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June 23, 2012 - These Safe Investments are Riskier Than You Think - By Zacks Investment Research
By: Todd Bunton
History shows time and again how investors become complacent when an asset class rises in price year-after-year. The collective wisdom is that the current boom will last forever, and we couldn't possibly be in a bubble because "this time is different".
It happened with tech stocks in late 1990s, real estate in the mid-2000s and there's a case to made that it's happening right now in certain safe haven investments. That's why Warren Buffett recently called traditionally "safe" assets like bonds, CDs and money market accounts "among the most dangerous of assets". The Oracle of Omaha went on to say that bonds "should come with a warning label".
In this article I will lay bare the serious risks posed by supposedly safe investments followed by a better path to steady investment success.
At the Very Least You Need to Beat Inflation
Let's think about why you invest for a minute. You forego spending today so that you can consume more at a later date. And if you've been around for a while, you know that the value of a dollar falls year-after-year due to inflation.
According to the Bureau of Labor Statistics, $1.00 just 10 years ago has the same buying power as $1.28 today. A dollar bill 20 years ago is worth about $1.64 today. And going back 30 years to 1982, that same $1 would have gotten you what $2.38 will today.
In other words, inflation is a huge risk for investors. If your returns don't topple this hurdle, then you are actually losing money over time.
Right now, core inflation is running at 2.3%. With the 10-year Treasury note yielding just 1.6%, investors are actually earning a negative real return on their money. And let's face it - the only way that the federal government is going to dig itself out of its enormous fiscal hole is to inflate its way out by printing money. So expect the value of the dollar to continue falling in the future - and probably at an accelerated pace.
Today's Low Rates Won't Last Forever
The 30-year bull market in bonds has been fueled by steadily declining interest rates in the United States. But how much further can interest rates fall?
And what will happen to the price of bonds if interest rates revert back towards their long-run average of 6.7%? They will get crushed. As in bubble-bursting crushed.
So there is really a double whammy with government bonds. First, you are losing money on the interest because the return is lower than inflation. Second, bond rates are at historic lows and likely to go up in the future. When they do, then the value of those bonds will plummet. This is the "warning label" that Warren Buffet was talking about.
Think stuffing your money in a savings account or a certificate of deposit is any better?
According to Bankrate.com, the average money market account is yielding just 0.5%, and the average yield on a 5-year CD isn't much better at 1.4%. Just like bonds, this fails to clear the inflation hurdle. Cash may be king if you need that money relatively soon. But with the dollar losing its value year-after-year, cash is trash for a long-term portfolio.
So what's the answer for beating inflation? Ask people on the street (or Wall Street for that matter) and the overwhelming response will likely be gold.
But let's not forget that gold is not a productive asset. It has very little industrial utility. And you can't live in it like real estate and it doesn't pay dividends like stocks. To generate any type of return from gold, prices need to go higher. And for that to happen there needs to be someone else willing to come along and pay a higher price for it than you did.
This "greater fool theory" can last a surprisingly long time. As prices rise, more people get interested and jump on the bandwagon, thereby sending prices even higher. But eventually the music stops, and prices collapse.
If you look at the tremendous run up in gold prices over the last decade and compare it to the surge in stock and real estate prices before those bubbles burst, the yellow metal looks very bubbly:
Yes, gold prices can go down over an extended period of time. Just because we haven't seen this happen for a while doesn't make it any less true. Gold may arguably have a place in a diversified portfolio, but this place should be relatively small. Don't count on gold to provide returns much greater than the rate of inflation over time.
So What Does Work?
While stocks as an asset class may be considered riskier, they are among the best at generating inflation-beating returns over the long haul. Keep in mind that when you buy stock, you're investing in a piece of a business. And good businesses have the ability to produce a good or provide a service that will retain its purchasing power value over time. Decades from now, people will still be willing to exchange a few minutes of their labor for a Big Mac and a Coke, no matter what the currency is.
But stock investors hoping for price appreciation alone are likely to be disappointed, just like they were over the last decade. All too often a company's growth expectations prove to be overly optimistic. And rather than paying out a portion of its earnings to shareholders through dividends, ambitious corporate executives often reinvest that cash in projects or acquisitions that end up with much lower ROIs than they hoped for. Or they excessively pad a 'rainy day' fund that earns very low rates of return.
A Bird in the Hand
But what investors often forget is that total return comes from two sources: price appreciation and dividends. Because of the roaring bull market of the 1980s and 1990s, many investors focus on the former much more than the latter.
But just how important are dividends to your portfolio? Over the last 80 years, dividends have accounted for more than 40% of the total return of the S&P 500. Even more amazing, a recent study by Ned Davis Research shows that from 1972 through 2008, stocks that didn't pay a dividend earned a measly +0.2% return per year. The S&P 500 was much better with an average annual return of +5.9%. But stocks that paid a dividend and raised it year after year generated a compound annual return of +8.6%! Look at the dramatic effect this had on the growth of a $100,000 portfolio over that time:
If you want to build wealth over time, dividend stocks are a vital component to your portfolio!
Where to Find a Special List of Dividend Stocks and More
It is important to note that all dividends are not created equal. Sometimes, companies pay too much and don't keep enough cash to grow their businesses. For this reason, I am directing a portfolio that includes rare stocks with both growth potential and the ability to sustain their high-dividend payouts for many quarters to come. These investments are the main engines for our new Zacks Income Plus Investor.
I also add other low-risk vehicles like MLPs, REITs, Covered Calls and special ETFs to outperform fixed income investments that actually lose out to inflation.
Good investing, Todd
Todd Bunton is the Growth & Income Stock Strategist for Zacks Investment Research and Editor of the Income Plus Investor service.