Key Risks and Opportunity Costs
You may have heard that guaranteed investment certificates are "risk-free". As nice as this would be, it doesn’t paint the full picture. There are some risks to holding GICs, as well as so-called “opportunity costs,” which are the lost benefits of doing one thing as opposed to another. To use a non-finance example, the opportunity cost of going to a concert on a summer evening is not being able to attend a baseball game that same night. Think of opportunity costs as trade-offs. We’ve compiled a list of key risks and opportunity costs to consider, before investing in GICs.
It is true that your principal – the original amount you invested - is guaranteed to be returned to you, when you purchase a GIC. Also, most GICs are insured by the government, in the event of a bank failure. Having said this, some risks remain. Let’s take a look at the potential risks of owning GICs:
In the event of a bank failure, only savings up to $100,000 are insured by the Canada Deposit Insurance Corporation (CDIC). Any amount over and above $100,000 is not guaranteed.
Some GICs are not liquid. Liquidity refers to the ease with which an investment can be bought and sold (converted to cash). Particularly with non-redeemable GICs, accessing your money in short order may not be possible. If liquidity is a top priority, consider either a high interest savings account or a cashable GIC instead.
Inflation, and particularly unexpectedly high inflation, reduces the purchasing power of a GIC upon maturity; this is arguably the biggest risk when buying a GIC. Particularly for long-term, non-redeemable GICs, any significant burst of inflation can wreak havoc with your investment. If your GIC interest rate is lower than inflation, your purchasing power goes down.
For example, let’s say you invested $10,000 in a 1-year non-redeemable GIC with an interest rate of 2.00%. By the end of the term, inflation has risen to 4.00%. What is your return on the investment?
The answer to this question depends on whether we’re looking at the nominal return or the real return. To calculate the nominal return, we simply take the initial $10,000 and add the interest payable. In this case, the GICs nominal return is 2.00% or $200.
But recall that in our example, inflation has risen to 4.00%. Another way of looking at this is to say that just to retain a stable purchasing power, you would need $1.04 for every $1.00 you had one year ago, or a $400 return on your $10,000 investment.
What then is the real return on the 1-year GIC paying 2.00% adjusted for inflation? It’s actually -2.00%. Here’s a simple formula to calculate the real (inflation-adjusted) return on an investment:
In this example, you actually lost $200 ($200 - $400) in purchasing power on your original investment.
Savers always need to keep a keen eye on the expected real return of an investment. Just as employees often have cost of living increases built into their contracts, investors need to be aware that inflation eats into their standard of living; this is true for all types of investments, not just GICs.
GIC opportunity costs
Let’s assume you have locked in a 5-year GIC at 3.00%. Shortly after making the investment, interest rates on GICs and GIC alternatives start to increase. Unfortunately, because your money is locked in with the bank, re-investing at the higher rate during the term may not be possible; this is the “cost” of going after an opportunity. But, again, it’s true for many investments.
Depending on your needs and risk tolerance, buying a GIC foregoes the possible benefits of investing in other higher-return options. Stocks, bonds, real estate, or precious metals have the potential for loss but also the possibilities of higher returns than GICs (though be sure to check out our explanation of market-linked GICs).