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When is it time to dump an investment?

My friend Robert (not his real name) is retired. Since he’s a risk-averse investor, I was surprised when I got an email from him last week with some bad news.

Back in 2007, when he was still employed and the economy was still awesome, Robert called his broker. “I was looking for extremely safe, conservative investments with good rates,” said Robert. “And he said, here are some extremely safe, conservative investments with good rates.”

The investments were with Lehman Brothers, GMAC, and Royal Bank of Scotland (RBS).

Lehman went bankrupt, GMAC was bailed out three times, and RBS was taken over by the government of the UK.

But it’s not as bad as it sounds: the Lehman investment was an FDIC-insured CD. The GMAC bond is still paying 5.85%.

But RBS? Big trouble. Robert bought $35,000 worth of RBS preferred stock paying a 7.25% dividend. RBS is the world’s second-largest bank and was founded in 1727. What could go wrong? Preferred stock sounds great. And 7.25%? Wow! To use an arcane financial term, that is one bitchin’ yield.

Robert and his broker were far from the only people who thought this RBS stock looked like a great deal. One blogger argued in 2009:

“I don’t believe that Royal Bank of Scotland would ever stop paying its preferred dividends because to do so would tarnish the name of that company forever—royalty sits on their board of directors and the company was incorporated before George Washington was born.”

Well, guess what? Preferred stock is risky. As Larry Swedroe put it in this book The Only Guide to Alternative Investments You’ll Ever Need. “Investors should be aware that in times of financial distress, the payment of preferred dividends could be deferred.”

You don’t say. As of April, Robert’s RBS preferred stock stopped paying dividends by order of the Queen. (Actually, it was the European Commission, but “by order of the Queen” has such a ring to it.) A chunk of Robert’s income went up in smoke.

Furthermore, the stock’s market value has collapsed, too—it’s currently down 31% from what Robert paid for it (although that’s an improvement from when it was down 50%).

Now Robert’s in a quandary. The Financial Times says RBS is expected to resume paying dividends in fall of 2010. Should Robert hold onto his investment in hopes that the dividends will come back and so will the price of the stock?

Stretching for yield

Robert got into trouble the moment he asked his broker for high yields. Higher yield and higher risk go hand-in-hand, and many people buy corporate bonds, preferred stock, dividend stocks, and brokered CDs without understanding that these instruments pay higher dividends because they are risky. Let’s take a quick look at each:

Corporate bonds: Buying an individual corporate bond, no matter how highly rated, still exposes you to the risk that the company will go bankrupt and default on its debt. You could lose everything.

Preferred stock: “A lot more is wrong with preferreds than right,” writes Jane Bryant Quinn in Making the Most of Your Money Now. Preferred stock offers less growth potential than common stock and more risk than bonds.

Common, dividend-paying stock: That’s even riskier than preferred stock: both bondholders and preferred stockholders get first dibs on dividends. Common stockholders are way down the list. As with preferred stock, you’re likely to lose your dividends and your principal at the same time, because when a company stops paying dividends, the stock usually collapses. I often see people advising retirees to buy AT&T (T) stock for the dividend income, as if nothing could possibly go wrong with AT&T.

Brokered CDs: Brokered CDs are generally FDIC-insured (although you should always check). There’s no chance of losing principal if you hold them to maturity, which makes them the safest of this cagey bunch. But they’re less safe than bank CDs for two reasons. First, brokered CDs are callable. That means that the issuer can, on a whim, give you back your principal and yank back its CD. This is likely going to happen at a time when you have to reinvest the money at a much lower interest rate, and that means the high rate on a brokered CD is essentially fictional. Second, say you want to get out of a brokered CD: you can’t just pay a small penalty and be on your way, as with a bank CD. You have to sell the CD—possibly at a loss.

I’m not saying no one should ever buy any of these things. But Robert bought them without realizing he was taking any risk at all.

“I was ignorant,” said Robert. “I listened to this broker, and you know what? He was ignorant, too. If there hadn’t been a financial crisis, there’d be no problem.”

Hold or sell?

I asked Robert whether he was going to sell his RBS stock. “I haven’t made a firm decision,” he said. “It’s very difficult to sell. I’m down $11,000. I look at this money I’d be losing, and it’s like a year of earning on my portfolio. It’s so much money.”

“Then you must think the stock is underpriced and it’s going to start paying dividends again,” I said. “Does that mean you’re going to buy more of it?”

“I’m not going to buy more of it! It’s obviously risky.”

“Then let me ask you this,” I said, reaching for the heavy artillery. “Let’s say I took away your RBS stock and gave you the market value in cash. Would you buy it back from me?”

Pause. “I have to think about that.”

He called me back about ten minutes later. He’d decided to sell the RBS and buy a 7-year credit union CD paying 3.49%. It’s insured, non-callable, and (because it’s in an IRA) has no withdrawal penalty. In other words, it’s safe. Just what he was looking for in the first place.