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Four Income Investing Pitfalls to Avoid

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Don't make the mistake of falling into one of these traps with your hard-earned nest egg.

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In the "zero interest rate" world that we live in, searching for yield can be a perilous journey. I have seen many investors make the mistake of becoming too confident in a one-dimensional portfolio strategy that fails to take into account changing market conditions. 2013 has been a wake-up call for those conservative income seekers that are focused on the dual threats of rising interest rates and market volatility. With that in mind, I want to examine several of the most common mistakes income investors make with their portfolios.

1. High Yield = High Risk

One of the most fundamental tenets of income investing is that "there is no free lunch." With a higher yield comes a greater level of volatility and risk for your portfolio. Investors that were lured by the double digit dividend yield of the iShares Mortgage Real Estate Capped ETF (NYSEARCA:REM) have traveled a rocky road in 2013. REM initially soared on the back of low rates and high demand for risk assets but mortgage REITs quickly fell out of favor when interest rates began rising. This ETF fell more than 20% from high to low this year, but has since rebounded from its July lows.

In order to mitigate the risk of high yield stocks or ETFs making a dent in your portfolio, consider sizing them smaller than a normal position. In addition, you can consider pairing your high yield positions with high quality holdings that will offset the risk of a sharp decline.

2. Overallocation to One Asset Class

Diversification is a key component of any sound risk management plan and having a portfolio primarily focused on one asset class can be a recipe for disaster. Many investors have been lured into the relative safety of municipal bonds over the last decade. Municipal bond funds have seen their assets grow substantially and retirees love the tax-free income that they throw off. However, the recent Detroit bankruptcy coupled with rising interest rates has shed a new light on the risk of being over allocated to an asset class like muni bonds.

Instead consider diversifying your portfolio among short duration holdings such as the PowerShares Senior Loan Portfolio (NYSEARCA:BKLN), PIMCO 0-5 Year High Yield ETF (NYSEARCA:HYS), or the Vanguard Short Term Bond ETF (NYSEARCA:BSV). Each of these holdings offers improved insulation from the effects of rising interest rates as well as a healthy monthly yield.

3. Stagnant Portfolio Syndrome

Still sitting in the same old stodgy bond, real estate, or strategic income funds that you had in 2012? It's a whole new ball game out there. The pernicious effect of rising interest rates has seen a dramatic shift in many funds that were heavy in long-term Treasuries, REITs, and preferred stocks. These asset classes have been under heavy selling pressure since early May and continue to underperform.

Instead of having a portfolio that is made up entirely of interest rate sensitive investments, consider moving a portion to dividend paying stocks such as the iShares Select Dividend ETF (NYSEARCA:DVY) or the First Trust NASDAQ Technology Dividend Index (NASDAQ:TDIV). Each of these ETFs focuses their equity portfolio on companies paying the highest dividends within their respective underlying indices.

4. Sell Discipline

Another investing axiom that has served me well in my career is that "there is no shame in being wrong; there is only shame in staying wrong." I have written extensively about the need for risk management through the use of stop losses to guard against an investment going south. In my opinion, every position in your portfolio should have a sell discipline in order to define the amount you are willing to risk in the event that the tables turn against you.

By having a sell strategy in place and avoiding these four income investing pitfalls, you will be able to sleep well at night knowing that your hard-earned nest egg is protected from the numerous risks lurking in the shadows.

Read more from David Fabian, Managing Partner at Fabian Capital Management:

5 Funds to Buy for Rising Interest Rates

Dissecting The Irrational Enthusiasm for Stocks

Capital Strength and Low Volatility: What's Not to Like?


Twitter: @fabiancapital
No positions in stocks mentioned.
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