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For many investors, nothing's tougher than dealing with low interest rates. Yet with every indication pointing to the possibility that rates may stay low for an awfully long time, you have to be very careful that you don't make the same mistakes that investors have made during past interest rate cycles.
Passing on payouts
Increasingly, trying to get safe, reliable income from your investment portfolio is like getting blood from a stone. According to data from Market Rates Insight, the average rate on bank CDs fell below 1% earlier this week. Even top-yielding 1-year CDs from the banking divisions of MetLife (NYSE: MET ) and Discover Financial (NYSE: DFS ) no longer pay even 1.5%.
Things aren't any better with Treasury bonds. You have to be willing to lock up your money for five whole years to get over a 1% return on your money. And in the inflation-protected TIPS market, negative real returns extend all the way out to 2017. That's benefited those who've owned the iShares Barclays TIPS Bond ETF (NYSE: TIP ) , which has jumped 22% in the past two years. But it doesn't bode well for those who are just buying into the fund now.
Even worse, none of those returns considers the impact of taxes. With tax rates potentially going up next year, even more of that tiny amount of income you receive could go to Uncle Sam rather than into your own pocket.
Dealing with risk
It's no surprise that those who rely on investment income are taking on more risk, out of necessity rather than by choice. Indeed, one of the objectives of the Federal Reserve's latest round of quantitative easing was to encourage investment in riskier assets, in the hope that by doing so, all the money that the Fed has released into the financial system will actually start going to work rather than sitting in cash hoards among financial institutions and other businesses.
Yet many of those who most rely on income from their investment portfolios can't really afford to take on more risk. Retirees, for instance, can afford to have some stocks among their investments. But pushing retirees toward an all-stock portfolio simply to increase their income will put them at risk of principal losses they truly can't afford.
The safest stocks
Now it's true that some stocks are riskier than others. Recently, I pointed out how low-volatility dividend stocks can help reduce the risk of allocating more of your money into the stock market. As safe as dividend stalwarts Altria Group (NYSE: MO ) and Kimberly Clark (NYSE: KMB ) may seem, though, unexpected events like a further round of tobacco litigation or a major product recall could send even these stocks for a loop.
More importantly, though, is the impact that sustained low rates will have on dividend stocks. Right now, you can still find plenty of stocks that not only pay strong dividend yields but also are priced at low P/E multiples. Both Chevron (NYSE: CVX ) and Kraft Foods (NYSE: KFT ) , for instance, yield 3% or more and have P/Es of 12 or less. But over time, if rates remain low, investors will start bidding up these shares to prices at which they'll no longer look attractive -- and that in turn will push down dividend yields below the point where they're useful for retirees and other income-hungry investors.
What to do
As difficult as it is to sit on cash earning next to nothing right now, your best bet may be to hope that the international community puts enough pressure on the U.S. government to persuade it to reverse QE2 and its other rate-stifling policies. Countries like China and Russia have both criticized the U.S. for encouraging dollar devaluation and taking steps that they see as potentially destabilizing international capital flows. If their arguments win the day, then the reversal of QE2 could push interest rates back up over time to reasonable levels.
In the interim, though, it's more important than ever to gauge the risk level in your portfolio. As hard as it is to live on minimal income, it's much more important not to lose the retirement nest egg that you're counting on to sustain you for the rest of your life.
Not every high-yielding stock is as risky as most. Click here to take a look at the Fool's free report on dividend stocks, which includes 13 picks for your consideration.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.