In Part one of the “Retirement Investment Squeeze”, we described the investment challenge facing investors who are near or in retirement, or, are sticking with money market funds because they are simply too afraid to invest in stocks. Yields are at all-time lows on traditional, more conservative income-generating investments, such as bonds and money market funds. Making matters worse, when inflation is factored in, the real returns on these investments are actually negative.
Volatility in the stock market has given investors of all ages a reason to be concerned about investing in equities. Recent surveys reveal the lack of confidence individual investors have in the stock market. More significant than what investors are saying, is what they are doing. Investors continue to pour money into bonds, CDs and money market funds.
Faced with this historically unprecedented investment atmosphere, what can investors do to protect their principal while generating the returns they need to meet their investment goals?
One common solution advises investing in dividend-paying stocks that can provide higher potential income than bonds or money funds. There is a long list of mutual funds and web-based stock screening tools that you can use to come up with specific ideas. Depending on your search criteria, you can still find stocks paying dividends of three to six percent.
While this strategy sounds pretty attractive, the bottom line is, regardless of the attractiveness of the dividends, at the end of the day, you still own stocks. You might hear that dividend-paying stocks are “less volatile” than other stocks because their dividend acts like a cushion in down markets. However, remember that 80% of all stocks follow the direction of the market. So, if your stock pays a four percent dividend and the stock drops 10%, you may still receive the dividend, but you have still lost principal. So, if you are concerned about the volatility of the stock market and your primary goal is principal preservation, this might not be the right solution. Also, dividends can be reduced or even eliminated. If that happens, your income goes away and there is a pretty good chance the stock price will be negatively affected.
Another common solution is to invest in bonds that pay higher yields than CDs or government backed securities. This might involve investing in long term bonds (10 years or more in maturity), foreign bonds or high yield bonds.
Investing in long-term bonds might provide a higher interest rate for now, but if interest rates begin to rise, your principal is going to get hammered. Foreign bonds have currency and political risk. High yield bonds are high yield for a reason. These used to be called “junk” bonds, but Wall Street didn’t like the sound of that, so they have re-named them “high yield” bonds. Typically, the risk of default is higher. Plus, if interest rates rise, you have the same problem of watching your principal erode as interest rates increase.
It’s hard to find anyone right now who believes interest rates are poised to go up. The Federal Reserve has announced that they have no intention of raising rates any time soon and it seems that, unless the global economy begins to improve, rates will stay low for the foreseeable future.
Just remember: Few “experts” foresaw the bursting of the technology bubble and the resulting 2000 market crash or the financial crisis that overwhelmed the markets in 2008 and 2009. Is there a “bond bubble” getting ready to burst that will catch everyone off guard, again? If you think a bond bubble is possible, investing in bonds at these prices could be as risky as investing in stocks in January of 2000 or July of 2007.
Investors saving for retirement may feel safer in bonds or money market funds but the reality is, ultimately, they may have no choice but to invest in stocks. The first consideration for anyone planning the transition from the “accumulation phase” of their retirement planning to the “withdrawal” phase, is the amount of capital you will have available to invest to generate the income you require.
This may seem incredibly obvious, but maximizing the amount of capital at retirement is the first step to ensuring successful income stream for retirement: An investor with $500,000 is in a better position to generate the income they require than an investor with only $100,000.
How can investors balance the risks of investing in bonds at these prices against the risks of the stock market? They will need to ignore the traditional advice Wall Street has shelled out to the retail investor for the last two decades and start to use some of the same investment strategies institutions have been using.
In our next installment, we will explain what institutional investors use to generate returns to meet their goals while preserving and growing their capital and how individual investors can, too.
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