Dividends & Income Digest: What Investment Risks Are You Taking?
I’m sure I’m not alone here: The older I get, the less of a risk taker I become. I look back at things I did 10 or 20 years ago and am in awe of my younger self! I was brave and bold – and in some cases downright reckless – in ways I cannot fathom today.
Part of it is that as we age and gain more experience, we become more aware of danger and consequence. I see this happening already in my sons. At age 2, my eldest just barely made the height requirement to ride the kiddie roller coaster at a local amusement park, yet he boarded it without fear, as if he’d ridden it 100 times before. I was white-knuckled the whole ride, while beside me he just laughed. A year later, though, at the wise old age of 3, he took one look at that roller coaster and gave it a hard pass. Way too scary, now that he had a slightly better sense of what was at stake.
Part of it, too, is the burden of responsibility. I’m a wife, a mother, and a breadwinner. These roles define me in ways the younger me could only dream of. When I take risks now, I in turn put my family at risk, financially or otherwise.
So I’ll admit I don’t take a lot of risks these days, investments included. Not long ago, my husband and I bit our nails over the purchase of a bitcoin. A single bitcoin. We didn’t want to risk missing out on the ride, but I imagine 20 years ago we would have just jumped right on that roller coaster with our hands in the air.
Certainly, there’s plenty for investors to be nervous about right now. As Regraded Solutions wrote recently:
Nobody knows if the recent turbulence will last. Thus far, over the past 7-8 years, the markets have bounced back and gone even higher. If that happens once again, great, no harm no foul. The point is to be prepared for the WORST and hope for the best. Do your homework, and know why you are invested, as well as your tolerance for risk.
My tolerance for risk might be particularly low right now due to the fact that I have young children and am in the process of buying a new house (both risks in their own right, really). But I suspect I’m not alone in terms of my overall tolerance for risk decreasing as I age – not to mention as an eight-year stretch of market gains can feel like a correction is due at any time.
With this in mind, I asked several of our authors to respond to the following question for this week’s Digest:
What, if any, investment risks are you taking right now?
Here’s what they had to say:
Financially Free Investor
The markets have been a little volatile recently. While that is nothing unusual, investors have become a bit complacent due to lack of volatility in the last year or so. On the other hand, in spite of the fact that the economy has been chugging along, there has been a constant fear that the bull market is long in the teeth and valuations have become pricey, so we might see some level of correction in the near future. The next bear market may happen next month or may not occur for the next two years; we do not know.
That said, I believe in a few key principles, the primary one being “strategic diversification” in the form of a pyramid. The base is formed of long-term DGI (dividend growth investing) holdings. The middle piece is a risk-adjusted income-focused portfolio, and the top could be formed from alternative assets or growth/speculative investments depending on one’s risk profile. We wrote an article last week that fits into the top piece of the pyramid for income-seeking investors.
The second key principle is “systematic investing.” Once a system has been put in place after carefully examining the goals and risk-tolerance, we need not worry about day-to-day gyrations and follow the system diligently without fear and emotions. In the long run, the majority of profits go to people who set their paths and walk on them. Nobody gets to the destination by standing still. As the old Wall Street saying “Bulls make money, bears make money, pigs get slaughtered” goes, the systematic investing approach helps overcome the excessive greed or impatience.
To be more specific, in our DGI allocation, we are not initiating new positions right now because of high valuations for almost everything. But instead, we are selling put options for the stocks that we want to have and at strike-prices that are 10-15% below the current levels. However, one needs to be careful that these are the companies that you want to own long-term, and their share price may have come down temporarily. Some recent such examples are Verizon ( VZ ), AT&T ( T ) , Realty Income ( O ), Altria ( MO ), Exxon Mobil ( XOM ) and Omega Healthcare ( OHI ). Either way, we won’t lose. If the stock falls in the next 4-6 months, we will own it for the attractive dividend, which will be 10-15% higher than today’s yield. If not, we will at least earn income in the range of 5-7% on our idle cash. We described this strategy in one of our recent articles .
Adam Aloisi
For any investor with an equity-income dominated portfolio, simply holding richly valued, low-yield dividend-growth-slowing stocks in today’s market appears less favorable from a historical risk/rewards perspective. While this does not mean that a harsh wholesale selloff is necessarily in the offing, it does mean that forward total return and dividend growth expectations should be severely tempered. Portfolio performance we’ve seen over the past 8 years will not sustain itself the next 8 years.
My somewhat muted returns prediction also assumes the macroeconomic backdrop remains tame, which, at this juncture, may be an optimistic view. Investors may be underestimating the domestic impact that unfunded public pension liabilities and health care dispensary issues may have on John Q. Public and collectively, Main Street America.
Indeed, the stagnation and squeezing of the middle class continues, which arguably led to the election of Donald Trump, which currently is leading to rising social discontent. Socio-political/philosophical division, while something our nation has always contended with, appears more threatening than any time in recent memory. Geopolitical risk, primarily from North Korea, is a factor investors should consider.
Further, despite the fact markets are trading at all-time highs, dividend investors continue to witness “rolling corrections” in the equity/economic realm. Over the past five years income-producing fossil fuel and retail stocks have been rocked by commodity price and e-commerce threat, respectively. Given the rapidity of technological advance and increasing competition in the marketplace, further disruptively-inspired corrections both of individual-equity- and market-sector-ilk should be anticipated.
On a personal level, while I haven’t been allocating meaningful new capital to stocks as of late, I continue to approach income portfolio construction with the belief that interest rates will remain low and somewhat non-volatile. That is certainly a big risk, assuming neither of those things occur. To leverage that belief I continue to hold and trade some of the UBS 2X ETN products, including [[MORL]] (Mortgage Reits) and [[CEFL]] (Closed-end funds), which yield in the neighborhood of 20 percent. Caveat emptor.
I’m also overweighting equity REITs, but not to the extent I was last year. As I noted in a recent article, I see the foundation cracking a bit there. Largest positions are STORE Capital ( STOR ), which is extremely rate sensitive and Mid-America Apartment Communities ( MAA ) – an apartment landlord primarily in the Sunbelt region.
Elsewhere, I have made oversized commitment to green energy over the past few years, with large positions in Pattern Energy ( PEGI ) and NRG Yield ( NYLD ), currently yielding 6.8% and 6.1%, respectively.
Finally, I would note heavy allocation to technology. While the majority of that is held in large caps like Apple and Microsoft, which aren’t generally considered risky, I’m also taking some chances on some smaller dividend payers like Silicon Motion ( SIMO ) and Cypress ( CY ), which are.
Blue Harbinger
One beaten-up and underperforming area of the market where we are starting to see attractive risk-versus-reward opportunities is real estate investment trusts (REITs). For example, as the “Death of Retail” narrative grows to a louder chorus, we think there will be clear winners and losers within both the retail REIT space (e.g. we like some of the higher-quality shopping mall owners), and the industrial REIT space (e.g. we like some of the industrial REITs serving both traditional customers and e-fulfillment businesses). Further still, we also like some of the data center REITs on pullbacks.
Regarding shopping mall REITs, we like quality. That doesn’t necessarily mean only the tier 1 properties with the highest rents, but also some of the tier 2 properties that have sold off but are still not overextended in terms of their debt loads relative to their funds from operations. As members of our marketplace service ( The Value & Income Forum ) know, we’ve had some recent success generating attractive income by selling put options on Simon Property Group ( SPG ), which is one of the higher quality ample-cash-flow retail REITs that we wouldn’t mind owning at an even lower price if the shares were to get put to us. Also, we have an interesting view on another retail REIT, Washington Prime Group ( WPG ) (members-only article: ” Washington Prime: 12% Yield and The Death of Retail “).
Regarding industrial REITs, the space remains strong according to the SIOR Commercial Real Estate Index , but several of the names in this space have underperformed, offer attractive valuations, and have compelling dividend yields. For example, we believe Gramercy Property Trust ( GPT ) is worth considering, and we recently explained why in this members-only article: ” Gramercy Yields 5.0%: Buy This Dip or Abandon Ship? ” Also interesting, some of the industrial REITs will continue to benefit by providing facilities for online retailers, an area of the market that continues to grow, as shown in the following chart.
Regarding data center REITs, this is an area that continues to experience tremendous growth as companies continue to move data to the cloud. Data center REIT dividend yields tend not to be quite as high as many of the retail and industrial REITs, and they are also more volatile. However, the higher volatility makes for more attractive income-generating premium on put option sales. For example, we’ve recently generated attractive income selling put options on Digital Realty Trust ( DLR ), an impressive growth company, that will eventually mature into a higher dividend payer, and that we wouldn’t mind owning on a pullback if the shares were to get put to us.
Overall, they say the biggest risk is not taking any risk at all. There is a lot of truth to that, but investors should still work to cater their risk exposures to meet their own individual needs. They should also work to take advantage of the current opportunities that the market is providing, rather than trying to force something that is better suited for a different market environment.
Making a Spectacle
In a previous article , I discuss uncompensated risk and its implications for the dividend investor. I went into some depth about why we shouldn’t necessarily shy away from risk, as that very act of taking risk can result in outperformance. In addition, I also went over how simply going long the S&P 500 with your entire portfolio exposes you to “uncompensated risk” – being overweight U.S. equities is an active investment stance compared to the only truly passive investment of long MSCI Global or some equivalent worldwide index. However, what I didn’t discuss was my own portfolio. At the moment, I’m heavily overweight Europe and Canada relative to the U.S., and this is because of my belief in continued Chinese economic performance. Convoluted, yes, but I will explain.
Recent European outperformance has created a strong tailwind for companies with lots of business locally, and while the euro has been strengthening lately, the world economy is still growing fast enough to support companies with some exports. As such, one of my largest positions is in BMW (traded on the German exchange, not the U.S. OTC ones). The continuing strength of the Chinese economy (one of BMW’s largest markets), for the next 2 or 3 years, will support German automobile growth in the mid-term. Again, local European growth will also help tremendously.
I’m also long Canada generally (through REITs, banks, telecoms, and insurance companies). As mentioned, I expect Chinese growth to continue, and this growth will prop up commodity prices – not as much as it has in the past, but enough to drive up Canadian economic growth past what most experts are predicting.
ScottU
We are in a bit of a different position than most. My wife is 9 months from graduation from Law School and we’re currently looking to purchase a new home, so we’ve been looking to conserve cash, work through the next year and then re-evaluate.
We are still making our investments into our retirement accounts on a regular basis. My 401K has a 55/45 split between bonds and equities. The idea behind the portfolio is to work towards market performance but without the risks associated with being in an all equity portfolio.
In our taxable investment account we did sell Avista on news of the future all cash merger. The funds from that sale were moved to Dominion Resources ( D ) and Starbucks ( SBUX ). The total income increased by just over 19% and the overall quality of the portfolio increased with this move. Any funds added in the next year will have a focus on quality versus trading off quality for increased current income.
Our family does have one small position left in Avista ( AVA ) that we will be selling at some point in the next few months. Right now our thought is to let the market settle a bit. My best guess there is that we’ll do with it what we did with the other stakes and add a bit of income while increasing the quality of the portfolio as a whole.
Dividend Investors
Our broader stance is that risk is actually not a bad thing, as long as it is diversified. With greater risk come the greater potential for rewards, and those rewards can help to keep you solvent when markets become unpredictable. There are some differences that should be considered as far as age demographics are concerned. Older investors with a larger nest egg might not see the need to enhance risk exposure because there is less incentive to generate substantial returns when you have already done the work to accumulate savings over time.
That said, we believe that the market as a whole is vulnerable to growing risk levels. Stock markets that continue to hold at all-time highs could be vulnerable to rising market volatility if global interest rate levels start changing as widespread growth begins to stall. Currently, we are looking at positions that should benefit from rising oil prices . The main contention here is the shift toward alternative fuels but, in our view, many of these forecasts are overly optimistic. These are transitions that will take more time than many in the market realize, and we have started to position with that view in mind.
Since these are contrarian positions (with oil prices remaining depressed for a substantial period of time), there is definitely risk involved. But we feel as though our entry points have been favorable enough (taken after most of the damage was already done) that the inherent risks here should ultimately prove to be profitable given the way they are structured. There are many opportunities for dividend investors to capitalize on these type of stances but it should be understood that the find factor is a vital component when structuring these positions and in adding them to a portfolio. These are not necessarily positions that should be held for thirty years, and that can deter some investors with a highly conservative mindset.
Added risk does mean added reward, however, and we do look for opportunities that have been shunned by most of the market. We will continue to look at the weakening energy space as a source for new investment ideas. But at the same time we will structure those positions in ways that factor time as an important element in order to shield against potential losses. We also make sure to keep these positions active within a well-diversified portfolio in order to gain added protection and to give us greater flexibility to move in and out of positions as market trends change.
What about you? Are you taking any risks right now? Please chime in in the comments below!
If you enjoy the D&I Digest and would like to be alerted to future editions, don’t forget to “follow” me! And, please let me know if there’s a topic you’d like to see covered in a future D&I Digest, either by commenting below or sending me a private message. I’d love to hear from you.
Finally, here’s some recent Dividends & Income content you might want to check out (if you haven’t already):
Nervous? Go For Quality, Diversify, Don’t Reach For Yield – And Survive Investing Adversity by Mike Nadel
Why Berkshire Is Destined To Become The Ultimate Dividend Growth Stock by Dividend Sensei
The Preferred Investor by Norman Roberts
Prospect Capital: Expected Dividend Cut Of 20% To 30% by BDC Buzz
My Take On Tanger by Brad Thomas
REITs: The Foundation Has Become Increasingly Shaky by Adam Aloisi
Tracking The Treasury Rate For A 9% Yield On This Healthcare REIT by George Schneider
The One Thing Every Self-Directed Investor Must Do by Bob Wells
Retirement Crisis: It’s As Simple As Not Saving Enough by Alpha Gen Capital
My 5 Favorite Dividend Investments Of 2017 by Colorado Wealth Management Fund
See also AcelRX: A Misunderstood Diamond In The Rough on uniquefinance.org
