Too Much Yield Can Be Harmful
Thursday, September 10, 2015

How much yield is too much yield? Put another way, at what point does the quest for portfolio income lead to more harm than good?

It’s a question worth asking, especially for those of you who rely on retirement savings for income. Even if the Federal Open Market Committee (FOMC) does decide to raise interest rates next week—and I don’t know if the FOMC will or if it will leave rates unchanged—yields on many assets will be continue to be low. There aren’t great options currently for investors desiring portfolio income and I don’t expect this to change very much in the foreseeable future (though my crystal ball remains cracked). 

Given this, how much yield is too much? Brian Meath, a managing director at Russell Investments, puts the number at 3.5%. In a post on the Russell Blog, Meath said his firm’s research found “that yield objectives over 3.5% begin to erode a portfolio’s capital base.” The rate of erosion increases as “forecasted yield increases to 5% and beyond.” By overreaching for yield, investors sacrifice future wealth for current income.

Yield is the amount of cash paid by a security relative to its market value. Depending on the asset and how its payout is structured, yield can represent earnings (in the form of dividend payments), interest (e.g., on bonds) or the return of capital. A multi-asset portfolio will offer some combination of these yield sources.

The danger of overreaching for yield occurs when an investor sacrifices quality for income. It can be helpful, in this instance, to think of yield as a valuation measure instead of as a measure of income. Certain securities and funds have higher yields because investors perceive a greater risk of losing the money spent on the investment (or, in financial terminology, capital.) If an investment is perceived as being riskier, investors will demand a lower valuation as compensation. Since yield and valuations are inversely related, higher yields imply lower valuations and greater perceived risk.

Downside risk can unravel the underlying premise of “never touch capital.” The idea of only living off of dividends, distributions and interest payments is to preserve the underlying value of the portfolio. So long as only income is taken, the portfolio’s value is not reduced, or so the concept holds. If too much income is sought, however, the value of the underlying securities will fall, thereby reducing capital. The investor will have unintentionally “touched” capital by taking on excessive risk.

A better strategy is to sacrifice yield to focus on fundamentally sound securities or funds that target higher quality assets. The lower yield can be offset by using capital gains to supplement income. While using total return may seem like an antithesis to never touching capital, it can actually do a better job of protecting capital by reducing the overall level of risk.

Keep in mind that it’s easy to downplay risk when downside volatility has not fully reared its ugly head. Though master limited partnerships (MLPs) have fallen significantly over the past 12 months, many stocks, bonds and real estate investment trusts (REITs) have not experienced significant downside volatility over the past several years…the last few weeks notwithstanding. Assets in all categories can drop in price, often without much warning. So even if you have successfully been able to realize higher yields without any downside penalty for taking the additional risk, there is no guarantee that you will be able to continue to do so in the future. Downside risk often seems like it’s a scream coming out of Chicken Little until it suddenly smacks your portfolio.

More on AAII.com

The Week Ahead

Just three members of the S&P 500 will report earnings next week: FedEx Corp. (FDX) and Oracle Corp. (ORCL) on Wednesday and Adobe Systems (ADBE) on Thursday.

The Federal Open Market Committee will hold a two-day meeting starting on Wednesday. The meeting statement and updated committee member forecasts will be released at 2 p.m. ET on Thursday, followed by a press conference with Chair Janet Yellen at 2:30 p.m. There is a large amount of scuttlebutt about an interest rate hike potentially being announced at this meeting, but it is uncertain what the committee’s decision will actually be.

The first economic reports of note will be released on Tuesday: August retail sales, August industrial production and capacity utilization, the September Empire State manufacturing survey and July business inventories. Wednesday will feature the August Consumer Price Index (CPI) and the National Association of Home Builders September housing market index. August housing starts and building permits and the September Philadelphia Federal Reserve’s manufacturing survey will be released on Thursday.

The Treasury Department will auction $13 billion of two-year notes on Friday.

Friday will be a quadruple witching day, meaning that both options and futures contracts will expire.

What’s Trending on AAII
  1. 16 Financial Ratios for Analyzing a Company’s Strengths and Weaknesses

  2. My Investment Letter: Words of Advice for My Grandchildren

  3. Get Organized! How to Maintain Your Personal Financial Files

AAII Sentiment Survey

Optimism rose to its highest level since June in the latest AAII Sentiment Survey. Pessimism is also higher, while neutral sentiment fell.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 2.3 percentage points to 34.6%. This is the largest amount of optimism registered by our survey since June 25, 2015, (35.6%) and is the third-highest reading since March. Even with the rebound, bullish sentiment remains below its historical average of 39.0% for the 27th consecutive week, the longest such streak since a 29-week stretch in 1993.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 5.6 percentage points to 30.3%. The drop reverses last week’s rebound and puts neutral sentiment below its historical average of 31.0% for the second time in three weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, rebounded by 3.3 percentage points to 35.0%. The rise keeps pessimism above its historical average of 30.0% for a seventh consecutive week. This is the longest streak of consecutive above-average readings for bearish sentiment since a 16-week stretch between August 30 and December 13, 2012.

Since volatility returned to the stock market, a larger proportion of individual investors are optimistic about the six-month prospects for equities. Bullish sentiment is above 30% for a third consecutive week for the first time since last April. This improvement from low levels reflects the perception among some individual investors that valuations have improved and that the recent volatility is providing a buying opportunity.

Bullish sentiment remains below average, however. At the same time, pessimism continues to be above average. The slightly higher level of pessimism in this week’s survey reflects concerns among many individual investors about the possibility of stock prices falling further due to valuations, slow earnings growth and slow economic growth among other factors.

This week’s special question asked AAII members how comfortable they are with the current valuations of stocks. About 30% said they are either uncomfortable or have very little comfort with prevailing valuations. Many of these members said that stocks are still pricey even after the recent pullback. Others pointed to the slow pace of economic and earnings growth. Slightly more than 25% described themselves as being comfortable with current valuations. Many of these members said that the market’s recent volatility has lowered stock prices, making valuations more attractive. Roughly 10% of respondents described stocks as being fairly valued or said that their opinion depends on the stock or sector being looked at. Smaller groups of respondents said that although prices have recently declined, valuations are still high, or that they anticipate further declines in stock prices to occur.

Here is a sampling of the responses:

  • “Good. P/E ratios are now reasonable, so buying in moderate amounts is appropriate.”
  • “I feel that after this correction stocks have returned to more reasonable valuations.”
  • “Overvalued. Growth prospects are not strong and risks are rising that growth will turn negative.”
  • “They seem to be overvalued based on historical P/E ratios.”
  • “Depends on the stock. Some have been beaten down into buy territory. Others may still be overpriced or at fair value.”


This week’s Sentiment Survey results:

Bullish: 34.6%, up 2.3 points
Neutral: 30.3%, down 5.6 points
Bearish: 35%, up 3.3 points

Historical averages:

Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!