Reach For Yield At Your Own Risk

I originally posted the following in the Moller Financial Services May Newsletter. Everywhere I look, there are signs of people searching for or creating investments that offer more income with low risk.  This reaching for yield is one of the biggest mistakes an investor can make.

“More money has been lost reaching for yield than at the point of a gun”
– Raymond F. DeVoe, Jr., of Legg Mason Wood Walker Inc., February 1995

Reaching for yield is one of the common behavioral follies of the human race, not just with money management but throughout everyday life. We always try to make something out of nothing and ignore the potential cost. Some of my favorite examples of “reaching” are:

  • How many people can we pack into this tiny elevator?
  • This tank of gas can go one more exit before I need to fill it up, right?
    • Or if you’ve ever had young children – C’mon son, you can make it to the next rest stop to go to the bathroom, right?
  • I can squeeze one more dab out of this toothpaste tube!
  • Just 10 more important photos, then I’ll back them up.

Then, there is my own recent “reaching for yield” mistake of trying to get one extra slice from the butternut squash using a mandolin slicer. I’ll spare you the details, but let’s just say I paid the price for trying to squeeze an extra gluten-free noodle from my squash. As Raymond DeVoe described, I lost some money reaching for yield with my emergency room visit.

Reaching for yield not only gets us in trouble in the kitchen, but with investing as well.

What Is Investment Yield?
Yield is the cash (or income) that ends up in your pocket by owning investments like stocks, bonds, and real estate. For example, if you have an investment worth $100,000 that pays $3,000 cash each year, your yield is 3% ($3,000 ÷ $100,000). For stocks, yield comes in the form of dividends. Bonds, CD’s, and other forms of fixed income pay interest. Real estate has net operating income (rental income minus operating expenses). In general, you would receive the most yield from real estate, followed by bonds, then stocks.

Since 1871, the average yield of a U.S. Treasury bond due in 10 years is 4.6%. This number is not bad, especially when you consider today’s interest rate is around 2.7%. How do bonds compare to stocks? Surprisingly, they are very similar. Large U.S. stocks have averaged a yield of 4.4% since 1871, but currently pay about 1.9% to shareholders.

How much yield can an investor expect from real estate? According to the National Council of Real Estate Investment Fiduciaries, real estate has earned a 3% higher “yield” than bonds on average (1992-2012). This higher yield is necessary to compensate investors for capital improvements and other costs of owning a property. In addition to these additional costs, real estate income and bond interest are generally taxed at an investors “ordinary” (higher) tax rate. Qualified stock dividends, on the other hand, receive preferential tax treatment with rates at 0%, 15% or 20% depending on your level of income.

Examples of Reaching for Yield
Now that I’ve described what investment yield is, how does an investor “reach” for it? There are three primary ways to reach for yield (besides risking one more slice on the mandolin):

1. Loan money over a longer period. Investors should expect to receive a higher interest rate for money loaned over 30 years compared to 10 years.

2. Loan money to less creditworthy people/entities. Investors should receive more interest when lending money to their friend Sam or Sam Corporation than to Uncle Sam (the U.S. government). Less creditworthy borrowers pay a higher interest rate, but investors carry a greater risk of not getting their money back.

3. Invest in a financially engineered product. Leveraged loans, collateralized debt obligations, asset backed securities, mortgage backed securities, and structured notes are all examples of financial engineering.

Unfortunately, I see examples of each of these mistakes fairly often. Each strategy sounds great at first, but oftentimes end very badly.

Let’s take #1, lending money over a longer period. Today, the U.S. Treasury pays 2.7% interest on the 10-year bond and 3.6% interest on the 30-year bond (as of March 31, 2014). An investor can reach for yield and buy the 30-year bond because it pays more interest. But what happens if interest rates rise by 1%? Before giving the answer, it is important to understand that a change in the interest rate has a compounding affect – longer term bonds are more sensitive to interest rate changes than shorter term bonds. According to J.P. Morgan, the 10-year bond would lose 8.4% that year. If you think that sounds bad, the 30-year bond would suffer a 16.4% loss. OUCH!

With #2, lending money to less creditworthy people/entities, investors should know better. The risk of lending money over longer periods is not intuitive, but understanding creditworthiness is pretty basic. According to J.P. Morgan, the least creditworthy companies had to pay a 5.9% higher interest rate than the government over the last 25 years on average. Today, these riskier loans only pay 4.1% more interest than the government. If riskier bond interest rates rise to their long-term average (a 1.8% increase), high yield bond investors will feel like junk, losing 10% compared to plain vanilla U.S. Treasury bonds.

Even the most sophisticated investors get hoodwinked into believing financially engineered products (#3) are a safe place to get some extra yield. As we learned during the 2008-2009 financial crises, even the brightest individuals and biggest investment banks can go bankrupt with these products. And some of the banks that survived did so by selling financially engineered products to their “clients” and taking the opposite bet themselves.

Observations for Today
You don’t need to look far before you find examples of investors reaching for yield today. Below are some of my favorites (as in, I would never invest in any of these).

1. Peer-to-peer investing is the latest craze and is a billion dollar industry in the U.S. Since banks have been rather tight-fisted, yield seeking investors have stepped into the marketplace of directly lending money to other individuals. Now, you can lend money to people with credit grades of A through G and hope they can pay you back. I like the free-market idea, just not as an investment.

2. I remember thumbing through Barron’s last year and saw an ad for a new product – a gold fund that pays a dividend! My first response was “how can a shiny metal that does nothing provide income that will go in my pocket?” Silly me, I forgot about financial engineering! The engineers created an investment product (kind of like the Twinkie is a food product) that owns a gold fund and sells options. The option selling creates the “income”. Unfortunately, this investment lost over 30% in 2013 – even worse than just plain gold.

3. Now for my favorite. Would you like to own a yogurt shop in Chicago in the middle of the polar vortex? Well now you can! Simply invest $10,000 and you will get 9% interest plus an equity option. I wish I made this up, but this “offer” is for real, search for it yourself. I have no doubt that some “crowdfunding” investments will turn out to be wildly profitable, but most will simply end up lining the pockets of brokers and individuals who sold their business.

Reaching for Yield Solution
Before we get to the solution, it is important to understand a company’s options for allocating their profits. A company can

1. Return profits to shareholders in the form of dividends.
2. Reinvest profits in the company including new products, services, and equipment or paying off debt.
3. Acquire stock from shareholders or another company.

If an investor solely focuses on yield (dividends and/or interest), they ignore the benefits of reinvestment and acquisition which can generate growth and appreciation for investors. In fact, the S&P Price Index of U.S. stocks has grown over 5% per year since 1900 in addition to dividends paid to shareholders. That is a total return of over 9%. Over the last century, investors have benefited more from growth than from yield.

Savings + Growth + Yield + Goals = Successful Financial Plan
For our investment management, the focus is on achieving a good balance of total return and downside risk management. Whether the total return comes from yield or growth, it does not matter. Return is return. What matters most is having personalized strategy to save enough, invest wisely, and spend within our means.

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