29 Apr Fences

You know the grass is always greener on the other side of the fence because when you look at the lawn next door you’re getting a side view of one blade of grass next to and after another.  It’s just a sea of green.  But, when you look straight down at your own lawn you can only see the tips of each blade and ground all around.  When you jump the fence and look back across at your own lawn, you see that the grass suddenly appears much lusher and greener there than the grass now under foot.

Investors have a tendency to view investments in the same light.  They hop from one investment to another with better recent performance.  By the time they do so, they’ve missed most of the upside and start scouting all over again.  This pursuit of illusory returns handicaps most investors; but it creates profit potential for the peddlers of financial products.

Increasingly popular ETFs that invest in high-dividend-paying stocks offer a good example.  With interest rates scraping the very bottom of their potential these days, income hungry investors are peering over the fence at what appear lusher sources of interest and dividends.  Savvy marketers in the mutual fund industry have taken notice and begun hotly promoting funds that invest in companies who rather than plow their earnings back into their mature industries, pay them out to shareholders in the form of generous dividends.

Stocks in these companies have done very well over the past several decades, because as interest rates on bonds and CDs have steadily declined, their stable dividends have become increasingly more attractive.  Additionally, because investors enjoy an unabated flow of income even when prices are depressed, these stocks have exhibited less downside risk than the market in general.   As they attracted more and more investors over the years, their prices rose.  Thus, owners of these stocks reaped the best of both worlds: superior income and capital appreciation.

So, while these wonderful investments are being promoted to an ever-increasing number of investors these days, let me share with you the other side to the story.  Suppose interest rates stopped declining at some point in the future.  Suppose they actually began to rise.  Then the yield on these stocks would become increasingly less attractive.  After a while, people who recently bought them through these ETFs might begin comparing their losses with the rising interest rates on the bonds and CDs on the other side of the fence.  Prices on their ETFs would begin to decline.   They’d be experiencing the worst of both worlds: inferior income and capital depreciation.  At some point, perhaps near a top in interest rates, they might tire of looking down at losses and leap over another fence into a new batch of ETFs that invest in… well, variable-rate bonds will have done well recently.

Now, what happens to the income on variable-rate bonds as interest rates begin to decline again?  The moral to this story?  Build high fences you can’t see through.  We have a name for these fences.  We call them “discipline.”