Chasing Yield Is Fraught With Risk

Over the last several years we have operated in a low interest rate environment. This has been particularly difficult for investors who rely heavily on investment income for the purposes of servicing living expenses. This has led to countless investors taking undue risk in order to make up for the gap between income and expenses.

To illustrate my case I will use an example of a couple living in the US who retired prior to the Financial Crisis and who have no lucrative defined benefit pension plan.

Our Hypothetical Couple and Their Dilemma

While this couple doesn’t have a defined benefit pension plan, they have lived financially prudent lives. This couple has:

  • Worked hard and smart
  • Lived well within their means
  • Put their children through college/university
  • Paid off their mortgage and any other debt

In addition to the above, they have amassed a $2 Million investment portfolio.  At the beginning of 2007 they invested these funds in CDs since they were concerned about the financial stability of most Americans and suspected not all was well; they did not want to run the risk of a permanent impairment to their capital if the economy hit the wall.

At the time, this couple decided they would ladder their CDs with terms ranging from 6 months to 5 years. At the beginning of 2007, they would have been able to purchase CDs in the ~3.5% – 4% range (historical CD rates). Using an average rate of 3.75% they would have generated $75,000 in pre-tax interest income on their $2 Million.

Fast forward to 2016 and none of their CDs are generating yields close to 2007 levels; we’re now in the 0.15% – 0.85% range.

Let’s suppose this couple pulled a rabbit out of the hat and found a financial institution which, out of the goodness of their heart, was willing to pay them 1%.

On $2 Million of CDs, this couple is now generating only $20,000/year in interest income. That is insufficient to sustain their lifestyle and they will need to encroach on their capital for the basic necessities of life.

If this hard working couple, who has done all the right things in life, needs to maintain an annual pre-tax income of $75,000 they would have had to save $7.5 Million. Keep in mind that $75,000 in pre-tax income in 2016 is not the same as $75,000 in pre-tax income in 2007! Imagine what income will be required 10 years from today to be equivalent to $75,000 in 2007!

Alarm Bells Go Off

Longevity is in their genes and this couple realizes the math just doesn’t add up. They will outlive their money unless they make some changes to their investment strategy.

This couple has a lot of free time on their hands so they watch a lot of television. They used to watch entertaining programs but now these entertaining programs are mostly investment news channels.

After being bombarded with a ton of irrelevant garbage they get this ‘AH HA!” moment. There are companies out there that are paying attractive dividend yields. 1% from safe CDs? Forget it! Sub 3% dividend yields from high-quality companies? Forget it! Man, there is a ‘boat load’ of companies paying high single and double-digit yields!

What does this couple do? Well, they don’t really know how to analyze companies so they talk to their neighbors. Their neighbors tell them about ‘stock screeners’ where you can filter information and narrow down a vast universe of companies to a small subset from which you can pick and choose your investments. ‘It is like fishing in a barrel’.

If it seems to good to be true

Huge Mistake!

If this couple had accessed the Sure Dividend site they would have found a list of companies with 5%+ dividend yields. Sure Dividend would have also warned them that high dividend stocks make great investments if:

  1. the dividend is sustainable
  2. the company is still retaining adequate earnings for internal growth

If either of these two ‘ifs’ is compromised, this couple will likely realize sub-par investment returns.

In order to ascertain whether a company meets these two key criteria, it is imperative this couple conduct proper due diligence. Only after doing so can they expect to make an informed decision that the high dividend yield is:

  • a warning sign of a company in serious trouble OR;
  • a sign a company is experiencing a temporary hiccup because of an isolated situation which the company has identified and for which a strategy has been developed to rectify the situation.

This couple’s research may also reveal that the current high dividend yield is the result of the cyclical nature of the industry in which a company operates (eg. oil and gas industry).

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Disclosure: Sure Dividend is published as an information service. It includes opinions as to buying, selling and holding various stocks and other securities.

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