Bad kinds of investing risk

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(MoneyWatch) With interest rates being so low, many investors aren't getting the interest income they need to meet expenses. This causes many to turn to riskier bonds and other fixed-income assets, such as high-dividend stocks, preferred stocks, and master limited partnerships.

But while these investments may look attractive, historically they haven't been a good solution.

As readers of my books and blog know, the main role of fixed-income assets in a portfolio should be to reduce portfolio risk to the level appropriate for the investor's unique circumstances. Therefore, fixed-income assets should generally be limited to the safest bonds, bonds that carry the full faith and credit of the U.S. government, federal agency debt, FDIC-insured CDs, and AAA/AA municipal bonds.

To help understand why, Jared Kizer, co-author of my alternative investments book and blogger at MultifactorWorld.com, looked at how these alternative strategies fared during difficult market times. His findings confirm exactly what we would expect: These are risky assets and aren't substitutes for safe fixed-income investments. (The data runs through June 13, when Jared's blog post first appeared.)

The next table reports the difference in returns over these same periods for the above strategies relative to U.S. Treasury bonds. A negative number represents underperformance of these strategies relative to U.S. Treasury bonds.

This table shows that these strategies tend to dramatically underperform high-quality bonds when market risks show up. Simply put, there's considerable risk involved when replacing high-quality bonds with higher-yielding strategies.

Stretching for yield -- whether in the form of dividends from common or preferred stocks or of interest on junk bonds -- is a bad idea. The historical evidence demonstrates that these risks haven't been well-rewarded, and their returns haven't mixed well with stocks in a portfolio.

The only right way to view an investment is to consider how its addition impacts the risk of the entire portfolio. If you need or want more return from your portfolio, the most efficient way to achieve higher expected returns has been to add more size and value exposure to the stock portion of the portfolio.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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