With yields at all-time lows on safer, income-generating investments and volatility in the stock market giving investors of all ages a reason to be cautious about investing in equities, conservative investors in or near retirement are asking: what can I do to protect my principal while generating the returns I need to meet my investment goals?
In parts one and two of this series, we described the unusual combination of challenges and common solutions offered to investors close to or already in retirement. Unfortunately, these tried and true investment solutions aren’t effective in today’s investment environment.
Yields on short and intermediate term fixed income investments are almost non-existent. Making matters worse, an investor using a longer term fixed income strategy to generate a slightly better yield than short term investments, runs the risk that one day, between now and the next 10, 15 or 20 years, interest rates rise. In this scenario, the value of their portfolio drops while the income stays stubbornly low.
Another investment offered for those seeking higher yields is high yield corporate bonds or what was formerly known as “junk” bonds. In addition to interest rate risk, these bonds typically have a higher risk of default. Think General Motors (GM). Once considered one of the highest quality corporate bond issuers in the country, GM bond holders ended up with little to nothing when the company declared bankruptcy. This doesn’t mean that all high yield bonds default, but the risk is real.
Other options include foreign bonds, municipal bonds and bond funds that can invest in one or all of these bond categories. Each has risks but all share the risk that, as interest rates rise, their value drops.
History shows that this interest rate squeeze has happened before, making an investment in a long term fixed income investment at today’s levels unattractive and risky. For example, an investor purchasing a 20 year bond in 1976 yielding 10%, saw the value of their bond drop by as much as 50% as yields rose from 10% to 19% by 1979. Putting that in perspective, it would only take an increase in today’s interest rates from 2% on a 20 year bond to 4% to have the same effect. What is the likelihood that rates will stay at today’s low rates for the next 20 years?
So, the idea that bonds are “safe” or “conservative” or that there are “safe” stocks, should be taken with a grain of salt. Making money in bonds or stocks, like any other asset class, comes down to timing. When you invest often determines the return as much or more, than other factors investors ordinarily consider. Whether its real estate, gold, stocks, bonds - whatever the investment or asset class – timing the market, not time in the market, is a critical element and often it’s the difference between profit and loss.
So, what does the interest rate environment mean for conservative investors? The reality for most investors, whether they want to or not, and regardless of age or “risk tolerance”, is that they will need to invest some portion of their retirement savings in stocks. Whether it pays a dividend or not, ultimately, stocks offer the best opportunity for an investor in today’s market to achieve their investment goals. Most importantly, stocks also offer the potential for conservative investors to grow their capital. And, growth of capital is more likely to occur with stocks than bonds, especially considering the current interest rate environment.
Why would a conservative investor consider growth of capital as a substitute for income? Because capital growth can be converted into income. An investor that grows their stock portfolio from $10,000 to $20,000 can liquidate a portion of their growth for income just as easily as an interest payment or dividend can. Plus, if you can grow the value of your account, when the interest rate environment improves, investing $20,000 in a bond or CD would generate more income than $10,000 invested in the same instrument.
As much as the idea of investing in stocks might cause most people to loose sleep or feel the need to constantly keep at least one eye open to the Equities.com site, there are ways to maintain exposure to stocks and minimize the risk.
Our fourth and final installment will describe how individual investors can take advantage of the same techniques institutional investors use to minimize their risk of owning stocks.
DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer