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Managing the Income
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
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"
12/02/2005
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