If you’re a hockey fan, you know that every player has a role to fulfill. The offence needs to score goals, the defence needs to prevent goal-scoring opportunities, and the goalie needs to keep the puck out of the net. An investment portfolio should work in a similar fashion.
Each component exists to perform a specific task and to contribute certain qualities to your financial well-being. Together, these different components should work in harmony.
Stocks are the offence in a portfolio. Traditionally, they’re the asset class that will provide the greatest long-term returns to an investor. This is due to the combination of dividend income and capital gains they can generate.
Of course, with greater returns comes the possibility of greater losses. Stocks may be a great bet over the long haul, but in the short to medium term they can be very volatile. Even in bull markets (where stocks are generally rising), it’s common for the stock market to fall 10% before resuming its uptrend. And in bear markets or crashes, losses of 30% to 40% aren’t unusual.
If equities are the offence in your portfolio, bonds (fixed income) are your defence and GICs are pretty much your goalie. So what role should GICs play among your investments?
The most important thing GICs do is protect your capital. Unlike stocks or mutual funds, your initial investment (plus interest) is guaranteed to be returned to you. This not only protects you from loss, it allows you to sleep better at night. This guarantee actually comes from two separate places. First, when you purchase a GIC, it’s the bank’s legal obligation to pay you. It is, in effect, in debt to you. And in the unlikely event that the bank fails, your GIC will be insured by either the CDIC or provincial credit union insurance (subject to certain caps and restrictions).
It’s important to note that GICs are safer for your capital than some other kinds of fixed-income investments. For example, if you buy a corporate or government bond (excluding a savings bond), it’s possible to suffer a capital loss. This can happen in two ways: first, if the issuer defaults on their obligations (for example, if it goes bankrupt) you may not get your money back. Second, if interest rates on similar bonds rise, the bond you purchased will be worth less if you sell it before maturity.
So in the spectrum of fixed-income investments, GICs are definitely very conservative choices. They’re a rock in your investment portfolio because when equity prices decline, GICs will hold their own.
The other benefit GICs bring to your portfolio is reliable interest payments. Depending how often a particular GIC pays interest (annual, semi-annual, etc.), you’ll receive a steady return on your investment. It may not seem like much, and you certainly won’t get rich with GICs, but the interest will often eclipse what you’d get with a high-interest savings account. And if you put them in a TFSA or RRSP, you’ll earn tax-free income. This is particularly advantageous because interest income is not treated favourably from a tax perspective.
It’s important to keep in mind that there are various kinds of GICs, and each one can play a slightly different role for you. For instance, a long-term non-redeemable GIC is best if you want the highest possible interest rate, don’t need access to the money, and are fine with taking the risk that the rate of inflation will rise in the meantime (which eats into your return). On the other hand, if you want to earn some interest but also have access to your money at any moment, a cashable GIC is probably best. Make sure to familiarize yourself with the different kinds and the best GIC rates before buying one so you can align your goals with the best possible product.
GICs are not goal-scorers in a portfolio, but that’s not their job. Just like the defence on a hockey team, GICs are a steadying force for your finances. They probably shouldn’t comprise too much of your investments, but they definitely have a role to play.
Flickr: Ken Teegardin