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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 achievable in a risk-free environment…ie, an FDIC-insured bank account. Risk comes in many forms, but the main concerns of the average investor are “credit” and “market” risk…especially when it comes to investing for income. Credit risk involves the ability of corporations, government entities, and even individuals, to meet 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 first by choosing only high quality (investment grade) securities and the second by diversifying properly, understanding that Market Value fluctuations are normal, and having an action plan to deal 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 misused. within the financial community. It’s also important to recognize that you don’t need a fancy computer program or a flashy presentation with economic scenarios, inflation estimators and stock market projections to align you properly with your goal. You need common sense, reasonable expectations, patience, discipline, soft hands and an oversized driver. The KISS Principle must be at the foundation of your Investment Plan; emphasis on Working Capital will help you Organize and Control your investment portfolio.
Planning for Retirement should focus on the additional income required by the investment portfolio, and the Asset Allocation formula [relax, 8th grade math is plenty] required for goal achievement will depend on only three variables: (1) the amount of liquid investment assets you start 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 quit smoking hard and develop a growing stream of income… if you keep the income growing, the Market Value growth (which you expect to grow) will take care of itself. Remember, a higher Market Value may increase the size of the hat, but it doesn’t pay the bills.
First deduct any guaranteed pension income from your retirement income goal to estimate the amount needed from the investment portfolio alone. Don’t worry about inflation at this stage. Next, determine the total Market Value of your investment portfolios, including corporate plans, IRAs, H-Bonds… everything, except the house, boat, jewelry, etc. Liquid personal and retirement assets only. This total is then multiplied by a range of acceptable interest rates (6%, up to 8% 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! Certainly, this process will give you a clear idea of where you stand, and that, in itself, is worth the effort.
Organizing the Portfolio involves deciding on an appropriate Allocation Allocation… and that requires some discussion. Asset Allocation is the most important and most often 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 percentage of total assets. A second misconception describes Asset Allocation as a sophisticated technique used to mitigate the downward impact of movements in stock and bond prices, and/or a process that automatically (and stupidly) moves investment dollars from a weakening asset class to a stronger one. a subtle “market timing” device.
Finally, the Asset Allocation Formula is often misused 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 switching. The Asset Allocation formula itself is sacred, and if properly constructed, should never be changed due to conditions in either the Equity or Fixed Income markets. Changes in the investor’s personal situation, goals and objectives are the only things that can be allowed into the Asset Allocation decision process.
Here are some basic Allocation Allocation Guidelines: (1) All Allocation Allocation decisions are based on the Cost Basis of the securities involved. The current Market Value can be more or less and it just doesn’t matter. (2) Any investment portfolio with a Cost Base 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 units (all types of retirement programs) should host the bulk of the Equity Investments. This rule applies from the age of 0 to the 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 by a decimal point. All the money in the portfolio is earmarked for one category or the other. (4) From Retirement Age – 5 on, the Income Allocation must be adjusted upwards until the “reasonable interest rate test” says that you are in target or at least in range. (5) At retirement, between 60% and 100% of your portfolio may need to be in Income Generating Assets.
Controlling, or Implementing, the Investment Plan will be best accomplished 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-oriented, non-competitive, hands-on, decision-making process that doesn’t require advanced degrees or a rocket science IQ. In fact, being too smart can be a problem if you tend to overanalyze things. It is useful to establish guidelines for selecting securities, and for removing them. For example, limit Equity exposure to Investment Grade, NYSE, dividend paying, profitable and widely held companies. Do not buy any stock unless it is down at least 20% from its 52-week high, and limit individual stock holdings to less than 5% of the total portfolio. Take a reasonable profit (using 10% as a target) as often as possible. With a 40% Income Allocation, 40% of profits and dividends would be allocated to Income Assets.
For Fixed Income, focus on investment grade securities, with above average but not “top in class” yields. With Variable Income securities, avoid buying near 52-week highs, and keep individual holdings well below 5%. Keep individual Preferred Stocks and Bonds well under 5% as well. Closed End Fund positions may be slightly higher than 5%, depending on type. Take a reasonable profit (more than a year’s income to begin with) as soon as possible. With a 60% Share Allocation, 60% of profits and interests would be allocated to shares.
Monitoring Investment Performance the Wall Street way is inappropriate and problematic for goal-oriented investors. It deliberately 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 that your unhappiness is Wall Street’s most coveted asset. Don’t humor them, and protect yourself. Base your performance appraisal efforts on goal achievement…yours, not theirs. Here’s how, based on the three basic goals we talked about: Growth of Basic Income, Profit Production of Business and Total Growth of Working Capital.
Basic Income includes the dividends and interest produced by your portfolio, minus the realized capital gains, which should actually be the larger number much of the time. No matter how you slice it, your long-haul comfort requires regularly increasing income, and using your total ticket cost base as the benchmark, it’s easy to determine where to invest your accumulating cash. Because a portion of every dollar added to the portfolio is reallocated to income generation, you are sure to increase the total each year. 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-term income goals.
Profit Production is the happy face of market stock volatility, which 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! Successful investors learn to sell the ones they love, and the more often (yes, soon), the better. This is called trading, and it’s 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, you’ve arrived. You won’t see WalMart hold out for higher prices than their standard markup, and you shouldn’t either. 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 will show you. … a portfolio of equity securities that have not yet met their profit targets and are likely in negative Market Value territory because you sold the winners and replaced them with new inventory… compounding the earning power! Similarly, you will see a diverse group of income earners, punished for following their natural trends (this year), at lower prices, which will help you increase your portfolio and overall cash flow. If you see large plus signs, you are not managing the portfolio correctly.
Working Capital Growth (total cost basis of a portfolio) just happens, and at a rate that will be somewhere between the average yield of 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 return than the safer 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 prudent selection process) is greater than it is with Income Securities. This is why the Equity Allocation moves from a larger to a smaller 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 adjusted occasionally as we approach the time in life when it needs to provide the yacht… and the gas money to run it? By using Cost Basis (Working Capital) as the number that needs to grow, accepting trading as a reasonable, even conservative, approach to portfolio management, and 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 grandkids.
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