There’s an old adage in the brokerage community that you should speculate for growth, not for income. Speculation isn’t the right word, but the broker who coined it (pun intended) probably wasn’t an English major (most brokers aren’t). The point is that you should take risk with investments which you expect to increase in value, i.e., stocks, but not with investments made to generate current income, i.e., fixed income securities. This is an essential maxim if you are dependent on that income.
Greater income (return), always entails greater risk. It’s the way the world works. One rule of thumb is to compare your investment to others in the same class. There’s a reason a money market fund has a higher yield than its peers – it’s taking more risk. The same is true for any bond fund. A second rule of thumb is to stick with quality. Buy funds which invest in government securities or investment grade bonds. If you invest in long term bond funds, they will fluctuate in price due to changes in interest rates, credit spreads and the yield curve, but you will not run the risk of serious loss of income or principal. Anyone who stuck to investment grade bonds came through the recent/continuing mortgage debacle relatively unscathed. If you owned funds invested in US Treasures, you actually made money.
Funds that invest in bank loans, junk bonds, and other low-rated or unrated debt instruments, or employ leverage to enhance their returns (see Leverage Land Mines) are too risky for the average investor. These investments need to be watched and analyzed similar to your equity investments and are not for investors who need a reliable income stream.
The above rules of thumb apply to equities as well as to debt. There are many dividend paying stocks which are relatively safe, and a portfolio of these would be safer than, for example, a portfolio of subprime mortgages. I’ve been watching a mortgage REIT with a 20% current yield. It doesn’t have subprime exposure, has taken its write-downs and appears to have good liquidity. Good investment? Maybe, but I’d buy it because I thought the stock would appreciate as the mortgage market returns to normal. I wouldn’t buy it for its dividend. I expect the dividend will be cut because no stock can yield 20% for long. Carry this thought through to the equity income funds you own or are considering and remember: the higher the current income, the greater the risk that it’s unlikely to continue.
“Speculate” might not be the right word when talking about reaching for income, but it gets the point across. Take your risks in the stock market and don’t stretch for higher income because you might end up with none.
