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The Risk of Being Safe

When Margaret and John (pseudonyms) inherited $100,000, the debate began about how that money should be invested. Margaret wanted to play it safe — GICs all the way. John thought putting some of the money in higher-growth investments made more sense.

Both John and Margaret were retired and had enough income to meet their day to day needs, at least for the moment. But John was concerned about how Margaret would manage on her own. With a seven-year age difference and John's medical history, there's a strong likelihood that Margaret will find herself on her own, living on only 60 percent of John's pension. And since she is only 58 and in good health, there's a very real possibility that Margaret will live for another 28 years.

Margaret's main concern is the safety of the principal. "I don't want to gamble with this money," she said. But John thought that putting all the money into GICs had its own risks.

Many women have a strong reluctance to investing in equities, or stocks. According to a study done by the Toronto Stock Exchange only 39 percent of women surveyed indicated they would be willing to take some risk for a chance to realize greater gains, as compared with 58 percent of men. The difference arises in part because of the way women have been socialized. According to Olivia Mellan in her book Money Harmony, "Women's long history of being financially dependent on men and of earning less money than men do may contribute to women's hesitation to risk much money when investing." While many women want to play it safe, safe is not always the best bet. Taxes, inflation and long life spans are all working against the purchasing power of your money.

Assuming Margaret and John invest their $100,000 at four percent, they will earn about $4,000 a year. Since that money isn't sheltered in an RRSP or RRIF, they'll have to pay tax on every cent of interest. At an average tax rate of 30 percent, they'll end up with only $2,800. In effect, their return would fall from 4 percent to 2.8 percent.

Then there's the spectre of inflation. In ten year's time, that $2,800 won't buy nearly as much as it buys now. The average rate of inflation for the past forty years has been about 4 percent. Assuming this holds course, their $2,800 will be worth only $1,900. And inflation will eat away at the principal too — $100,000 will be worth only $68,000 in ten years, and only $46,000 in twenty years.

Another risk — particularly for women — and one that Margaret may very well face, is that she will outlive her money. With life expectancies on the rise, the average woman can expect to live to 87, six years longer than her male counterpart. Longer life spans mean more exposure to inflation risk and, by extension, more need for those investment dollars to work doubly hard.

The first golden rule in building a healthy investment portfolio is diversification: a little of this, and a little of that. Some stocks, some bonds such as Canada Savings Bonds or provincial bonds, some GICs. A touch of foreign investment, a little tucked away in a money market account — which works like a bank account but earns interest based on investments such as treasury bills and promissory notes — where it is easily accessible. By hedging your bets you'll protect yourself from negative swings in any one type of investment. When the stock market dumps and bonds glow, your bond portfolio will pull you along. When bonds dive and the market soars, your equity investments will save the day. And when Canada spirals while Europe, South America or Asia sky-rockets, you'll have enough invested internationally to keep your return balanced.

While there's a different asset mix for each person based on your objectives and how comfortable you are with different types of investments, almost everyone needs to aim for an after tax return that significantly outpaces inflation. Typically, asset mix falls into one of three groups: conservative, balanced, or growth-oriented. A typical conservative investment portfolio might hold 20 percent in cash, 60 percent in fixed-income investments such as bonds or mortgages, and 20 percent in equities. So if Margaret remains true to her conservative nature, she and John should invest at least 20 percent of their inheritance in equities. A balanced portfolio would hold 10 percent in cash, and 45 percent each in fixed-income and equities. A typical growth portfolio would hold 10 percent in cash, 30 percent in bonds and 60 percent in equities.

Just 20 years ago, it would have been impossible for most investors to diversify sufficiently if they had less than $150,000 to invest. But thanks to mutual funds, you can now have a healthy portfolio with as little as $500. The instant-coffee approach to balance, for example, has you buying a balanced mutual fund that has a pre-packed mix that combines fixed-income and growth investments. More confident investors may want to brew their own portfolio rather than using the balanced-fund approach.

With so much to choose from, how do you decide what's right for you? That's where the second golden rule comes in: buy quality. Never mind the ads that promise you 36 percent. Don't be greedy. Look at the track record of the investment you want to buy. Don't look simply at the average rate of return –– great years can mask the mayhem caused in rotten years. Instead, ask for the year-over-year returns so you can see how volatile the investment has been. Choose an investment that has a good history of stability and long-term positive return.

Of course, only you can decide which investments — and how much of each kind — you're comfortable with. You may need the help of an advisor to guide you through the maze of investment alternatives. As you weigh the pros and cons of each, keep in mind that an overwhelming concern for capital safety shouldn't ignore the risk of not keeping pace with inflation. Remember, there's no such thing as "no risk." It's all a matter of degree.

How Would You've Done?

If you had $10,000 to invest from January 1970 until June 1995, how much would you have earned?

  • If you were a conservative investor, your portfolio would have glided to $69,815.
  • If you were willing to take a little more risk and went the route of a balanced portfolio, your $10,000 would have soared to $89,082.
  • If you picked the growth portfolio, your investment would have jetted to $100,263.
  • If 20 percent of equities in your growth portfolio was in foreign investments, your $10,000 would have sky-rocketed to $110,510.

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Gail Vaz-Oxlade is a best-selling author, regular contributor to various publications and the host of the television series Till Debt Do Us Part.