Wednesday, February 29 is the last day to make a deposit to your RRSP and still get a tax deduction against your 2011 income taxes, and as this RRSP season comes to a close Iíd like to share a few final thoughts.
While I am happy that people are saving for their future, too many of them just bought the wrong product for the wrong reason. To elaborate, hereís a bit of a history lesson.
Question 1: How many people bought tech stocks in 1999? Answer 1: Lots and lots. Question 2: How many people regretted it? Answer 2: Pretty much all of them.
The reason that so many people bought tech stocks in 1999 was because these were the investments that had just done well. Following some impressive short-term performance, people jumped on the tech stock bandwagon, thinking that the party was still in full swing and wanting a piece of the action. And then, shortly after, the bottom fell out of the market for tech stocks, with catastrophic results.
So have people learned anything from that painful mistake?
Nope. Lots and lots of people are still chasing past performance.
Right now the investments with impressive short-term past performance are bonds. And, across the country, that is what most of the money has gone into lately.
While there might be plenty of good and valid reasons to have bonds in a portfolio, chasing past performance is not one of them. Hereís what you need to know about bonds.
In essence, bond investing is pretty simple. You lend money to someone, and they pay you back with interest. You can make money on bonds in two ways. The first way is the interest that you receive for lending your money. The second way is if you happen to own a particularly attractive bond, and you can sell it at a premium.
Okay, so letís look at the first way Ė the interest that you receive. I donít think that it will surprise anyone to hear that interest rates are really low right now. In fact, current interest rates are some of the skimpiest ever seen.
The interest rate on a ten-year Government of Canada bond is under two percent. That rate has never been lower. Can you imagine? You lend your money for ten whole years, and your compensation is a measly two percent annually? Clearly people arenít being paid very much to lend out their money.
The second way that you can make a profit on your bonds is if you can sell them at a premium. Over the last 30 years this has been pretty easy to do. All you need is declining interest rates.
If you have a Government of Canada bond that is paying five percent, and the current issues are paying two percent, you have a valuable asset. People will gladly pay you a premium price since the bond that you own is paying a better rate than the bonds currently offered.
In Canada bonds have benefitted from a 30 year tailwind of declining interest rates. But now that interest rates are near zero, how much lower can they fall?
Unfortunately for bond investors, changes in interest rates can work against you too. If interest rates are increasing, thatís a tough environment for a bond investor. How much do you think your two percent Government of Canada bond will be worth if itís competing against bonds paying five percent?
In the short-term, bond investors are going to be unhappy with the rising interest rates because their bonds wonít be worth as much. But they are going to be really unhappy in the long-term, because the reason that interest rates are rising is almost certainly due to inflation, and inflation cripples the eventual purchasing power of money held in fixed income investments.
Now ask yourself this Ė given the current interest rate environment; where you are getting paid diddly-squat to own bonds, where interest rates really canít go much lower so you can probably forget about a repeat of past windfall profits, where interest rates will inevitably head higher so you can probably expect that eventually the value of your bonds will decline in the short term, and given that inflation cripples fixed income investments Ė are you still sure that the investment that did well last year is the investment that you want to buy today?
The opinions expressed are those of Brad Brain, CFP, R.F.P. CLU, CH.F.C., FCSI.† Brad Brain is a Senior Financial Advisor with Manulife Securities Incorporated, in Fort St John, BC. Manulife Securities Incorporated is a Member of the Canadian Investor Protection Fund. Brad Brain can be reached at firstname.lastname@example.org†or www.bradbrainfinancial.com.