To start July, we are introducing a series looking at common investor errors. This is the part two of ten. Yesterday, we looked at the impact of excess fees on performance.
In the current low rate environment, many investors make the mistake of reaching for yield. That is our #2 investor error after excess fees.
The first law of economics is there is no free lunch. You would think the mathematics of that would itself be a warning as to the perils of chasing the higher yielding paper, and that it should be self-explanatory. But its not
History shows us there are few investment mistakes more costly then “chasing yield.” Fixed income is supposed to be your safe money, what you have to have back, what will cushion the ups and downs of the equity markets. Hence, you should be first concerned with return of your money, and second, the return on your money.
In other words, safety first for your bonds and preferred.
Don’t take my work for it, just ask the folks who loaded up on sub-prime mortgage-backed securities for the extra yield how that worked out for them. Some people have suggested I cut the RMBS investors some slack, as the paper was rated AAA. I don’t because they willingly violated the Free Lunch edict.
Quick war story: In 2004, I worked at a firm that was occasionally pitched products from other shops. One day, I walked into the conference room to hear Lehman Brothers offer a higher yielding fixed income product. “AAA rated, Safe as Treasuries, yielding 100-300 basis points more. I was subsequently called into my bosses office for saying:
“You guys are either going to win the Nobel prize in economics or go to jail. There is nothing in between.” (Does a firm ending faceplant count as the equivalent of the latter?)
Regardless, we know the outcome of THAT free lunch.
There are three common ways to chase yield: 1) Go out on the duration curve, i.e., buy longer dated bonds; 2) Go down the credit scale, i.e., buy junkier, riskier paper; or 3) use leverage, which amplifies your gains but also amplifies your losses as well.
With the 10 Year Treasury at 1.6%, I see lots of folks trying to capture more income using some combination of the above. Anyone who engages in this sort of ill-advised risky behavior should best understand the risks you are taking, and what that might mean if and when things go awry.
Simple rule of thumb: Never reach for yield.
What are you chasing for Yield?
Top 10 Investor Errors
1. Excess Fees
Top 10 Investor Errors
1. High Fees Are A Drag on Returns
2. Reaching for Yield
3. You (and your Behavior) Are Your Own Worst Enemy
4. Mutual Fund vs ETFs
5. Asset Allocation Matters More than Stock Picking
6. Passive vs Active Management
7. Not Understanding the Long Cycle
8. Cognitive Errors
9. Confusing Past Performance With Future Potential
10. When Paying Fees, Get What You Pay For