- Wall Street doesn’t make money if things aren’t moving, so beware of interesting new investment vehicles marketed with the guise of offering you better returns.
- In this article, we’ll share an old investing gem that is essential to know for every investor.
- The time to spice up your portfolio is when it looks like the world will end tomorrow.
It has been a boring summer. The S&P 500 reached new highs, but has traded in a 2% trading range for the last two months.
The situation isn’t better in the longer term. In the last two years, the S&P 500 is up 4.3% per year which is not spectacular for stocks, but it’s also not bad.
Figure 1: S&P 500 in the last two years. Source: Yahoo Finance.
When we add the dividend yield of around 2% to the above return we get a 6% return, which is exactly what the S&P 500 should have returned through earnings as its PE ratio in 2014 was slightly above 18.
As the current PE ratio is 25.22, we can expect a 4% yearly return from investing in stocks over the next few years if things stay stable. If something bad happens,—like a recession or higher interest rates—apart from special trading vehicles or a very defensive portfolio, you’ll find the best protection is a well-diversified asset, like the S&P 500.
If you’re investing for the longer term, you should realize that at current levels all stocks offer is a 4% return with a potential downside of unforeseeable future events. A similar downside could happen to bonds—or any other investing asset for that matter—if rates go up.
Aside from staying the course as a long-term stock or bond investor, and being ok with the inevitable downside risks, you could lower your equity exposure and raise your cash levels as one way to try and improve your overall long-term returns by having more cash on hand when valuations are more attractive.
If, however, you decide to stay invested, don’t fall for the Wall Street “pitch” of trying to spice things up in order to increase your returns with new investment vehicles created by Wall Street, which only generate and line their pockets with additional fees from investors.
Traders on Wall Street aren’t paid to watch paint dry. They have to do something to make money and do invent new investment vehicles all the time, which often only increase your risk over just owning a diversified S&P 500 index fund. Sometimes the best option as an investor is to sit on your hands and do nothing.
This article will go through some of these new investment vehicles and will explain the risks investors take for a possible return that is really just a few percentage points higher than what stocks offer at the moment.
Buffett & His Partnership: An Example of Doing Nothing
In 1969, Buffett told his investors that he was retiring as he couldn’t find any investments that suited his criteria and wasn’t willing to lower his standards or increase his risks.
Figure 2: Excerpt from Buffett’s letter to partners in 1969. Source: RBCPA.
In both 2000 and 2007, it’s likely you didn’t hear from your financial advisors warning you that it was time to leave the market. You’re also not likely to hear from them now, but the Buffett wisdom above is an investing gem, not only for its rarity, but also for its character. And character is what you need in order to do nothing.
Going further, the VIX Index—which is a measure of expected volatility in markets—has been remarkably low and stable in the last few months, with the exception of the time around BREXIT. But this is exactly what we should expect at or near a mature market that is reaching a top.
Figure 3: VIX index. Source: Google.
As things are a little boring on the market and the returns are historically low, here is an example of how Wall Street might entice you with the idea of “spicing up” your portfolio:
Figure 4: iShares by BlackRock home page. Source: iShares.
ETFs are a perfect example of a new invention that makes money for Wall Street. They are currently the most popular investment vehicle and have grown from 1 ETF in 1993 to 1,982 ETFs today. The catch is that ETFs cost more and lead you toward greater risks.
As you can see in Figure 5 below, iShares markets income ETFs that can give you greater income without taking “undue risks.” These ETFs are:
- High-yield corporate bonds ETF,
- Their preferred stock ETF,
- The high dividend yield ETF, and
- The international dividend yield ETF.
Beginning with the first on that list, the synonyms for “high-yield bond” are “non-investment grade bond,” “speculative grade bond,” or “junk bond,” but you’ll find they are often marketed as an investment without “undue risks,” when in reality the risks are substantially higher.
Figure 5: iShares by BlackRock U.S. home page. Source: iShares.
But what happens to junk bonds if something goes wrong? Well, you won’t just lose a part of your investment, you could lose it all as markets will quickly become illiquid as no one wants to own junk bonds in troubled times.
The situation is different with preferred stocks and high dividend stocks. The returns there are mostly related to interest rates, which is also the main risk. Higher interest rates would quickly lower their values.
International stocks might be the best option currently, but they are under the influence of market sentiment and could be priced much lower as they were in 2009 when they dropped more than 66% from their highs.
Figure 6: iShares International Select Dividend ETF. Source: iShares.
The time to spice up your portfolio is not at the peak of a 7-year bull market, but rather in the depths of a bear market. Therefore, remember the opportunities provided to you at this time as well as the risks, stick to your guns which have hopefully given you nice returns in the past few years, and be ready to load up on the riskier assets—such as high yield bonds or international stocks, which are more often priced at such bargain prices—when it feels like the world is going to end tomorrow.
This article shouldn’t be understood as an attack on BlackRock as its ETFs are great tools if used properly. Of course, you are properly warned of the risks before investing as it is your responsibility, but it’s just that the “undue risks” explanation seems a bit of an understatement and is a great example of how Wall Street operates when things get boring.
This is especially the case for unsophisticated investors who are not familiar with all the risks and possibilities of the various investment vehicles available to them.
In the end, be careful not to let being bored lead you to do something irresponsible. As Charlie Munger—Warren Buffet’s partner in crime—said, “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”