---- — Today’s low-yield environment has left investors frustrated and searching for a reasonable return on their money. Seniors who rely on their portfolio income to help fund spending needs are especially vulnerable.
Conventional sources of income such as certificates of deposits and money market funds yield almost nothing. Bond yields, while slightly higher, come with increased interest rate risk, which threatens to drive down the value of the underlying investments once rates begin to rise.
In an attempt to generate more income, many are turning to complex investments promising higher returns. They are doing so, however, without conducting the due diligence required to understand what they are buying into and the risks they are assuming.
Over the last 12 months retail investors have poured tens of billions of dollars into high-yield products, including junk bonds, variable annuities, master limited partnerships, non-traded real estate and loan securities, closed-end funds and other structured or financially engineered products. To the yield-starved investor, the lure of higher returns can be irresistible, especially when framed by commission-driven salespeople who don’t understand the investment and do not adequately disclose the risks and unfavorable terms they entail.
Those in search of greater yield can almost always find it. To earn it, however, they must be willing to accept the risk that not only may the investment fail to deliver the expected income but also may fail to return the original principal. The following example illustrates the point.
The yield on 10-year U.S. Treasury bonds is currently just over 2.5 percent. This compares to yields of over 8 percent and 12 percent respectively on comparable term Greek and Nigerian bonds. Most investors would be uncomfortable buying these foreign securities regardless of the promised returns because of the high probability of default.
They understand that the “promised” yield means nothing if the underlying investment is wiped out. In other words, promised or expected returns tell just half the story. We have to know what kind and amount of risk we are underwriting before we can judge whether the investment makes sense. For some reason the same analytical approach is not taken when evaluating many other high-yield investment products.
There is a fundamental relationship in the capital markets between risk and return. In general, investors are risk-averse, so in order to attract capital, riskier investments must offer higher returns to compensate for the increased probability of loss. Since issuers of securities are sophisticated financiers, they don’t overpay investors for the use of their money. They will only offer the minimum yield necessary to attract buyers. In other words, the opportunity to earn a higher return comes with commensurate risk.
Sophisticated investors have the skills and resources to evaluate the risk and return characteristics of specific securities and businesses. Only after a thorough analysis can they determine if the investment is consistent with the goals of the portfolio and if they are adequately compensated for the risks they are asked to bear.
However, even after careful analysis, in some cases these investors sustain significant losses. The reality is that the average individual possesses no such skill in evaluating investments. Instead, these products are purchased on the advice of salespeople with a vested interest without proper investigation or a clear understanding of the risks, expenses and onerous terms that usually accompany them. If investors followed the advice “don’t buy what you don’t understand,” sales of most of these products would fall dramatically.
John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions