In my first article (Guaranteed income – part I), I mentioned investing a lump sum of money into five staggered GICs and invest the GIC interest into a mutual fund.

The primary objective was to protect the principal but still leave room for some potential growth by investing in mutual funds.

A reader might observe that the opportunities for growth are rather limited as GICs are likely only yielding at best about 3% on a staggered basis or 3.5 % on a five year GIC.

That observation is largely correct as interest rates are low by historical standards and investing only 3% per year appears at first blush, to be insignificant money.

One cannot forget though, about the magic of compound interest and what appears to be insignificant now can accumulate into very significant amounts over time.

It all depends on what the investment objective is. Here are three possible choices:

1. Protect all capital at all times.
2. Protect all the capital, but invest the interest earned from a GIC into mutual funds.
3. Invest all of the money into the market and not worry about any guarantees at all.

Option “A” is the least “risky” of the three investment objectives but over a long period of time it has tended to produce the least returns. The only straight forward investment I can think of that does not fluctuate in value and has a 100% guarantee would be a GIC (Guaranteed Investment Certificate).

Option “B” invests all of the money into GICs but the interest from an annual pay GIC is used to buy stock market investments using mutual funds. Because you are only investing the interest produced from the GIC, even if the mutual funds went to zero, your principal would still be intact.

Option “C” is likely to be viewed as the conventional way of investing. It refers to investing money in things that fluctuate in value and have the potential to appreciate in value. It could be investing in real estate, gold bars, stocks, bonds, mutual funds, etc. All of these fluctuate in value, hopefully up in value but most people realize there is always a chance that any or all of these investments can also drop in value.

I have thought about a fourth type of investment strategy – a variation of Option “B”.

Let’s call it Option “D”.  In Option “D” below you are risking only the interest portion of a compound annual GIC:

1. You have $100,000 to invest.
2. Invest $84,197.32 into a 5 year compound GIC @ 3.5%.
3.  Invest the balance of the money, $15,802.68 into well diversified stock based mutual funds. If the stock market gets wiped out and you lose the entire $15,802.68, the GIC will still mature to an amount of $100,000 in 5 years.

You would have no return, and lost time, but at least you get your $100,000 back.

In reality, the chances of the value of stock markets everywhere being precisely zero five years from now is extremely remote so you would likely have some positive rate of return even under the most dire economic circumstances.

The advantage of the Option “D” is that you are investing more money initially yet still obtaining a 100% guarantee of your principal. If you thought you were closer to a stock market low than a stock market high, then Option “D” could be a more attractive than Option “B” because more money would be invested sooner.

Summary

There are ways to invest in the stock market while minimizing risk.

Be mindful that there is a tradeoff between risk and return. Generally, the higher the risk, the higher the potential return. The lower the risk, the lower the return.

If your requirement is to have close to zero risk to your capital and you are happy with a 3.5% interest rate on a 5 year term GIC, then a GIC represents your ideal investment. You will get no more and no less than 3.5%. Option “A” is your best bet.

If a 3.5% interest rate is not sufficient then there are other alternatives to look at. If you believe the stock market can produce an average return in excess of 3.5% (annually) over the next 5 years, then Option “B” or Option “D” are two alternatives that will protect your capital but still keep a toe in the market.

If guarantees are not important and you wish to have full exposure to the stock markets, investing directly into an investment like a stock based mutual fund could be the most suitable candidate.

As I write this in late July 2009, the U.S. stock market is up about 47% since March 9^th so we all know that things can turn around very quickly when we least expect it.  The Bank of Canada is hinting that the Canadian recession may be over. So perhaps earning more than 3.5% from a GIC doesn’t seem so farfetched after all.