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Hidden hazards of safe investments

With many analysts talking about a double-dip recession and an uncertain future, safer investments like government bonds and GICs are on people's minds again.

With the market trading in a narrow range and day-to-day volatility remaining high, investors are growing more concerned that their hard-earned money is not growing for them as we come out of the recession. As many analysts talk about a double-dip recession and an uncertain future, safer investments like government bonds and GICs are again on people's minds.

Can an investor avoid possible losses in the future and still make money if the stock market’s performance is flat? What types of investments would make individuals feel secure and allow them to grow their money?

Many people seem to be looking at GICs (Guaranteed Investment Certificates) or Government Savings Bonds as an option. Both provide safety of principal and guarantee a fixed interest rate until the investment matures at a set date in the future. Currently, the interest paid on a one-year GIC is very low (approximately 1.80 per cent). Many GIC buyers believe that even though their returns are low, they are at least making some money with little to no risk. But are these buyers really protecting and growing their wealth?

Interest income is taxed fully at an investor’s marginal tax rate. If an individual is in the 46 per cent (highest) tax bracket and earns 1.80 per cent, after tax, their return would be approximately .97 per cent. This is why many investors hold GICs or bonds in their RRSP account to defer paying the tax.

In Canada, inflation is currently at about two per cent. If an investor is making 1.8 per cent on a GIC or bond, pays 46 per cent tax on what they earn and then loses two per cent of their spending power due to inflation, their real rate of return is a negative 1.03 per cent.

Most GIC purchasers feel they cannot lose money by buying GICs or government bonds because of their guarantees. But what that same investor does not realize is that they are losing spending power of their money because they are not earning enough to keep up with the rising costs of everything around them.

So what can an investor do if they are looking for growth and wish to keep risk to a minimum in their portfolio? There are a couple of ideas and products which can help.

The first idea is time in the market. If you have a long horizon of more than 10 years, you have little to fear. There's plenty of time to ride out the ups and downs of the stock market. Think of investment accounts in a similar manner as savings accounts: The more you put in, the more you will have at the end.

With an investment account you can actually buy investments to grow your money, whereas a savings account can only hold cash. I'd recommend you add to your investments as much as possible, through good times and bad. When you are set to retire, history tells us you will have more money than if you had not invested. An investor’s protection and success is based on time in the market, not timing the market.

A second idea that goes along with long-term investing is diversification — an investor today, more than ever, must be diversified. By doing so, one can limit loss without limiting the gains on a portfolio. There are other investments, such as corporate bonds or preferred shares, that provide a higher rate of return than GICs and government bonds. In the case of preferred shares, an investor receives a dividend every three months, which is taxed at a lesser rate than interest income you receive from bonds or GICs. These types of investments tend to be held outside of an RRSP account because of the dividend tax credit an investor receives.

With these methods, I see investors getting the most bang for their buck out of the equity markets. The risk versus reward scenario clearly points to individuals investing in good-quality companies that are sector leaders, trading at historically low valuations while paying dividends. There may be more risk with these investments than with GICs or government bonds, but it is possible to reduce that risk while maximizing your returns.

If you have any questions regarding the above article or are looking for an Investment Advisor to help you with your portfolio, please send me an email at asmall@dundeesecurities.com. I will be glad to speak with you.

Allan Small is an Investment Advisor with Dundee Securities Corporation, a DundeeWealth Inc. Company. This is not an official publication of Dundee Securities and the author is not a Dundee Securities analyst. The views expressed are those of the author alone, and are not necessarily those of Dundee Securities or Metro Canada.

 
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