By Arnold Machel, CFP®
Canadian banks are required by law to meet certain liquidity requirements. In overly simplistic terms, they are required to essentially match their deposits to their mortgages. For example if they have $50 million in GICs maturing in 5 years, they need a similar amount in mortgage or other debt instruments payable at around the same time so as to ensure that they are able to pay the deposit holders upon maturity. Insurance companies and pensions have similar requirements, only longer-term in nature. This principle is known as Asset–Liability Matching and serves to simultaneously limit the risk of being unable to pay deposit holders and to encourage the earning of reasonable risk-adjusted returns by proper management of investment time horizons.
As individuals we are not required to follow the same principle, but we ignore it to our own detriment. For example, it is not at all uncommon to see RRSP money (money that is not to be spent for 20 – 40 years) deposited in savings accounts or term deposits ranging from 1 – 5 years, which is a clear mismatch.
Why should this be a concern to us? Because, generally, the return that we get by thinking longer-term is higher than the return we get by thinking shorter-term. For example, generally speaking one can expect to earn more by purchasing a 20 year bond, which typically would earn more than a 5 year GIC, which in turn usually earns more than a 1 year GIC. And over the long run, the difference of that extra little bit can make a huge difference.
To illustrate this and to introduce you to the Rule of 72, let’s just say you need a new fridge. You run down to the local appliance shop and see the same fridge with two prices on it. The first one sells for $1,000, the second for $2,000. The salesman explains to you that the catch with the second one is that in 24 years you will get all of your money back. Which one should you buy?
Rule of 72
To figure out which is the better deal, there is a simple rule of thumb that you can use called the Rule of 72. Bear in mind that this is not perfectly mathematically accurate, but it is a simple rule of thumb that allows most people to do the math in their head.
Simply divide your expected rate of return into 72 and the result is approximately how long in years it will take for your money to double. For example, if you get 3% interest, your money will double about every 24 (that’s 72 divided by 3) years. Earn 6% and it will double about every 72/6 = 12 years.
So let’s say that you only ever put your money in GICs or term deposits. And for the sake of argument let’s say that you can find a 2% term deposit. 72 divided by 2 equals 36. So at 2% if you purchased fridge No. 1 and took the extra $1,000 it would have taken to buy fridge No. 2, and dumped it into a term deposit, then it would take about 36 years for your money to double. Yet you can double it in only 24 years by purchasing fridge No. 2. Looks like Fridge No. 2 is your better bet.
Maybe you are OK investing in a conservative mutual fund that you expect will pay you in the neighbourhood of 3%. At 3% your money will double about every 24 years because 72 divided by 3 equals 24. Same as your return in buying fridge No. 2. It’s a wash.
Solomon says to invest for the long term (“ship your grain across the sea, after many days you may receive a return” Eccl 11:1). Maybe you heed his advice and invest in a solid but long term investment like a growth oriented mutual fund that you anticipate will get you 6%. Now your money doubles every 12 years. You start off with the extra $1,000. In year 12 it’s $2,000. In year 24 it’s $4,000. Now we’re seeing a MUCH better return than what the appliance store is offering. Clearly a better choice.
Now Solomon also says to “Invest in seven ventures, yes, in eight” (Eccl 11:2), so maybe you go one step further. You invest in a handful of higher risk investments that you expect to earn 9%. Just for the sake of this article, let’s assume that all of them work out. Now your money doubles every 8 years. Look what happens now!
| Year 0 | You start with... | $1,000 |
| Year 8 | It grows to... | $2,000 |
| Year 16 | It grows more... | $4,000 |
| Year 24 | And more... | $8,000 |
We often underestimate the value of compounding over time. Over longer time-frames a small increase in return makes a huge difference, but the point here is not necessarily to take higher risks - rather that we should start off by assessing our timeline and then acting accordingly.
So next time you make a money decision of a long-term nature, make sure that you consider your time horizon thoroughly and think hard about the long-term consequences of that decision. Count the long-term cost of thinking short-term.
Arnold Machel, CFP® lives, works and worships in the White Rock/South Surrey area. He attends Gracepoint Community Church where he serves on the Leadership Team. He is a Certified Financial Planner with IPC Investment Corporation and Visionvest Financial Planning & Services. Questions and comments can be directed to him at dr.rrsp@visionvest.ca or through his website at www.visionvest.ca. Please note that all comments are of a general nature and should not be relied upon as individual advice. While every attempt is made to ensure accuracy, facts and figures are not guaranteed.