Individuals choose to save money for a variety of future expenditures, such as purchase of a car or a house, college costs, or retirement. It makes sense to allocate these savings into assets which grow in value with time or which pay interest or dividends, which can be reinvested to grow the value of the savings account.
If the money is needed soon, within a year or two, it is typically advisable to hold the money in assets which are unlikely to drop in value, such as savings accounts, certificates of deposit, or money market funds. These assets have low risk, but they typically pay relatively low interest. These short-term interest rates have been almost zero in the U.S. for the past several years, although now the Federal Reserve Bank is increasing these short-term interest rates.
For longer investing time-frames, some fluctuation in values may be tolerated. Often the assets with higher volatility can give higher returns over the long haul. Two traditional longer-term investing vehicles are stocks and bonds.
Stocks represent an ownership stake in a profit-making enterprise. The value of a stock may fluctuate greatly, depending on the fortunes of the enterprise (typically quantified as earnings per share), and market sentiment. The stock in a particular company may fall from $40/share to $1/share, if business conditions radically change or some competitor takes over the market niche. Even if a company is doing well financially, its stock may drop dramatically due to general pessimism in the market. On the other hand, some stocks can double in a year. Investing in fund that holds many stocks can smooth out some of this drama, but even a broad index can drop significantly and take years to recover. However, over the long term (decades) the total return, including reinvested dividends, of the broad S&P 500 index of large U.S. stocks has been nearly 10%. Most of that return has depended on the price of the shares rising.
A bond represents a legal obligation for the issuing entity (e.g. a corporation or government) to pay a specified amount of interest plus return of principal by the time the bond matures. Unless the company or government goes bankrupt or otherwise defaults, you know exactly what the bond will pay you. “Risk-free” U.S. Treasury bonds are yielding 2.2-3.2%, depending on years to maturity. Typically longer-term bonds pay higher interest. High-quality, investment-grade bonds from stable corporations yield 2.5-4 %. Non-investment grade (high-yield or “junk”) bonds pay 4.5-6%, depending on maturity and on how junky they are.
I wondered whether there are investing assets which, like bonds, pay regular cash returns and don’t depend on share prices rising, but which, like stocks, yield close to 10%. Looking into it, I found the answer is, “Yes, but”. Yes, there are funds available to the ordinary investor which regularly pay out 8-10% cash. These include business development companies, option-writing funds, mortgage REITs, and leveraged closed end funds holding preferred stocks and master limited partnerships. But the payouts are not as certain as with bonds, and the share prices can move around like stock prices. With these aspects understood, these funds may find a place in an individual investor’s portfolio for diversification. I have described these funds in a recent article here.
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