Published October 6th, 2015
Have you heard of Warren Buffett’s two famous investing rules?
Rule number one: never lose money
Rule number two: never forget rule number one
As virtually all investors know… Safety matters in investing.
But what investment class offers real safety to investors?
In one sense, interest bearing savings accounts with less than the $250,000 Federal Deposit Insurance Corporation amount in them are as safe as possible. But, the average interest rate offered at savings accounts is around 0.17%.
An interest rate of 0.17% means you get a ‘nice’ return of $170 dollars a year for every $100,000 invested… Unless you are already a multi-billionaire with a frugal lifestyle, you will never reach financial independence with those type of returns.
There is a time and place for savings accounts, CDs, T-bills, and other short-term investments in an ultra-low yield environment. If you will need all of the money you have to invest in under a few years, there’s no since in investing in riskier asset classes.
When discussing safety and investments, we must not forget about the effects of inflation.
Inflation Destroys Low Return Investments
In August of 1971, President Nixon removed the United States dollar from the gold standard. This marks a significant shift in United States policy.
From 1972 on (the first full year of a full fiat monetary system), the inflation rate in the United States has averaged 4.2% a year.
Inflation from year 2000 to now has averaged 2.3% a year. Currently, inflation is hovering near 0%. The Federal Reserve Bank of St. Louis is expecting an average inflation rate over the next 5 years of 1.8%.
Some people expect hyperinflation in the coming decade. Anything is possible, but I prefer to look at history to guide expectations.
Let’s take the mainstream view and assume that inflation will continue on at around 3% a year over the long run. This number is lower than inflation since 1972, but 1.2 percentage points higher than expected inflation over the next 5 years.
This means that any fixed income investment that currently pays 3.0% or under will likely lose money over the long run.
Losing money is not a good investment policy, ever.
Long-Term Treasury Bonds
Current long-term treasury yields are listed below:
- 30 Year Treasury yield of 2.9%
- 20 Year Treasury yield of 2.5%
- 10 Year Treasury yield of 2.1%
As you can see, all of these investments are currently not offering investors significant real returns. To invest in long-term treasury bonds right not, an investor must expect near-zero or negative inflation for decades to justify the investment.
Inflation rates at such a low level may be possible for a few years, but I find it hard to believe we will see decades of deflation or near-zero inflation rates. As a result, holding long-term United States Treasuries to maturity will very likely result in negative real returns.
There is a second problem with United States Treasuries (and all fixed income instruments) currently. We have historically low interest rates. The image below shows a very long-term view of 10 year Treasury yields:
It’s never good to buy at historically high prices. Historically low interest rates mean historically high prices for bonds.
Corporate bonds have the same inflation and interest rate risks that treasury bonds do. In addition to these risks, investors must also be concerned with the ability of the issuing company to pay its debts.
For high quality businesses, this is of little concern. No matter how strong the business, corporate bonds will always be less safe than United States Treasury Bonds. The simple reason is that government bonds are backed by the ability of the United States government to tax its citizens.
There is no corporation around today that can take as much money from people as it wants (but I’m sure there are more than a few CEOs who wish they could).
As an investor, if you are going to take on business risk by investing in corporate bonds, in most cases it is preferable to gain the advantage of business growth afforded by stocks.
Blue Chip Dividend Stocks
Blue chip stocks are well established stocks with long dividend histories. They are often market leaders and have strong and durable competitive advantages.
Examples of blue chip stocks include: Coca-Cola (KO), 3M (MMM), and Johnson & Johnson (JNJ). Click here to see 11 undervalued blue chip stocks.
Blue chip stocks tend to pay their investors higher dividend payments year after year. The advantage that investing in high quality stocks offers investors is that they provide inflation protection and rising real income.
As an example, if the value of the U.S. Dollar were suddenly cut in half, Coca-Cola would simply double its prices and be no worse-for-the-wear. Investors who invested in treasury bonds, however, would see a 50% decline in their real investment income.
The real benefit to investing in high quality dividend paying blue chip stocks is rising real income. Truly high quality businesses can maintain growth well above inflation for decades. They reward shareholders with rising dividend payments – which grow faster than the inflation rate.
Several blue chip stocks with dividend yields over 3% and 25+ years of dividend payments (including parent company history in the case of spin-offs) without a reduction are listed below:
- Coca-Cola (KO) – dividend yield of 3.2%
- Caterpillar (CAT) – dividend yield of 4.4%
- Altria Group (MO) – dividend yield of 4.0%
- General Mills (GIS) – dividend yield of 3.1%
- McDonald’s (MCD) – dividend yield of 3.3%
- Verizon Wireless (VZ) – dividend yield of 5.1%
- Procter & Gamble (PG) – dividend yield of 3.6%
- Southern Company (SO) – dividend yield of 4.8%
- Johnson & Johnson (JNJ) – dividend yield of 3.2%
- Philip Morris International (PM) – dividend yield of 5.0%
Investors in dividend paying blue-chip stocks do face more risks than investors in Treasury Bonds, however. There is always the risk that a business will lose its competitive advantage and no longer be able to pay steady or rising dividends.
This risk can be controlled (to some degree), by creating a diversified portfolio of high quality dividend stocks that have historically performed well through a full range of economic cycles. Stocks in general – even blue chip stocks – will always have a greater risk that dividend payments will be eliminated than Treasury Bonds… But, blue chip dividend stocks also have much greater upside.
The biggest risk with any investment is also the most controllable – you must be committed to your investments and not sell because of temporary price declines.
Outside of that, investors must set themselves up for success. Hoping is not enough. Investing in a portfolio of Treasury Bonds will very likely produce negative real returns over the next decade or longer.
Investing in high quality blue chip dividend stocks will very likely produce rising dividend income for the long-run.
The trade-off is one of risk for return. You trade more price volatility and a chance that any one company in your blue chip portfolio could cut its dividends for income growth that will very likely beat inflation.
To me, a very high probability of positive real total returns and rising income is more than fair compensation for taking on added price volatility and a small amount of business risk (which is reduced through investing in high quality businesses and diversification).