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Managing the Income Portfolio
The reason people take risk in investing is the prospect of higher returns than can be achieved in a risk-free environment… i.e. an FDIC-insured bank account. Risk comes in many forms, but the main concerns of the average investor are “credit” and “market risks” … especially when it comes to income investing. Credit risk involves the ability of companies, government agencies and even individuals to meet their financial obligations; market risk refers to the certainty that the market value of the selected securities will change. We can minimize the former by choosing only high-quality (investment-grade) securities and the latter by properly diversifying, understanding that changes in market value are normal, and having an action plan to deal with such fluctuations. (What does the bank do to get the guaranteed amount of interest to depositors? What does it do in response to the market’s expectation of a higher or lower interest rate?)
You don’t need to be a professional investment manager to manage your investment portfolio professionally, but you do need to have a long-term plan and know something about asset allocation…a portfolio management tool that is often misunderstood and almost always misused in the financial community. It’s also important to understand that you don’t need a fancy computer program or a glossy presentation with economic scenarios, inflation estimates and stock market forecasts to achieve your goal. You need common sense, reasonable expectations, patience, discipline, soft hands and an oversized leader. The KISS principle must be the basis of your investment plan; the emphasis on working capital helps you organize and control your investment portfolio.
Retirement planning should focus on the additional income needed from the investment portfolio and the asset allocation formula [relax, 8th grade math is plenty] needed to reach your goals depends on only three variables: (1) the amount of liquid investment assets you start with, (2) the time until retirement, and (3) the range of interest rates currently available in Investment Grade Securities. . As long as you don’t let the “engineer” gene take over, it can be a fairly simple process. Even if you’re young, you need to quit smoking and increase your income… if you keep your income growing, the increase in market value (which is expected of you) will take care of itself. Remember, a higher market value may increase the cap size, but it won’t pay the bills.
First, subtract your guaranteed retirement income from your retirement income goal to estimate the amount you need from your investment portfolio. Don’t worry about inflation at this stage. Next, determine the market value of your investment portfolios, including corporate plans, IRAs, H-bonds…everything except your house, boat, jewelry, etc. Only liquid personal and retirement plan assets. That total is then multiplied by a reasonable range of interest rates (currently 6% to 8%) and hopefully one of the resulting numbers is close to the target amount you came up with a moment ago. If you are within a couple of years of retirement age, even better! Certainly, this process will give you a clear picture of where you stand, and that in itself is worth the effort.
Portfolio management involves deciding on an appropriate asset allocation… and that requires some discussion. Asset allocation is the most important and most commonly misunderstood term in the investment lexicon. The most basic confusion is the idea that diversification and asset allocation are one and the same. Asset Allocation divides the investment portfolio into two main classes of investment securities: Equities/Shares 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. Another misconception describes asset allocation as a sophisticated technique used to cushion the impact of changes in stock and bond prices and/or a process that automatically (and foolishly) 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 by trying to apply a valid investment planning tool to speculative strategies that have no real merit, such as: annual portfolio repositioning, market timing, and mutual fund reallocation. The asset allocation formula itself is sacrosanct and, if constructed correctly, should never be altered by conditions in the equity or fixed income markets. Changes in an investor’s personal circumstances, goals and objectives are the only issues that can be factored into the asset allocation decision-making process.
Here are some basic asset allocation guidelines: (1) All asset allocation decisions are based on the value of the securities involved. The current market value could be more or less and it just doesn’t matter. (2) Each investment portfolio with a cost base of $100,000 or more must have at least 30% invested in income securities, either taxable or tax-exempt, depending on the nature of the portfolio. Tax-deferred entities (all types of retirement plans) should house the majority of equity investments. This rule is valid from age 0 until old-age pension – 5 years. Under 30, it’s a mistake to have too much income in your portfolio in securities. (3) There are only two categories of asset allocation, and neither is ever described with a comma. All the money in the portfolio is intended for one category or another. (4) From retirement age – from age 5 onwards the income distribution must be adjusted upwards until the “reasonable interest rate test” says you are on target or at least within range. (5) In retirement, 60-100% of your portfolio can be in income-producing securities.
Those who are least emotional, most decisive, naturally calm, patient, generally conservative (not politically) and self-actualized are best able to control or implement an investment plan. Investing is a long-term, personal, goal-oriented, non-competitive, hands-on decision-making process that doesn’t require a college degree or the IQ of a rocket scientist. In fact, being too smart can be a problem if you have a tendency to overanalyze things. It is useful to prepare instructions for the selection of securities and their transfer. For example, limit equity exposure to Investment Grade, NYSE, dividend paying, profitable and widely held companies. Don’t buy stocks unless they’re down at least 20% from their 52-week highs, and limit individual stocks to less than 5% of your total portfolio. Take reasonable profits (using the 10% target) as often as possible. In the case of a 40% income distribution, 40% of profits and dividends would be distributed to income securities.
For fixed income, focus on investment-grade securities with above-average but not “best-in-class” returns. For variable income securities, avoid buying near 52-week highs and keep individual holdings well below 5%. Also keep individual preferred stocks and bonds well below 5%. Closed-end fund positions can be slightly higher than 5%, depending on the type. Take a reasonable profit (more than a year’s income for beginners) as soon as possible. In the case of a 60% stock distribution, 60% of the profits and interest would be distributed to the stock.
Tracking 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, causing constant frustration and encouraging inappropriate transactional responses to natural and innocuous events. With a media that thrives on sensationalizing anything outrageously positive or negative (such as Google and Enron, Peter Lynch and Martha Stewart), it’s hard to keep up with changing environmental conditions. First greed, then fear, new products instead of old ones and always the promise of something better, when in fact boring and old-fashioned investment principles still do the trick. Remember, your misfortune is the most sought-after asset on Wall Street. Don’t make fun of them and protect yourself. Base your performance on the achievement of goals… your goals, not theirs. Based on the three main goals we’ve talked about, proceed as follows: base income growth, trading profit, and overall working capital growth.
Basic income includes the dividends and interest your portfolio produces, minus any realized capital gains, which should actually be the majority of the time. No matter how you divide it, your long-term comfort requires income that grows on a regular basis, and using the total value of your portfolio as a benchmark makes it easy to determine where to invest the accumulated cash. Because a portion of every dollar added to the portfolio is redistributed to produce income, you’re sure to increase your total each year. If market capitalization is used for this analysis, you could be pouring too much money into a falling stock market, harming your long-term income goals.
Profit Production is the happy face of market value volatility, which is a natural feature of all securities. To make a profit, you need to be able to sell the securities that most investment strategists (and accountants) want you to marry! Successful investors learn to sell what they love, and the more often (yes, in the short term), the better. It’s called trading, and it’s not a four-letter word. If you can get to the point where you think the securities you own are quality stock on the shelves of your personal portfolio boutique, you’ve arrived. You don’t see WalMart expecting prices above the normal markup, and you shouldn’t either. Cut the slow mover markup and sell at a loss the damaged goods you’ve held too long when you have to, and all the while trying to anticipate what your standard Wall Street 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 have sold the winners and replaced them with new stock… increasing earning power! Likewise, you’ll see a diverse group of income earners being punished for following these natural trends (this year) with lower prices, which will help you increase your portfolio’s performance and overall cash flow. If you’re seeing big plus signs, you’re not managing your portfolio properly.
Working capital growth (based on the total cost of the portfolio) just happens and at a rate somewhere between the average return on the portfolio’s income securities and the total realized gain on the equity portion of the portfolio. With higher equity allocations, it is actually higher because frequent trading yields higher returns than safer positions in the income distribution. But, and this is too big a but to ignore as retirement approaches, trading profits are not guaranteed and the risk of loss (although minimized by a judicious selection process) is greater than that of income securities. Therefore, the distribution of assets moves from a higher percentage of equity to a lower one as retirement approaches.
So is there really such a thing as an income portfolio to manage? Or are we really just an investment portfolio whose asset allocation needs to be adjusted from time to time as we approach the age of life when it needs to provide a yacht… and the gas money to run it? By using the cost base (working capital) as the number to grow, accepting trading as an acceptable, even conservative approach to portfolio management, and focusing on income growth instead of ego, this whole retirement investing thing becomes significantly less intimidating. Now you can focus on changing the tax code, reducing health care costs, saving for Social Security, and pampering your grandchildren.
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