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
http://www.sancoservices.com
Professional Portfolio Management since 1979
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"
