Peering into the Twisted World of Income Investing
Calling the way that we advise those who consider themselves to be “income investors” clueless doesn’t quite fit. Clueless means knowing nothing, but this is worse than that.
There are degrees of badness when it comes to investment advice, but there’s nothing that even comes close to the way that those who consider themselves to be conservative investors seeking income are being advised these days. It is not that these advisors haven’t been doing a terrible job at this all along, but the current low yield environment, they have gone a step further and completely lost their minds.
We might be thinking that it can’t be anywhere near this bad, as the people doing the advising must have some level of competence. While they may not lead us down the best path, we should at least expect to be going down a decent one, one that at least points us in the right direction to achieving our goals, but this isn’t what happens when it comes to this type of advising.
When you go as far as to advise people who consider themselves so conservative that they shun stocks in favor of treasuries and tell them to go with energy stocks instead, this just isn’t unspeakably bad, it even takes us right to the theoretical limits of bad investment advice.
If someone has moved to Florida because they don’t like the cold weather, and the weather in Florida no longer is warm enough for them, it might make sense to have them move a little further south, but not all the way to Antarctica. It doesn’t get any colder than where energy stocks live these days, and while moving money to energy stocks is the most terrible thing any investor could do right now, it is all the more terrible if you need to be conservative.
This is the absolute worst thing these investors could be doing, but if you have no idea what good and bad investing is, this might escape you, although it might be hard to imagine how anyone who has thought about this a little would be able to maintain this delusion. If we simply do not think at all though, that does the trick.
We’ll need to flesh out a few things before we can gain the perspective that we need to know what we should and should not be doing for these investors, and we need to start with the concept of income investing itself.
Traditional thinking puts investments into three classes, which are growth, income, and savings. We already leave the road right here, not by grouping them this way, but by calling the middle group the income class. It would be much better if we classified them by the actual type of investments that they are, which are equity, debt, and deposit investments, and we at least wouldn’t have the name of them mislead us right off the bat.
The only investments that can properly be called fixed income investments are the ones that only provide income, like a deposit account, a certificate of deposit, or an annuity. Bonds, which are in the debt class, do not belong here, and the equity class, stocks, surely don’t.
We cannot afford to let ourselves be confused about the type of return that these investments provide, and not realize that what we normally call savings are the actual income investments. The other two, what we call income and what we call growth, are both hybrid investments involving a portion of both income and capital fluctuation. Growth isn’t even a good word here this can go against us as well as be for us, and what we really need to do to make this transparent is to grade them according to both their fixed component, the interest payment we receive, and the variable component, involving changes in value of assets over time.
The two together comprise our expected return, as with hybrid investments such as stocks and bonds, changes in value will depend on how the total value of these assets have changed or may change over time. This is always viewed from the perspective of potential change since we’re always looking forward to figure out what to do.
Deposit investments pay out according to their fixed rates, and we can even include fixed annuities in these because this is really a form of deposit account, where you deposit money into them and collect a periodic fixed payment from them. Since their nominal value doesn’t change, this is what makes them the real fixed income investments.
Both bonds and stocks have a variable component, with the potential variation being significantly higher with stocks, due to the way that they are traded. Bonds fluctuate in value depending on how much people are willing to pay for the fixed income part of them, which isn’t yield, it’s the coupon rate, the rate of interest they pay.
What yields do is provide us with a ratio between the price of the bonds and their coupon rate, and even though some bonds don’t even pay interest and their entire value is expressed in price, we still get a yield which is the ratio between the price and the face value. We won’t worry about these or other non-mainstream bond offerings because the ones that pay interest are what retail investors focus on, other than to say that their returns are purely variable, like a stock without dividends.
If we buy a bond that has a 2% yield at the time of purchase, this means that at the present time, our initial investment will return that much, everything else remaining equal. Yields change though and move inversely with price, so as the value of the bonds rise, the current yield goes down, but it’s not our yield, this is what current buyers get and everyone is subject to changing yields and valuations.
Price Movement Matters a Lot, and we Ignore This at Our Peril
Just as it is said that we want to buy low and sell high with stocks, we want to do the same thing with bonds, buying low as far as price goes and selling higher. This translates to wanting a higher yield initially and then wanting it to go down as we hold the bonds.
Since stocks go up over time, we really don’t want to actually be buying low, we can instead buy high and sell higher and that’s actually the best way to invest. Buying low can have us buying stocks that are less desirable, and buying higher steers us more toward ones that are performing better.
This is not the case with bonds though, as bonds trade in a range, and it is the buying of bonds at higher prices, or lower yields if you are looking at that, that gets you in trouble, as this is indicative of them being higher on their range with less upside potential and more downside potential.
The direction that stocks are moving matters a great deal of course, and while investors are somewhat aware of this, they don’t appreciate how much this matters and will often buy or hold on to stocks that are in serious decline. We should not want to either buy these or hold them because their expectation is negative right now.
The same principle applies with bonds, and if you think that the yield will go up, this is what you want to avoid, even though it may seem counterintuitive to many. The fixed payment that you get becomes worth less and less when this happens, and when you sell, you also get less.
Returns are therefore not fixed, and the fixed part is the interest paid and the constant, with the variable part determining how their value is expected to change and the part we need to look at. You get a 1.75% coupon rate with a 10-year treasury for instance, and that part stays the same, but how much this income is worth can change a lot, and we need to pay attention to get in and get out at the right time lest we just invest blindly.
These are therefore far from fixed income investments, and if we pretend that they are, we are not even thinking about them properly. While this variability speaks to return, it especially speaks to risk, and since the whole idea of people preferring these is to reduce risk, that’s not only important but central.
Our understanding of risk is woefully inadequate, especially with bonds where we pretend that it just doesn’t exist. People look at default risk, but that’s only a small part of the risk of bonds and virtually non-existent with treasuries. It is the risk of price fluctuation that is where the real risk likes with bonds, just like it is with stocks.
People even will buy stocks and try to pretend that this risk doesn’t exist, which we would think would be a lot harder to do given that everyone knows that the value of stocks can change quite a bit. Just like so-called fixed income investments pretend that the value of bonds don’t change and all they have to worry about is the coupon rate, more and more people are thinking that all they need to worry about with stocks is collecting dividends and they don’t need to worry about or pay attention to price risk.
This makes so little sense that it is very hard to imagine anyone getting this wrong, but somehow, they manage it and we’re especially seeing a lot more of this lately.
These Investors Could Do Well in Stocks If They Actually Played to Win
It’s not that investing in stocks is a bad thing for anyone, properly managed that is, but when we see investors who tell us that the most important thing to them is to keep risk down, and they get into investments that do not match with this objective, and haven’t even really thought of the risks, this can lead to real trouble.
It may be that they just don’t understand how to manage risk well enough and that they may end up being much better off going all in with stocks instead of bonds regardless of their situation, provided that they manage their risk with these positions, but you won’t get there with naked stock positions which ignore risk management altogether, otherwise known as the buy and hold approach.
They already said no to this, and now with yields so low, more and more of them are saying yes, but are being tricked into turning a blind eye to risk now and just keeping their mind on these dividends. If you make 4% with the dividend but you lose 10% on the price of the stock, you aren’t making money nor managing risk.
The biggest problem with this is that we are investing in growth investments but aren’t even selecting according to growth potential, which means betting on this but ignoring how good or bad our bets may be, as we instead look at something else, these dividends. This not only can have you in the wrong stocks, these higher-dividend stocks are generally wrong in themselves, as their higher dividends are usually an indication that the stock is doing badly and is likely to continue to underperform.
Taken to the extreme, this can have us directing these risk-averse investors toward the worst and riskiest stocks out there, which these days are energy stocks. We started out by telling them to invest in bonds without understanding the risks involved, but bonds are at least less risky than stocks, and have now pointed them to stocks that not only have the worst returns but the most risk. This is a long way away from income land, the furthest away we could get in fact.
We need to understand more about risk than the common view to really get how bad this really is. Our risk is the potential for an investment to be sold at an uncompetitive return, and this just doesn’t measure losses, the gap is between what we could have had with something else versus what we got. If the market has risen 20% and our stocks have lost 20%, the gap here is really 40% even though we only lost 20%.
We would normally call such a thing the opportunity cost of the investment, and the risk that we need to account for is the risk of this opportunity cost, where the risk rises as the potential for opportunity cost losses increase.
If we were given the task to find the highest risk ones out there, energy stocks would win hands down, because they are going down in value as other stocks are going up. If we think that they are less risky overall than stocks which can do down faster but tend to do much better overall over time, we don’t understand risk.
If we are looking to hold for 5 years for instance, we need to look at where we’ll be in 5 years with these energy stocks versus the potential of other stocks, and this is where the biggest gap is based upon current conditions and what we know about how the future may play out.
To advise that anyone should be going long these stocks right now is bad enough, but if we want to reach the pinnacle of outrageousness, we’ll tell the most conservative of investors who normally stick to treasuries to get in them as some sort of substitute, because their dividend yields are comparable to treasuries.
If the goal is to lose the most that we can over these 5 years or whatever our timeframe is, this is the perfect plan. These investors have their retirement savings on the line and are telling us that they want to do what they can to avoid losses, so by directing them through the door that offers the most potential to lose, we are doing our utmost to see them fail.
This applies whether we are advising them to put a portion of their money in this garbage or all of it. An idea is just as bad regardless of the portion. This is not adding spice to our portfolio, we are poisoning it. This ingredient is simply toxic to anyone and especially to these investors who can least tolerate this poison.
There is so much that is badly broken about the way we advise investors, but none more than this. Selecting stocks based upon dividend yields is what really sinks the boat, and when we throw conservative investors into this sinking ship, those who can least afford to make terrible decisions like this, this becomes all the more appalling.
Some very basic lessons need to be taught here, as you might do with someone like Tarzan who has spent his whole life living among apes and has no idea what investing is. Stocks do pay dividends, Tarzan, but we also place bets on whether they will go up or down, and we do need to pay attention to what our chances are with that and not just ignore the most important part.
If we instead make a bet like this and then pretend that we didn’t, even Tarzan will probably get how ridiculous this is. Maybe we need to be more like him and not his ape friends with their monkey-see monkey-do culture. He has at least graduated from the jungle, while so many of us are still stuck in it and happily just keep throwing ourselves and others into the mud.
We are dealing with a lot of elderly investors who may be kicking the can for the last time, and this is not the time to break your foot. We can do much to educate these investors and teach them that if they need to play the stock game, they need to play it well, and look at actually increasing their total return, while at the same time actually having the margin of safety that they require instead of just pretending.
Perhaps more than anything, we need to teach these investors that returns are returns, and as long as our investments are liquid, we can collect a paycheck every month by just pulling money out of them. Even Warren Buffet, as big of a champion of holding stocks as there is, understands that if you need to live off your investments, focusing on fixed income as the only way to get paid is downright foolish, especially when this leads you down the wrong path where you have to settle for much lower profits just because you haven’t figured out that you can sell some stock instead.
You can manage risk with stocks to get them more in line with bonds while shooting for far superior returns, and this should be exactly what these investors should be striving for to best achieve their investment goals. If you don’t like bear markets, and you can’t handle them either, just stay out of them. This is the time you want to be defensive, when you need to manage risk, when it increases and approaches our tolerance levels.
Meanwhile, if we’re going to pick stocks, or pick a category of them, we need to want to pick good stocks and good categories unless we don’t care about making money. We may all claim to want to make money, but our actions need to match.
Editor, MarketReview.com
Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.
Contact Robert: robert@marketreview.com
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