Don’t Be Stupid When Chasing Higher Yields

One of my biggest financial pet peeves is when people refuse to realize the connection between return and risk. Whenever you see an investment that offers a “guaranteed safe” or “insured” return that is significantly above what an FDIC-insured bank can offer, it’s safe to assume that your risk has gone up.

The latest example is the Stanford Investment Group, which the SEC accuses of massive investment fraud:

SIB has sold approximately $8 billion of so-called “certificates of deposit” to investors by promising improbable and unsubstantiated high interest rates. These rates were supposedly earned through SIB’s unique investment strategy, which purportedly allowed the bank to achieve double-digit returns on its investments for the past 15 years.

Do the math, people! Double-digit returns + a bank based offshore in Antigua + no FDIC-insurance = Either fraud or risk to principal. And remember, in schemes like these the interest is always very reliable, coming every single month like clockwork…. until one day it doesn’t. Been that way since the real Ponzi.

And there are plenty more to replace SIG, just Google “high yield CD”. Back in 2005, there was American Business Financial Services, which imploded. Now there is Millennium Bank (based in St. Vincent), Zannett Notes, and CPS Notes. All offer well over 8% interest.

Now, I am not accusing any of these companies of fraud. There is a difference between fraud and plain old credit risk. In both bases, you might manage to cash out before things fall apart, but there’s also a real chance you might never see your money again.

But especially in times of low interest rates, people start to look for just a bit more yield. Even SmartMoney magazine has gotten caught up in the act. Check out their cover this month.

A sure 7%? What, from buying shares of stocks with temporarily jacked-up yields like Altria or Vodafone? How about a highly speculative 7%? Bank of America had a really nice dividend yield as well once upon a time… before it got cut to a penny. Dow Chemical just cut its dividend for the first time in 100 years. Add in the fact that your share price could drop as well, and I’d keep your emergency fund far away from these stocks.

Comments

  1. Fantastic rant! It doesn’t matter if it’s a 50 year old doctor or a 25 year old accountant, so many smart people fail to understand the relationship of risk and return.

  2. Allen Stanford’s own lawyer blew the whistle on him. Stanford apparently courted US politicians with donations and trips in his attempt to minimise his tax liabilities. So, if it weren’t for this whistleblower, there would be no one to expose this fraudulent behavior. You would think that someone would have said something after the Madoff debacle.

    But, what I really started to think about is what the “experts” are saying about how to invest now. Since you showcased “Smart” Money, it would be interesting to see what other self-proclaimed experts say about investing in this economy (e.g., the Motley Fool, Jim Cramer, Suze Orman, Robert Kiyosaki). As opposed to Smart Money, a columnist in ‘Money’ said: “Ignore the experts. How many of those TV gurus actually predicted the 2008 market plunge? They were all dead wrong, yet still we watch them and follow their advice.”

    But then another “expert” in Money said: “Although there are no guarantees, your best shot at getting the long-term growth you need is to invest in a portfolio consisting mostly of stocks. That’s because over very long periods, stocks typically generate much higher returns than bonds and cash.” This same Money expert then said: “…save a bit more than the calculator suggests”… that is, if you have 30 to 40 years before your retirement.

    Well, I have about 20 years before retirement. I’m getting a bit tired of listening to the conflicting static. I don’t go for outrageous yields, but I suppose I can’t blame those who did. I can’t say that I’m exceeding the recommendations of those financial calculators. But, I’m sticking with the strategy of having investment diversification on top of having an emergency fund.

  3. Great Rant! If you want another possible pyramid scam to pick on check this out:

    capitalbankmexico.com

    It looks like scam, feels like a scam..

  4. A great piece. Really well said.

    I was speaking to a person in July who had 100% of her assets in perferred stock of financial companies. Needless to say, she would not diversify because the “yields were so good”. She got her clock cleaned.

    Even if the companies are considered solid, we’re better off by seeking total return than simply yield.

    Thanks for bringing this up.

  5. Off the subject a little but anybody notice how Dollar Savings Direct has dropped to 3.05%

  6. I remember a couple years back when people were going ape **** for Millennium Bank’s CD’s denominated in Icelandic krona which were yielding like 12%. Well, look at that currency now…the whole government has collapsed with it! If you would have just looked at interest rates for Iceland before investing in that CD, you would have seen how much of a rip-off it was, considering it was a “guaranteed” 12%!

  7. Good risk/reward is Vanguard Corporate Bonds,over 900 bonds.
    Mutual fund VBIIX or ETF BIV Yield 4.58% paid monthly.

  8. Why are you BS’ing Altria.
    They are for real and solid

  9. The title’s first three words cover it all. And that goes for pretty much anything in life.

  10. Everyday Finance says:

    Hey Todd,
    I fell for the Dollar Savings Direct. I signed up at 3.4 less than a month ago! It then dropped to 3.2 and I did a post on “bait and switch” from this company and others (credit cards as well). Now it’s at 3.05%. What a joke! Fed Funds has already been at 0-.25% for some time now; how can they justify continuously dropping the rate after plastering their ads all over the internet.

    At least with CDs (legit ones) you know what you’re getting.

    On this Stanford business, BusinessWeek did a writeup on it this weekend. If SEC didn’t act on it following their article (personally, I wonder if the article forced them into action), it would have been totally outrageous.

    They were offering 7% CDs when the avg was 3.5%.

    No tax benefit can help you pay out at 7%. It’s a joke it took SEC this long to catch on.

  11. You are indeed correct. People have to pay attention or they’ll get taken!

  12. I remember looking at these ads. I saw these high-yielded CDs and thought “this cannot possibly be true”. Then I looked on their web page, couldn’t find any mention of FDIC insurance, but found mention of some foreign countries. I decided – no way, thanks much. At least with stocks you know there is risk.

    @Terry: “Good risk/reward is Vanguard Corporate Bonds,over 900 bonds. Mutual fund VBIIX or ETF BIV Yield 4.58% paid monthly.”

    Why do you need over 900 bonds? Why not invest in individual corporate or municipal bonds instead. Bonds aren’t the same as stocks: a bond fund isn’t the same as many individual bonds. Fund may own many bonds, but you don’t get an option to hold some or all of them till maturity as you do when you buy bonds yourself. Bonds are fixed income investment; every bond comes with a fixed interest and a promise to return your principle at maturity unless the company goes bankrupt. Bond funds aren’t fixed income investments: the value of bonds fluctuates, even if each bond pays fixed interest. With individual bonds even if the value of your bond drops between now and the maturity date, you can just keep it, collect interest and wait till maturity. Yes, you may lose on interest if new issues are paying higher interest, but when the value of bonds in your funds drops it takes a long time to make up the loss in this extra interest.

    When interest rates go up, all bonds lose value. This possibility is remote now, but it will happen eventually. There is some room for bond values to go up: because of current fear, the spreads between corporate bonds’ yields and that of treasuries are still too high. At the same time, the interest rates cannot go down much. So yes, there is risk in a bond fund. Individual bonds may carry risk of default but a) you know what credit rating you are getting b) unless the bond issuer defaults you are guaranteed to get your money back at maturity. Diversification may reduce the risk of default, but your risk of simply losing in bonds value is higher.

    BTW – last November I got a couple of AA and AAA municipal bonds with a tax free yield of 5.3% (interest rate 5% on one and 5.25% on another issue, free from both federal and state taxes; I bought below par). The yields are not nearly as high now, but you could still get better yields than on CDs, especially if you are in a high tax bracket. As to corporate bonds, last time I check you could get long term Verizon bonds with a yield of 6%. I doubt Verizon goes out of business any time soon. Goldman Sachs bonds’ yield is even higher – if you aren’t afraid of financials.

  13. I’m not saying that dividend-paying stocks or corporate bonds are a bad investments in general, only that you need to be aware that you’ll be taking additional risk. Don’t be the widow with millions all in Lehman Bros. bonds.

  14. Very well put Jonathan.

  15. @kitty

    What was the minimum purchase amount of those municipal bonds you bought? I was always under the impression that most individual bonds had minimum purchase amounts around $10,000, which makes it difficult for most investors to diversify. The fact that you can fully diversify with a bond fund for very little money is what makes them most attractive.

    Do you mind sharing what resources and services you use to research and buy bonds? Admittedly, I’m still young and just getting into bonds and treasury notes, no doubt influenced by the current financial mess.

  16. @Rich,
    The minimum purchase requirement was $5000 in face value (i.e. the original value of the bond – the amount you’ll get back in maturity). This was the minimum for most bonds I looked at. I bought last November when the spreads or the difference between the bond yields and treasury yield were greater because of the credit crisis. Hence, the bonds were selling “below par” i.e. for less money. So normally you can spend less or more than this depending on whether the bonds are selling above par, at par or below par. YTM – yield to maturity – reflects this i.e. if a bond’s rate is 5% but you bought it below par the actual yield is higher.

    I am not really diversified at this point – I only have 2 municipal issues (AA and AAA) and one corporate (Goldman Sachs, I paid $3700 for it, so I got 9% yield-to-maturity), but I plan to increase my bond holdings in the following months. But you are right, investing in individual bonds requires more money than bond fund, so for those with little money a fund (or just plain CD) may be the only option to invest in bonds. But one needs to realize that diversification is only part of bond fund risk and that even without defaults, bond funds can lose value e.g. when interest rates start going up.

    If you just want to read about bonds, yahoo finance (finance.yahoo.com/bonds) has a nice explanation. I believe cnnfn.com also has articles.

    I usually look for bonds from my brokerage account – I use TD Ameritrade. They have a bond search feature that allows to enter various search parameters – years to maturity, taxable or tax free, credit rating, how much money you have, etc. . With municipals I choose general obligation bonds since the risk of default on tax revenue bonds in NY where I live may be higher now (although I read that the risk of default on AA and AAA municipal bonds is very low). With companies, I generally look for well-known companies; ignore yields that are suspiciously high like a double digit yield on a AAA-rated stock. This was OK at the height of credit crisis a few months ago, but now it’s unusual and likely to mean something is wrong with the company. I’d imagine other brokerages have bond search feature too.

    @Jonathan – I agree with you here. One needs to always be aware about risk and not put all the money in one place.

  17. Very true. At the same time I must say US government securities now seem pretty crazy. The yield is so low that other investments (with higher yields seem batter). But I rarely invest in bonds in any form so I am not really in the market. But if I were I think I would be leaning to medium term, high grade, corporate bonds.

    But for saving type money, FDIC insured banks are the best option I see (or credit unions with the similar insurance).

  18. Preach it brother…. as vital as money is to people’s every day life, it is amazing how ignorant some can be…. a guaranteed 7% with the Fed rate is… what? 1%… argh, a recipe for disaster.

    I’m not a fan of government regulation as a cure all but in some cases it has merit… helmet laws for motorcylist (and I am one) is a great idea because some folks are too ignorant to think otherwise. Similarly, I think we need a ‘helmet law’ or ‘driver’s license test’ for folks wanting to invest in anything more than a CD.

    In rant mode… know how to swim BEFORE jumping from the high dive!

    Thanks for your article and allowing me the opportunity to share in your rant!

    Dave

Speak Your Mind

*