When you retire, your investment priorities tend to shift. Instead of focusing on growing your money for the future, the key is to create a sustainable income stream and preserve your nest egg.
With that in mind, some stocks simply have no place in a retiree's portfolio due to red flags such as the amount of risk they carry. Here are three such stocks.
Dividends that are too good to be true
As the old saying goes, "if it's too good to be true, it probably is." This definitely holds true in dividend investing, as sky-high payouts are inflated for a reason.
A great example of this is Annaly Capital Management (NYSE:NLY), a real estate investment trust that makes most of its money by investing in mortgage-backed securities issued or insured by Fannie Mae and/or Freddie Mac. To increase its returns, the company leverages up by borrowing money at low short-term rates in order to fund its investments. With a current leverage ratio of a little over five-to-one, the company can pay an annualized yield in excess of 11%.
The problem is that this makes the company highly vulnerable to interest rate changes. For example, if Annaly can borrow at 2% interest and collect 4% from a mortgage, the 2% "spread" is the profit. So, at five-to-one leverage, the yield would be roughly 10%.
However, if the short-term rate jumps to 3%, the cost of borrowing rises, but the mortgages Annaly already owns still pay just 4%. So now the spread drops to 1% and the total annual yield is cut in half.
With a sufficiently large rate spike, it's easy to see how the company's profit margin can disappear, or even become negative. That's why money you need to support your retirement shouldn't be anywhere near Annaly, or any other highly leveraged company for that matter.
Some stocks are great for speculation, but should not be bought with money you can't afford to lose. These companies could be long-term winners, but a lot of things need to happen before they get there.
A great example is Amazon.com (NASDAQ: AMZN). Now, Amazon is an extremely innovative company, and has been quite successful in growing its revenue stream. The only problem is the company hasn't quite figured out how to make money yet, which makes it difficult to value.
Amazon's recent quarterly results showed 15% year-over-year sales growth and nearly $89 billion in revenue for 2014. However, the company actually lost $0.52 per share for the year.
I know Amazon prioritizes long-term growth over short-term profits, and I tend to agree with this philosophy. It's completely possible Amazon will eventually grow its sales to 10 times the current amount, earn $50 billion per year in profit, and command a trillion-dollar valuation. However, Amazon's ability to be profitable remains to be seen, so it's still a rather speculative stock, and should generally be avoided by retirees.
Stocks with a shaky history
When investing, past performance doesn't guarantee future results, but it can predict certain things. Specifically, companies that always pay a dividend and increase their payments like clockwork generally continue to do so. And companies with a history of questionable risk management and financial difficulties tend to do continue facing those issues.
For example, I feel Citigroup (NYSE:C) is a bank stock with tremendous upside potential, but I wouldn't touch it with a 10-foot pole if I was retired or close to it. Reckless management has gotten the bank in trouble several times, and the financial crisis was just the latest example.
Many analysts (myself included) believe Citigroup is cheap enough that it makes sense as a speculative investment. There is simply much more potential to the upside than to the downside at this point.
However, when it comes to your retirement savings, stick to stocks that are relatively predictable, such as Wells Fargo in the financial sector. Sure, the stock is unlikely to double over the next year, but it won't get cut in half, either. Can you confidently say the same about Citigroup?
What you should have in your portfolio
The recurring theme here is you should stick to low-risk, predictable stocks when you are retired or close to it. In retirement, your goals shift away from growth and excitement and toward income and stability.
In a nutshell, don't swing for the fences with your retirement savings, or you might strike out. Go for a bunch of base hits, though, and you'll be just fine.