The risk of chasing short-term rates

Who wouldn’t be interested in hearing about a Guaranteed Investment Certificate (GIC) with a rate of return above 5%? At face value, this sounds great, but there may be more than meets the eye. When it comes to your portfolio, we recommend aligning the diversification of your investments to your comfort with risk, time horizon, and financial goal. Ensuring appropriate diversification can help you take advantage of attractive yields today while helping to manage risk and remain focused on what you’re trying to achieve.

Do GICs have a downside?

When investors think of ‘risk’, they tend to think of the potential for losses. One key benefit of investing in GICs is that they’re guaranteed, up to Canada Deposit Insurance Corporation (CDIC) limits, to return the rate stated when you purchase the investment. However, GICs do carry other types of risk.

Inflation Risk

Inflation risk is the risk that the cost of goods and services you buy everyday will rise faster than the return expected on your investment portfolio. Inflation risk is always present in a well-functioning economy, but it does erode your purchasing power, meaning you are not able to buy as many goods and services as you once could with the same amount of dollars. When looking at your portfolio, if your after-tax annual return is 5% and inflation is 3.5%, your real rate of return on your portfolio is 1.5%.

Reinvestment Risk

Reinvestment risk is the risk that when the investment matures or pays interest, those funds may not be able to be reinvested at the same (or better) rate. If you purchase a one-year GIC today and earn 5%, there is no guarantee you will be able to get 5% again next year when it matures.

Shortfall risk

Shortfall risk is the risk that your investment may not grow to the size sufficient to cover the cost of the goal you were attempting to achieve. Risk and return are a tradeoff. By accepting more risk in your portfolio, you attempt to achieve higher returns and reach your goal faster. By not accepting enough risk, you may not earn the return you require to achieve your goal and therefore you have a shortfall.

Other Considerations

After-tax return

Depending on which account type you hold your investment in, you may need to pay tax on the interest, dividends, or capital gains earned. When comparing the potential return on a GIC to that of an alternative investment, ensure you compare on an after-tax basis. GICs pay interest, and in Canada, interest is taxed at your marginal tax rate¹. For example, if you hold a GIC in a non-registered account and it earns 5% interest annually, at a 30% marginal tax rate, the after-tax return is 3.5%.² Like in the previous section, if you assume 3.5% inflation, your return is reduced to zero.

Opportunity cost

Opportunity cost is a measure of the potential benefits that you do not receive by selecting one investment over another. Opportunity cost can only be reliably measured after the fact but should be considered when deciding how to allocate the cash in your portfolio. By selecting a one-year GIC at 5%, you forgo the opportunity to buy another investment that may perform better over the same period, especially after tax is accounted for. Opportunity cost applies not only investments you didn’t make, but for all uses of the money, including making lump sum payments on a mortgage, line of credit or other debt.

Stick to the plan

It may be tempting to allocate assets to GICs and other short-term investments while they are earning returns that have not been seen in over 20 years. But before allocating to these short-term investments, ask yourself these questions:

• What am I trying to achieve?
• Have my goals changed?
• Do my goals or my time horizon suggest that I should hold a higher allocation to short-term investments?
• Do I want to accept the opportunity cost of other investments to chase short-term rates?

History has shown that a well-diversified investment portfolio, tailored to your unique needs and situation will exceed the returns found in short-term products. Below are the returns of different investments over the past 33 years. As would be expected with an All Equity portfolio, the returns are the greatest however it also carries the greatest amount of risk. You can also see, GICs with maturities between 1 and 5 years are some of the lowest performing but have less volatility.

^{*Source Bloomberg, Morningstar Direct. Portfolio objective returns are total returns and sourced through Morningstar Direct. Returns are gross of fee's and assume monthly rebalancing. If a fee was charged, returns would be lower. GIC returns assume the average GIC yield as reported by the Bank of Canada Charter Bank Interest Rates Guaranteed Investment Certificates for 1-, 3-, & 5-year GICs from 1990 - 7/2023 was earned by investors. Cash represented by FTSE Canada 91-day T-bill Index. Past performance does not guarantee future results.}

Avoid market timing

It may be tempting to try to exit and enter the markets during the peaks and valleys. To successfully time the market, you need to get two decisions right: when to get out, and when to get back in. Getting one of these decisions right is difficult, getting both right is nearly impossible. The graph below demonstrates the effects of missing the markets best performing days. You can see an enormous impact to your wealth, simply by missing the markets 10 best performing days.

^{Sources: FactSet and Edward Jones calculations. 12/31/1992 - 12/30/2022. These calculations assume the best days, as defined as the top percentage gains for the S&P/TSX Composite Total Return Index. Total return includes reinvested dividends. These calculations do not include any commissions or transaction fees that an investor may have incurred. If these fees were included, it would have a negative impact on the return. The S&P/TSX Composite is an unmanaged index and is not available for direct investment. Past performance does not guarantee future results. Dividends can be increased, decreased, or eliminated at any point without notice. This is not meant to depict a real investment. Further distribution prohibited without prior permission.}

Select an asset allocation that allows you to reach your goals

GICs and other short-term investments can be valuable additions to an investment portfolio, but for most people, there is no reason to maintain a large allocation. The assets in your portfolio should be based on your personal goals, the timing of those goals, and your comfort and ability to accept risk.

Bottom line

Discuss your goals with your Edward Jones financial advisor so that they can help you determine a strategy that is tailored to your needs.