Beware Of Financial Alchemy

In 1822 a Scottish soldier sold £200,000 of bonds offering a 6% yield. The bonds were backed by the full faith and credit of Poyais, a territory in Central America. Unfortunately for investors, Poyais didn’t exist and they lost everything.

In 2020 people are still attracted to investments that aren’t what they seem. This post covers three red flags to avoid.

The Folly of Chasing Yield

Safe bond investments no longer offer a meaningful return. This has led to demand for “bond alternatives” with higher yields.

Income-oriented investors tend to buy first and ask questions later. History shows how stretching for yield can end:

Wall Street Journal headline about individual investors that got burned by investing in high yielding complex securities

There are two bond alternatives to be wary of:

Dividend Stocks: Swapping out a low yielding bond fund for dividend stocks misses the point of a bond allocation: safety. Dividend stocks aren’t immune to stock market volatility. For example, Vanguard’s high dividend fund (VYM) fell 32% in 2008.

Selling Options: Like bonds, selling options generates income. Unlike bonds, the strategy crashes along with stocks. An S&P 500 option selling index erased four years of gains in a month:

Chart showing the performance of the CBOE S&P 500 Put Write index since 2016

Disclosures

Dividend stocks and selling options aren’t inherently bad, but swapping bond money into risky strategies is a recipe for disappointment.

I disagree with the narrative that older investors now have to take more risk. Today the 10-year Treasury yields 0.8%. It averaged 2.2% over the past decade. If this year’s drop in rates breaks someone’s financial plan then it was never sustainable to begin with.

Betting on Pattern Repetition

We have a tendency to see patterns everywhere and financial markets are no different. Complex patterns can emerge from random processes. 10,000 coin tosses look awfully like a stock chart:

Page from The Misbehavior of Markets showing the historical record of a simulation of 10,000 coin tosses

Source: The Misbehavior of Markets

Some investors base their portfolio around historical patterns repeating. This is optimizing for what has worked, not what will work.

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Disclaimer: MVMT Capital LLC (“Movement”) is a registered investment adviser located in Jackson, MS and is registered in the state of Mississippi. Movement may only transact business in ...

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