There's no Such Thing as a Sure Thing...

Throughout my years in the investment management business I have witnessed how both fear and greed affect investors’ decision making. As markets approach the pre-financial crash levels, it is probably an appropriate time to assess how emotions impact investing. Investing is basically a set of trade-offs. I believe that many investing mistakes occur in the attempt to ignore this reality.

Life is full of consequences and most of our troubles come from ignoring this fact before we make decisions. I see so many people searching for the ever elusive holy grail of investing – a good return with no risk. Deep down I think everyone knows that if something sounds too good to be true then it probably is. You cannot get a return without some type of risk.

Greed influences us to go after short-term benefits at the expense of the long-term. We want our investments to pay off now, not 20 years down the road. We chase things like performance rather than developing a balanced strategy. Investing is the quintessential act of delaying gratification. Fear on the other hand causes us to shirk away from opportunities that could be essential to our progress. Both fear and greed can cause us to miscalculate opportunities and risks.

Risks of “Safe” Investments

Almost everyone acknowledges that investing in the equity markets carries risk. The performance of the stock markets over the past decade has certainly heightened this awareness with many swearing off stocks altogether.  I have met many who no longer desire to have any fluctuation at all in their investments. For now most of these people indicate that they will be satisfied with the low returns of their newly found conservative strategies. We will see how that plays out over time.

Many have been so scared off by the volatile markets that they are seeking safety in bonds or other conservative type investments. I believe that bonds and other conservative investments are essential components of a balanced investment strategy, but they are not without their inherent risks as well. They may for the most part be less volatile in their price movements, and it is this volatility that most people define as risk. 

It is first probably good to look at the risks of a conservative allocation in general. The main risk is that the return realized is less than what is needed to reach a goal, support a lifestyle or maintain the portfolio’s real value after the effects of inflation. Quite simply low risk equals low return. Inflation is a particularly pernicious risk and probably the bondholder’s worst enemy. Due to the unprecedented government actions and deficits, the risk of inflation getting out of control is very real. With inflation running at three percent, which is close to the historical average, it only takes five years for your purchasing power to decline by 14 percent. You can imagine the damage if inflation ran even higher. To fight inflation governments must tighten the money supply which is usually done through increasing interest rates. Since the prices of bonds move inversely to interest rates bondholders could be faced with losses on what they thought were “safe” investments. The risk is exaggerated with interest rates still near historic lows. 

The problem that many investors have is that they want equity type returns with a conservative portfolio’s risk, thereby setting themselves up for inevitable disappointment. I also see a lot of conservative investors that are yield hunters. These are people who just look at the stated yield of a particular investment, usually without regard to how it is calculated (which is a crucial factor), and buy whatever is the highest. Yield hunters say they don’t care about the fluctuation of the principal as they just want the juicy dividend or interest. As long as they get it, everything is OK. Reality is hard to face when they realize tht the yield they purchased is in reality unsustainable and now face possible capital losses.

Understanding the Risks

What are some of the risks of investments typically held in a more conservative allocation? Many like the safety of cash-like instruments such as savings deposits and money market funds. These are very short-term and liquid investments and hence offer about the lowest return available at any given time. Bank deposits are usually FDIC insured up to $250,000 per bank. Short-term investments are usually very safe and liquid, but you are exposed to the credit risk of the institution (i.e. the financial ability of those to whom you give your money to pay you back). During a financial panic, such as 2008, the weakness of these types of instruments can be exposed in the form of a liquidity crunch. This occurs because everyone wants their money at the same time and assets are unable to be sold fast enough to cover the demands. All of the sudden that “safe” investment doesn’t feel so safe anymore. Even though the probability of this occurring is low, it could be devastating nonetheless.  

Certificates of Deposit or CD’s are one step up the risk ladder and offer higher yields than cash in return for locking your money up for a specific period of time. They are often FDIC insured as well but are subject to the credit risk of the issuer. You also run the risk of locking in low rates that don’t provide a sufficient return or keep pace with inflation.

Government, corporate and municipal bonds are subject to interest rate risk, inflation risk and credit risk. Before the financial and European debt crisis the latter seemed to be a remote possibility for government bonds. However, the growing debt burdens of governments across the globe have called into question their ability to sustain and ultimately service that debt. Ask the holders of Greek, Irish, and Portuguese bonds how their “safe” government bonds have fared? Even municipal bonds have been having trouble lately due to the debt burdens of states and municipalities. There is never enough money to bail everyone out at the same time.

Paragon's Approach

At Paragon, we believe in creating a balanced approach by obtaining income from a variety different sources rather than just bonds in general. That way we don’t get crushed if one area runs into a problem. We look at the yield or return of a particular investment in relation to the risks involved. Currently in our Managed Income portfolio we are invested in preferred stocks, REITs, high-yield bonds, and dividend paying stocks in addition to bonds. We are keeping the maturities on most of our bond holdings on the shorter side to protect against rising rates. Over the long-run, we believe that investing in a diverse source of conservative asset classes and overweighting the areas we feel have the best return for the risk is an effective strategy.