Smart investors avoid chasing yields

Government fiscal stimulus and central bank programs are making an effort to motivate you to spend more by keeping the interest costs low, but it could be at the detriment of your long-term savings.

More and more people are abandoning the safe investment course they’ve been on—some, for decades—and are launching into a futile chase for yield. The reason? Many responsible savers are struggling with painfully low yields on their savings certificates, just as they get ready to retire and live on the proceeds of their nest eggs.

With paltry yields of 1% to 2% on the most conservative investment products, longer-dated fixed income maturities or lower credit fixed-income securities are tempting ways to bolster yields. Buying dividend-paying stocks can seem like a necessity just to cover income for retirement.

But going ahead with these changes can leave you vulnerable to the downside risks associated with higher-yield investments. Don’t confuse yield with return; the highest yield does not necessarily represent the best investment potential.

Credit risk is very closely correlated with equity risk. In other words, higher yields are offered for a reason: the underlying risk associated with the investment could pose a real threat of the principal investment being lost, or at least a good portion of it.

Historical Returns

While historical returns from bluechip stocks, including the reinvestment of associated dividends, on average outperform long-term corporate bonds, long-term government bonds, and U.S.Treasury bills, they don’t outperform the alternatives all the time.

From 1928 to 2010, the lowest annual return for a five-year U.S. Treasury bond was -5.1%.

The lowest annual return for high-dividend equities during the same period was roughly ten times lower. In years where the annual return of the S&P 500 was negative, the returns of five-year Treasuries averaged +5.7%, while the returns on high-dividend strategies averaged -10.9%.

First Priority is Return of Principal

Some risk can, of course, be a good thing but the fixed income portion of your portfolio should be kept safe, maintaining its value even if equity markets decline. The first priority of any investment you make must be to provide at least the return of principal. A return on principal is a secondary objective.

If you introduce credit risk into your liquidity portfolio, you need to be sure to get paid with appropriate return potential. The cold reality is that an even slightly more aggressive capital appreciation strategy may run counter to your capital preservation requirements.

Ultimately, there is a higher level of risk with a higher-yield investment so you should invest only to the degree that you’re prepared for potential capital losses. Higher risk isn’t a bad thing, as long as you go into any investments with both eyes open and make sure that a portion of your portfolio is safe.

Murray Belzberg is president and founder of Perennial Asset Management, a Toronto-based wealth management firm.