Over the last several years, investors of all sorts, from large multinational institutions to individuals trading online brokerage accounts have struggled with the ongoing challenge of earning a respectable income yield in many categories of financial investments. Never ending low interest rates (sometimes even negative rates) throughout the world have forced investors to stretch risk tolerances and make compromises on quality, liquidity and transparency that can often prove very costly in the long run.
The truth is, that proper income and total return investing are often something of a Black Art; a sometimes shadowy process that can be both esoteric and counter intuitive.
Investors seeking income yield often buy the financial instruments that simply seem to pay the highest stated return, without examining from what the income is derived and how it compares to other assets. In many cases, income investors just chase the asset that has the most current popularly; an improvident behavior seen in other asset categories as well.
But proper and successful income and total return investing is a complicated business, often involving more of a process of elimination than a process of acquisition.
In order to derive a working income and total return portfolio that consistently makes positive net returns, one would need to avoid owning investments that pay good income but lose value over time and result in net negative returns. The avoidance of money-losers is at least as important as the acquisition of net money gainers. Adherence to this one rule alone can give the income and total return investor a material advantage.
And what are the net money losers you would want to avoid? It’s not the asset categories themselves which must be avoided, it is the relative price level of these assets when acquired is where the problem lies. And it is here where this all becomes a bit of a Black Art.
Many investors have purchased junk bonds, Master Limited Partnerships (MLPs), closed end mutual funds and high yielding stocks of all sorts in the hope of deriving a better than average income yield. Results from these purchases are mixed at best, as investors often buy these assets when their prices are high and sell them when their prices fall. A couple of rules to play by:
First, the avoidance rule must be respected; MLPs and Junk Bonds are not indispensable asset groups, however popular they might be from time to time. Be discriminating in what you own, buy assets that have a shot at gaining in value, not just those that pay high current income. This rule can pay off in the long run, even if it means bypassing a currently popular investment play.
Second, when prices for many income paying assets fall, investors too often flee the entire class, accepting losses as they try to get out of the way. This is where it gets a bit counter intuitive. In order to properly own income payers such as junk bonds, MLPs, many closed end mutual funds and other income payers, the only time to buy them is when the news sounds terrifying and everyone else is trying to sell them. Only then can an investor derive the properly low acquisition price necessary to make that sort of investment work; otherwise you are likely paying too much.
The same rules apply for higher grade assets; chasing high flyers after they have made a big run upward often proves to be unprofitable. When looking for income and total return; value is a primary criterion.
There is much more to the Black Art of income and total return investing than the explanation in the short essay above, but follow the basics as described and you may be on your way to better and more consistent income and total returns. More on this topic of Black Arts later.