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.
