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One of the biggest mistakes investors make is ignoring the “income objective” portion of their investment portfolio… many don’t even realize there is such a thing. The second biggest mistake is to test the performance of income securities the same way they do “growth objective” securities (equities).
The following Q&A assumes that portfolios are built around these four great financial risk mitigators: all securities meet high quality standards, generate some form of income, are “graded” diversified, and “reasonably” target profit. Sold when received.
1. Why should one invest for income; Aren’t equities a better growth vehicle?
Yes, the objective of equity investing is to produce “growth,” but most people think of growth as an increase in the market value of their securities. I think of growth in terms of the amount of new “capital” that is created from the realization of profits, and the compounding of earnings when that new capital is reinvested using a “cost based” asset allocation. .
Most advisors don’t view profits with the same warm and fuzzy feeling that I do…perhaps it’s a tax code that treats losses more favorably than profits, or a legal system that forces people to become advisors. allows to sue if in retrospect it appears that a wrong turn may have been taken. Truth be told, there is no such thing as bad profit.
Most people would not believe that, over the past 20 years, a 100% income portfolio would have “outperformed” all three of the major stock market averages in “total return” … 4% as a conservative annual distribution number. Using as : Percentage profit per annum:
NASDAQ = 1.93%; S&P 500 = 4.30%; DJIA = 5.7%; 4% Closed End Fund (CEF) portfolio = 6.1%
- *Note: During the past 20 years, taxable CEFs have actually yielded around 8%, tax free, just under 6%…and then there were all opportunities for capital gains from 2009 to 2012.
Try looking at it this way. If your portfolio is generating less income than you are withdrawing, then something must be sold to provide for the money spent. Most financial advisors would agree that no less than 4% (payable in monthly increments) is needed in retirement without considering travel, grandchildren’s education and emergencies. Only this year, most of that money had to come from your principal.
- Similar to the basic fixed annuity program, most retirement plans have an annual reduction of the principal. A “retirement-ready” income program, on the other hand, leaves principal for heirs while increasing annual spending money for retirees.
2. How much of an investment portfolio should be income-oriented?
At least 30% for anyone under the age of 50, then an increasing allocation as retirement becomes larger… The size of the portfolio and spending money requirements should dictate whether the stock market How much risk is the portfolio exposed to? Generally, no more than 30% in equities for retirees. Very large portfolios can be more aggressive, but isn’t true wealth the wisdom that you no longer have to take significant financial risk?
As an added additional safeguard, all equity investments should be held in a diversified group of investment grade value stocks and equity CEFs, thus ensuring cash flow from the entire portfolio at all times. But the key from day one is to do all asset allocation calculations based on position cost rather than market value.
- Note: When equity prices are very high, equity CEFs provide significant income and excellent diversification in a managed program that allows for participation in the stock market with less risk than individual stocks and income mutual funds and income. Much higher returns than ETFs.
Using total “working capital” rather than current or periodic market values allows the investor to know where new portfolio growth (dividends, interest, deposits and trading income) should be invested. This simple step will guarantee that total portfolio income grows year after year, and lead to retirement significantly faster, as the asset allocation itself becomes more conservative.
- The asset allocation should not change based on market or interest rate predictions; Projected income needs and financial risk mitigation are primary issues to prepare for retirement.
3. How many different types of income securities are there, and
There are a few basic types, but variations are many. To keep it simple, and in ascending order of risk, there are US government and agency debt instruments, state and local government securities, corporate bonds, loans and preferred stocks. These are the most common types, and they usually provide a fixed level of income payable semi-annually or quarterly. (CDs and money market funds are not investments; their only risk is “opportunity” diversification.)
Variable income securities include mortgage products, REITs, unit trusts, limited partnerships, etc. And then there is the myriad of incomprehensible Wall Street manufactured speculation with “trunch”, “hedges” and other strategies that are too complicated to understand. To the extent necessary for prudent investment.
Generally speaking, higher yields indicate higher risk in personal income securities; Complex maneuvers and adjustments increase the risk exponentially. The current yield varies according to the type of security, the fundamental quality of the issuer, the length to maturity, and in some cases, the conditions in a particular industry…and of course the IRE.
4. HHow much do they pay?
Short-term interest rate expectations (IRE, appropriately), stir the current yield pot and keep things interesting because the yields on existing securities change “inversely” with price movements. Yields vary greatly between types, and right now range from below 1% for “no risk” money market funds to over 10% for oil and gas MLPs and some REITs.
Corporate bonds yield about 3%, preferred stocks yield about 5%, while most taxable CEFs are yielding closer to 8%. Tax-free CEFs yield about 5.5% on average.
- Income possibilities greatly expand, and there are investment products for every investment type, quality level, and investment duration imaginable… not to mention global and index opportunities. But without exception, closed-end funds pay significantly higher returns than ETFs or mutual funds… it’s not even close.
Individual bonds of all types are expensive to buy and sell (the markup on the bond and the new issue is not required to be prioritized), especially in small amounts, and it is nearly impossible to combine bonds when prices drop. Preferred stocks and CEFs behave like equities, and are easier to trade as prices move in either direction (i.e., easier to sell for a profit, or buy more to reduce the cost basis and increase the yield). Is).
- During the “financial crisis”, CEF yields (tax-free and taxable) nearly doubled … almost all of them could be sold for more than one “one-year interest-in-advance” profit, before that they returned to normal levels in 2012.
5. How do CEFs generate these high income levels?
There are several reasons for this wide difference in investor returns.
- CEFs are not mutual funds. They are separate investment companies that manage portfolios of securities. Unlike mutual funds, investors buy shares of stock in the company itself, and have a limited number of shares. Mutual funds issue an unlimited number of shares whose price is always equal to the net asset value (NAV) of the fund.
- The price of CEFs is determined by market forces and may be above or below NAV… thus, sometimes, they can be purchased at a discount.
- Income mutual funds focus on total return; CEF investment managers focus on generating spendable money.
- The CEF raises cash through an IPO, and invests the proceeds in a portfolio of securities, from which most of the proceeds will be paid out as dividends to shareholders.
- The investment company may also issue preferred shares at a guaranteed dividend rate that they know they can get in the market. (For example, they may sell the callable, 3% preferred stock issue, and invest in bonds that are paying 4.5%.)
- Finally, they negotiate very short term bank loans and use the proceeds to buy longer term securities that are paying a higher interest rate. In most market scenarios, short term rates are much lower than long term, and loan terms are as short as the IRE scenario will allow…
- This “leveraged borrowing” has nothing to do with the portfolio itself, and, in crisis situations, managers may hold off on short-term borrowing until a more stable interest rate environment returns.
As a result, the actual investment portfolio contains substantially more income-generating capital than the capital provided by IPO proceeds. Shareholders receive dividends from the entire portfolio. For more information, read my “Investing Under the Dome” article.
6. What about annuities, stable value funds, private REITs, income ETFs, and retirement income mutual funds?
Annuities have several unique characteristics, none of which make them good “investments”. They are excellent safety nets if you don’t have enough capital to generate enough income on your own. The “variable” variety adds market risk to the equation (at some additional cost), rendering the basic fixed amount annuity principles useless.
- They are the “mother of all commissions”.
- They charge a penalty that effectively locks up your money for up to ten years, depending on the size of the commission.
- They guarantee a minimum interest rate that you receive because they give you your money back over your “actuarial life expectancy” or actual lifetime, if it’s greater. If you get hit by a truck, the payments stop.
- You can make additional payments (i.e., reduce your payments) either to benefit others or to ensure that your heirs will receive something when you die; Otherwise, the insurance company gets the full balance when you check out of the program.
Stable value funds assure you the lowest possible yield you can get in the fixed income market:
- They include the shortest duration bonds to limit price volatility, so in some scenarios, they may actually yield lower returns than money market funds. Those with slightly higher yielding paper include an insurance “wrapper” that assures price stability at no additional cost to the annuitant.
- They are designed to reinforce the misguided Wall Street emphasis on market price volatility, the harmless and natural individuality of interest rate sensitive securities.
- If money market rates ever return to “normal,” these bad joke products will disappear.
Private REITs are the “father of all commissions,” illiquid, mystery portfolios, in many ways far inferior to the publicly traded variety. Take the time to read this article from Forbes: “One Investment Option to Avoid: Private REITs” by Larry Light.
Income ETFs and retirement income mutual funds are the second and third best ways to participate in the fixed income market:
- They provide (or track the prices of) a diversified portfolio of individual securities (or mutual funds).
- ETFs are better because they look and feel like stocks and can be bought and sold at any time; The obvious downside of most is that they are built to track indices and not generate income. BAB, BLV, PFF, PSK, and VCLT are some that produce marginally more than 4% (just for information and not exactly a recommendation).
- For retirement income mutual funds, the most popular (Vanguard VTINX) has a 30% equity component and yields less than 2% in actual expense funds.
- There are at least one hundred “veteran” tax-free and taxable income CEFs, and forty or more equity and/or balanced CEFs that pay more than any income ETF or mutual fund.
More questions and answers in Part II of this article…
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