RRSP Strategies Part 3: Keep it Safe to Start. Use Cash, Bonds, and GICs to Build Your RRSP Base

Many investors aren’t going to want to read this, much less act on it, but I think the first thing you need in your RRSP is a safe base. This is the so-called fixed income or guaranteed part of your holdings. The money should be invested in boring, probably low-interest, (almost) totally safe options. These include cash, bonds, term deposits and GICs. For the really adventurous it could include money market funds and T bill funds. These are dull, predictable investments that you would likely be embarrassed to mention at a party. These are the investments, though, that will see you safely through many investing storms ahead.

How Much Money Needs to Be in the Safe Base for a RRSP Account?

Some of you are likely itching to get past the “safe” investments and move into the glitz and glamour of investing in stocks, options and hedging. You may be asking “How much do I have to have in ‘safe’ investments before I can move on?”

There is no right or wrong answer.

Personally, I would suggest having $25,000-$50,000 in safe investments before putting money into riskier ones. It’s very calming when the markets are bouncing around like lawn chairs in a flatbed truck on a washboarded road to know that a large chunk of your money is figuratively buried in the back yard perfectly safe and sound.

The gap between $25k and $50k yawns wide. How should you pick which side you need to stand on? Here are some factors to consider:

Do you have a maxed out TFSA? If so, how much is in it? How secure are the investments in it? If you have $31 000 $25,500 in cash and GICs in a TFSA (perhaps waiting to buy your next car or deal with any emergencies) then you probably only need $25,000 in safe investments in your RRSP before you lift the rope and cross into the deep end of the pool.
Also, how far from the shallow end are you planning to swim?

• If you’re planning to invest in dividend-paying blue-chip stocks you can probably take those first strokes into the deep end while you have a fairly small safe base. Examples of the types of stocks I mean are shares in TD (a bank) or FTS (a utility company).
• If you’re planning to try to pick individual stocks that will double in value in 6 months, you should have a substantial safe base. Examples of the types of stocks I mean are shares in BB (a high tech stock) or small aggressive oil and mining stocks.
• If you’re planning to go for penny stocks, hedging, options, or leveraged investments you shouldn’t really be reading my blog. But if you are, consider having enough invested in total safety to buy you an annuity you can live on (at least spartanly) if all of your other investments fail.

Why is Losing Money by Investing Poorly When You Are Starting as an Investor So Serious?

The” You’re Young You Can Bounce Back from a Loss” Argument is Severely Flawed

So you are a new investor and you lost $2000. Why is that so bad? Yes, it hurts. But if you are a young new investor, you have many years to earn more money and hopefully make up the loss. That’s the logic used by many investment advisors who push their new clients towards high risk and volatile investments. (They’ll also push older new investors in the same direction but are a bit more wary of lawsuits.)

The problem is that many new investors who lose what feels like a lot of money will decide never to invest in that type of investment again. Ever. So if they buy a mutual fund that loses 40% of its value, they may never buy another mutual fund: not even an ultra-low-risk bond fund. And if they buy a stock that drops 25%, they may never invest in shares again. Even if they lost money on a hot tech stock they may refuse to buy even blue-chip dividend-paying stocks in the future.

Back when the dinosaurs roamed, I bought some index mutual funds in my RRSP. (There were no ETFs then.) They appeared to lose 25% of their value within the first 2 years. From then on I bought GICs for a very long time. Luckily I held on to the mutual funds. Eventually they evened out to earning about 7% a year over the long term. Still, it left me with a long-lasting reluctance to invest in the stock market, even by index investing.

Invest in Risk with Your Vacation Money Not Your Rent

One of my children was watching me update my financial spreadsheet with some dividend payments and capital gains one day. She was intrigued by the daily stock price chart shown on the brokerage account screen. So I stopped to let her really look at it.

“You know how you have money in the bank earning interest, right?” I asked. (She had it in one of the few accounts that actually paid interest: a 2% children’s savings account at ING Direct.) She nodded. “And you know you get $2 a year on every $100 in your account, right?” She didn’t but she nodded anyway.

“Well, if you look at this graph, you can see if you bought a share in TD this morning for $60, this afternoon it would be worth almost $62. So you could have sold it and made $2 profit on $60, not on $100. And it only took one afternoon, not one year.” Her eyes got bigger.

I flipped to the monthly stock price view.

“And if you bought the share last month for $55, you could have made $7 in one month.”
I flipped to the five year stock price view.

“But, uh oh, if you’d bought the share here” I pointed to 2008, “then sold it at this time here” I pointed to mid-2009, you would have LOST $30.

“That’s why you don’t want to put all of your money into stocks. Your Dad and I keep the money to pay for our house and food and the TV and the telephone in the bank. We only put the extra money, like for vacations, into stocks. Because it would be really sad if we couldn’t go on vacation and we’d be upset. But we would still have somewhere to live and something to eat and something to do. You should only risk the money you can afford to lose.”

And she got it. Whether she will make good choices when she’s old enough to control her own investments remains to be seen. But she did see that stocks are not safe investments and that only extra money should be put at risk.

Of Course I’ll be Safe: I Only Invest in Huge Blue Chip Dividend Paying Stocks

Can you say “Nortel?”

No company is immune from sudden, catastrophic failure.

Nortel, for those of you too young to remember was Canada’s bluest chip tech company with worldwide assets and employees. In mid-2000 shares were trading at $124.50 on the TSX. By 2002 it was worth less than $1 a share and was de-listed.

If you don’t believe it can happen again, search the history of Enron, WorldCom, Bre-X, Lehman Brothers, GMC, Chrysler and many more.

Dividend paying stocks do have a Secret Weapon that helps when the markets tumble. That helps make them lower risk than many non-dividend paying stocks. And dividend payers are usually older more established companies which may also make them safer investments. But you still need to have a truly safe base for your RRSP if you want to sleep easily.

What Kind of Investments Should Make Up the Safe Secure Fixed Income Part of Your RRSP

Cash
This is obviously a safe choice. Almost anywhere you invest your cash it will be covered by CDIC insurance up to a maximum of $100,000 per account. Make sure your cash will earn some interest, however. ING Direct, for example, offers a no-fee RRSP daily interest savings account.

Most discount brokerages do not offer ANY interest on cash balances at the time this was written. At some brokerages like CIBC Investor’s Edge you can get around this by buying no-fee mutual fund shares in a daily high interest account. (Please see ATL5000 High Interest Savings Account Fund at CIBC Investor’s Edge Online Discount Brokerage) At other brokerages like BMO InvestorLine you can’t unless you lock in $5,000 or more. (Please see Investing in AAT770. )

Guaranteed Investment Certificates (GICs)
Like cash, GICs offer a totally safe investment. They are insured by CDIC up to $100,000 if their term-to-maturity is 5 years or fewer.

GICs are often dismissed by financial advisors in recent years because the interest rate on a 1-year term is about 1.7-2% a year at the time this was written. Interest rates, however, have never been this low for this long. In 1991, I was earning over 10% interest on 1-year RRSP GICs offered by BMO. Not a bad return considering the investment was 100% insured and at no risk.

Boomer and Echo reviewed an insightful book by David Trahair in their article: Can You Succeed with an All GIC Portfolio? It’s worth reading. Did you know over the last 40 years, GICs have earned about 7% on average?

While I’m not advocating you invest only in GICs I am saying that having part of your safe secure base invested in GICs is worthwhile.

One caution when investing in GICs: Most GICs are not cashable. You cannot redeem them early. So if you suddenly need the cash they represent, you can be out of luck. You have to wait till they mature to get access to their cash value. If you might need access to your cash quickly, consider one of the other investment types.

You can buy RRSP GICs at almost any bank or credit union. The usual minimum purchase is between $500 and $1000.

You can buy GICs issued by a wide variety of financial institutions within self directed brokerage accounts. Usually the interest rates are higher than those offered directly at banks. The usual minimum purchase is $5000 per GIC.

Money Market Funds
Like GICs, the interest rates paid by money market funds have been hit hard over the past few years. Personally, I would not advocate investing in them right now when you could earn the same interest or more by investing in a daily interest account or GICs. Money market funds are not totally safe. They can lose money. And you have to pay a fee (a MER) which is deducted from the value of the fund before you are paid any earnings from the fund.

Term Deposits
Term deposits are very similar to GICs but are usually cashable after a certain period of time, often 30 days. Consequently, they usually pay a lower interest rate. They may require a larger initial investment.

T Bill Funds
These funds invest in government T bills only. They are very secure, however right now the rates paid by these funds are very low.

Bonds and Bond Funds and Bond ETFs
These are actually one of the riskiest investments for the safe and secure part of your RRSP. So in defiance of alphabetical order I’m placing them at the end of the list.

Buying individual bonds is difficult and can be costly. Most brokerages offer bonds for sale. The fee or commission is built into the price of the bond. That can make it difficult to compare different bonds. The face value of many bonds is also high which requires you to invest a lot in a single bond.

Bond funds make investing in bonds easier. You can let an experienced team pick and choose the best bonds. They have the buying power to negotiate the amount of commission they pay. And you can liquidate your holdings much more quickly and easily.

That said some of the best bond funds require a large initial investment. To buy PH&N funds through a discount brokerage you must buy a minimum of $5000 of a fund. There are annual fees charged by the bond mutual funds. Check these MERs carefully before making any purchases.

Bonds and bond funds may drop significantly in value if interest rates rise. People have been predicting this rise in interest rates and fall in bond values for several years now. One of these months it will actually start to happen.

[UPDATE: There are, of course, bond ETFs that like mutual funds invest in a variety of bonds. Unlike mutual funds, you buy and sell units of an ETF on the stock market like shares in a company. You usually have to pay a commission for each sale and for most purchases. Bond ETFs also have management expenses, MERs, but they may be lower than the annual fees for mutual funds. If you read about couch potato investing, you will find descriptions of commonly purchased bond ETFs.]

[UPDATE: in 2014 the US government has stated it will begin to stop “quantitative easing.” This may lead to a sharp increase in interest rates and a sharp fall in bond values. You should discuss the risks of investing in bonds with your financial advisor. Depending on your risk profile you may decide not to invest in bonds at this time. Personally I still have  money in bonds but I am expecting to suffer losses of up to 10-15% over the next few years.]

Concluding Recommendations for Building a Safe Secure Base for your RRSP Portfolio

In conclusion I would recommend

• Invest at least $25,000 in truly safe and secure RRSP investments.
• Invest in 1-2 year term GICs while rates are low and flat. Do not lock in to long terms at low rates.
• If you invest in bonds, consider investing in a bond fund.
• If you invest in a bond fund, to reduce the risk of losses, choose one with a short average term to maturity, such as the PH&N Short Term Bond and Mortgage Fund. (NOTE: The value and security offered by this fund may have changed by the time you read this article. Always fully research any investment suggestion before buying it. I’m not great at picking the winners!)
• As your RRSP’s value increases, keep increasing the size of the safe and secure base. You want to end up with an investment pyramid built on a wide sturdy secure base, not an inverted pyramid balancing a top-heavy load of high-risk investments over a pinpoint of safe secure cash!

Further Reading

• Losses, gains, and brains: Neuroeconomics can help to answer open questions about loss aversion by Scott Rick U of Michigan.

Related Reading

• RRSP Strategies Part 1: How to Best Get your RRSP Money Contributed Before the Tax Deadline
• RRSP Strategies Part 2: Move the Money Where You Want to Keep It. Choosing a Long Term RRSP Investment Account
• RRSP Strategies Part 4: Expanding your RRSP Portfolio Diversity by Investing in ETFs and Mutual Funds
• Questrade has the Lowest Annual Fee RRSP Brokerage Account with No Minimum Balance: Or Does It?
• RBC Direct Investing has a No Annual Fee RRSP Brokerage Account with No Minimum Balance!
• The 5-year GIC Ladder Strategy: No Longer a Scheme to Maximize GIC Returns
• Maximize GIC Returns by Carefully Considering the Annual Rates Before Locking In Long Term

Join In
Do you have your RRSP anchored with a firm safe base? What proportion of your RRSP is in safe fixed income investments? Please share your experiences with a comment.