Degrees of Risk

Investors often say they don’t want to put their hard-earned dollars in risky investments. That is prudent and shows they understand some investments are likely to be worth less or even nothing at some point in the future. Sadly, the lower risk investments carry a great deal of unrecognized risk. Consider cash, for example. At first it seems cash kept in a bank account earning 0.01% interest is a safe investment. While it is true your $10,000 of cash at the beginning of 2020 will still be worth $10,000 at the end of the year, there has been a loss of purchasing power. The dollar at the beginning of the year was a heavier dollar than today’s dollar. You may have received $10 in interest and you still have your $10,000, but you are losing ground. If you repeat this thinking for ten or more years, you have taken on some serious risk.

Cash has an investment risk that isn’t obvious in this illustration.

The Emergency Fund Exceptions

There is one budget category most younger adults need to have: cash set aside for emergencies. I’m not suggesting you should take your entire cash pile and invest it. If you need $15,000 to cover a potential emergency event (including losing your job), then don’t put the money to work in stocks, ETFs, or mutual funds. But your emergency fund may have a different level of urgency when you are 25 or 65 years old.

When you are 25, it is likely that you have less income from your investments and need to have a cash emergency fund. When you are 65, you might have sufficient income from your investments to make an emergency fund less important or even necessary. Because Cindie and I don’t have any car loans, credit card debt (we pay it off every month), or a mortgage, our costs of living are small. It is unlikely that we will be surprised with any huge expenses. If we are, it is also highly likely that the income from our investments (in any given month) will cover the total cost of most surprises. This is, of course, with the exception of health care costs. Even there, however, the typical cash emergency fund could fall far short.

Other Reasons Cash Is Good

Don’t forget that cash is a handy tool. If I see a great investment opportunity but am cash-poor, I don’t have a way to purchase the investment without selling an existing investment. For that reason, I usually like to keep 3-4% of our total portfolio in cash (FDRXX or SPAXX). But perhaps even here I am missing some income potential. There are some investments with less short-term risk than the S&P 500, dividend-paying common stocks, and REITS. One such investment is preferred stocks. If you are a store’s preferred customer, you should expect something for that status. If you are a preferred stock owner, the same applies.

What is a Preferred Stock?

Common and preferred stock ownership is ownership in a company. Preferred stockholders don’t have voting rights, while common stock shareholders do. This, in my opinion, isn’t a big advantage for common stocks. Preferred shares are also less likely to go up dramatically in value because they are more like a bond. Preferred shareholders have a priority over the company’s income, so they will be paid their dividends before any dividends are paid to the common shareholders. It is also usually true that preferred shares often have a higher yield than you can get from common share dividends. However, don’t expect to see dividend growth. The benefits, therefore, for owning preferred shares are: 1) Higher monthly or quarterly income; 2) Less volatility in the preferred share stock price; and 3) Improved likelihood you will receive the income even during more difficult times. You can improve your prospects by purchasing a preferred stock ETF instead of an individual preferred issue.

Preferred Stock ETFs

It is possible to buy preferred shares in any company that offers this type of stock ownership. One resource to investigate preferred shares is the website “Preferred Stock Channel.” A link is provided at the end of this article. However, for the average investor, including me, using an ETF that holds preferred shares from many different companies is far less risky. There is still a degree of risk, and this became very evident during the Covid-19 market turbulence earlier this year. However, if you have cash that is sitting idle, putting a portion to work in an ETF like PFF might make sense. For example, I hold 400 shares of PFF in my traditional IRA.

Other Preferred ETFs

There are other ETFs one might consider. Some examples include PFXF, SPFF, PGX, PGF, VRP, PSK, PFFD, and FFC. Pay attention to the expense ratio for each ETF. One way to get a realistic picture is to subtract the expense ratio from the dividend yield. For example, DFP seems attractive until you subtract their expense ratio from the yield. The expense ratio (from Seeking Alpha) is 1.75%. That is ridiculous. I am not recommending any of these ETFs. They are examples only.

AAII A+ Investor

Here is the A+ Investor view of PFF. I pay a subscription for this information.

PFF is a good income investment. It is not a growth investment.

Preferred Stock Channel Tools and Cautions

Wells Fargo has various issues of preferred stock. One reason the novice investor should not purchase a single preferred issue has to do with the value of the shares and the dividend yield. If the shares have increased in value and are now selling at more than $25 per share, then the yield will be less than the “Original Coupon” yield. In this example, the Wells Fargo Preferred series A stock had an original coupon yield of 7.25%. If you pay more than $25 per share, your yield will be less. Furthermore, the company may “call” your shares and pay you $25 per share. They don’t care how much you paid for the shares on the open market. Be careful before you buy an individual preferred stock investment. Recommendation: Buy a preferred shares ETF like PFF instead.

Full Disclosure

Cindie and I own 600 shares of PFF as a long-term, income-producing investment. This investment is currently worth about $23,000 and earns over $1,100 per year in dividends. This means our yield from this idle cash we put to work is currently 4.8%.

LINK: Investopedia Preferred and Common Stocks

LINK: The Motley Fool Preferred Stocks

LINK: Preferred Stock Channel