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The persistent, low interest-rate environment we’ve had over the past few years seems to have changed investor behavior significantly. Where, earlier, investors would routinely diversify their portfolio with a balance of stocks and bond; now, ultra-low interest rates on bonds and a rocketing stock market have led to an exodus from bonds to a combination of cash and investments that offer higher yields such as dividend stocks. But many of these income seeking investors must know that this flight-to-yield comes with its own set of hidden costs and risks. Today, I plan to bust some popular misconceptions so my listeners can make better, more informed investment choices.
The idea for today’s talk came to me through an article titled “Income-Seekers: These ‘Myths’ Could Come Back to Haunt You” by a former guest on my show, Christine Benz, Morningstar’s Director of Personal Finance and well-known author on personal investing guidebooks.
Christine writes, “A chronically low interest-rate environment breeds confusion about what we’re supposed to be doing… and the current, ultralow interest-rate environment is messing with our heads.”
So I’ll jump straight into addressing three myths that Christine highlights.
Myth 1: If rates rise, you’re always better off buying individual bonds than bond funds.
The logic most investors have on this is if they buy a credit-worthy corporate or government bond, they will receive interest payments at set intervals and their entire principal at the bond’s maturity date. I can see how this surety is enticing, specially if they get a decent rate but corporations know that investors are hungry for inflation-beating yields and see this as a great time to offer long-term bonds at low interest rates that are still enticing enough for yield-hungry investors. This way, corporations lock-in capital at really low rates. But investors are on the losing side of this transaction. Locking into low rates for long periods. This will mean that you will miss out if rates rise and will be subject to what is called opportunity cost.
If rates rise, lower-rate bonds lose value and psychologically deter investors from exiting their positions. Your upside is capped because rates really can’t go down by too much anymore. Individual bonds are not really your best bet right now because rates can only go up from here.
On the flip side, if you buy a bond fund, fund managers have the ability to exit low-interest bonds and move your money into higher yields as rates keep rising. What you can earn in interest in a bond fund in a rising rate environment often trumps individual bonds. I know there are arguments on both sides, but I want you to take this into consideration. In today’s rate environment, the advantage is with the borrower, not the lender. Taking on a mortgage today is preferable to lending money for 30 years at less than 4%.
Myth 2: Dividend-paying stocks are safer than bonds.
Over the past few years, investors have dumped bonds and flocked to dividend paying stocks. They’ve been rewarded handsomely with dividend income and solid capital appreciation, especially if they got in around 2008 right at the peak of the financial meltdown. But while high-quality dividend stocks are a safe trade over the long-run, stocks will be stocks over the short-run, subject to the vagaries of the market. If you need to pull your money out in, say, less than 10 years, you run the risk of having to do so when stocks are down, in a manner that could potentially wipe out your income and capital appreciation gains.
While dividend stocks have been darlings on Wall Street, they’ve begun to lose some of their shine on talk of rising interest rates. That 2-3% dividend yield could well be had with the added safety of a bond in a rising rate environment. Dividend stocks are directly impacted by interest rate increases and will most likely lose more value in a rising rate scenario.
Over time, stocks do a pretty good job of beating inflation, but it can be a rough ride and not for everyone.
Myth 3: Cash is safer than bonds.
Undoubtedly, cash is king if you need it for near-term expenses such as paying your property tax or buying groceries in retirement. If you have a longer holding horizon, cash is a horrible place to be because it loses purchasing power each year to inflation. Don’t stay in cash until rates rise but put your investable cash into a combination of short-term bonds that you can exit when rates rise, and stocks that you plan to hold for the next 10-20 years. Always maintain a diversified portfolio that will serve you well and protect you should there be a downward move in the stock market.
In the investment world, we consider any investment less than one year in maturity and liquid as cash. Don’t be fooled by CD’s which may offer you a 1% yield for a 2 or 3 year investment. After taxes and inflation, you’re actually earning a Negative rate of return! That creates wealth destruction not wealth creation.
If you’re going to get your money to work as hard as you do, make sure you are investing in things that become more valuable in the future. That’s the best way to become financially independent.