I recently saw a Canadian bank offering a GIC with a 2% rate of return. However, Canadian banks, such as Toronto-Dominion Bank (TSX:TD)(NYSE:TD), provide dividend yields of at least 4% today. Bank of Nova Scotia (TSX:BNS)(NYSE:BNS) yields 5%. Do you think two or three percentage points don’t make a difference? Think again.
Let’s say you invested $10,000 in a GIC for a 2% return. Assuming that at maturity you reinvest the principal and earned interest for the same rate of return, in 10 years you’d amass a total of $12,190.
What if instead you invested in Toronto-Dominion Bank for its 4% yield? Assuming at the end of each year you reinvested all dividends into the bank, in 10 years you’d amass a total of $14,802. With two additional percentage points of return, you would get an extra $2,612.
What if you invested in Bank of Nova Scotia for a 5% yield? Assuming at the end of each year you reinvested all dividends into the bank, in a decade you’d amass a total of $16,289. With three additional percentage points of return, you would get an extra $4,099.
It’s not as simple as investing for higher returns, though. Investors should keep the following in mind: the principal, the rate of return, the risk associated with an investment, and the time horizon.
The principal is the amount you invested initially. The larger the amount you invest, the higher your returns are. Most people don’t invest a lump sum and then forget about it. Instead, more practically, a good investor consistently invests over a long time to build wealth. This practice also encourages a healthy savings habit and reduces the risk of entering the market at the wrong time.
Rate of return and risk
Generally, the higher the rate of return you target, the riskier it is. In other words, if you’re aiming for a 20% rate of return, that’s much riskier than investing for a 7-10% return, which is also the average market return.
Investing in a GIC is safer because it guarantees your principal and the interest rate. On the other hand, the share prices of the banks go up and down. The volatility is seen as risky to investors because technically any company can go bankrupt, in which case, investors likely wouldn’t get anything back. There’s also the risk that the banks could choose not to pay out dividends, in which case, investors would need to depend on share-price appreciation for returns.
Your investment horizon is another big factor to how much return you get. Compounding is your money earning you more money, which in turn earns you more money. The longer you stay invested, the longer your investments compound.
If you bought $10,000 worth of Bank of Nova Scotia shares at a 5% yield for 30 years instead of 10 (with all dividends reinvested), you’d end up with $43,219. This is more than four times your initial investment amount.
Food for thought
If you bought $1,000 worth of Bank of Nova Scotia shares each year over 30 years for a 5% yield, you’d end up with $69,760. The above compounding scenarios assume the rates of return and dividend yields don’t change for the GICs and banks and that there is no price appreciation expected from the banks’ share prices.
However, we all know that, in reality, change is inevitable. The likely scenario is that the banks’ share price will appreciate and their yields will go up and down, but they’ll continue to increase their dividends as they usually have in the past.
A few percentage points of additional returns makes a big difference to an investor’s returns over time. The important thing to do is to consistently invest in quality companies and to let compounding perform its magic over time.