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Fixed Income And MLP's Can Be High Risk Low Reward

Seinfeld Episode 'The Stock Tip'

A really good Seinfeld episode is in the first season, George gets a stock tip from a friend of a friend and acting like the big shot tells Jerry and Elaine. Of course it needs to be kept secret. Most people can relate and have their own story about a stock tip. Jerry acts on the tip and loses half his money in three days and Kramer can't help laughing at him to his face.

Stocks Are Risky and Everyone Knows It

The thing is, everyone knows stocks can be risky. Investors as a whole respect the risk of stocks and do all kinds of things to mitigate that risk by buying a portfolio of stocks or an index. They categorize how great the risk of a stock is by looking at things like beta. They allocate only a percentage of their portfolio to stocks.

Some people claim that individual stocks are too risky for the average investor due to the amount of homework that is necessary to stay informed on whether the stock should be held or sold.

Fixed Income and MLP's Carry Risk

What if you consider yourself a prudent person? You are not trying to 'double your money' in a week on a hot tip from George Costanza. You are merely trying to get a few percentage points of yield above Treasurys yet you lost 10-20% of your capital in the case of some bond funds or 75% or more like some MLP's.

Individual stocks are not the only asset class that can carry a lot of risk.

Efficient Portfolio Frontier Assumptions

The breakdown can be traced back to the assumptions of the efficient portfolio frontier which is part of Modern Portfolio Theory. The Efficient Frontier states that an investor should be compensated for taking on additional risk by receiving the potential for additional return. An investment that has a lower return potential should be lower risk.

If a stock can double, it should be expected it can go down 50%. Most investors are familiar with that type of risk reward payoff.

What if the expectation was 3 or 4% extra yield over Treasurys for a bond fund and the bond fund loses 20% in a few tough months? That's difficult math to handle for the average investor and not a very good risk reward scenario.

What should be the yield on a bond portfolio if it can go down 20% when Treasurys stayed steady? What should the yield be on an MLP that can lose 75% or more of its value?

These fixed income investments and MLP's were not on the efficient frontier. They were high risk, small reward. Look at the chart below to see an example of the efficient portfolio.

Image from smart401K.com

Low Return Doesn't Mean Low Risk

The fault is when an investor makes the assumption that if a given investment has a low return potential that the investment also has low risk.

Fixed Income and MLP Risk Not Easily Understood

What ends up happening is they find out the hard way that this investment had small upside but A LOT of downside. How many investors thought their MLP could go down 50% last year and down ANOTHER 50% this year? On the efficient frontier, what should the expected return be that would compensate an investor for potential risk of being down 75%?

The conclusion is that risk in bond funds, fixed income investments and MLP's are not easily understood and priced by most investors. The risk in a lot of these were vastly underpriced. The risk factors in these instruments were due to higher default risk and use of leverage.

Takeaways

Individual stocks are widely understood by investors to be high risk high reward.

The risk in bond funds and MLP's are more difficult to understand and can be high risk low reward.

Investors assume that since they are only looking for a small reward in an investment in fixed income or MLP's that the corresponding risks are small as well.

Don't act on stock tips from George Costanza.