Regain Confidence with Safer Strategies

Over the past 3 years, many physician-investors have become disenchanted with common equities. They're disappointed by their overall performance. In contrast, investors are pleased with the long-term performance of common stocks, which have surpassed other financial instruments. While this is good news for the investing world, it doesn't provide much solace to physician-investors who are nearing retirement (ie, retiring in less than 5 years). Unfortunately, these investors don't have 20 years to ride out a highly volatile market.

So, what is a physician-investor who plans on retiring within the next 5 years to do? They should adopt a more conservative investment posture, especially during these uncertain times. This means choosing investments that will provide an acceptable or moderate level of return without creating exposure to great risk. After you eliminate the risks (ie, common stocks, options and warrants, and commodities) and the possible risks (ie, CDs and money market funds), you're left with safer fixed-income investments and preferred equities.

TODAY'S POPULAR OPTION

Lately, investors have been moving their money into safer havens, such as bonds. However, bonds aren't risk-free. Interest rates can positively or negatively impact their returns. Therefore, when it comes to fixed-income investments, invest in those instruments or bond mutual funds that are shorter in duration, with only a few years remaining to maturity. By investing in bond mutual funds that will mature sooner rather than later, you minimize the interest rate risk should rates begin to climb. Expect to see returns in the 5% to 7% range.

In addition, you should also pay attention to the rating of the issue in which you intend to invest. Just because a bond has a shorter duration and term to maturity does not necessarily mean it is less risky. If you consider interest rates alone, a bond with a shorter maturity is subject to less price volatility. However, if the company that issues the bond is experiencing financial difficulty, the investor may be subject to potential default risk. Therefore, you should consider selecting only those issues that have scored as investment grade or better.

What does investment grade or better mean? Investment-grade issues are those that are rated "Baa" or better by Moody's rating service (www.moody.com) or "BBB" or better by Standard & Poors (www.standardandpoors.com). The highest investment-grade ratings given by both services are "Aaa" and "AAA." Because your strategy is to minimize risk for an acceptable level of return, a rating below "Baa" and "BBB" is less than investment grade and should generally be avoided. This doesn't mean that less than investment- grade issues don't offer investors opportunities. They're just not a good choice for investors who are nearing retirement.

THE PREFERRED CHOICE

Warning:

If you're getting closer to retirement and are determined to adopt a more conservative posture, your other options include preferred equities or preferred stock. Preferred stock is often referred to as a "hybrid" security. It combines the features of common stock and debt. This security ranks senior in claim to a firm's common stock and junior in claim to a firm's debt issues. Dividends must be paid in full on the preferred stock before the firm can pay any dividends to shareholders of common stock. Don't make the common investor mistake and confuse common stock with preferred stock.

Preferred stock issues usually have a cumulative dividend feature. This means that if dividends are missed, they become "cumulative" and must be paid first to the holders of preferred stock before being paid to the holders of common stock. Preferred stock also has a par (or stated value) of $25 for issues targeting individual investors and $100 for corporations. Just like common stock, preferred stock dividends are paid quarterly, but at a stated fixed rate.

Why do firms issue preferred stock? Unlike debt, if the firm misses a dividend payment, that event cannot force the issuing company into default. (Missing an interest payment on debt is considered a default.) Additionally, corporations that hold preferred stock dividends qualify for preferential tax treatment. And these dividends qualify for a 70% dividend tax exclusion when the preferred stock is held by another corporation. Therefore, most of the investors in preferred stock are corporations and not usually individual investors.

INFLUENCING FACTORS

There are other reasons why firms issue preferred stock. Corporations, particularly utilities, may have a high-dividend clientele who find preferred stock more attractive than the utility's common stock, because dividends compose a greater percentage of the preferred stock's return. Adding to their popularity is the fact that preferred stock has optional redemption privileges similar to those found in debt issues. It gives the firm the option to redeem the preferred stock at a stated price per share (usually $25), which is fixed at the time the stock is issued.

Lastly, preferred stock is much less volatile in price than common stock. To illustrate this preferred stock advantage, consider the following example. I randomly selected Maytag Corporation as the guinea pig and monitored its performance, paying particular attention to 4 factors: market price, weekly returns, volatility (as measured by the standard deviation in weekly returns), and yield for both the common and preferred stock of Maytag on a weekly basis during the prior 30-month time period (ie, August 2000 to March 2003).

However, one word of caution:

As the preferred stock table shows, Maytag's preferred stock had capital appreciation of 3.5% over the holding period, an annual yield of almost 7.9%, and its volatility was less than one fifth that of the common stock. If and when the market turns around (and it always does), you can expect little, if any, capital appreciation with the preferred stock, but may see substantial appreciation in the common stock. The old adage "the greater the risk, the greater the potential return" is true.

What kind of a return can an investor expect on preferred stock? Depending on the credit rating of the issue as rated by Moody's or Standard & Poors (and I prefer to stay with issues that are at least "BBB" investment-grade quality or better), yields in the range of 6% to 8% are common. So, if a 7% rate of return with little risk is something that is palatable to you, consider an investment portfolio comprised of shorter duration fixed-income securities and preferred stocks of investment- grade quality or better. This may just prove to be the solution to your current investing dilemma.

Thomas R. Kosky and his partner, Harris L. Kerker, are principals of the Asset Planning Group in Miami, Fla. Mr. Kosky teaches corporate finance in the Saturday Executive and Health Care Executive MBA Programs at the University of Miami and welcomes questions or comments at 800- 953-5508. For more information, visit www.assetplanning.net.