Sullivan's Market Sense: An investment column offering perspective on today's market noise
Evel Knievel Investing
Daredevil: One who pursues a dangerous course of action without thought or concern for the consequences.
Today's investors are being subjected to financial repression. In its current form, repression comes from government action to control interest rates, so that the government is not forced to pay, and investors do not receive, a just return. Repression of returns clearly helps debtors of all kinds at the expense of investors. For over three years the Federal Reserve has kept short-term rates near zero, and for over a year they have manipulated long-term rates to a figure below inflation levels. Government has forced these rates down to stimulate investment and demand, with marginal effect. As a consequence, low rates have lowered the dollar exchange rate and diminished investors' income.
Imagine an investor in Treasury securities who has seen the yield on his portfolio drop to half the former rate over the last ten years. If the investor was already retired and dependent on the income, he will have to cut his spending. Losing income, even in a low inflation environment, is difficult to bear. Investors in other types of fixed-income securities have seen similar drops in their income. Over the past few years, as investors' incomes have declined, they have looked for remedies.
Remedies for falling yields on portfolios come in two groups; efficiencies and risk taking.
First, efficiencies. Reducing the number of accounts you have in order to reduce fees and paper work is efficient. Using idle cash is efficient. Adjusting your asset allocation, to the minimum you must have in low yield investments, is efficiency. Forecasting your cash needs and resources to keep every available dollar working for you is efficiency. Managing both your assets and your liabilities for maximum return is efficiency.
Risk taking is another matter altogether. It is said more money has been lost stretching for yield than at the point of a gun. Think of the clients of Madoff and Stanford if you need current examples.
But less criminal ways of losing money are also popular. A friend of mine recently discussed a preferred stock of a second tier company he had bought; it carries a double-digit yield. He knew that the yield wouldn't last, it would be cut; but for the time being the yield was very attractive. He is a smart guy using a dumb strategy. He is very unlikely to get out of the investment before the price falls. He is stretching for yield by investing in risky investments, either knowingly or unknowingly.
Evel Knievel knew that the stunts he performed were risky. He also knew how to reduce the risk (while making a trick appear more risky!) but he pursued his death-defying career because he thought the return was worth it. My friend was risking the whole of his invested money to get a big yield for about six months. My friend's upside potential was five or six percent of yield, while his downside risk was likely fifty percent or greater of his capital. This is not a good risk- reward tradeoff. An investor getting 2% today can increase his risk slightly and get 3%. He can increase his risk even more and get 4%; but to go from 2% to 10%, he must be willing to risk a substantial portion of his principal. Such an investment must have a reasonable likelihood of a very bad outcome, or it would not be available at such a high yield.
The investment spectrum ranges from very safe and no yield Treasury Bills, to 2%-yielding ten year Treasury Bonds, to stocks with expected returns of about 7%, to venture capital expecting 15%. The further you get from T-Bills in yield, the closer you are to the risk level of venture capital.
Current yield-enhancing strategies which come with extra risk are: high yield stocks, Hybrid Mortgage REITS, MLPs, Preferred Stocks, Convertible Preferred Bonds, and anything else yielding 8% or more. Some of these investments will work out fine. Maybe all of them will-- but I am sure of this: investors who previously invested conservatively, but who now are desperate for yield, are not really aware of the risks they are taking. If on the other hand you are investing in these not just for their higher yield, but instead for a strategic reason such as diversification, then enjoy the risk, the yield and the diversity. Evel Knievel never took risks he didn't understand, and he never would have risked it all for 10%.
Some investors better fit the definition of daredevil than Evel Knievel ever did.
Brian B. Sullivan, CFA
© Regions Bank, Member FDIC. The foregoing represents the opinions of the author, Brian Sullivan, and not necessarily those of Regions Bank or Regions Investment Management, Inc. (RIM). RIM provides commentary to clients of Regions Bank, an affiliated company wholly owned by Regions Financial Corporation. The information contained in this report is based on sources believed to be reliable but is not guaranteed as to accuracy and does not purport to be a complete analysis of the security, company or industry involved. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This report is designed to provide commentary on market strategy and the opinions expressed reflect the judgment of the author as of the date of publication and are subject to change without notice. RIM assumes no responsibility or liability for any loss that may directly or indirectly result from the use of such information by you or any other person. Investments discussed in this report are not FDIC-insured, not deposits of Regions Bank or its affiliates, not guaranteed by Regions Bank or its affiliates, not insured by any government agency, and may go down in value. Investment advisory services are offered through RIM, a Registered Investment Adviser. RIM is wholly owned by RFC Financial Services Holding LLC, which in turn, is a wholly owned subsidiary of Regions Financial Corporation.