I read an interesting article titled, “Do Risky Assets Belong in a TFSA?” (Canadian MoneySaver – March/April 2014). The author compares purchasing a GIC paying a guaranteed 2% a year with a risky ETF tracking the TSX with an expected average return of 6%, but which could result in returns ranging from a gain of 20% to a loss of 15% in any given year.
Contrast this with, “The Great TFSA Race”, a contest in MoneySense magazine searching for the highest balance in a TFSA.
Related: Why TFSAs are still misunderstood
The winner, with a balance of around $300,000, took an investment risk with highly volatile penny stocks and, in fact, currently is 100% invested in only one stock!
I say, good for him, but I think he was also very lucky. This could have turned out very differently.
Should you take big risks to reap huge rewards?
The risky investment
One advantage of a TFSA is that investment returns are tax free – i.e. no capital gains tax. Would this influence the type of investments a person would purchase?
Here are some of the risks:
No capital gains tax also means no offsetting capital losses. Would someone be tempted to hold on to a losing investment longer than is prudent, hoping for a rebound? Many investors find it difficult to sell a loser anyway, even when it’s found to be unsuitable. No tax break could make it worse.
You may lose future contribution room. If you do sell a losing investment and have to withdraw the funds from your TFSA you’ll lose some re-contribution room.
e.g. Franklin uses his 2014 contribution of $5,500 to purchase XYZ Widget Company. His shares drop in value to $3,380. He needs the money so he withdraws this amount. Next year he can only re-contribute $3,380, not the original $5,500, so has essentially lost the re-contribution room of $2,120.
Investor behavior is the greatest risk of all. Markets have rebounded nicely since 2009, which might give investors the confidence to take on additional risk. Many investors are optimistic enough to believe they can’t lose, especially in bull market conditions. Who wouldn’t want a cool $300,000 tax-free like the Money Sense winner above?
Related: 5 lessons learned about investing
Final thoughts
Too many investors treat their accounts as separate, individual entities, especially when they are held at various different financial institutions. The question should not be whether to own risky investments in your TFSA. All holdings should be part of an overall, properly allocated and diversified portfolio based on your financial situation and needs.
When a TFSA is part of a retirement savings or income plan, it needs to be integrated with any RRSP/RRIF or company pension plan. Someone who is using a TFSA for short term to medium terms funds will choose much different types of holdings.
Related: Using tax free savings accounts in retirement
Any risks taken should be based on your own comfort zone, time horizon, and other guaranteed money. Don’t treat your TFSA like a casino hoping for huge wins. You may end up striking out.
