High Yield Strategies – Beware the Dangers

by Neal Frankle, CFP ®

Good for you for doing all you can to maximize your retirement income. But be careful. Many people get lured into high yield strategies and later have to deal with some very nasty “surprises” like big losses in value, slashed dividends or both.

Let me give you a few examples from last year*. Precious metals yielded 5.4%. That is pretty attractive…right? But had you invested in precious metals funds for the yield you would have ended up losing more than 13% – even after you add back the dividends. Why? Because the funds lost value – a lot of value. During that same period, junk bonds offered a yield of close to 7% but showed a total return of -1.63% because they also lost value.

So while you pursue higher income investments, don’t lose sight of the need to protect your capital at the same time. This is especially important now that rates are so low now.

Presently we have “perfect storm” conditions for fixed income investors. More and more people are desperately searching for higher yield strategies and at the same time it is increasing dangerous to do so. This is true no matter how “safe” the underlying securities you buy are.

That’s right. Because bonds drop in value as interest rates rise, even Treasury bonds and funds expose you to the same interest rate risk as junk bonds or any other fixed income security.

So what are good investment alternatives for safe income? There are two investments that stand out right now:

1. Equity

Equity provides potential long-term growth and (as a result) inflation-adjusted income. It’s true that equity investments don’t offer short-term stability. The value of your equity investments fluctuate. But over the long-term, equity can provide income growth like very few other alternatives.

Let’s take an example. Assume you start out with a 4% withdrawal rate on your investment AND the value doubles in 10 years. What happens to your income over that period? It doubles as well. Right?

If you are interested in getting started with equities, consider using a service like Betterment. They are a perfect fit for investors who want to grow their assets but have limited resources and experience.

Sure there will be times when your values drop and your income may go down as well. But over the long-run, this strategy has proven very effective. I believe that now is a great time to use such an approach – especially if you use a “market sensitive” investment strategy.

2. Real Estatehigh yield strategies

With real estate values down significantly, now could be the best time in your life to purchase rental properties to get income. Of course you must be careful to purchase in the right location and that may not be in your local neighborhood. In Los Angeles, I would have to invest $700,000 to generate $3500 in monthly income. But I could generate that same income with 40% less capital if I invest in other parts of the country. And that includes a generous payment to a broker to find my property and paying a property manager to manage it.

If you want higher income, you can still get a good return on your money. But you have to be mindful, think outside the box and do a little work. The easy solutions – like buying high yielding securities – may be far from the best solutions.

What are you doing for higher income right now?

 

*Through 9-30-11

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