Articles

Your Wealth Strategies Shouldn't Include Chasing Investment Yield

By Bruce Smith | October 06, 2015

With short-term interest rates hovering near .25%, we often hear from investors who are considering seeking alternatives to savings, money market accounts, certificates of deposit, and other fixed income investments.

Bruce Smith is a 401(k) Financial Advisor with Premier Financial Group in Eureka Humboldt CountyThough the tendency to jump ship and seek higher yielding investments is understandable, recent history reminds us of the inherent dangers of this approach.

Chasing high yielding, fixed income or equity investments will expose your portfolio to unnecessary risk: Continue reading to learn how to generate cash flow through a “total return” strategic wealth managment approach to investing.

The Problem

When the market is strong, the true risks of a given investment are often hard to see. Famed investor Warren Buffet sums it up: “It’s only when the tide goes out that you learn who’s been swimming naked.” And that’s exactly what happened during the recent market decline, when many bond managers and income-oriented investors were caught with their pants down.

The problem began in 2002; an economic recovery was on the horizon, whetting investors’ appetite for higher yields. However, like today, rates on traditional interest-bearing investment vehicles were very low, so investors looked elsewhere.

Many turned their attention to mortgage-related securities, high yield bonds, global shipping companies, Canadian Royalty Energy Trusts, and high-interest-bearing preferred stocks. And during the boom of 2002 to 2007, these investments performed well – but their risks were masked.

Investment professionals, including pension, hedge and mutual fund managers, poured billions of dollars into these vehicles, blind to the true risks hidden within, allowing brokerage firms to amass immense profits. When the bubble burst in 2008 and the economic, credit and corporate profit cycle rolled over, investors were left holding the (empty) bag, and these investment vehicles once championed as safe experienced huge losses.

2008 Total Returns

Shares I Boxx High Yield Bond Index

-17.4%

Shares US Preferred Stock Index

-23.8%

Oppenheimer California Municipal Fund

-41.3%

Claymore Canadian Energy Income fund

-54.2%

Oppenheimer Champion Income Fund

-78.5%

Adding insult to injury, yield-oriented investors tend to be retirees or those on fixed monthly incomes, making these types of losses enormously disruptive and a real cause of hardship.

The Total Return Approach: An Asset Management Solution

Rather than chasing higher yields in fixed income portfolios, Premier favors a total return approach to investing. This strategy targets cash flow generation through both income and capital gains.

Our total return approach consists of three components, or buckets, which help retirees meet current living expenses and unexpected cash needs, enhance financial peace of mind, and provide for portfolio growth to offset inflation. These buckets include:

  1. Liquidity and safety: Maintain at least a year’s living expenses in a safe, readily-accessible money market account

  2. Provide income and reduce volatility: Maintain several years worth of living expenses in high-quality, short-duration bonds, providing a safe source of funds to draw upon

  3. Highly diversified global equity portfolio: Tilt investment toward the most rewarding segments of the capital markets; dividends and capital gains can be used to replenish liquidity reserves and your short-term fixed portfolio as needed. During periods of poor market performance, draw on the money market account or fixed income portfolio and avoid selling equities at depressed prices 

This approach provides security, confidence and peace of mind – and most importantly, it allows exposure to the market to keep up with the rising cost of living over time.

Vanguard’s Findings Support Our Wealth Management Approach

Vanguard, a highly regarded mutual fund company, compared the yield-oriented income approach to the total return approach using 80 years of real market data, a $1M portfolio value and a 5% distribution rate. Vanguard’s conclusion? The total return approach is “the more prudent, and most likely only viable, long-term spending method.” Below is an inflation-adjusted ending asset balance projection for two $1,000,000 portfolios over 30 years.

Portfolio Blend

60% Stocks/ 40% Bonds

   100% Bonds

Best Case Scenario

$5,983,000 after 30 years

$3,300,000 after 30 years

Worst Case Scenario

Ran out After 19 Years

Ran out after 17 years

Median

$594,000 after 30 years

Ran out after 20 years

% of times Portfolio lasts 30 years

 75%

47%

Bruce Smith is a 401(k) Financial Advisor with Premier Financial Group in Eureka Humboldt CountyAs you can see, using the traditional approach -- a portfolio of corporate or municipal bonds or other yield-oriented vehicles -- to generate retirement income is fraught with risk. And as retirements grow longer due to increasing life expectancy, this approach leads to a higher likelihood that you'll simply outlive your money.

In contrast, a total return approach – in which a reasonable, targeted amount of cash flow is
withdrawn from a balanced portfolio’s income and capital gains -- has a higher likelihood of lasting 30+ years, a time horizon not unheard-of for today’s retirees.

Given today’s low interest rates, its easy to feel frustrated with low-yield investments. But if you’re looking for alternatives, avoid common, yield-oriented investments such as high-yield corporate or municipal bonds, preferred stocks and royalty trusts. These highly risky instruments may lead to significant losses.

Instead, employ a total return approach with a focus on maintaining sufficient liquidity reserves, a fixed income allocation of short-duration, high-quality bonds, and a globally diversified equity portfolio tilted toward the most rewarding areas of the global capital markets.


 

Posted in The Rational Investor

   
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