YIELD — THE CONVENTIONAL wisdom tells you it's the most important thing in investing, and today the world is engaged in a mad scramble to get it. But the conventional wisdom is wrong. Yield is the least important thing in investing. And in today's market climate, that's even truer than ever.
Yield is investment income: dividend income from your stocks, coupon payments from your bonds, and interest payments from your money-market funds. Sounds great, right? Who doesn't want income? And don't all the how-to's tell you that income is the safest way to profit from your investments?
It's a myth. There's nothing special about income. What investors ought to be concerned with is their investments' total return — the combination of income and capital gains. In fact, if you had to choose between the two, capital gains is the preferable way to earn investment returns.
And investments that focus on yield aren't necessarily safe, at least not when you think sensibly about what safety really means.
Let's dispose of the safety myth first.
The safest income-producing investments of all are Treasury bills issued by the U.S. government. But based on data from Ibbotson Associates, the gold standard for historical research in investment returns, over the last 80 years, T-bills have earned investors only a 3.7% average annual return. Take inflation into account, and the return falls to just 0.6% — barely more than one half of one percent.
So supposedly safe T-bills have been a one-way ticket to the poorhouse. Sure, their value doesn't fluctuate much from year to year. There's no such thing as a bear market in T-bills. But their low return practically guarantees that, if you're using T-bills for any kind of long-term investment goal, you simply won't make it. If it's retirement you're investing for with T-bills, you can be pretty sure you're going to outlive your savings.
Bonds have been a bit better — and I mean a bit. According to Ibbotson, long-term Treasury bonds have returned an average of 5.4% per year over the last 80 years. But inflation ate most of that up, leaving you only an average 2.2% annual return.
And along the way, there were some bear markets to suffer through. If you include the effects of inflation, the worst five-year period for bonds was from 1976 to 1981, when T-bond investors lost 41% of their money, including income. There have been five five-year periods in which T-bond losses were 20% or more, including inflation. Not exactly riskless.
Yes, I know — stocks are even riskier. Or are they? Including inflation, according to Ibbotson, there have been seven five-year periods in which stock losses were 20% or more, including dividends. That's two more than with T-bonds. Not really such a big deal over 80 years, if you ask me.
And here's an amazing fact that not one in a hundred investors knows. The worst-case experience for stocks has actually been better than the worst-case experience for bonds! It's true. The worst five-year period for the S&P 500 was from 1936 to 1941, when stock investors lost 39% of their money, including dividends and including inflation. That beats bonds' worst case of 41%.
That's all the more remarkable considering that the S&P 500 has returned 10.4% per year, on average, before inflation. After inflation, it's still a very respectable 7.1%. In other words, with stocks, investors have earned more after inflation than T-bond investors earned before inflation. And at least by the measures we just looked at, stocks really aren't much riskier.
But wait! Aren't dividends — the yield component of stocks — an important ingredient in the historical success story? At least that's what the conventional wisdom believes.
I don't know how many times I've heard supposed "experts" in the financial media come out with the "fact" that, historically, dividends account for three quarters of the total return of stocks. The implication is that you need to own stocks that pay dividends, otherwise, you're throwing away three quarters of your return.
The "experts" couldn't be more wrong. According to Ibbotson, over the last 80 years, dividends have explained only about 40% of total returns for the S&P 500. But even if companies were to stop paying dividends entirely, that almost certainly wouldn't make any difference to your total return as a stock investor. Companies have ways other than dividends to get money to you.
If companies want to return money to shareholders, they can just as easily do it by repurchasing their shares in the open market, rather than paying dividends. That way, if you need income from your investment, just sell some of your shares.
I think that's a better way to go. For companies, repurchases reduce shares outstanding and bolster earnings per share and the stock price. For investors, repurchases put you in charge of when you get your income from your investment, and how much. Which means you are in charge of when you pay taxes on that income.
Some economists who specialize in "behavioral finance" have done research into why some investors still prefer dividends. They theorize it's because those investors actually want to give up control of their income to the companies they invest in, like a child wanting a fixed allowance from a wise and kindly parent.
But most companies are figuring out that it's smarter to do share repurchases. That's why today the total dollar value of share buybacks is greater than the total value of regular dividends. Yet how often do you hear those "experts" complaining that companies aren't paying dividends "like they used to" — as though that's some kind of sign of weakness in corporate America, and things were better in some golden "good old days?"
Actually, I don't think there's necessarily anything good about companies returning money to shareholders at all, whether they do it through dividends or share repurchases. It means they don't have anything better to do with the money than get rid of it.
Think about it: When would you have rather owned Microsoft (MSFT: 30.43, -0.29, -0.9%)? During the glory years in the 1980s and the 1990s when its stock grew hundreds-fold, from virtually nothing to become the most highly valued in the world — while never paying a penny in dividends? Or, since 2003, when Microsoft finally started paying a dividend, and its stock has gone nowhere?
But all that's only reality, and most of the time markets operate on pure fantasy. Today there is what Fed chief Ben Bernanke calls a "global savings glut" — trillions of dollars held by central banks and financial institutions around the world. Those dollars are engaged now in what amounts to a global bidding war on financial instruments that can provide some income. It's a world-wide treasure hunt for yield.
That's why yields around the world have been driven to unusually low levels. Which is exactly why you shouldn't be seeking yield right now. It's just not there to be found.
Don't be dumb like those yield-seeking investors who were so desperate they threw hundreds of billions at the subprime-mortgage market, making home loans without even asking the borrowers to make down payments, do property appraisals or even fill out detailed applications.
Be smart like the folks in the booming private-equity business. They're not seeking yield — they're taking advantage of the suckers who are. They're buying stocks, buying whole companies in fact, and taking them private. And they're doing it with borrowed money. Why? Because the interest they have to pay to desperate yield-seeking lending institutions is so little compared to the value of the companies they are buying.
There are times when the opposite is true. In 1999 and 2000 it made sense to shun stocks and put the money in income-producing bonds, just because stocks were so insanely overpriced. For some reason, at that point in history the conventional wisdom favored stocks, and overlooked income. That's the time to go for income.
But that's not usually the case. And especially not now. With interest rates so low, and with stocks cheap based on their expected earnings — though stocks are indeed at all-time highs — now's not the time to be a yield-seeker.
Sure, if you are driving around and you see a "Yield!" sign, by all means obey it. But otherwise, as an investor, yield is something you're a lot better off just ignoring.
Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors. You may contact him at don@trendmacro.com.
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