Teacher and consultant to the futures industry since 1983
Teacher and consultant to the futures industry since 1983
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Managing the Income Investment Portfolio The reason people assume the risks of investing in the first place is the prospect of achieving a higher rate of return than is attainable in a risk free environment…i.e., an FDIC insured bank account. Risk comes in various forms, but the average investor’s primary concerns are “credit” and “market” risk… particularly when it comes to investing for income. Credit risk involves the ability of corporations, government entities, and even individuals, to make good on their financial commitments; market risk refers to the certainty that there will be changes in the Market Value of the selected securities. We can minimize the former by selecting only high quality (investment grade) securities and the latter by diversifying properly, understanding that Market Value changes are normal, and by having a plan of action for dealing with such fluctuations. (What does the bank do to get the amount of interest it guarantees to depositors? What does it do in response to higher or lower market interest rate expectations.
You don’t have to be a professional
Investment Manager to professionally manage your investment portfolio,
but you do need to have a long term plan and know something about Asset
Allocation… a portfolio organization tool that is often misunderstood
and almost always improperly used within the financial community. It’s
important to recognize, as well, that you do not need a fancy computer
program or a glossy presentation with economic scenarios, inflation
estimators, and stock market projections to get yourself lined up
properly with your target. You need common sense, reasonable
expectations, patience, discipline, soft hands, and an oversized driver.
The K. I. S. S. Principle needs to be at the foundation of your
Investment Plan; an emphasis on Working Capital will help you Organize,
and Control your investment portfolio.
Planning for Retirement should
focus on the additional income needed from the investment portfolio, and
the Asset Allocation formula [relax, 8th grade math is
plenty] needed for goal achievement will depend on just three variables:
(1) the amount of liquid investment assets you are starting with, (2)
the amount of time until retirement, and (3) the range of interest rates
currently available from Investment Grade Securities. If you don’t
allow the “engineer” gene to take control, this can be a fairly simple
process. Even if you are young, you need to stop smoking heavily and to
develop a growing stream of income… if you keep the income growing, the
Market Value growth (that you are expected to worship) will take care of
itself. Remember, higher Market Value may increase hat size, but it
doesn’t pay the bills.
First deduct any guaranteed pension
income from your retirement income goal to estimate the amount needed
just from the investment portfolio. Don’t worry about inflation at this
stage. Next, determine the total Market Value of your investment
portfolios, including company plans, IRAs, H-Bonds… everything, except
the house, boat, jewelry, etc. Liquid personal and retirement plan
assets only. This total is then multiplied by a range of reasonable
interest rates (6%, to 8% right now) and, hopefully, one of the
resulting numbers will be close to the target amount you came up with a
moment ago. If you are within a few years of retirement age, they better
be! For certain, this process will give you a clear idea of where you
stand, and that, in and of itself, is worth the effort.
Organizing the Portfolio
involves deciding upon an appropriate Asset Allocation… and that
requires some discussion. Asset Allocation is the most important and
most frequently misunderstood concept in the investment lexicon. The
most basic of the confusions is the idea that diversification and Asset
Allocation are one and the same. Asset Allocation divides the investment
portfolio into the two basic classes of investment securities:
Stocks/Equities and Bonds/Income Securities. Most Investment Grade
securities fit comfortably into one of these two classes.
Diversification is a risk reduction technique that strictly controls the
size of individual holdings as a percent of total assets. A second
misconception describes Asset Allocation as a sophisticated technique
used to soften the bottom line impact of movements in stock and bond
prices, and/or a process that automatically (and foolishly) moves
investment dollars from a weakening asset classification to a stronger
one… a subtle "market timing" device.
Finally, the Asset Allocation Formula
is often misused in an effort to superimpose a valid investment planning
tool on speculative strategies that have no real merits of their own,
for example: annual portfolio repositioning, market timing adjustments,
and Mutual Fund shifting. The Asset Allocation formula itself is sacred,
and if constructed properly, should never be altered due to conditions
in either Equity or Fixed Income markets. Changes in the personal
situation, goals, and objectives of the investor are the only issues
that can be allowed into the Asset Allocation decision-making process.
Here are a few basic Asset Allocation
Guidelines: (1) All Asset Allocation decisions are based on the Cost
Basis of the securities involved. The current Market Value may be more
or less and it just doesn’t matter. (2) Any investment portfolio with a
Cost Basis of $100,000 or more should have a minimum of 30% invested in
Income Securities, either taxable or tax free, depending on the nature
of the portfolio. Tax deferred entities (all varieties of retirement
programs) should house the bulk of the Equity Investments. This rule
applies from age 0 to Retirement Age – 5 years. Under age 30, it is a
mistake to have too much of your portfolio in Income Securities. (3)
There are only two Asset Allocation Categories, and neither is ever
described with a decimal point. All cash in the portfolio is destined
for one category or the other. (4) From Retirement Age – 5 on, the
Income Allocation needs to be adjusted upward until the “reasonable
interest rate test” says that you are on target or at least in range.
(5) At retirement, between 60% and 100% of your portfolio may have to be
in Income Generating Securities.
Controlling, or Implementing, the
Investment Plan will be accomplished best by those who are least
emotional, most decisive, naturally calm, patient, generally
conservative (not politically), and self actualized. Investing is a
long-term, personal, goal orientated, non- competitive, hands on,
decision-making process that does not require advanced degrees or a
rocket scientist IQ. In fact, being too smart can be a problem if you
have a tendency to over analyze things. It is helpful to establish
guidelines for selecting securities, and for disposing of them. For
example, limit Equity involvement to Investment Grade, NYSE, dividend
paying, profitable, and widely held companies. Don’t buy any stock
unless it is down at least 20% from its 52 week high, and limit
individual equity holdings to less than 5% of the total portfolio. Take
a reasonable profit (using 10% as a target) as frequently as possible.
With a 40% Income Allocation, 40% of profits and dividends would be
allocated to Income Securities.
For Fixed Income, focus on Investment
Grade securities, with above average but not “highest in class” yields.
With Variable Income securities, avoid purchase near 52-week highs, and
keep individual holdings well below 5%. Keep individual Preferred Stocks
and Bonds well below 5% as well. Closed End Fund positions may be
slightly higher than 5%, depending on type. Take a reasonable profit
(more than one years’ income for starters) as soon as possible. With a
60% Equity Allocation, 60% of profits and interest would be allocated to
stocks.
Monitoring Investment Performance
the Wall Street way is inappropriate and problematic for
goal-orientated investors. It purposely focuses on short-term
dislocations and uncontrollable cyclical changes, producing constant
disappointment and encouraging inappropriate transactional responses to
natural and harmless events. Coupled with a Media that thrives on
sensationalizing anything outrageously positive or negative (Google and
Enron, Peter Lynch and Martha Stewart, for example), it becomes
difficult to stay the course with any plan, as environmental conditions
change. First greed, then fear, new products replacing old, and always
the promise of something better when, in fact, the boring and old
fashioned basic investment principles still get the job done. Remember,
your unhappiness is Wall Street’s most coveted asset. Don’t humor them,
and protect yourself. Base your performance evaluation efforts on goal
achievement… yours, not theirs. Here’s how, based on the three basic
objectives we’ve been talking about: Growth of Base Income, Profit
Production from Trading, and Overall Growth in Working Capital.
Base Income includes the
dividends and interest produced by your portfolio, without the realized
capital gains that should actually be the larger number much of the
time. No matter how you slice it, your long-range comfort demands
regularly increasing income, and by using your total portfolio cost
basis as the benchmark, it’s easy to determine where to invest your
accumulating cash. Since a portion of every dollar added to the
portfolio is reallocated to income production, you are assured of
increasing the total annually. If Market Value is used for this
analysis, you could be pouring too much money into a falling stock
market to the detriment of your long-range income objectives.
Profit Production is the happy
face of the market value volatility that is a natural attribute of all
securities. To realize a profit, you must be able to sell the
securities that most investment strategists (and accountants) want you
to marry up with! Successful investors learn to sell the ones they love,
and the more frequently (yes, short term), the better. This is called
trading, and it is not a four-letter word. When you can get yourself to
the point where you think of the securities you own as high quality
inventory on the shelves of your personal portfolio boutique, you have
arrived. You won’t see WalMart holding out for higher prices than their
standard markup, and neither should you. Reduce the markup on slower
movers, and sell damaged goods you’ve held too long at a loss if you
have to, and, in the thick of it all, try to anticipate what your
standard, Wall Street Account Statement is going to show you… a
portfolio of equity securities that have not yet achieved their profit
goals and are probably in negative Market Value territory because you’ve
sold the winners and replaced them with new inventory… compounding the
earning power! Similarly, you’ll see a diversified group of income
earners, chastised for following their natural tendencies (this year),
at lower prices, which will help you increase your portfolio yield and
overall cash flow. If you see big plus signs, you are not managing the
portfolio properly.
Working Capital Growth (total
portfolio cost basis) just happens, and at a rate that will be somewhere
between the average return on the Income Securities in the portfolio and
the total realized gain on the Equity portion of the portfolio. It will
actually be higher with larger Equity allocations because frequent
trading produces a higher rate of return than the more secure positions
in the Income allocation. But, and this is too big a but to ignore as
you approach retirement, trading profits are not guaranteed and the risk
of loss (although minimized with a sensible selection process) is
greater than it is with Income Securities. This is why the Asset
Allocation moves from a greater to a lesser Equity percentage as you
approach retirement.
So is there really such a thing as an
Income Portfolio that needs to be managed? Or are we really just dealing
with an investment portfolio that needs its Asset Allocation tweaked
occasionally as we approach the time in life when it has to provide the
yacht… and the gas money to run it? By using Cost Basis (Working
Capital) as the number that needs growing, by accepting trading as an
acceptable, even conservative, approach to portfolio management, and by
focusing on growing income instead of ego, this whole retirement
investing thing becomes significantly less scary. So now you can focus
on changing the tax code, reducing health care costs, saving Social
Security, and spoiling the grandchildren.
Steve
Selengut
sanserve@aol.com http://www.sancoservices.com Author of: "The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read", and "A Millionaire's Secret Investment Strategy" NOTICE: Investment Reference does not recommend or endorse any products, brokerage firms, CTAs, CPOs or representatives. All material contained in any article is only the opinion of the person authoring the article. Investment reference will publish any article submitted as a way of offering a public forum and a means of exchanges of views and ideas. Investment Reference also reserves the right to make the final decision on what to publish, and will not publish anything that it considers offensive, slanderous, or fraudulent. Investment Reference cannot and will not be held responsible for any information or content in any articles except those which it authors itself. Get in touch with us by
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