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Yes, You Can Be a Successful Income Investor!Reaching for Yield in Today's Market
By Ben Stein Phil DeMuth
New Beginnings PressCopyright © 2005 Ben Stein and Phil DeMuth
All right reserved.
Chapter OneWelcome to the Real World
In a nation where the official inflation rate is presently 2.3 percent, the following table shows the yields available on our savings as of this writing.
In other words, we're earning a negative return after inflation and taxes. Still, even in today's low-interest-rate environment, higher yields are available. Look at the income tantalizingly offered by some of the securities on the next page:
Many more examples can (and will) be given. Yet most of us know little, if anything, about these investments. We want to extract the maximum possible income from our savings, and we'd love to earn these kinds of returns. But would our money be safe?
By the time you finish reading this book, you'll know-or at least, you'll know as much as we do. Gone are the days when you could turn over your investments to a bank or a brokerage house and be confident of getting a fair return on your dollar (if those days ever existed). Today, you need to learn everything you can about your money and how to put it to work for you.
Our plan is simple: We're going to talk about a number of different income-yielding securities, and then tell you how to combine them in a portfolio, where we'll endeavor to secure the maximum yield for the least amount of risk.
We're going to name names and be specific, rather than talk in generalities. The investments we call to your attention in this book are all available to ordinary retail investors. Our recommendations are guidelines but by no means exhaustive. They should be good jumping-off points, but there may be others that are superior. Our experience is that simpler is usually better, and that being well diversified and keeping expenses low-two of our goals-will serve you well in the long run.
If we mention a particular investment along the way that has you smacking your lips, please read the entire book before opening your wallet. One of the biggest differences between amateur and professional investors is that professionals have a top-down, "big picture" view of their investment portfolios, while everyone else tends to have a collection of individual securities that struck their fancy at one time or another, but without much regard as to how they all fit together. It makes more sense to decide on your overall strategy, first, and then choose the specific investments to park inside it.
The world of income-producing securities is a mysterious jungle. This book is a sightseeing tour bus, pointing out some of the lavish orchids you may wish to acquire for your garden, while steering you away from some of the tigers known to be man-eaters.
Let's start by looking at the circumstances that led us to write it.
Chapter TwoInvesting for Yield
In 2000, we could get 6.2 percent interest on a risk-free T-bill. Today, the rate has fallen to 1.7 percent. What happened?
The Federal Reserve Board tried to kick-start the economy after the stock market crash of 2000 to 2002 and the recession of 2000 to 2001 by flooding it with cheap money, and has used a major weapon-the power to set the federal funds rates-to lower them. Thirteen interest-rate cuts took us from 6.5 percent to 1 percent. By the time you read this, interest rates are rising once more-if the Fed's efforts to reflate the economy have proven successful.
In the meantime, for people living off their savings, this collapse has been a double whammy. First, many of them lost a fortune in the stock market crash of 2000 to 2002. Then, as they ran screaming from stocks like teenagers fleeing the Blob in the 1958 horror flick, the yields on their fixed-income investments vaporized. Everyone jumped into the fixed-income lifeboat at once, and it sank.
Retirees clung to the safety of T-bills, CDs, and money market funds to provide them with a secure, steady source of income. They took an 85 percent pay cut-not exactly what any of us want for our old age. This isn't just a statistic, but a figure with serious human consequences: It means cutting out trips to see the family, sending the grandchildren cards instead of presents on their birthdays, selling a diamond ring just to make ends meet, not being able to afford restaurants or movies or socializing with friends, and not getting prescriptions filled. As retirees and others living on fixed incomes confront their incredible shrinking monthly income checks, these low yields translate into loneliness, anxiety, depression, and even shortened life spans.
There's a moral here for the baby-boom generation, which lives on the cusp of retirement today with drastically insufficient savings for tomorrow. First, we have to save, save, save. Then we have to educate ourselves in how to safely squeeze the last drop of yield from our investment dollars.
The Growth Model
For years, people assumed that the stock market would solve their income needs, since it has historically compounded at a nominal rate of about 10 percent per year. All investors had to do was buy a diversified basket of U.S. stocks (such as an S&P 500 Index fund), sell off something less than 10 percent every year to meet living expenses, and by simple arithmetic they could tread water virtually indefinitely. The stock market was a cornucopia that would provide all the cash they'd ever need. So the thinking went-even by such "gurus" as Peter Lynch (who managed Fidelity's Magellan Fund with great success).
The promised long-term 10 percent return from stocks was served up like hotcakes on Wall Street, aided and abetted by pop-finance bestsellers like Jeremy Siegel's Stocks for the Long Run. Over extended periods of time, stocks have dramatically outperformed all other asset classes: gold, commodities, T-bills, bonds, and real estate; and stock ownership has handily beaten inflation over the long term. Although serious stagflation such as the United States experienced in the 1970s had the effect of cutting the value of the Dow Jones Industrial Average almost in half, during times of more benign inflation, stocks have raced ahead, providing a cushion for investors.
Figure 2.1 shows a plain-vanilla growth portfolio. Note how the stock position is cut with bonds in a 60/40 ratio to smooth out the economic ups and downs. The stocks aren't just from the S&P 500, but also include a little helping of small-capitalization stocks as well. In addition, one third are devoted to foreign markets, diversifying away from U.S. soil (and the U.S. dollar).
This growth-oriented portfolio can be constructed with just three holdings: Vanguard's Total Stock Market mutual fund (ticker: VTSMX), Vanguard's Total International Stock index fund (ticker: VGTSX), and Vanguard's Total Bond Market index fund (ticker: VBMFX). If your employer offers these options on your 401(k) menu, you should kiss your boss at once.
What's Not to Love?
The problem is that for any short-term span, the stocks in this portfolio can't be relied upon to provide investors with the total returns they've come to expect over the long run. There can be periods of 20 years or even longer-possibly much longer-when the total return from investing in the stock market is zero. For someone retiring at age 65, the prospect of a nest egg turning into a goose egg for the next two decades is bone-chilling.
In our book Yes, You Can Time the Market!, your authors argued that these eras of low return from equity investing aren't random events, but tend to follow periods when stock values have risen in excess of what might be justified by their historical fundamentals. Unfortunately, we now live in the shadow of such a period. The run-up of financial markets during the 1990s was unprecedented, and while stocks have fallen from their bubble highs, they are still pricey by most fundamental criteria as of this writing. This means that over the coming 20 years, the total returns from equity investing could fall significantly short of their historical yearly average of 10 percent.
In fact, there are two likely scenarios, neither of which holds much appeal. One would be for the stock market to fall dramatically. Following a period of consolidation, investment returns would return to their expected "normal" 10 percent per year. A second possibility is for the market to chug along, delivering significantly lower total returns than usual.
Unfortunately, we aren't the only ones who see it this way. Writing in the Financial Analysts Journal, Robert Arnott and Peter Bernstein, two of the brighter crayons in the box, have &constructed the annualized 10 percent total return that stocks have historically offered. First, they throw out the profit due to inflation, which cuts the real return down to less than 7 percent. This remaining amount has historically consisted primarily of dividends-about five percentage points in all. Seventy percent of the stock market's real return has come from the dividends that stocks have paid.
Why is this a problem? Because today, the dividend yield is abysmally low: instead of 5 percent, it's a measly 1.8 percent. This implies a total inflation-adjusted stock market return of closer to 3 or 4 percent going forward.
In other words, we're well advised not to rely entirely on the growth model to buy groceries and pay the rent.
The Alternative: Income Investing
If capital appreciation from the stock market isn't going to save us, what might?
This approach might be the answer to where to put our money when the stock market is just too expensive. Instead of shoveling our dollars into its gaping maw, we could invest them in income-producing securities. When everyone else is feverishly buying into growth that might happen extremely slowly (if at all), we could put our money into income. Or, to put it another way, if we want consistent income, we need investments that yield income fairly consistently. Capital gains are by nature uncertain and speculative, while income investments aren't. For this reason, we're going to advocate that investors seeking a steady paycheck put a substantial portion of their assets into an income-oriented portfolio.
To start this process, we're going to roll up our sleeves and help you learn a bit about the bond market-something you may have hoped to avoid. Then we're going to hunt for stocks that are bucking the trend by paying above-average dividends. We'll also take a hard look at some investment products that promise to deliver an enhanced stream of income to your bank accounts. If risk-free investing gets you less than 2 percent (and a negative return after inflation and taxes), you have to decide what risks are worth taking and which ones should be avoided. During the stock market bubble, everyone focused on the rewards of investing, paying scant attention to the risks. Then the NASDAQ blew up in their faces like an exploding cigar. The prudent investor is forever weighing the certainty of risk against the possibility of reward.
In the chapters ahead, we'll describe the basic building blocks of fixed-income investing. We'll tell you the ones we like-and steer you away from some we don't. Then we'll put it all together in some model portfolios that match your income requirements with your tolerance for risk.
We'll even throw in a free Website (stein-demuth.com), which we hope will be useful to you. If sharp-eyed readers point out any dumb mistakes we've made, we'll post them, and if we cite a Website in this book, there will be a link to it from our Website so that you don't have to worry about remembering it. Just bookmark stein-demuth.com and our magic carpet will take you there.
Here's a basic principle to keep in mind as we get started: The most basic way we compare income securities with one another is by comparing their yields. This is the amount of income they pay out, divided by their price. If a security pays $5 in interest a year, and it costs $100, its yield is 5 percent.
Unfortunately, yields are not calculated in the same way all over town. When we punch the ticker of a given security into three different Websites today to learn its yield, we get three different answers: 7.2 percent, 7.0 percent, and 6.9 percent. Who's right?
The answer is: They all are-but each one calculates the yield in a slightly different way. One takes the total amount of income a security has generated over the past year and divides this by today's price. Another takes the last quarterly income payment, multiplies it by four, and divides it by today's price. The next takes one of these income calculations and divides it by the price of the security at the end of the last month. Still others may not refer to a true dividend yield, but a "distribution" dividend, which includes all the income from the investment, such as dividends, capital gains, and even a return of principal. In addition, there's also the 30-day SEC yield, which the Securities and Exchange Commission requires to be presented in any advertising literature where a yield is cited. Be aware that money market funds calculate their yields on the last seven days, while bonds have their yield-to-call, yield-to-maturity, and yield-to-worst (whichever of the previous two is lower).
In truth, we don't really need to know how each of these is calculated, or even which formula a particular source is using. Instead, we simply need to make sure that we're comparing like to like when sizing up potential investments that are competing for our investment dollar. Remember:
1. Use the same source for all yield information. Don't assume that the yield you see quoted on Morningstar is the same as what you see on Yahoo! Finance or read in Barron's. By getting all your quotations for the same type of security from the same information service, you can make head-to-head comparisons.
2. The yield refers to the past month or quarter or year, and doesn't tell you what the yield will be next month or quarter or year. We can't know the future. Investing is about rational probabilities, not certainties.
3. Some of the information in this book is time sensitive. The yields on many of the investments we cite here will surely be different by the time you read this. Even so, the same general principles will apply.
We'll begin with the classic income investment: bonds. Before making specific recommendations, we want to prepare the groundwork by talking a little bit about what bonds are and how they work. That way, when we do make suggestions, you'll understand our reasoning.
Excerpted from Yes, You Can Be a Successful Income Investor! by Ben Stein Phil DeMuth Copyright © 2005 by Ben Stein and Phil DeMuth. Excerpted by permission.
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