Bathed in the cold incandescent of my refrigerator’s light, I stared vacantly at my sparse options. Condiments, beer, a block of cheese… My stomach growled in hunger. Aha! What’s this? Leftover sushi from … probably not too long ago, right? I did a quick risk assessment. When did I bring home sushi? What kind of maniac saves leftover sushi? Doesn’t that defeat the whole point? How long can you keep sushi in the fridge before it goes bad? Did the old man mean Eastern or Central time when he said I shouldn’t feed the mogwai after midnight? I could take my chances with this somewhat fresh-ish raw salmon, but even a slight miscalculation would have dire consequences later. But I’m hungry now!
Due to the indeterminate origin and date of acquisition, I threw the sushi away. No late night snack tonight. The miniscule reward of satisfying a late night snack-attack was not worth the risk of explosive illness later.
What does this have to do with investing? Today, investors are stuffing their pockets with as much leftover sushi as they can handle. Artificially low interest rates have spurred a chase for yield. Investors are being told they need higher dividends and higher yielding bonds regardless of their goals. The people telling them this usually have a high dividend, high yield, or “bond replacement” product to sell. This is the classic “create a sense of urgency” sales pitch. There’s nothing inherently wrong with high yield investments, but when they replace a core fixed income allocation, the risk profile of the entire portfolio shifts dramatically.
Core fixed income generally acts as ballast for a portfolio – something that will hold up well during bad stock markets. It is not a return-driver so much as it is a risk-reducer. High yield bonds (both municipal and taxable), floating rate, and bank loan funds are being sold by product peddlers as core fixed income replacements even though these securities have experienced sharp drops, often at the same time as the stock market. During the financial crisis they dropped as much as 30%. The Barclays Aggregate Bond Index’s largest drop was less than 4%. It wasn’t sexy. No one was cold-calling investors trying to sell vanilla bond portfolios, but that’s what worked. An investor looking to squeeze out another couple of percent of return ended up with a mouthful of stale sushi.
When looking at these asset classes, be mindful of how risk and return are framed. Over the last 3 or 5 years, high yield looks fantastic, but that would exclude 2007 and 2008 where it caused some serious indigestion. Also look at what assets would need to be sold in order to chase yield. Selling a low volatility asset to buy a high volatility asset dramatically ramps up the volatility of the portfolio as a whole. After the financial crisis and the subsequent bull market, most investors are looking to keep a cap on their investments’ volatility, not increase it. Lastly, look to the cost of the product. Is the person selling it getting a commission? The C share class of mutual funds is particularly generous to those selling it. Is there a less expensive no-load alternative?
Do investors really need this extra risk to achieve their goals or are they being fed someone’s leftover unagi?