It is the RRSP season in Canada (Your last chance to contribute to your registered retirement saving plan for the year 2008 on March 2nd), and we see a lot of government bonds advertisements. They offer bonds at about 3% interest rate and they tell you that it’s 100% and suggest that you put them into your RRSP account.
The thing is that 3% seems a lot more than your balance portfolio that did -20%, right? Many investors have the bad habit of doing linear assumption. “At a rate of -20% per year, I’ll lose all my money within the next 5 years”. Even though this assumption is mathematically wrong (as you will lose 20% of the balance of your funds each year and not 20% of you original amount), it is even more wrong to think that we will make -20% for 5 years.
To these clients, I ask them the following question:
The price of gas was at $1.50 a litre back in July 2008, 6 months later, it now around $0.80. At this rate, don’t you think that next summer we will pay $0.25 a litre?
They all think I’m stupid, however, if their linear assumption is good for the stock market, it should be good everywhere, right?
Back to our dear Government. So they offer bonds with cheap yield (I can’t blame them on that since we are living in a world of very low interest rate) and they tell you it’s good to include this in your retirement account.
Let’s do the math for fun… $5,000 per year at 3% in… 25 years. That makes a total contribution of $125,000 (5K times 25 years). Your portfolio will worth $182K. How much do you think you will be able to withdraw from it for 20 years?…. not much!
If you do the same exercise with a yield of 5%, you will get 238K and with a 7% yield (if you are aggressive); 316K. This is what we call the power of compounding interest.
I’m not saying that government bonds are not a good investment options, but depending on your age and the number of years you have before retiring, you should consider other option.
How would you react when the market comes back with a +20% in a year? How would you feel with your 3% return? If you think that you will still be happy with it, then the government bonds are a good investment option… if you swear that you won’t go back into the market after it came back from the dead!
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