Have you ever played kickball? When you get up to bat, you have two choices. The first is to kick for the home run, and the second is to put the ball on the ground in a spot where no one else is so that you can run to first. Your natural inclination is to kick that ball as hard as you can. However, the odds are greater that you’ll hit a pop up that will be caught then you will kick a home run. So, you hold back just a little bit to get the finesse, and lower your risk of getting out. You forego reaching for yield of a home run in favor of a single base.
In major league baseball you see something similar. The home run hitters get all the glory, but if you look closely most of the time they strike or pop out. Meanwhile, the most runs in the year are created by the single base hitters. You know the ones, they boringly get onto first a high percentage of the time and ultimately make it home as others like them hit. Usually, though not always those singles are what results in the game win. And yet we only seem to remember the homers years later.
Investing and Not Reaching for Yield
Investing is a lot like hitting. You have a choice. You can take more risk of loss, and be rewarded by a higher return in a riskier growth stock or a junk bond. You can hit a single by investing in a boring holding like an index fund. Just like when watching baseball, no one looks back on the index fund and 10 years later goes “Man, I set a record matching the market back in 2012”. However, studies show that the index fund ends up ahead of most active investments reaching for yield.
In the bond arena the same is true. Your risk free savings bonds are extremely boring as I highlighted in my post which probably put half my audience to sleep. They deliver year in and out so that ultimately my portfolio continues to climb. If you invest in more risky junk bonds, then your returns are more correlated with stocks, and usually low quality stocks at that. Sure, you see a higher return on those bonds, but the likelihood that the value of those bonds will go to zero can be substantial. If just one junk bond went bust, you would need to have 20x that principle amount returning 5% to make your portfolio whole.
My Experience Reaching for Yield
Sure, I remember that long ago an internet stock holding that earned me 500% and then promptly imploded to nothing during the dotcom boom (for the record, in my case I sold it at 2 dollars a share down from 25). I also remember that real estate Mortgage Backed Security (pre 2008) went to 30 cents on the dollar and then recovered to almost par over the last 5 years. The ups were euphoric, but for obvious reasons these high yield items have not contributed to my long term portfolio return. So remember that when you go looking for yield, it’s so tempting to shoot for the high yield, but you’re probably better off shooting for reliable.