Five Reasons Why Reaching For Yield Is Risky
August 30, 2016
by Loic LeMener
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Investing only for income is fraught with peril, and there are five reasons why investors shouldn’t select investments based on asset yield. Investing for value is the smarter approach, but the hard part is having the patience and discipline to wait for better values. For a healthy portfolio, investors should take a total-return mindset.
Many times in my career, I’ve heard investors say that because they are retiring soon, they need their portfolio to generate income to fund their retirement years. It’s an understandable sentiment, but it is not the soundest starting point for building a portfolio that delivers the value investors want.
Here are five reasons why you shouldn’t focus on income:
- Because income is such an obviously attractive feature of an investment, it is seldom ignored and often overpriced. If you’re only willing to buy income-producing assets, you are limiting your portfolio to assets that have the most obvious and sought-after trait. If successful investing is about being a contrarian and not following the crowd, this isn’t a good start. In the chart below, you can see that for quite a while now, income-producing assets have attracted a huge amount of money.
- If it’s too good to be true, it probably is. Once every decade or so, an “innovation” comes along that promises high yields with low risk. The junk bond craze in the 1980s was an example of this, as were the “new” types of collateralized mortgage bonds that led to the most recent financial crisis. Investors thought that getting an extra 1%-2% on AAA mortgage-backed securities was a good idea – only to find a lot of them worthless just a few years later.
- You are less likely to pay as close attention to principal risk and growth if you’re focused on yield. All the nuances of income, growth and risk combine to determine an investment’s merit. Overweighing any one of these traits will lead to suboptimal decision making. The chart below demonstrates that many high-yielding investments, while relatively stable during good times, are not immune to severe capital losses during bad times.
- Investing for income is less tax efficient. With high income investments, your investments potentially create unneeded taxes. Interest is taxed at your highest marginal tax bracket. If you are in the highest bracket, you’re paying about 43.4% on interest at the federal level and 23.8% on capital gains. That equates to an 82% higher tax rate on interest versus capital gains. Furthermore, if you need 4% yield from your portfolio to live, and you enjoy a portfolio yielding 5.5%, you’re creating 37% (the difference between 4% and 5.5%) more taxes than necessary.
- Yields are not consistent. If you want to live off yield alone, you’ll have an inconsistent retirement income. This has been starkly obvious as rates have continually dropped over the last 30 years. Many retirees started their retirement investing in CDs, moved on to high-grade bonds and eventually moved to junk bonds as rates dropped. Imagine their surprise during the financial crisis when their principal dropped more than 25%.