Over the past two decades, Iâ€™ve worked with thousands of investors. From long range retirement planning – to college funding and far beyond. Iâ€™ve seen a lot of things.
In helping such a diverse group of investors reach their financial goals, itâ€™s quite interesting there are such consistent misunderstandings regarding their investments. If you donâ€™t understand the basics, you run a great risk of damaging your ultimate financial success.
While the list is long, 3 things stand out to me as the most common – and the most impactful – principles. If you can grasp these three things, youâ€™ll go a lot farther towards a successful financial and investing experience!
1. Donâ€™t Chase YieldÂ
Letâ€™s face it, the reason we invest is to earn a return on our money. We all want our money to work as hard for us as we did for it right?
That â€œinvestment returnâ€ comes in the form of capital appreciation and cash flows. The â€œtotal returnâ€ is a direct result of how much your investments increase in value (capital appreciation), and how much they pay you (cash flows such as dividends and interest) in the interim.
The biggest mistake most investors make is focusing on the components of total return, rather than the total return itself. For example, some investors seek to buy small companies in hopes of selling it higher later. Their priority is capital application only.
While everyone wants capital appreciation, many investors – specifically retirees – focus solely on cash flows. They seek out investments with the highest interest payment or dividend yield.
They focus on high dividend payouts and yieldsÂ because they assume they need the cash flow to live on. Unfortunately, they forget the fact that risk and return are proportional to each other. The more risk you take, generally the higher return you can achieve.
This is reversed for chasing yield. The higher the cash flows an investor gets, the higher the risk theyâ€™re taking. Oftentimes they feel high dividend paying stocks and other investments are â€œsaferâ€ because of their yield. This isnâ€™t the case, in fact, itâ€™s the opposite.
The â€œchasing yield syndromeâ€ is so common in fact, FINRA warned investors specifically to avoid chasing investment yield.
Higher yield investments have correspondingly higher risk levels. Thereâ€™s a reason that preferred stock is paying 6% – ITâ€™S RISKY! Itâ€™s obviously riskier than the stock paying a 2% dividend, or it wouldnâ€™t be yielding 3 times as much!
Yield is also (typically) taxed at ordinary income tax rates. This reduces your net return after taxes. Granted, some investments pay what we call â€œqualified dividendsâ€ which are taxed at capital gain rates, but many are not. So while you may be taking more risk for a higher yield, your net return after tax might be substantially less than you think!
Finally, remember why companies pay dividends. Theyâ€™ve got cash on the books and need to do something with it. They can invest it in more property, plant, and equipment, or pay it to shareholders/investors in the company.
If the company can invest and generate a return – or profit – why would you want them to pay out their cash to you the shareholder? The fact is, if the company can use its cash to grow the business, theyâ€™re likely better off doing that than paying out some outrageously high yield. Iâ€™d prefer little to no cash flows over an abnormally high yield.
2. Your Total Return Is Irrelevant HoweverÂ
The second great misconception is investors donâ€™t truly understand investment returns. Far too often investors think they need â€œX.X%â€ rate of return. The reality is thatâ€™s just the top line number.
Like any business, thereâ€™s revenues and expenses. You need to think of inflation like an expense charged against your investment returns. That means you must separate the â€œreal investment rate of returnâ€ from the â€œnominal investment rate of returnâ€.
Any quality financial plan will increase your future expenses for an assumed rate of inflation. This helps your financial planner more accurately predict the cost of things youâ€™d like to do or buy in the future.
That $50,000 car you really want will cost over $60,000 in 10 years thanks to inflation. The $20,000 European vacation youâ€™ve dreamed of will cost about $30,000 in 20 years.
Because your financial goals increase in cost due to inflation over time, you must consider your investment returns relative to inflation rates. An 8% return may be fantastic if inflation is running 4%, but it may leave you far short of your financial goals if inflation is 7%.
Make sure your total investment return exceeds the rate of inflation by a real rate of return that your financial plan requires. We measure this over minimum 5 year rolling periods to have a reasonable sample size. Most financial plans will require a real rate of return from 3% to 4% above the rate of inflation.
3. Volatility Matters
Without getting into advanced statistics, volatility really matters! In the investment world, volatility is measured by â€œstandard deviationâ€.
In simple terms, aÂ standard deviation is how high and low your investment portfolio may fluctuate over a sample period of time. The more aggressive your investments are, the higher your standard deviation will be.
Take for example this chart of portfolios from conservative (25/75) to aggressive (85/15):
Youâ€™ll notice the farthest right column is labeled â€œstandard deviationâ€. The higher the standard deviation goes, the higher your expected investment return and the greater your risk of short-term loss!
Volatility is so important because:
- You may be more inclined to make a bad decision and sell out of stock investments if the volatility is greater than youâ€™d expected.
- For retirees, selling shares of highly volatility investments at the wrong time can do irreparable financial harm to your lifelong plan.
- You may NEED the returns of a more aggressive investment portfolio to accomplish your financial plan goalsÂ but will need to embrace the additional levels of risk.
There are many investing concepts the average investor doesnâ€™t normally grasp. Itâ€™s understandable; however, because the subject matter can be highly complex.
Remember, you should never chase investment yield. Chasing yield can get you into a great deal of trouble! I canâ€™t tell you how many times people have invested into preferred stocks or limited partnerships for an amazing 8% dividend, only to see their principal value get cut in half over time.
Focus on total investment return. Whether your investment gains come from capital appreciation or cash flows doesnâ€™t matter near as much as the total return itself.
Donâ€™t forget, thereâ€™s also a difference in your real rate of return and your total return. It doesnâ€™t matter if you earned 8% over the last five years if inflation ate up 7% of it. You must achieve a real rate of return which is required for your financial plan to be successful.
Finally, pay special attention to investment volatility. While this may not matter as much for younger investors who can withstand the short-term impacts, it can be financially devastating for those nearing retirement, or already retired!
About the Author
Greg Phelps, CFPÂ®, CLUÂ®, AIFÂ®,Â AAMSÂ® is the President at Redrock Wealth Management. His firm is a fee only fiduciary advisor in Las Vegas, Nevada. Greg has been a financial planner for over 20 years, and specializes in retirement focused planning.