US Dollar Purchasing Power (Photo credit: fbobolas)
Is there such a thing as a guaranteed rate of return? There seems to be a trend for people to “flock to safety” by buying certificates of deposit (CDs) or their Canadian equivalent, guaranteed investment certificates (GICs). There is no risk if a capital loss, at least in nominal terms.
However, money is just a scorecard. What matters is what we can acquire with that money in terms of real resources. What happens if you earn a rate of return of 2% on your CD, but prices increased by 3% over the same period of time?
CDs and GICs can make sense when compared to leaving your cash in a chequing or savings bank account. If you’re using it for that purposes then that’s one thing. However, what about as a long-term investment? Can CDs and GICs preserve your capital over the long term?
What is the real rate of inflation?
Inflation is a hard and pernicious thing to measure. The traditional measure of inflation, and the one I agree with, is that it is a monetary phenomenon and not a price phenomenon. What this means is that if you buy a computer in year 1 and it costs $1,000, you buy another computer in year 2 and it also costs $1,000, and both the money supply and production doubled in the mean-time, you just got screwed out of half of your money, even though prices didn’t rise. Inflation is not just about rising prices. Had there been no inflation, the computer would have dropped in price to $500, since workers are now producing twice as much.
However, it is very hard to measure how increasing money actually affects the economy, and the individuals within that economy. To a certain extent, credit creation based off of demand is legitimate and some of both inflation and deflation is to be expected in a healthy, functioning economy. Problems set in when bad debts are papered over rather than being allowed to fail, and when the government spends money into existence and spends this money on favoured parties. These favoured parties get to spend the new money first before prices have risen, thereby transferring over real resources to themselves and screwing over those who get the new money last, if they even get it at all.
On top of it, you have various ways that the official rates get fudged. If I no longer have enough to buy steak, and I buy hamburger meat instead for the same price, then my consumer basket has changed. In a sense, since I’m not paying more, I didn’t experience any inflation at all, right? 😉
Getting screwed out of our hard-earned cash
Let’s say the official government inflation rate is 2.5% (in line with official numbers), and that skeptics are claiming that the real rate of inflation is actually 6%. Let’s say that the truth lies somewhere in between and use 4% as our inflation rate. We’ll take a look at how our time deposit fares in this scenario, using a 5-year time deposit rate of 2.10%, compounded daily.
| Invested | $100,000.00 |
| Interest | $111,070.73 |
| Less: Taxes at 20% | $2,214.15 |
| Net payment | $108,856.58 |
After five years, we receive interest of $11,070.73 on our investment, pay taxes of $2,214.15 on our gains, and lock in a gain of $8,856.58. Not so bad? Not so fast.
The purchasing power of our money has changed over this period of time. We can no longer buy the same amount of real goods, per dollar. It would be short-sighted of us to consider our nominal gains in a vacuum, without considering the impacts on our purchasing power. Let’s discount this net payment at varying rates of inflation, depending on your favourite statistic:
| Real returns after taxes | Loss | |
| Discounted @ 2.5% | $96,065.18 | -$3,934.82 |
| Discounted @ 4% | $89,123.25 | -$10,876.75 |
| Discounted @ 6% | $80,640.95 | -$19,359.05 |
There is nothing flattering about this picture. Not only did we lose money in real terms, but to add insult to injury, the government taxed us on our loss! Even going by the official government statistics, we still lost 4% on our investment, and going by the skeptics’ estimated inflation, we lost a full 20% on our investment. Ouch!
My personal rate of inflation
Home prices in Canada have been increasing at a nominal rate of something like 7% per year throughout the last decade. Gas prices… at 8% per year. I don’t remember how much food cost 10 years ago, but I do remember I used to get a lot more for $50 than I do, today. Inflation here is probably at least 3% to 4% per year.
Add it all together and I think that I have been personally experiencing an inflation rate far greater than 2% to 3% over the past few years. Some of you might say “well, you’ll recover on the housing inflation when you sell”, but I don’t think so; another decade of 7% per annum in a country with plenty of land doesn’t make too much sense to me. Rents have been increasing more or less at the same pace; at some point these rises have to temper out.
Dear reader, what is your personal rate of inflation? What are your thoughts on investing in GICs and CDs in an environment where rates of return are very low, but rates of inflation are high?
The rates are too low right now to buy CD. I’m sure it will go up in a few years so I’m holding on to my liquidity and invest in other areas for now.
Our personal rate of inflation is pretty low. I think it is around 1-2%, but that’s because I’ve been trying hard to hold down the expense.
Going forward in the future, if we’re careful, hopefully we can keep our inflation down, too. Only so much you can do with energy, food, and taxes though.
A real loss is a real loss, not a fake loss due to inflation.
I’d rather be up 2% despite inflation being up 3%, then losing 3% and inflation being up 3%!!
So do millions of others during the last down turn.
Not sure what you mean by the first sentence Sam; my point is that a fake gain is actually a real loss. 😉
I agree with the rest of your comment, and given alternatives a CD may still be the most reasonable choice. It sure beats 0% at the bank.
It makes me bullish that you know you can beat the market with 100% conviction.
This is why I am very positive about the recovery. People don’t really need jobs, because it’s easy to make money on their own.
Gotta have faith right? 😉 For other readers, Sam’s talking about my decision to go it alone and a comment I had on his site that I am investing in myself rather than in the stock market (Sam, correct me if I’m off-track). It’s not really quite the same since I’m investing my time, with the hope that it will pan out. Nothing’s 100%, and I would not call it “easy”; staying at my job would have been easy. Then again, nothing’s just about the money, either, and the whole picture has to be considered.
Actually, I was just making a generalization that because people have supreme confidence in beating the markets, that folks don’t really need to worry about money or work as much as they should since there are so many money making opportunities.
Just be careful, as I don’t know anybody who gets everything right in the markets.
Oh I got it. 🙂 I agree in general. I do find it interesting your latest posts where you show the opportunities that do come up as you have access to more money.
Kevin,
Sam’s point is that a 2% is essentially guaranteed rather than a possibility of losing 5 or 10% in the market PLUS the inflation loss.
Probably why everyone needs a little of everything!
Agreed, you’ll find no argument from me there. If you locked in a 12% gain and are riding things out, then why not. My argument is directed more toward long-term investment within CDs and GICs, and is also a jab at inflation.
CDs and GICs are good to park your money. That’s it. No one should use these instruments to make money. Over the long haul, index fund investment or real estate investment can beat CDs and GICs handily. I think if you are going to need money in next few years, it’s wise to park money in the savings, money market or short term CDs.
That makes sense to me as well. Over longer terms you need to deploy your money, otherwise you’ll get destroyed by inflation.
The rate of return on CDs and GICs is too low. Which is why I invest in dividend paying stocks, just to keep ahead of inflation. I especially like companies that continue to increase dividends year after year.
That could be an attractive alternative too. I remember reading somewhere about companies sitting on a lot of cash and this is starting to filter out via dividends.
In terms of actual money spent I am experiencing deflation. When I break it down to the individual expenses obviously things have gone up but my moving around countries means there is no constant. Airfares don’t really seem to have changed for me much in the last 10 years though (be interesting to see the official figures on those!).
I wish this whole devaluing of money didn’t happen, it’s a false wealth created to spur growth and as you say ultimately favours the chosen parties.
Deflation in terms of expenditures is sweet! I wonder about the official airfare figures too. I think competition has probably lowered prices from one side, but fuel prices, airport taxes and stuff like that has been raising it from the other side.
I would prefer to see money in the hands of the people and I think it’s going to happen in some form, some day not too long from now. It will be a great change.
I have friends who have “investments” in RRSPs at 1% and don’t understand why I’m nearly screaming at them to find something better, but they trust their banks, and I’m not a “financial expert”.
They’re right, I’m not an expert in taking their money.
I ran into something similar when trying to convince my gf not to go with her “investment friend” a long time ago. She didn’t listen to me at first, but now she believes me after we learned about the loaded fees. Good thing we didn’t put too much in there.
“There is nothing flattering about this picture. Not only did we lose money in real terms, but to add insult to injury, the government taxed us on our loss! ”
Getting screwed is right. I can’t believe how many people don’t consider the risks associated with earning 1% or less with respect to c.d.s. My understanding on the topic has evolved with my risk profile. Still, for those who locked in 5% c.d.s in 2007, they have probably been sleeping well. I understands Sam’s point, as he has been making it for years. It is a different approach that works for him.
Yep! Though things are getting interesting as we get closer to 0%, eh? Plus with the bad market and jobs data, maybe QE3 will be stepped up.
Hi Kevin, check out the US Savings I Bonds and Treasury Inflation Protected Securities. They will protect your principal from the ravages of inflation. (At least the inflation calculated in the USA). You can invest at treasury direct dot gov.
Hi Barb,
I guess you’d just have to trust that the CPI reflects true inflation. 😉 Personally I don’t have a lot of faith in the bond markets. A lot of capital is fleeing to it out of fear, but it seems like a game of hot potato to me.
Good explanation of inflation. Thanks.
Thanks! 🙂