Income Risk, the Sneak
Attack on Your Investments Income Risk, the Sneak
Attack on Your Investments
To properly understand the concept of income risk, one has to consider the effect of the movement of interest rates on an investment portfolio. Let's say we have salted away $1,000,000 in bank GICs after winning the Olympic lottery in 1981. We quit our job and decide to write books on the romantic habits of earthworms. Being conservative, we decide to only spend the income generated by our investments.
At this time interest rates were nearly 20% in Canada. That meant our tidy nest egg earned almost $200,000 a year. While we were out in the garden, studiously observing the heat being generated by our slimy charges, we were generating far more income than the average family. As central bankers around the world fought the good fight against inflation, interested rates dropped until 1986. In 1986, inflation had dropped to single digits and interest rates had followed. Taking time out from our research, we would have found that our GICs were rolling over at less than 10%. This meant our interest income had dropped to less than $100,000 a year, a 50% decline in income. Poking our head up from the dirt in 1991 when the GICs came due again, we would have found a similar picture, leaving our income nearly the same.
The big shock comes in 1996. The interest rate on 5 year GICs is presently around 5%, giving us a $50,000 income. At this point, if we don't want to dip into our capital, we clearly have to consider getting a real job and leave our beloved worms to their own devices.
Something has clearly crept up on us and caught us in our unawares. We've been the victim of "income risk", which has executed a sneak attack on our investments. Income risk is one of the least understood and most poorly communicated risks in the financial world. Everyone seems to know that inflation is an ugly enemy which results in major shifts in wealth and income flows. Not many understand that disinflation does exactly the opposite thing, leading to hugely underestimated shifts in income and living standards for the unsuspecting.
How does one protect oneself from this lurking menace? That is a good question, and very hard to do after the fact. Beforehand, however, one must match there income needs to a proper maturity debt portfolio. If we wanted to lock in or "fix" our income, we should have invested in a longer term "fixed income" instrument or bond. Let's say we knew this when we won the lottery and began our study of romantic worms. Being sharp, we would have bought the longest-term bond we could have found in 1981, which was then about 25 years. This would have locked in our $200,000 income stream until well after the year 2000. Of course, in 1981, with rampaging inflation paramount in everyone's mind this would have been a gutsy thing to do. By 1986, however, it would have been a reasonable thing to do, sparing us the latest income ravages of the latest bout of declining interest rates.
What does one do now, however, with low rates and few income boosting investments available? "Stretch for yield" and "buy equities" seems to be the favourite advice of many financial experts. Patience is an investment virtue. If you need income stability, forget market vagaries and outlook. Find a good quality, longer-term bond that matches your need and invest "for the long term". Don't "stretch for yield". Avoid speculative securities which might only pay their stated coupon for a few payments before defaulting.
Equities, as an investment in the rising cash flows of good companies, are always a fine choice. Beware the hype, however. Stocks not only go up, they also go down. Experts of all stripes are floating theories based on demographics, spirographs and sunspot activities to explain why "it is really different this time." Stocks are not just bundles of risk and return and blips on a graph that always moves up. The dividend yield on stocks, the actual cash payout from holding stocks, is below 3% in both Canada and the United States. Our unanimous experts are counting on very large price increases to support their rosy projections (and pay for their next Porsche). If your cash income need is over 3%, there is a fairly good chance that you will need to dip into your capital at a point when the market is down. With an equity portfolio, your acid test will be whether you will be able to keep yourself from throwing in the towel and selling, as Sir John Templeton calls it, "at the point of maximum pessimism." This is when you are probably down 30% and the experts cannot see any light at the end of the tunnel. How likely is a 30% drop? Investment history shows that this is not that remote a risk.
Just when everyone has recognized the pitfalls of floating rate investments and the income deprivation caused by plummeting interest rates, caution should be your watchword. The experts who were unanimously agreed on the great dangers of inflation cannot now conceive of its return. Easy money has made fools of those bearish on financial assets of any sort. The last time the financial experts mocked those stupid enough to invest in low yielding treasury bills, early 1994, we had an unexpected tightening of monetary policy and horrendous meltdowns in the value of all but the shortest-term financial assets.
"When cash is trash, prepare for the smash."
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