Invest Skeptically

I’ve been going through a file I keep of newspaper clippings that remind me of worrisome issues in retail investing. This file includes things like my favourite Dilbert strip where Wally’s Financial Advisor recommends giving him 2% of his money and investing the other 98% in “things that sound good if you don’t look into them too closely”.

In this file I also found an ad from the Globe and Mail on February 20, 2007 for a 5-year stock indexed GIC (a type of principal protected product) that gives you the “potential to earn additional returns based on stock market performance” with a minimum return of 10.41%. Sound good? Yes it does.

Now for the fine print.

• The 10.41% minimum return is really just a 2% annual return compounded over 5 years (0.1041 = 1.02^5-1).
• The “stock market performance” you receive is not linked to the broad market indices but to a customized index of financials and utilities.
• Although this customized index is full of relatively high dividend paying stocks you only participate in the price appreciation of the stocks and not the total return (price+dividends).
• In fact, you only participate in the average price appreciation of this customized index over the 5-year term.
• Actually, you only participate in 60% of the average price appreciation of this customized index over the 5-year term.
• And for that very specific upside potential you must lock in your money for 5 years for a guaranteed return of 2%, or 1.5% lower than posted GIC rates at the time.

Let’s do a numerical example of what you’re really getting here. At 3.5% annually, a plain vanilla 5-year GIC would return 18.8% at the end of the 5-year term. The stock indexed GIC would need a price appreciation in the underlying index of about 47% just to breakeven with that!* This works out to an annual rate of 8%. Do you think financials and utilities are going to appreciate by more than that over the next 5 years? Maybe. But if you were that bullish on these sectors then why not just buy the stock (you’d also be getting paid dividends if you went this route)?

At any rate, this newspaper advertisement just highlights the need to think critically about what you’re really buying and to invest skeptically.

*Assumption: as a quick and dirty way of acknowledging that the price moves up and down I assumed that the average price appreciation is equal to 2/3 of the price appreciation of the customized index.