Considering Risk

Where is the stock market headed?  Will interest rates rise?  We hear these questions often, and while we certainly wish we could pull a crystal ball from the desk drawer and make an accurate prediction, we have to muddle along without the aid of magic.

One common complaint we hear is in regard to the disappointingly low yields on money markets and other short-term fixed income investments.  In times like these, the natural tendency for investors is to stretch for yield.  And, when you look at where most people are investing their money, this ‘stretch’ is what appears to be happening.

When the stock market was falling in 2008, there was a flight to quality which swelled the balances of money markets and bank deposit accounts.   But in 2009, we saw nearly $400 billion move from money markets into mutual funds.  Far and away, though, the mutual funds receiving the bulk of the money were bond funds.  Bond funds, in general, are paying higher yields than money markets. But it’s important to understand that if interest rates start rising, this will put downward pressure on the value of those bond funds, potentially offsetting the benefit of the higher yield.  And, if interest rates increase significantly, bond funds will likely see substantial declines in value.

We’ve also receive questions about moving funds from money markets and investing those monies in “blue chip, high dividend paying stocks.”  Let’s be very clear: There is a tremendous difference in the level of risk between stocks (even blue chips) and money markets.  You need look back no farther than the recent market correction to see the potential danger of a strategy that ignores the wisdom of diversification.

Below is a sampling of the performance of various dividend-paying stocks that, prior to the market correction, were certainly viewed as “blue chip.”   The returns cover these stocks’ performance from the peak of the market in 2007 through the March 2009 trough, and include the dividends paid:

Exxon Mobil -28.3 percent
Proctor &Gamble -35.6 percent
Johnson &Johnson -26.6 percent
Sysco Foods -41.4 percent
Exelon -41.4 percent
Ameren -49.9 percent
Bank of America -92.2 percent
Citigroup -97.6 percent
AIG Group -99.5 percent
Fannie Mae -100 percent
Freddie Mac -100 percent
Baer Stearns -100 percent
Lehman Brothers -100 percent

It is rare that you find a ‘free lunch’ when it comes to investing.  The fundamental rule that “higher return means higher risk” is no less true today than it’s ever been.  Can you get a higher return than what is currently being paid on money markets and bank deposits?  The answer is a resounding, “Yes!”  But you must ask yourself:

  1. Are you willing to take the additional risk that comes with the higher expected return?
  2. Is the premium enough to compensate you for that risk?

Considering we view fixed income as the defense side of the portfolio, we would suggest the risk may not be worth the potential gain.

Brooke Hunady, CFP®

Brooke is the professional consultant for Tim Halls.

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