In recent years, investors both big and small have been reaching for income return in a variety of asset classes, some of which resulted in capital losses instead of anticipated gains. In the first installment of this series, we looked at a few popular investment categories that have proved rather costly to many income seeking investors. In this article, we’ll look at some of the psychology that drives this kind of behavior.
While yield-chasing has long been a habit of many investors, the recent ultra-low interest rate environment has caused investors to think in terms of “financial repression”, where savers who own bank deposits earn very low interest rates, well below the rate of inflation. In effect, financial repression is a tax on savings. Add to that, repeated rallies in bond prices, where interest rates earned by bond buyers fall, while prices of bonds rise. In more ordinary circumstances, bond buyers who overpay and accept very low interest rates would normally regret their purchases as interest rates later rise to more normal levels, causing bond prices to fall. But this has not occurred in recent years as high grade bond prices continued to gain. These conditions lead investors to reach for yield by making certain critical compromises that often result in net negative returns, some of them more negative than investors can first imagine.
The one most costly habit income seeking investors both private and professional continue to make is simply grabbing the highest quoted yield number. Income seekers often grab assets that offer a big current yield number without looking into exactly what the investment is, how it purports to pay the quoted income, and other vital details. Private investors who routinely lose a chunk of their money grabbing a variety of strange and often malodorous securities that quote a high yield number can be forgiven, as the complex and intricate aspects of income asset markets can take years to understand properly. But it is the portfolio-manager professionals who often prove to be the more perplexing victims, as they are pressured to overpay for income paying assets their clients wish to buy immediately, while their institutional bosses insist they buy yield, even when it seems rather imprudent.
Overpaying for what look like good income returns occurs in a variety of income markets, from ‘High Yield (Junk) bonds, REITs (Real Estate Investment Trusts), Closed End Mutual Funds, Master Limited Partnerships, ETFs, and many others. But the psychology that drives this behavior is the same in every case; if an asset offers a high quoted yield, investors will tend to grab it, though that asset most likely has significant price volatility risk that often results in negative overall returns. Those same assets can potentially offer very positive results, but those opportunities present themselves only when markets are very stressed and investors are frightened by a variety of negative news headlines. Having the guts to buy income paying assets cheap when everyone is freaking out is really very hard to do.
Another very common and rather costly investor behavior is what market psychologists call “recency bias”, where investors make decisions based on the most recent market price trends. When prices are trending upward, investors will pay up for what has performed best most recently. If markets are trending lower, investors will sell what has lost value most recently. Trend following in general is the most prevalent of all market behaviors, but when investing for income and total returns, this short-sighted tendency can prove costly.
There are a variety of other counterproductive behaviors that can cost income seeking investors a big chunk of their money, but above are the most common. Successful income and total return investors understand that net overall results, not the quoted yield number or the most recent price trend is what truly matters. In the next installment of this series we’ll take a first look at how income and total return investing can be done correctly.