Investors inevitably become unsatisfied with the status quo. This seems to be an unwritten rule and why the cycle of mistakes keep repeating.
I was reminded of this after reading an article Seth Klarman wrote for Forbes in 1992 that still applies today.
There is always a tension in the financial markets between greed and fear. During the 1980s investor greed frequently got the better of fear, with the result that yield-seeking investors, known among Wall Streeters as “yield pigs,” were susceptible to any investment product that promised a high current rate of return, the associated risk notwithstanding. Naturally, Wall Street responded by introducing a variety of new instruments–junk bonds, option-income mutual funds, international money market funds, preferred equity return certificates (PERCS)–anything that promised high current yields to investors.
Unless they are deluding themselves, investors understand that to achieve incremental yield above that available from U.S. government securities (the “risk-free” rate), they must incur increasing levels of principal risk. There is no risk-free yield enhancement on Wall Street. The painful result: Higher risk investments often erode one’s capital and produce lower returns–the worst of all investment worlds. Higher-returns-for-higher-risks only applies on average and over time.
…
Some investors, desperate for better yield, have been reaching not for a new Wall Street product but for a very old one–common stocks. Finding the yield on cash unacceptably low, people who have invested conservatively for years are beginning to throw money into stocks, despite the obvious high valuation of the market, its historically low dividend yield and the serious economic downturn currently under way.
How many times have we heard in recent months that stocks have always outperformed bonds in the long run? Funny, but we never hear that argument at market bottoms. In my view, it is only a matter of time before today’s yield pigs are led to the slaughterhouse. The shares of good companies and bad companies alike are vulnerable to sharp declines. Moreover, many junk bonds that have rallied will tumble again, and a number of today’s investment-grade issues will be downgraded to junk status…
Sure, the yields being discussed are quite different but the attitude is the same. When interest rates are falling, income investors long for the higher yields of the past. And selective memory helps overlook why rates were so high in the first place.
Klarman’s answer to this is simple. Stop reaching for yield and accept the status quo because the alternative carries more risk.
…I would advise people to ignore conventional wisdom and consume some principal for a while, if necessary, rather than to reach for yield and incur
the risk of major capital loss.
Stick to short-term U.S. government securities, federally insured bank CDs, or money market funds that hold only U.S. government securities. Better to end the year with 98%
of your principal intact than to risk your capital roofing around for incremental yield that is simply not attainable.
Investors tend to forget the reason why they set an allocation in the first place. It’s not because “higher yields” (maybe it is if the allocation was not thought through).
Your allocation is built to meet your goals without assuming more risk than you can handle. It should get you close enough to your goals if you just leave it alone. When you think you need to reach for yield, caution is the better response.
Source:
Don’t Be a Yield Pig, Forbes 1992
