People take on the risks of investing primarily for the chance to earn a higher return than what is offered in low-risk environments, such as an FDIC-insured bank account. Risk manifests in various forms, but for most investors, the primary concerns are credit risk and market risk, particularly when investing for income. Credit risk relates to the ability of corporations, government entities, or individuals to meet their financial obligations, while market risk involves the inevitable fluctuations in the market value of investments. You can reduce credit risk by choosing high-quality (investment-grade) securities and mitigate market risk through proper diversification, a solid understanding of how market fluctuations work, and having a clear plan in place to handle these changes. (For example, what does a bank do to generate the interest it offers depositors, and how does it respond to shifting interest rate expectations?)
You don’t need to be a professional investment manager to effectively manage your portfolio, but having a long-term strategy and understanding Asset Allocation—a tool often misunderstood and misused in the financial world—are crucial. You also don’t need fancy software or complex economic projections to align your investments with your goals. What you need is common sense, reasonable expectations, patience, discipline, and a bit of flexibility. The K.I.S.S. Principle (Keep It Simple, Stupid) should be the cornerstone of your investment strategy, and focusing on working capital will help you organize and control your portfolio.
Planning for Retirement
When planning for retirement, the focus should be on generating the additional income you’ll need from your investments. Your Asset Allocation formula (don’t worry, basic math will do) for reaching this goal will depend on three key factors:
- The amount of liquid investment assets you have today.
- The time remaining until retirement.
- The range of interest rates currently available from investment-grade securities.
If you resist overcomplicating things, this process can be surprisingly straightforward. Even if you’re young, you should focus on developing a steady income stream. If you keep your income growing, the market value growth of your portfolio will take care of itself. Remember: while higher market value can increase your portfolio’s worth, it doesn’t pay the bills.
Start by deducting any guaranteed pension income from your retirement income goal to estimate the income needed from your investment portfolio. Don’t worry about inflation yet. Then, determine the total market value of all your liquid assets—retirement accounts, company plans, IRAs, etc.—excluding non-liquid assets like your home or car. Multiply this total by reasonable interest rates (currently 6%-8%), and hopefully, one of the results will come close to the income you need. If you’re nearing retirement, it should be close! This exercise will give you a clear picture of where you stand, and that alone is invaluable.
Organizing Your Portfolio: Understanding Asset Allocation
The next step is deciding on the right Asset Allocation. This is a critical and often misunderstood concept. Many people confuse diversification with Asset Allocation, but they are not the same. Asset Allocation divides your investments into two primary categories: Stocks/Equities and Bonds/Income Securities. Most investment-grade securities will fit into one of these two groups. Diversification, on the other hand, is a risk-reduction technique that controls the size of individual holdings relative to the total portfolio.
There are also common misconceptions about Asset Allocation, such as thinking it’s a tool for market timing or a way to automatically shift investments from weak assets to strong ones. The reality is, Asset Allocation should not be altered based on short-term market movements. It is a long-term strategy that should only change in response to changes in your personal situation or financial goals, not due to fluctuations in the market.
Asset Allocation Guidelines
Here are a few basic guidelines to help you organize your portfolio:
- Base Asset Allocation Decisions on Cost Basis: The original cost of your securities matters more than their current market value.
- Income Securities Allocation: If your portfolio’s cost basis is $100,000 or more, at least 30% should be invested in income-producing securities (e.g., bonds). The equity portion should be concentrated in tax-deferred accounts (like retirement plans). For younger investors (under 30), it’s usually a mistake to put too much of your portfolio into income securities.
- Two Categories: Your portfolio should have clear allocations to either equities or income securities. Don’t get caught up in the details or try to split hairs with decimal points.
- Increase Income Allocation as You Near Retirement: As you approach retirement (about five years out), your allocation to income-generating securities should rise to meet your income needs.
- At Retirement: Between 60%-100% of your portfolio may need to be in income-generating securities, depending on your needs and goals.
Implementing Your Investment Plan
Implementing your investment strategy works best when you’re calm, decisive, patient, and disciplined. Successful investing is a long-term, goal-oriented, non-competitive process that doesn’t require a rocket scientist. In fact, overanalyzing can be a problem. To stay on track, establish simple guidelines for selecting and managing your securities. For example, limit equity investments to investment-grade stocks—those that are profitable, widely held, and dividend-paying. Avoid stocks unless they’re down at least 20% from their 52-week highs, and limit individual stock holdings to less than 5% of your total portfolio. Take profits regularly, and reinvest them wisely.
For fixed-income securities, focus on investment-grade bonds or preferred stocks with solid, but not excessive, yields. Avoid purchasing near 52-week highs, and keep individual holdings below 5%. For closed-end funds, positions may be slightly higher depending on the type. Again, take reasonable profits, and focus on income generation.
Monitoring Performance
Traditional Wall Street metrics for performance evaluation are often not helpful for goal-oriented investors. These metrics tend to emphasize short-term fluctuations and cyclical changes, which can lead to frustration and inappropriate decisions. The media exacerbates this by sensationalizing any extreme market event, making it difficult to stick to a plan.
Instead, base your performance evaluation on goal achievement—specifically, growing your base income, generating profits through trading, and increasing your overall working capital.
- Base Income: This includes the dividends and interest from your investments. It’s the reliable, growing stream of income that will keep you comfortable in the long run. Focus on growing this aspect of your portfolio, and use your cost basis as a benchmark.
- Profit Production: Volatility can be an advantage if you embrace trading. Successful investors know when to sell high-quality stocks that have appreciated and replace them with new opportunities. Treat your portfolio like inventory, and regularly “clear out” the old to make way for the new.
- Working Capital Growth: This refers to the total cost basis of your portfolio, which should naturally grow over time. The key is balancing the risk of trading with the stability of income-generating securities. As you approach retirement, reduce the equity portion of your portfolio to minimize risk.
Final Thoughts
The concept of an “income portfolio” is somewhat misleading. What you’re really managing is an investment portfolio that requires periodic adjustments to its Asset Allocation as you get closer to the point when it needs to provide you with reliable income. By focusing on growing your working capital (cost basis), treating trading as a conservative and acceptable strategy, and prioritizing income over market value, you can reduce the stress and complexity of retirement investing. This leaves you free to focus on more important matters, like tax reforms, healthcare, and spoiling your grandchildren!