Conservative investors are in a very uncomfortable position right now, as their regular sources of portfolio income have seen their payouts slashed in recent years.
Yet before you go ramping up the risk level of your portfolio just to make ends meet, you really need to consider whether doing so won't just trade one problem for a potentially much larger one that could put your entire life savings at risk.
The income dilemma
The huge problem that many conservative investors face is that the investments they've traditionally relied on to provide the income they need have essentially dried up. Even prudent investors who wisely prepared bond and CD ladders to take advantage of higher interest rates in the past have steadily seen their income fall, as old CDs yielding 5% or 6% get replaced with new ones that pay only 1% or 2%.
In response, those desperate for income have piled into asset classes that involve very different types of risk. Lower-grade corporate and municipal bonds offer higher payouts than other bonds, but they also carry with them much weaker credit ratings and significantly greater chances of losses from default. Many investors have also started to give up on bonds, moving money into the stock market.
In particular, some highly specialized segments of the market have attracted a lot of attention:
- In the natural resources space, master limited partnerships have drawn interest because of their sizable distribution yields and favorable tax characteristics. Yet ALPS Alerian MLP ETF (NYSEMKT:AMLP) and the MLPs that make up the fund's holdings have returns that are highly dependent on conditions in the oil and gas industry, leaving many investors dangerously concentrated in that area.
- Real estate investment trusts offer some of the highest yields in the market, and floods of money have poured into REITs, especially those specializing in mortgage-backed securities. Annaly Capital (NYSE:NLY), American Capital Agency (NASDAQ:AGNC), and other major players in the mortgage REIT market have seen their market capitalizations soar as successive secondary offerings and high levels of leverage have greatly boosted the size of their balance sheets. Yet even having taken steps to hedge some interest rate risk through the use of derivatives, mortgage REITs are still vulnerable to any adverse conditions that threaten their ability to gain access to leverage.
There's nothing inherently bad about any of these investments. The problem, though, is that they're a far cry from the bonds and CDs that their new investors are used to, and without a complete understanding of what they've gotten themselves into, conservative investors won't know what to expect from them or the potential problems that may arise with them.
The whole-portfolio approach
In considering whether to replace low-yielding bonds and CDs with higher-risk investments like stocks, the key to making a smart decision is to focus less on individual securities and more on your overall allocation. In many cases, conservative investors were too conservative in focusing exclusively on risk-free CDs and bonds, as they gave up any prospect of growing their principal -- something that's increasingly important as lifespans get longer.
In that light, boosting stock exposure by investing in the relatively well-known dividend payers that Vanguard Dividend Appreciation ETF (NYSEMKT:VIG) or iShares Dow Jones Select Dividend ETF (NYSEMKT:DVY) own can lead to a less risky outcome in terms of increasing the odds that you won't run out of money in retirement.
The reason these and similar ETFs are good choices is that they make it easy to get well-diversified exposure to income-producing stocks. Diversification keeps you from having to deal with the specific risks of individual securities, as you don't have to worry that a failure in any single investment will lead to devastating losses. By contrast, if you simply pile into the hot income investment of the moment, you greatly increase the risk that you'll be the one who suffers when the music stops.
Be as safe as you should be
Don't let pressure to boost your income lead you to make bad investment choices. By making an informed decision about your overall portfolio risk, you can find a viable mix of stocks, bonds, and other investments that can get you to the goals you're seeking.
Fool contributor Dan Caplinger owns shares of Vanguard Dividend Appreciation and iShares Dow Jones Select Dividend ETFs. The Motley Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.