Wednesday, February 29, 2012

Hidden Erosion of Principal

A mistake that many fixed-income investors make repeatedly is failing to protect their principal. In the pursuit of higher interest to live on, they fail to see the erosion of their assets.

I first saw this with some older family members who bought GICs in the 1980s. In the first half of the 1980s, inflation averaged 7.5% per year and 5-year GICs paid an average of 13% per year. These family members just spent their interest payments and felt secure that they weren’t eating into their principal. Of course, their principal was eroding at an alarming rate.

In the 5 years starting in 1980, the purchasing power of their savings dropped by 30%. So much for feeling good about not having touched their principal. The real shock came when they renewed their GICs at much lower interest rates. Not only did the interest payments drop dramatically, but the prices of everything they had to buy had gone up considerably.

Another good example of principal erosion was discussed by Canadian Capitalist in his review of BMO’s covered-call bank ETF with ticker ZWB. The first year dividend was 9.2%! Combine this with the perception that Canadian banks are safe made this a popular ETF.

However, this dividend is essentially digging into principal. We can see this by comparing ZWB to another ETF (whose ticker is ZEB) that invests in Canadian bank stocks but just pays the regular dividends from the bank shares. In fact, ZEB outperformed ZWB when we add principal and dividends. ZWB investors have the illusion that their principal is untouched because they still have the same number of shares, but in fact if they have been spending the dividends, they are spending their principal.

The lesson here is that it is no good to think of your principal in terms of absolute dollars or in terms of number of shares. You have to think in terms of purchasing power. If your principal is not keeping up with inflation, then you are spending it.

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