Why you should be wary of index-linked GICs

Special to the Financial Independence Hub

Index-linked GICs (Guaranteed Investment Certificates) provide the buyer with a return that is “linked” to the direction of the stock market in a given period. A quick look at the rules on these deals may give you the impression that the investor can profit substantially with little risk. However, the link depends on a formula or set of rules that is buried in the fine print.

These investments are marketed as offering all of the advantages of stock-market investing with none of the risk. But banks and insurance companies aren’t in the business of giving customers something for nothing. The capital gain that holders get depends on an ingenious formula which is cleverly designed to sound generous while minimizing the potential payout.

Index-linked GICs fail to offer the big tax advantages of stock investing

Another drawback is that returns on index-linked GICs are taxed as interest. That’s because you’re not actually investing in the stock indexes themselves; you’re just getting paid interest based on the change in the indexes. That’s a drawback because interest is the highest taxed of all investment returns.

Usually, stock-market investing produces capital gains and dividend income, both of which are taxed at a much lower rate than interest. (Of course, if you hold the GICs in an RRSP, all income is tax deferred.)

These GICs do protect your principal. But few investors if any make a good return on index-linked GICs. Most make less (at times substantially less) in index-linked GICs than they would have made in old-fashioned GICs.

If safety is your primary concern, you’d be better off with “plain vanilla” stocks and bonds. If you already own index-linked GICs, our advice is to cash them in at the earliest opportunity. If you don’t own them, we recommend that you stay out.

No matter what kind of stocks you invest in, you should take care to spread your money out across the five main economic sectors: Finance, Utilities, Consumer, Resources & Commodities, and Manufacturing & Industry.

By diversifying across most if not all of the five sectors, you avoid overloading yourself with stocks that are about to slump simply because of industry conditions or investor fashion.

You also increase your chances of stumbling upon a market superstar—a stock that does two to three or more times better than the market average.

Our three-part Successful Investor strategy:

1. Invest mainly in well-established companies
2. Spread your money out across most if not all of the five main economic sectors (Finance, Utilities, Consumer, Resources & Commodities, and Manufacturing & Industry.)
3. Downplay or avoid stocks in the broker/media limelight.

Note: This article was originally published in 2012 and has been updated. Here is the most recent version that ran at TSINetwork.ca. Permalink: http://www.tsinetwork.ca/?p=53526