Stock Market Investing for the Faint of Heart
The stock market’s rally during the first half of 2023 came as a welcome relief to weary investors. Finally, they had a gain to show (albeit a small one) after two years of losses.
I’m impressed the drought lasted only that long. The disruption caused to the global economy by the coronavirus pandemic was enormous. In another era, it may have triggered a deep recession.
Now, some analysts are anticipating both the stock market and corporate earnings to hit new highs next year. If that happens, then we should consider ourselves lucky. Whether you love or hate the Fed, it will have done its job.
But if that does not happen, then what? Will investors change their attitude towards stock market investing? Especially if bond yields remain near current levels.
To my way of thinking, it does not matter if we hit new highs next year or not. The bigger issue is the overall direction of the economy and the extent to which it will allow most companies to growth their profits.
In that regard, remaining invested in the stock market makes sense. Long-term appreciation always outweighs short-term diversions from the mean (i.e., stock market corrections).
That said, if you can’t stomach the idea of another year or two of sideways movement, you don’t have to get out of the stock market altogether. There are ways to obtain indirect exposure to the stock market that are considerably less risky than having direct exposure.
As its name suggests, a convertible bond can be converted to something else, most often common stock. As the price of the underlying security goes up, so does the price of the bond. But as the price of the underlying security goes down, the price of the bond will flatten out since it has a known maturity date with a fixed value.
Individual investors rarely buy convertible bonds directly unless they have a lot of money to devote to that purpose. That’s because convertible bonds are in high demand by institutional investors, so they are sold in large lots. But that doesn’t mean that you can’t benefit from them.
The SPDR Bloomberg Convertible Securities ETF (NYSE: CWB) “seeks to provide investments that, before fees and expenses, correspond generally to the price and yield performance of the Bloomberg US Convertible Liquid Bond Index.” The fund holds roughly 300 convertible bonds with an average maturity of 3.5 years.
Over the past ten years, the fund has generated a total return (share price appreciation plus dividends paid) of 149% compared to a return of 226% for the SPDR S&P 500 ETF Trust (SPY). That works out to compound average annual return (CAGR) of 9.6% for CWB versus 12.6% for the SPY.
In the long run, the CAGR for the SPY will always be higher than for CWB. That’s because there is a risk premium priced into convertible bonds at the onset. That assumes, of course, that stock prices eventually go up.
However, in the short term, stock prices are almost as likely to go down as up. And if they go down a lot, you might feel better owning a convertible bond than the underlying security.
You may be familiar with fixed annuities. That’s a contract with an insurance company that agrees to pay you a fixed return over a specific period. They are considered quite safe so their yields aren’t much higher than what you can get on a bank CD or investment grade bond.
An equity-indexed annuity is also a contract with an insurance company. However, its return is variable and based on the performance of an associated stock market index such as the S&P 500 Index.
Of course, you do not fully participate in the performance of that index. If it loses value, you lose nothing. If it gains value, you receive a portion of that as stipulated in the contract.
That is, if you hold the annuity until its maturity date. If you liquidate it prior to that, then all bets are off. In addition to paying an early surrender charge, the value of your principle might be less if the stock market performed poorly.
Like all tax-deferred annuities, you do not recognize any gains for income time purposes until they are distributed to you. That is an especially valuable feature for high wage earners only a few years from retirement. After they retire and the annuity matures, they may be in a much lower income tax bracket when those gains are paid out.
Since equity-indexed annuities are insurance products, you do not buy them on a stock exchange. You can purchase them from a licensed agent working for an insurance company, financial advisory, or bank.
Because they come with limited downside risk, convertible bonds and equity-indexed annuities have less upside potential than owning stocks. For investors seeking high investment returns, they may not be appropriate since there is almost no chance of that happening.
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