Lunch Is Still Not Free, Even If It’s Potatoes

I occasionally hear from readers who want to know which ETF or index fund portfolio would be a suitable place to stash their short-term savings. Inevitably I disappoint them with my reply: “Short-term savings belong in a high-interest savings account or GICs.”

With even online banks paying just 1.5% to 2% in savings accounts these days, it’s tempting to look at an ETF of real-estate investment trusts (REITs), preferred shares or high-yield bonds and try to pull down 5% to 7%, or more. It’s also a terrible idea for short-term investors.

The Couch Potato strategy works over the long-term because it dramatically reduces fees and provides broad diversification. However—and this is a critical but often misunderstood point—an index strategy offers absolutely no protection from falling markets. Indeed, it may offer less protection, since actively managed funds have the option to move into cash when markets are volatile. Index funds are as fully exposed to the market as a streaker on the TSX trading floor. That’s why index portfolios are not appropriate for people who want to protect their capital for a couple of years as they save for a house, or a vacation, or their child’s education.

Diversification doesn’t eliminate market risk

Using diversified ETFs and index funds can eliminate the risk that any single security will torpedo your portfolio. Buying a fund of REITs, preferred shares or high-yield bonds is certainly less risky than trying to pick two or three individual winners. But your fund can hold hundreds, even thousands of individual names and still plummet in a market downturn. There’s only way to eliminate market risk, and that is to get out of the market.

Imagine that you were saving for a down payment, or for your 14-year-old’s university education, in early 2007. One-year GICs were paying well over 4%, but you wanted more. So you put your savings in the iShares S&P/TSX Capped REIT Index Fund (XRE) in February 2007, attracted by its generous yield. Well, you would have watched it fall more than 60% in two years.

Had you invested in the Claymore S&P/TSX Canadian Preferred Share ETF (CPD) or the iShares iBoxx High-Yield Corporate Bond ETF (HGY) around the same time, you’d still be down over 16% after more than three years. Dividends and interest would have reduced these losses, but only if you somehow managed not to panic and sell in 2008 or early 2009. Either way, your plans for buying a house or paying for your daughter’s university would have been wrecked.

In general, if you need your money in less than five years, none of it should be in stocks, and that includes equity index funds and ETFs. With interest rates at record lows, it’s possible that even a bond a fund could lose money over a period of a couple of years. Meanwhile, a five-year GIC today will earn you 3.75% with zero chance of losing your principal. If you prefer, a five-year GIC ladder will earn you about 3% this year and give you an opportunity to take advantage of rising rates in the future.

In a period of 1% inflation, that’s not bad for a guaranteed investment. And like or not, that is the price of safety.

 

12 Responses to Lunch Is Still Not Free, Even If It’s Potatoes

  1. DM August 16, 2010 at 11:34 am #

    Thanks Dan. Well said.

  2. Echo August 16, 2010 at 12:01 pm #

    So true, I recently had a family friend ask me what to do with his savings of about $15k. I asked him when he would need the money, and he wanted it the following year to use for school. Do NOT put it in the market, use a high interest, no fee savings account.

  3. Thomas August 16, 2010 at 12:17 pm #

    Excellent advice. Make sure your GIC’s are redeemable without a high penalty in case rates go up or choose a laddered approach. As they say, never lose your capital!

  4. Tiny Potato August 16, 2010 at 12:23 pm #

    Very well said. So many people ask “what to do with my $X that I don’t need to use for 1 or 2 years”. The temptation to invest it is probably due to some grand dreams of striking it rich quickly (the low interest rates definitely don’t help either).

    What is most concerning is that most people asking this question are probably not sophisticated investors that have a understanding of their own personal risk tolerance; which leads to taking more risk than they are actually comfortable with!

  5. Canadian Couch Potato August 16, 2010 at 12:30 pm #

    I recently told an advisor friend of mine that someone had asked me how he could get good yield with no risk, which I thought was an obviously nutty request. He shook his head said, “Dan, I get some variation of that question every day!”

  6. Financial Cents August 17, 2010 at 10:25 am #

    Good stuff Dan.

    @Dan – is this part of your personal plan as well: to slowly decrease your equity index holdings and replace them with GIC-ladder products (e.g., like Claymore CBO) in your RRSP as you move closer to retirement? Curious.

  7. Canadian Couch Potato August 17, 2010 at 11:08 am #

    @FinancialCents: I’m a long way from retirement but, yes, I expect so. I’m currently 70% in equities and plan to decrease that slowly as I get older. With my kids’ RESPs, I do plan to start converting them to GICs about five years before they begin university.

  8. Think Dividends August 17, 2010 at 5:58 pm #

    Just buy a Strip Bond whose maturity date corresponds to when you need the funds.
    IMO – Strip Bonds make great RESP investments.

  9. Canadian Couch Potato August 17, 2010 at 6:14 pm #

    @ThinkDividends: In theory I’d agree, but in practice this sounds complicated. You would have to time your bond purchases carefully to get the maximum benefit of the grant money. There’s a $500 limit per year (up to $1,000 if you’re carrying over unused room), so you’d likely have to deposit $2,500 in your RESP account, wait a month for the grant to arrive, and then buy a strip bond for $3,000. Then you’d have to do that every year for about 15 years. You’d also want to set it up with four target maturity dates so one quarter of the money matures before each year of university. Have you done this?

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