Los Angeles Times columnist Tom Petruno writes an excellent piece on how low rates are forcing investors to do things they don't want to do. The article, "Cash misery fuels rush to risk", says, "Near-zero yields from cash accounts are tempting more investors to chase higher returns in stocks, bonds and other riskier assets."

It explains, "With short-term interest rates still near rock-bottom, traditional cash hideouts such as bank savings accounts and money market mutual funds earn so little interest that it almost seems unfair you should have to report it on a tax return. The average money market fund's annualized yield is an infinitesimal 0.02%, according to iMoneyNet Inc. At that rate, $10,000 earns all of $2 a year. And that's before Uncle Sam and the state take their share (interest earnings, remember, are fully taxable)."

Petruno continues, "With the tax-season reminder of the virtually nonexistent returns on cash accounts, more investors may find themselves compelled to move money into riskier alternatives in search of higher earnings power. That's exactly one of the Federal Reserve's goals in keeping short-term rates near zero. The Fed wants idle cash flowing into stocks, bonds, real estate and other assets as a way to stimulate the economy."

He warns, "It's a dangerous game because of the potential for desperate people to reach beyond their true tolerance for risk-taking. Yet there are plenty of signs this year that a growing number of investors have reached the point of severe misery with cash and are heading elsewhere, for better or worse." The piece quotes Morningstar Inc.'s Kevin McDevitt, "People feel they have no choice but to go 'risk on' because of the Fed."

The Times also writes, "One of the year's biggest surprises so far has been small investors' willingness to buy domestic stocks again. U.S. stock mutual funds were bleeding cash for much of last year as people sold out, a trend that continued even as the market surged in the fourth quarter. But by mid-January, the funds began to see net inflows again, meaning new purchases exceeded redemptions. U.S. stock funds took in a net total of almost $21 billion in the first two months of this year, industry data from the Investment Company Institute show. That's a small sum compared with domestic funds' total assets of $4.4 trillion, but the change of heart is what's significant. Nearly $86 billion had flowed out of the funds last year."

But, Petruno tells us, "[T]hings have become much more complicated for investors who are looking to put cash to work in the bond market. Small investors began to pour into bonds two years ago, after stocks crashed. It was a smart move. Market interest rates mostly declined from early 2009 through late last year, which meant that older bonds issued at higher fixed rates rose in value. Now, however, ... [the] tax-free municipal bond market suffered a vicious sell-off from November through mid-January, pushing bond fund share prices down as much as 10% and driving market yields to two-year highs. Investors were spooked by fears that state and local governments' budget woes would lead to widespread bond defaults. Muni bond mutual fund investors have pulled $40 billion from the funds over the last five months ... [and] money still is coming out of muni funds."

He explains, "That raises a critical question: Do many of the investors who have joined the rush into bonds since 2008 fail to understand the basic risks? If market interest rates rise, the value of older bonds declines, and your investment can slide into the red. Americans now have $2.6 trillion in bond mutual funds, up from $1.7 trillion three years ago. That's a lot of money that could be shocked if interest rates should jump across the board and depress bond prices."

Finally, Petruno says, "So the Federal Reserve is getting what it wanted -- people are putting more of their cash to work. What we're still waiting to find out is how well many newbie bond investors understand that there really is no free lunch. Higher yields come with higher risk. Cash has never looked less attractive as an asset than it does now, especially with inflation rising. But as some muni bond investors learned the hard way, for money that you absolutely cannot afford to lose in the short run, cash is a form of misery worth enduring."

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