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Oct 4, 201211:14 AMFinancial Perspectives

with Michael Dubis, CFP

Where’s the yield?

Where’s the yield?

Be careful of chasing yield. In a low-return, low-yield environment, everyone wants to find enhancements to their portfolios. This is understandable. Unfortunately, investors often do so by chasing returns. Chasing yield or return is one of the biggest mistakes investors can make.

The unfortunate reality is that 10-year Treasury Bonds yield about 1.6% to 1.8%. This is abysmal. We can debate why this yield is so low another time, but the rates are what they are, and they have a material impact on your long-term investment plan.

Unfortunately, when the Treasury is low, all other yields and returns of all other investments follow because all other investments benchmark their “risk-premium” on the Treasury bond. Stock market prices tend to get bid up because everyone is looking for a place to get greater return as well. Why is this the case? Simple: you can buy the Treasury and be guaranteed of payment, or if you want a greater return, you buy other investments that do not guarantee payment. All of those other investments must pay you more for that risk of not getting paid. That return must go up if it’s less likely that payments will be made. There’s not much more to it than that.

Thus, in a low-yield environment, more people chase yields because they want more return, bidding up prices of other investments, and subsequently lowering future potential return while increasing or at least maintaining a higher risk exposure. Unfortunately, chasing yield or return is always a bad idea if not done with the right understanding of risk-return.

This “spread” of return – whatever it may be – mathematically and unarguably must come with a much greater potential for experiencing risk. Risk means potential for loss, not an entitlement to return. When one fortunately experiences those great returns, it is because the risk you assumed never happened; it is not because the risk was never there. This is a common misunderstanding and dangerous as well.

If Treasuries yield 1.8% and someone is offering (or worse, promising) you a return of 4%, 8%, or more, be very careful! Going from 1.8% to 4% is an increase of over 100% in yield/return. Going from 1.8% to 8% is a 400% increase. The promise of double-digit returns, in this environment, is fraught with potential risks one needs to be aware of.

The best way to understand your risk-return exposure is not only to look at historical and forward-looking potential returns, but also, and more importantly, have your advisor show you the one-year and three-year worst-case scenario of the portfolio you’re looking to replicate along with the potential ongoing volatility of the portfolio. Those worst-case scenarios may not happen again, but as an investor, you are responsible for your money and should understand the portfolio’s potential behavior so you know how you will behave if that event occurs. You also need to know whether you even have the financial capacity to absorb such a potential risk.

Many investors would have had a much better experience with their portfolios from 2007 to 2009 had that simple exercise been conducted in advance. Investors could proactively adjust their portfolios to honor their goals and risk tolerance. If you can’t figure this out on your own, find someone who is fluent in both the return and risk discussions and acts in your best interests and not theirs or their firm’s.

Targeting greater return always comes with potentially greater risk exposure. The more you can focus on the risk-return parameters of your portfolio, the better you will be as an investor and the higher the likelihood that you can achieve your goals. There is no free lunch. Be smart about the trade-offs.
 

Michael Dubis is a fee-only certified financial planner and president of Michael A. Dubis Financial Planning, LLC. He is also an adjunct lecturer at the University of Wisconsin Business School James A. Graaskamp Center for Real Estate. Mike can be reached at financialperspectives@gmail.com.

This article contains the opinions of the author. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services described in this website or that of the author’s. Mike Dubis does not guarantee the relevancy, appropriateness, or accuracy of any outside information or links. Mike Dubis does not render or offer to render personalized investment advice or financial planning advice through this medium. All references that might be made to an investment or portfolio's performance are based on historical data and one should not assume that this performance will continue in the future.
THIS COMMUNICIATION MAY NOT BE USED BY YOU AS A RELIANCE OPINION WITH RESPECT TO ANY FEDERAL TAX ISSUE DISCUSSED HEREIN AND IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY YOU FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON YOU BY THE INTERNAL REVENUE SERVICE.

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It is an understatement to say the world has experienced a radical shift in capital markets. There are more layers of information and opinions on the direction of the world than we've seen in decades. The internet and the media do not always make it easier, but Michael Dubis' contribution through IB blogs will help you sift through the noise and give you some perspective. You can find his company online.

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