Guaranteed Investment Certificates (GICs) are contracts where you deposit money with a bank or other financial institution for a period of time, in exchange for a guaranteed return (interest rate). Depending on the macroeconomic conditions, the interest rate can vary, but can range from around 1% to around 5%. When the opportunity presents itself, is a 5% GIC worth it?
In the short term, a 5% GIC can provide a solid, safe investment. However, it’s not recommended to invest in 5% GICs for terms longer than a year or two. Over the long-term, 5% GICs will vastly underperform the market. This creates opportunity cost, which can lead to significantly lower returns.
Let’s outline when a 5% GIC may make sense, and when you’re better to invest in longer-term asset.
When is a 5% GIC Worth it?
GICs are best suited for short time horizons when you have a specified need for the money at the end of the term.
This could be an expense like an upcoming tuition payment, money earmarked for a wedding, a downpayment, etc. All these represent cases where you know you’ll need the money, and you can’t afford to lose value in the interim. And rather than just store in a savings account, you want to get some growth.
GICs have the advantage of being incredibly safe. As suggested in the name, GICs are guaranteed to provide the interest rate, and are covered up to $100,000 under CDIC. So for you to lose money in a GIC, not only would the bank fail, but the government would also need to fail. If that were to happen, there would likely be greater concerns than the state of your investments.
Now it is important to consider the broader economic conditions when a 5% GIC is offered. Often this will be in a recessionary period, where the central bank interest rates are high. And this often correlates to a period of high inflation. As such, though 5% may sound great on paper, you need to consider the real interest rate (return minus inflation).
All in all, GICs are well suited for time frames of 1-2 years or less, where you have a specified need for the funds at the end of the term. If you’re looking for anything longer term, you’re better off to invest the money.
How Much Will a 5% GIC Grow?
A 5% GIC will grow the base deposit by 5%. To calculate the dollar amount, you can multiply your base capital by 1.05.
For example, if you put $1,000 into the GIC, it would grow to $1,050. Or, if you deposited $10,000, it would grow by $500 to $10,500. Ultimately, the more money you put in, the more money will come out.
Now if you were to have a GIC that lasted longer than a year, your gains would start to compound. Starting with $10,000, in year one it would grow to $10,500. Then, in year two, the 5% return would apply to the base capital and the year one growth. So, you’d grow your $10,500 to $11,025. This $25 increase in return may not seem like much, but with time the growth with accelerate:
As you can see, with time the growth rate (the slope of the line) starts to increase. This is the magic of compound growth, which Einstein called “The Eighth Wonder of the World”.
Now as much as this growth looks great, it’s dwarfed by the stock market. Hence why long-term investment in 5% GICs is not recommended.
What is the Growth in the Stock Market?
Now let’s compare the performance of GICs with that of the stock market.
Since 1957, the S&P 500 has grown by an average of around 10% per year. So similar to our analysis, to get an estimate of one year of growth, you can multiply your base capital by 1.10. So, if you invested $1,000, it could grow to $1,100. Or if you invested $10,000 it could grow to $11,000.
Now this is ignoring a key characteristic of the stock market, which is volatility. Unlike GICs, which will provide guaranteed returns as defined in the terms, with the stock market, there are no guarantees. A 10% annual return may be the average, but it’s by no means a smooth ride. Let’s look at the value of $10,000 invested over the last 25 years:
As you can see, unlike the GIC, it’s not a smooth ascent. And depending on the timing of the analysis, your average annual return may be above or below that 10% average.
And that’s the key thing to realize, the 10% is the average return over a long time frame, not the expected return from one year. In fact, if we look at the annual returns for the last 25 years, this volatility is demonstrated:
As you can see, there are years where the market rises by more than 30%, and other years (2008) where it drops by almost 40%. That’s why it’s key to have a long-term horizon when investing in the stock market.
So on average the S&P 500 returns around 10% per year (corresponding to doubling after around 7 years), but the year-to-year returns can vary drastically.
What is the Opportunity Cost of a 5% GIC?
Let’s compare the 10-year growth of a 5% GIC with the performance of the S&P 500. Imagine in 2013, you invested $10,000 in the S&P 500, and also bought $10,000 worth of GICs at a 5% return. Here’s the performance of each of them:
Even with the volatility of the stock market, you can see the value of your S&P 500 investment after 10 years is almost twice that of the GIC. Therefore, the opportunity cost is the difference between the two:
As you can see, in the first couple years, the opportunity cost is pretty small. However, as time goes on, you can see the difference increases exponentially. That’s why even at 5%, based on the historical performance of the S&P 500, GICs will always underperform in the long-run.
To learn more, check out our articles on the stock market.