Last Updated on December 2, 2024
Overview – The Allure of High–Yield Investments
Many investors are drawn to high-yield investments for a variety of reasons.
A portfolio that’s comprised of exceptional, high-yield investments can serve as an excellent source of income, perhaps even replacing the income earned from a traditional salary. Instead of relying on a pension, retirees can maintain their standard of living by supplementing their pension with investment income.
Because of these reasons, along with countless more, many investors make yield an important criterion when looking for prospects, with some even using it as a primary indicator of investment merit.
Surely, this means that an investment that offers a high yield is always worth adding to your portfolio, right? Although high yields are certainly desirable, this doesn’t make every investment that offers them a no-brainer to pursue.
Why Do You Want High-Yield Investments in the First Place?
Just like most other things in investing, whether or not a certain decision makes sense to pursue depends on what exactly you’re trying to work towards. The importance of beginning with the end in mind cannot be overstated.
Let’s clarify something right away: wanting to pursue high-yield investments isn’t an inherently bad thing. After all, people who want a higher salary search for a new job and businesses who want more revenue look for new ways to increase sales. It all comes down to what exactly you’re trying to accomplish by seeking high-yield investments in the first place.
Whatever those reasons may be, it’s important for investors to have a clear answer in mind to this question because it will dictate the types of decisions they’ll make, the kinds of strategies they’ll deploy, and even how they’ll perform their investment analysis.
For example, an investor wants to pursue high-yield investments because they want their portfolio to act as their source of income in their retirement.
So, when looking for prospective investments they’ll most likely focus on the ability of a given investment to maintain its ability to pay dividends/interest, as well as the likelihood of this payout to increase.
They also probably won’t focus nearly as much on an investment’s future growth prospects unless the benefits of that growth mean higher payouts in the near future.
When it comes to specific types of investment instruments, this investor may probably lean more towards fixed income securities like high-grade corporate bonds and GICs. If they want to add some equities into the mix, then they’ll most likely fixate their attention on REITs and the stocks of companies in relatively stable industries, like utilities.
Because this investor has a clear reason behind why they want to pursue high-yield investments, they know what sort of portfolio composition they want to create, as well as the steps and strategies they’ll need to pursue to achieve that.
Another way to think about this is to work from the inside out, that is, start by having a clear “why” in mind, then every future action or decision that follows will serve the purpose of building on top of that foundation.
If an investor wants to pursue high-yield investments but doesn’t have an underlying reason behind wanting to pursue them in the first place, then how do they expect to know what they want to do next, and how will they know if they’ve “succeeded” if they don’t know what success is supposed to look like?
To illustrate this point, let’s look at weightlifting.
Many people are interested in lifting weights and, if they aren’t doing so already, likely plan to in the future. While weightlifting is great, the first step is having a clear reason behind why you want to do so.
Some people choose to lift weights as a way to maintain their level of fitness, others do so as a way to prevent muscular atrophy, some want to improve their physique to boost their confidence, while others have hopes of one day competing in a powerlifting competition. These reasons directly impact your approach to weightlifting such as how often you’ll lift, what sort of exercises you’ll perform, and how to structure your workouts.
If you decide to start lifting one day without some clear motivation in mind, then it will be very difficult to figure out how often you’ll do so, what exercises you’ll perform, and what muscle groups to target on a given day. Working out simply because you “feel like it” with no intrinsic motivation is nothing more than just a waste of time.
It’s fine to seek certain things as an investor, but it’s important to understand why you want those things, otherwise what you’ll end up doing is simply wasting your time, energy, and money as you try chasing something without understanding why you want it in the first place.
Now, some investors may want to pursue high-yield investments because they’ve conflated the ideas of “high yield” and “strong investment merit”, but that isn’t necessarily the case, and believing this false notion may end up being very harmful to their portfolio.
A High Yield Isn’t an Automatic Indicator of Strong Investment Merit
There are a wide variety of factors that determine whether a prospective investment is worth pursuing or not, and one of the factors that many investors look at is its yield.
It’s very easy to look at a high yield and think somewhere along the lines of “if the enterprise offering this investment is able to offer such a high yield, and can do so consistently, then surely they have a strong underlying business needed to maintain this high payout.”
This line of thinking isn’t entirely flawed, in fact, it does have some truth to it.
Generally speaking, it’s true that if an investment instrument offers a high yield, then the enterprise issuing it should have strong enough underlying business fundamentals needed to keep offering such a high payout in the first place.
At the height of the COVID pandemic, many companies were quick to slash, or even suspend, their dividends in an attempt to try and keep funds within the enterprise to try and stay afloat.
One notable exception to this was Canada’s Big 5 banks, who chose to keep paying dividends even in the face of such extraordinary business circumstances. Even during the 2007-2008 Financial Crisis, Canada’s banks didn’t waver on their commitment to distribute funds to their investors. Their commitment to keep paying dividends through thick and thin signalled many things to investors, one of them being that their underlying business fundamentals are solid.
While a high yield is an encouraging sign, a problem with the “high yield = high investment merit” train of thought is that it quickly falls apart when looking at prospective investments that offer extremely small yields, or worse, ones that have no yield at all.
Berkshire Hathaway, Tesla, and Air Canada stock don’t offer any dividends, while companies such as Brookfield Asset Management and Apple offer relatively small dividends. Does that mean these prospects aren’t worthy of an investor’s attention?
Some companies feel that they can provide better shareholder value by choosing to pump their surplus funds back into the business instead of distributing them.
Countless enterprises around the world have proven to their investors that this approach makes the most sense to take, and in return, their investors are rewarded handsomely with a steady increase in stock price.
It’s entirely possible to come across an investment that looks very promising even though its yield is very small or even non-existent.
Similarly, it’s also possible to stumble across a prospect that offers an outsized yield, yet will clearly harm your portfolio – junk bonds, low-grade corporate/government bonds, and even some publicly-traded companies are classic examples of that.
Yield is something many investors keep an eye out for when evaluating prospects, but it certainly isn’t something that carries so much weight that it can “make or break” a prospect. Remember, investment merit is comprised of several quantitative and qualitative factors. Yield may play a role in that, but it’s just one out of many factors that an investor will need to consider.
High yields are usually very well received, but a high yield is worthless if it can’t be sustained for a sufficiently long enough period.
Yield, Sustainability, and Duration: A Tricky Balancing Act
Although high yields are well received by most investors, it’s very important to stop and ask themselves if the high yields they’re currently enjoying are something they can continue to reasonably expect in the future, or if it’s something that will soon come to a grinding halt.
It’s very easy to offer an outsized yield, but the hard part is maintaining it for the long term without any disruptions. A publicly-traded company that offers a 15% yield on its common shares seems very impressive, but if they’re forced to slash it back to 1% after only four quarters because they had insufficient cash to sustain that yield, then is the company’s performance really as impressive as investors initially thought?
An investment’s yield is closely related to two other factors: duration and sustainability. Duration is how long a given yield can be offered, and sustainability is the ability to offer a certain yield without compromising an enterprise’s finances in the process.
Ideally, an investor would want all three factors to be satisfied, but in the real world, the best that they can usually hope for is for two of these factors to be met to an acceptable degree while being forced to make some sort of compromise with the third.
Canada’s Big 5 banks are famous amongst investors for their uninterrupted dividend payments that have spanned more than 100 years. However, the trade-off is that the yield isn’t superbly high: it usually hovers in the 4% – 6% range. So, their dividend satisfies the conditions of sustainability and duration, but the yield takes a hit.
Enbridge has steadily increased its dividend yield every year since 1995, yet it still hovers around 6% – 8% on a given day. Since 1995, they haven’t slashed or suspended their dividend either.
Based on this, it appears that companies are more interested in duration and sustainability rather than the size of the yield. Although they’ve increased the yield over time, the increases were done incrementally.
Logically speaking, this approach makes a lot of sense.
Instead of offering an extremely high yield (in this case, something that exceeds 10%) just for the sake of offering one, a relatively modest yield is offered and the remaining funds are retained in the business for future growth projects and initiatives.
As business operations expand and this growth starts to materialize in the form of increased revenue and a stronger financial position, then the yield is increased. Small, incremental increases allow the company to slowly increase the yield without it being a sudden financial shock. The result is a win-win scenario for both the company and its investors.
Again, high yields are great to see, but they’re only as good as their ability to be sustained. A high yield that only lasts for a fleeting moment is of very little use to an investor, especially if they’re looking for an investment that can pay a reasonably high yield for a long time.
Remember Not to Chase After High Yields
In a previous article, the danger of chasing after high yields no matter what was discussed, and how it can quickly bring ruin to any investor. Once again, that warning will be reiterated here.
Investments that offer high yields are great, but the first condition that must be met is that there’s investment merit to be had. It’s not unheard of for junk bonds to offer double-digit yields, but there’s a reason why they’re called “junk bonds”: they have very low investment merit because of their high probability of defaulting.
The major problem behind chasing after high yields is that an investor takes on a disproportionately large amount of investment risk in the process. Whatever gains they stand to make are quickly overshadowed by the investment risk they’ll need to shoulder.
Buying a $10,000 bond with a 30% yield may sound very enticing, but the possibility of getting $3,000 in interest is moot if you have a very high chance of losing $10,000 because of the bond going belly up.
To reiterate what was said at the beginning, there’s nothing inherently wrong with seeking high-yield investments. Problems arise when investors make it their sole mission to secure high-yield investments no matter what, even if this means skipping any sort of analysis and taking on lots of investment risk in the process.
Fixate on the carrot on the stick for too long, and you may find yourself unexpectedly walking over a cliff someday.
Wrapping Up
Many investors seek high-yield investments for all sorts of reasons, so it’s no surprise that many investors try their best to include them in their portfolios. However, this doesn’t mean they’re automatically worth pursuing no matter what.
Although many investors seek high yield investments, not enough stop and ask themselves why they want to pursue them in the first place. Without some sort of intrinsic motivation, investors who want high yields just because it sounds nice to have will end up just running around without knowing where to go or what to do next.
Some investors believe that a high yield indicates strong investment merit, but that isn’t always the case. Some very outstanding investments offer a very small, or even non-existent, yield. Similarly, some very speculative ventures offer outsized yields as a way to lure people to park their money with them, even though the risk of loss is very high.
Ultimately, enterprises who offer payouts on their investment instruments must find a balance between the size of the yield, how long they plan to offer this payout, and if they can afford to do so without harming their financials.
Although there’s nothing inherently wrong with seeking high yield investments, problems arise when investors seek the highest yields possible no matter what and ignore all the investment risk they shoulder in the process.
