For most investors, risk is a difficult concept to fully appreciate. Not only are the traditional definitions cumbersome to quantify but types of perils can vary wildly, including everything from permanent loss of capital, volatility or even something as indirect as opportunity cost.
But when it comes to assessing risk, the most conservative investors tend to disregard common definitions, instead focusing on the safety of the investment guarantees. Unfortunately, the hazards with the current guaranteed investment market comes in a form that people are not easily able to identify, yet the danger is just as malicious to a financial plan, if left unguarded. Ironically, it's the most conservative investors accepting this risk, unaware that there is a money illusion at work and that it's as impactful as it is.
In today's highly volatile capital markets, investors who can't stomach the fluctuations have hunkered down in good old Guaranteed Investment Certificates (GICs) and other traditionally categorized 'low-risk' investments. Although it only pays a modest rate of return, you can always count on your money being there when you need it. Or can you?
Imagine that you live a conservative lifestyle that requires about $50,000 per year in spending that you plan to fund from your investments. To be generous, suppose that your local bank is offering GIC rates of three percent interest. With a little money set aside for taxes, it would take about $980,000 in savings to fund your expenses over the next 30 years.
The risk that you are taking however is the loss of your purchasing power over time. The Bank of Canada has a target inflation rate of two percent. That means that they have an objective to grow the economy of Canada, which results in the cost of goods and services to increase at that pace each year.
Even in realizing that costs go up by two percent each year, remember that the two percent increase since last year, increases as well. The rate of inflation is compounded! That means that your $50,000 of expenses today will cost you more like $74,300, twenty years down the road.
Without anticipating inflation and rising costs, a GIC investor will be losing purchasing power over time and that is a risk that many conservative people underestimate. In the people's defense, we are not 'hard-wired' to value inflation. We tend to think of our wealth in terms of current values and prices. The reason why your grandmother gives you $20 each birthday for the last 25 years is because there is a certain mental stickiness to the current price levels that we more easily relate to. We are not naturally programed to think in terms of compounded price increases and we have a very difficult time digesting the impact of inflation.
If you want to remain invested in GICs be forewarned. At a three percent return and a two percent inflation rate, you will need to save over $1,500,000 in order to keep up with costs. That's 53% larger nest egg required than without inflation.
This information should not be construed as investment advice, nor can it take into account your own specific circumstances. The opinions formulated within this article are based on sources believed to be reliable and may not reflect the opinions of any organizations that I am affiliated with.
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