, it’s worth keeping in mind that the higher income with index funds still comes with the chance that companies start cutting their dividends.
Rather than picking one or the other, most investors will want to have both index funds and GICs in their portfolio (as well as other kinds of assets, potentially). Index funds will provide higher returns over the long term, but GICs will provide much-needed balance and stability. They’re also a good way to park your money until such a time that equity markets look more attractively priced, in the event you think stocks are overvalued.
It may seem like a bit of a cop-out to just own both kinds of assets but the truth is that there’s real wisdom in diversification. The problem with putting all your eggs into one basket is that you never really know if that basket will perform well. Over the long run, the index funds will perform well. But for times when the market’s lagging, GICs will let you sleep at night.
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Flickr: Andreas Poike