When I was younger, I worked at an amusement park known for its historic, hand-carved carousel. Typically considered a children’s ride, the carousel began as a mediaeval amusement in which horsemen, riding at full speed, would attempt to pierce a ring hanging beyond their reach. When carousel rides were built to simulate this competition, a brass ring was suspended just beyond the perimeter of the carved horses. Riders would stretch to grab the brass ring, with successful riders getting a reward. However, most carousels don’t have the rings anymore. The risk of injury to those who fall from their steeds caused many ride operators to remove the brass rings, leaving the reward forever outside the rider’s reach.
Like grabbing the brass ring on a carousel, investing in the financial markets is also about risks and rewards. In the investment world, the rewards come in two forms: income and appreciation. Income represents the periodic cash-flow generated from investments, like dividends from stocks and interest payments from bonds. Appreciation is found in the increase in the market value of any investment, such as higher prices on stocks. Together, income and appreciation make up an investment’s total return.
The problem is, reward is only half the story.
All investments, even those that appear to be safest, come with risks. Stocks offer the potential of significant appreciation, but the past decade has reminded investors that the pursuit of this market reward can come with great volatility and the possibility of steep losses. Conversely, bonds offer the reward of a stable cash flow, but the inflation of the 1970s taught investors that pure bond portfolios offer little protection against the ravages of rising prices. While those bond investors sought the safety of a fixed income, they experienced another risk – the erosion in the purchasing power of their assets.
For years, many risk-averse, income-oriented investors were able to earn enough interest from the relative safety of the bond market to maintain their standard of living. During the inflationary ‘70s, while bond values fell, interest rates rose to double-digit levels. Since then, interest rates have been on a three-decade decline, giving bond investors a double reward – the benefit of their interest earned and an appreciation in the value of their bond holdings – their total return. In fact, despite a more-than 10% annualized return in stock prices during that time frame (1981-2011), the long drop in interest rates produced the first 30-year period in which long-term U.S. Treasury bonds outperformed the S&P 500 in total return – a real bonanza for bond investors.
Yet, the current environment of historically low interest rates has created a new problem.
For many buyers of CDs and short-term bonds, near-zero yields simply don’t provide the income they want. Like the carousel riders of days-gone-by, they will have to lean further off their horses if they hope to capture a greater reward. Fortunately for them, there is still a brass ring to grasp – but not without risk.
Longer-term bonds are one option for a higher income. A 30-year Treasury bond currently yields about 3.1%. Though their returns were stellar over the past 30 years, it is unlikely – even mathematically impossible – for them to provide the same kind of return over the next 30 years. In fact, a long-term reversal in the direction of interest rates would replace those big gains with big losses in principal – a serious risk for safe investors.
Dividend paying stocks are another possibility. Many investors focus on them, thinking their higher yield makes them a safer bet. They do offer the potential for greater cash flow, but safety is another matter. It hardly needs to be stated that stock prices can fall as quickly as they can rise. This is true for high-dividend stocks as well as low yielding companies. Over the long-run, however, stocks have provided a healthy return and have generally done a good job of keeping up with inflation, but stock investors need a lot of patience and long-term horizon to endure the ups and downs.
So what are safety-conscious investors to do?
Choosing the most stable assets means almost no income and the risk of losing their purchasing power to inflation; investments with greater appreciation potential also mean greater volatility.
Figures stated as of October 2011. Source: Bloomberg. Opinions expressed are for general information purposes only and are not recommendations or solicitations to buy or sell any particular security, product or service. Past performance is not indicative of future investment results. Diversification does not ensure a profit or protect against loss in a declining market. Any investment involves potential risk, including potential loss of capital. Before making any investment decision, please consult your legal, tax and financial advisors. Non-deposit investment products are not bank deposits and are not insured or guaranteed by Canandaigua National Bank & Trust, or any federal or state government or agency and are subject to investment risks, including possible loss of principal amount invested.
Often, the best solution is a well-designed mix of strategies that combines the risks of owning only the “safest” investments with the differing risks associated with investments that have more potential for reward. These assets include different types of bonds, such as corporate, high yield, or international issues. Additionally, stocks of many types of companies (including large, small, domestic and foreign) offer dividend yields above what the safest bonds are paying – plus appreciation potential. Real estate investment trusts (REITs) and preferred stocks also offer the opportunity for higher income while providing additional diversification to a portfolio.
Successfully investing one’s assets is not simply a question of whether or not to take risks. It’s a recognition that risks come in many forms. There is just no escaping risk, and no single solution fits everyone. The key to grabbing the brass ring of investment returns begins with understanding the investor’s specific investment goals (whether saving for a near-term down payment on a house, funding a child’s college education, or preparing for a far-off retirement), then assembling the proper mix of asset types to fit those goals while balancing the various investment risks against the potential rewards.
The advisors at CNB’s Wealth Strategies Group can help you understand the risks and the potential rewards on the financial markets carousel, and put together the right strategy to help you reach the brass ring without falling off your horse.