Managing Your Income Portfolio
By Steve Selengut
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
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
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 has been in professional portfolio management since 1979, and is
the 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."