How To Be Prepared for Rising Interest Rates

I’ve seen a lot of discussions lately that erroneously conclude: “rising interest rates are something to be feared and prepared for” by buying short duration bonds or by liquidating income purpose securities entirely. Have they all gone mad!

A rising interest rate environment is super good news for investors… up to a point. When we loan money to someone, is it better to get the lowest possible rate for the shortest period of time? Stop looking at income investing with a “grow the market value” perspective. That’s not what it’s all about.

The purpose of income investments is the generation of income, and that goes for all forms of bonds, preferreds, government securities, etc. Control the quality selected, diversify properly, and compound that part of the income that you don’t have to spend. Bond prices are pretty much irrelevant since you spend the income and not the  market value.

Long, long, ago, many bonds were of the “bearer” variety; my father never owned any others. Each month, he went to the bank, clipped his coupons, cashed them in, and left the bank with a broad smile. If interest rates went up, he knew he could go out and buy new bonds to put larger coupon dollars in his pocket.

He had no reason to even consider selling the bonds he held — they were, after all, income purpose securities that had never failed to do their job. Market value never fluctuates (visually) if the securities are kept in the (mental) safe deposit box.

No, this is not at all what I’m suggesting to you as an investment… this is a mindset you need to embrace to become a successful income investor.

Even when your statement shows bond prices at chest-pounding wealth levels, the income generated hasn’t changed. And the profits your statement reports… really just another Wall Street illusion.

The thing dear old Dad thought about least was the market value of his bonds. This was his tax free retirement plan (one way or the other). He bought them for income, and the coupons were always redeemed without question. The only problem with the periodic decreases in market value was the inability to add to existing positions.

Before I move on to the simple solution to this non-problem, a word or two on the only real benefit of lower interest rates — there is none if you don’t already own individual, income producing, securities. If you own interest rate expectation (IRE) sensitive securities in a downward interest rate cycle, you will have the opportunity for what I call “income-bucket-gravy”.

This is the opportunity to sell your income purpose securities at a profit, over and above the income you’ve already banked. Income investors rarely are advised to do this, which is why they lament the thievery of higher rates. They didn’t sell at a premium, and now “actionlessly” watch the profits disappear.

This behavior achieves the lowest possible yields while pushing scared-silly investors into an overpriced market for short duration debt… the ultimate Wall Street “markup” machine, where brokers literally make more than bondholders.

The solution is simple, and has been used successfully for decades. Closed End Funds (scoff, laugh, and say “leverage makes them volatile” all you like) solve all the liquidity and price change problems… in a low cost, much higher income, environment.

Read that again, and again, until you get mad at your advisor.

Answer this question before you throw stones. Is 7% or more on a diversified, transparent, income portfolio, compounded over the past ten years and still growing income, better or worse than the 3.5% or less that most investors have realized in individual securities during the same time period… and then there are the profits that you never realized you could realize so effectively.

Of course CEF market values fell during the financial crisis, but at their peak in November 2012, they had gained nearly 18% per year since 3/9/09…. nearly outperforming the S & P 500. But speaking of “drawdowns”, what do you think the economic activity drawdown of near zero money market rates has been, particularly for “savings account” Baby Boomers.

Did the Fed’s messing around with short term interest rates help or hurt your retired relatives… really, think about it.

Rising interest rates are good for investors; so are falling rates. Fortunately, they routinely move in both directions. They can be traded quickly for exceptional results from “stodgy” income CEF portfolios.

So much for Total Return, short duration, and leverage-phobic thinking.

What if you could buy professionally managed income security portfolios, with 10+ years income-productive track records? What if you could take profits on these portfolios, for a year’s interest in advance, and reinvest in similar portfolios at higher yields? What if you could add to your positions when prices fall, increasing yield and reducing cost basis in one fell swoop?

What if you could prepare for retirement with such a powerful income engine?

Well, you ca do all four. but only if you add both higher and lower interest rates to you list of VBFs.

Can’t attend the next Income investing Webinar? Contact Steve Selengut for a FREE video.

To Rollover 401k Plan Assets or Not To… That Is The Question

The major purveyors of 401k products, and those who benefit from using them remind me of politicians… they press the party line, and use their power to demonize the competition.

Their position and deep pockets allow them to get their message out while we who have neither can only shake our heads and whimper about the sacred purpose of retirement income programs.

But, in the simplest of terms, since when has 2% been better than 6% (both after expenses)? The DOL, fiduciaries, and plan sponsors are staring back at me, eyes wide shut.

LinkedIn discussion groups have been talking about the pros and cons of 401k rollovers to private IRA portfolios. Most of the articles, and not by a slim margin, are institutionally biased advertisements for low cost Mutual Funds and ETFs, despite the fact that have absolutely no “preparation for retirement income bones” in their mass marketed bodies.

When the market corrects, the results will be what they have always been for market-value-growth-only programs. This time though, the DOL will fine the Plan Sponsors (i.e., the corporations so bitterly hated by our government), for allowing plan participants to make investment judgment errors with their own money plus the matching contributions…. let hindsight reign in the 401k space!

The 401k “space” as they call it, has become a lucrative product shopping mall, totally out of touch with what should be the long run purpose of these “quasi” retirement programs: it’s the monthly retirement income that pays the bills, Charlie Brown, not the market value.

If a person were a conspiracy theorist, he or she could make a case for institutional/congressional manipulation of interest rates… keeping them near zero so that gurus will continue to predict that stock market “returns” will outpace those of income purpose securities. Hmmm.

None, absolutely none, of the products provided by the top institutional peddlers produce nearly as much after “expense-ratio” income as Closed End Income Funds. These outstanding (and income paying far longer than any income ETF) managed portfolios are never, ever, found in 401k Plans… except the Self Directed, “safe harbor” variety.

Interestingly, all the major 401k product providers, also manage Closed End Fund product lines that generate generous income, even after higher fees. These fees, so important to regulators and politicians, are never paid by the recipients of the much higher income.

CEFS paying 6% to 9% after expenses are commonplace, but not available in 401k plans. Similarly, there are no restrictions on speculation in the equity markets, where similar high quality managed equity portfolios have been available for decades.

The retirement plan (401k) community has gotten so paranoid over goose-stepping DOL auditors and other regulators armed with crystal clear hindsight, that they have completely lost site of “spending money” as the be all and end all purpose of retirement portfolios. They must “outperform” half their brethren, and be dirt cheap to boot.

Yeah, I know that 401k Plans are not retirement portfolios, but neither the regulators, plan sponsors, congressional leaders, POTUSs, fiduciaries, or plan participants seem able or willing to accept that reality… why should they?

Looking inside the multi-billion dollar Vanguard 2020 TDF, we find 60% invested in equities (no less than 7000 individual positions) and income of about 1.5%. Wake up regulators… the “unfairness” is in the “emperor’s new clothes” products provided to the plan sponsors for inclusion in employee product menus.

You the fiduciaries, you the regulators, you the witch hunters, and you the do-gooders need to look at the product providers instead of their victims.

If you insist upon looking at investment plans as retirement programs (ERISA = Employee Retirement Income Act), perhaps you need to mandate that an outside-the-mainstream, “Self Directed”, income program be a major part programs you supervise. Until the focus changes from market value and expense control to after expenses income, these plans cannot provide what is expected of them… retirement readiness.

So in answering the “To rollover the 401k or not to rollover the 401k” question, I would say: “Run like _ _ _ _, just as fast as you can, to get out of that 401k and never ever buy a low income or no income security in the Rollover IRA you move to.

As long as plain vanilla portfolios of high quality equity (IGVSI companies) and Income CEFs yielding an experienced average, net/net 6% or more, are banned from participating in the 401k marketplace by (possibly) illegal monopolistic practices, rollovers to IRAs should be a requirement, not an option.

See how they run: https://www.dropbox.com/s/b4i8b5nnq3hafaq/2015-02-24%2011.30%20Income%20Investing_%20The%206_%20Solution.wmv?dl=0

As long as regulators are blaming generous employers for the investment mistakes of their employees, self-directed, income purpose, 401k plans are a much less scary, “almost a retirement plan”, option.

Retirement Income Investing: The Dreaded RMD

All of us are approaching retirement, many of us are already there, and some of us (myself included) are thinking about the ultimate IRS slap-in-the-face… The Required Minimum Distribution. It’s time to make sure that your retirement income program is actually ready.

Every investment program becomes a retirement income program eventually.

First off, you need to get to a place where you can say:

“a stock market downturn will have no significant impact on my retirement income”

This applies to everyone; income development is always important, and Tax Free Income (outside the IRA or 401k) is The Very Best. Only private “safe haven” 401k plans are capable of focusing on income development.

Retirement readiness requires active consideration of your asset allocation, your overall diversification, and most importantly, the quality of your holdings. Those of you who are relying on 401k assets to fund your retirement income requirements need to look inside the program.

If you are within five years of retirement, repositioning at the top of a stock market cycle (now) is essential; if you are in retirement, get your portfolio out of any employer plans and into your IRA… you just can’t protect yourself  (and especially, your income) in Mutual Funds or ETFs.

If you are approaching 70, the RMD is “in your face”… here’s how to handle it:

• Position the portfolio to produce slightly more income than you must take from the program.

• Take the income monthly and DO NOT pay the taxes in advance. Lump sum withdrawals require uninvested cash reserves and/or untimely sell transactions.

• Move the RMD disbursements into an individual or joint account and reinvest at least 30% in Tax Free Income CEFs.

• If you hold equities (in addition to the RMD income producers you need), set your profit taking targets lower than usual… and maintain the Cost Based Asset Allocation.

I’m relatively sure that some of you are currently dealing with the RMD incorrectly… with “lump sum + the taxes” distributions.

Some of you have been to my ongoing series of “live SRS portfolio review, Income Investing Webinars”.

Follow this link to the recording of the January 22nd private presentation and don’t hesitate to post it where ever you like… wouldn’t it be cool to have this presentation show up on YouTube.

https://www.dropbox.com/s/28ty6z5dkgn5ulu/Retirement%20Income%20Webinar.wmv?dl=0

The Microsoft Retirement Income Program

Reading Between the Lines

Once we recognize that all investment portfolios eventually become retirement income portfolios, we can begin to focus on the regular recurring income that they produce… retired or not, the market value of your private portfolio (or of your 401k plan) has no purchasing power.

Yet all 401k programs are performance evaluated on market value growth as opposed to income production.

In late 1999, Microsoft Corporation (MSFT) common stock was at an all time high of $58.38 (split adjusted), and there were thousands of MSFT multi-millionaires out there confident that their retirement was secure…. with a guaranteed monthly income of ?

Please send me an email with the amount of income produced by a million dollars worth of Microsoft in 1999… or your favorite ETF or TDF today.

Several years later, one of those millionaires, and a golf buddy of mine, disclosed that he had just sold the 7 series BMW he had purchased with the proceeds of his MSFT stock… the one “asset” he still had from his dot.com fortune. Pushing 65, he just couldn’t bear the memory any longer.

If only he had sold the entire portfolio… or converted enough to tax free Closed End Funds to assure a lifetime income.

Yet no 401k programs today will hold income Closed End Funds (yielding 7% or so right now). Why? Because, according to the Department of Labor, 2% after low expenses is better than 7% after higher expenses.

By September 2000, MSFT stock had fallen by almost 50%; nearly 15 years later, with the market near its highest numberl ever, MSFT (at $47.60) remains 18% below its 1999 level… it didn’t pay a dividend until 2003, and its dividend yield today is only 2.6%, after many increases.

Back then, most Mutual Fund portfolios contained MSFT and hundreds of similar NASDAQ securities…  and this was OK with all varieties of regulators and plan fiduciaries because the markets, after all, were trending upward.

MCIM portfolios contained no NASDAQ equities, no Mutual Funds at all, and a growing income component of at least 30%… hmmm.

It took more than 15 years for NASDAQ to regain its 1999 level… how many of the heroes survived?

Today, most Mutual Fund investment portfolios and ETF gaming devices contain 1999 Microsoft look alikes, and most pay very little income…

MCIM portfolios? Well, no… no Mutual Funds, and no ETFs, just IGVSI (NYSE dividend paying) equities, and an income CEF component of at least 40%.

Can you get an MCIM Income Purpose portfolio in your IRA… absolutely;  in your 401k…  it’s a long sad story.

What’s in your wallet?

Retirement Income Webinar Sign-Up

Dealing With Stock Market Corrections: Ten Do’s and Don’ts

A correction is a beautiful thing, simply the flip side of a rally, big or small. Theoretically, corrections adjust equity prices to their actual value or “support levels”.  In reality, it may be easier than that.

Prices go down because of speculator reactions to expectations of news, speculator reactions to actual news, and investor profit taking.

The two former “becauses” are more potent than ever before because there is more self-directed money out there than ever before. And therein lies the core of correctional beauty!

Mutual Fund holders rarely take profits but often take losses. Additionally, the new breed of Index Fund speculators is ready for a reality check. If this brief hiccup becomes a full blown correction, new investment opportunities will be abundant.

Here’s a list of ten things to think about doing, or to avoid doing, during corrections of any magnitude:

1. Your present Asset Allocation is based upon long-term goals and objectives. Resist the urge to decrease your Equity allocation because you expect lower stock prices. That would be an attempt to time the market. Asset allocation decisions should have nothing to do with stock market expectations.

2. Take a look at the past. There has never been a correction that has not proven to be a buying opportunity, so start collecting a diverse group of Investment Grade Value Stocks as they move lower in price. I start shopping at 20% below the 52-week high water mark… the shelves are full of bargains.

3. Don’t hoard the “smart cash” you accumulated during the rally, and don’t get yourself agitated if you buy some issues too soon. There are no crystal balls, and no place for hindsight in an investment strategy. Buying too soon, and selling too soon is investing brilliance.

4. Take a look at the future; you can’t tell when the rally will resume or how long it will last. If you are buying IGVSI equities now, you will to love the next rally even more than the last… with yet another round of profits.

5. As the correction continues, buy more slowly as opposed to more quickly, and establish new positions incompletely. Hope for a short and steep decline, but prepare for a long one. There’s more to “Shop at The Gap” than meets the eye, and you should run out of cash well before the new rally begins.

6. Your use of “Smart Cash” proves the wisdom of Market Cycle Investment Management; it should be gone while the market is still falling… gets less scary  every time. So long your cash flow continues unabated, the change in market value is just scary, not income (or life) threatening.

7.  Note that your Working Capital is still growing in spite of falling market values, and examine holdings for opportunities to reduce cost basis per share or to increase yield on income Closed End Funds). Examine fundamentals and price; lean hard on your experience; don’t force the issue.

8. Identify new buying opportunities using a consistent set of rules, rally or correction. That way you will always know which of the two you are dealing with in spite of media hype and propaganda. Focus on Investment Grade Value Stocks; it’s easier, less risky, and better for your peace of mind.

9. Examine portfolio performance with your asset allocation and investment objectives in focus and in terms of market/interest rate cycles as opposed to calendar quarters and years. The Working Capital Model allows for your personal asset allocation.

Remember. too, that there is really no single index number to use for comparison purposes with a properly designed MCIM portfolio.

10.  So long as everything is “down”, there is nothing to worry about. Downgraded (or simply lazy) portfolio holdings should NOT be discarded during general or group specific weakness.  BUT, you must have the courage to cull them during rallies… also general or sector specifical (sic).

Corrections (of all types) will vary in depth and duration, and both characteristics are clearly visible only in institutional rear view mirrors. The short and deep ones are most lovable (kind of like men, I’m told); the long and slow ones are more difficult to deal with.

If you overthink the environment or overcook the research, you’ll miss the party.

Stock Market realities need to be dealt with quickly, decisively, and with zero hindsight. Because amid all of the uncertainty, there is one indisputable fact that reads equally well in either market direction:

There has never been a correction or a rally that has not succumbed to the next rally or correction..

Why so much ado about interest rates?

Mal Spooner
Mal Spooner

Why the popularity of shorter-term interest-bearing securities among Canadians, in particular GIC investments?  In fact, we in Canada are not the only investors who seem satisfied investing our money knowing that the rate-of-return might just barely cover the rate of price inflation, with a significant risk of actually losing money if inflation should rise even modestly.  And it is not just people who are content with the arrangement between ourselves and the borrowers of our money – banks, insurance companies and credit unions alike – corporations have been hoarding cash since the Financial Crisis too.

This past summer, Statistics Canada reminded us that corporations in Canada continued to grow their cash hoard rather than invest the funds in their businesses.  Of course, like people, companies don’t actually hold cash, but rather invest the money in low risk short-term interest bearing securities, often in Government of Canada T-bills and bonds, as well as commercial paper offered by financial institutions.

At the end of the second quarter of 2008, corporations held $373.4 billion in cash balances (Statistics Canada November 17th, 2009 study: Indebtedness and liquidity of non-financial corporations).  By the first quarter of this (2014) year the number had grown to a whopping $629.7-billion. So why the stubborn tendency to tolerate a near-zero rate-of-return?

There are at least two factors at work in my estimation.  One has to do with the economics of interest rates in the current environment, another with human nature and demographics.

First of all, what is an interest rate?  It embodies three important expectations-related factors: Real returns, inflation and risk.  We all are reluctant to part with our cash unless we’re able to earn what economists call a ‘real’ return.  Ask yourself, what rate-of-return would make you happy if there was essentially no risk (default, volatility) to speak of and no price inflation.  Whatever you buy today, will in theory cost you the same price next year and every year after that.  Most agree that the very long-term real rate of interest is somewhere between 2% and 4%.  Real Rates Canada 2004 to 2014However, you can easily see from the graph that the real rate of return provided by Government of Canada (as low risk as you can find) long-term real return bonds over the past ten years has been driven down since the Financial Crisis, as all governmental central banks strove to fight disinflation by dampening the general level of interest rates.

Has the return we expect from lending our funds really adjusted downward, or is it that the availability of securities providing the returns we normally demand has changed?  My guess is most folks would agree that the adage ‘once burned, twice shy’ aptly summarizes our tendency to be  biased by recent experience.  It is human nature to be sensitive to bad or good things that have just happened and to oftentimes unreasonably expect them to continue.  Also, we are confronted by a lack of options.  Securities available to us are not promising the rates-of-return we want, given the amount of risk we are prepared to stomach.

In fact, a quick look at one of many high-dividend oriented ETF’s, the iShares Core S&P/TSX Composite High Dividend Index ETF suggests that a collection of dividend paying stocks yielded 4.31% (as of October 2, 2014) over the past (trailing) 12 months.  As a bonus, the tax treatment of dividends is more generous than it is for interest income.  Indeed the stock market has done perhaps too well over the last few years, but judging by the massive dollars invested in short-term securities those equity returns have not been earned by everyday people. The issue is people just don’t seem to want the volatility that comes with investing in stocks; even when the selection of stocks is less risky than the overall stock market.  A real return with some risk is less attractive than no return at all, and it has been like this for quite awhile now. The second ingredient to interest rate levels is inflation expectations.

Source: Bank of Canada
Source: Bank of Canada

Admittedly, we haven’t seen a whole bunch of price inflation have we?  Central bank policy around the world has been more interested in creating some inflation, fearing that disinflation would prove devastating to our economic welfare.  These efforts are in fact evidenced by the historically low level of administered interest rates we have.  If our collective expectations concerning future price inflation are significantly different from what we are experiencing then our behaviour will reflect it. Could it be that the extraordinarily high commitment to GIC’s and equivalents is that Canadians, and Americans are doing it too, are content to simply keep their money (even at the risk of a small loss) intact until rates of inflation and returns get back to levels they think they can believe in?

The third important determinant of interest rate levels is our toleration for risk, and it exists in many different forms.  Our appreciation for the risk of default was certainly modified during the Financial Crisis; and in short order we’ve been willing to tolerate none of it.  We’ve turned a blind eye to significant stock market appreciation and even bond returns preferring to ‘check’ rather than ‘raise’ and ‘all in’ has certainly been out of the question.   But this intolerance to take risk has become very sticky at the individual level and at the corporate level.  This might have more to do with demographics than anything else.

Younger people are quite surprised to learn that real interest rates got as high as 6% – 9% during the mid-1980’s, and during the 90’s and up to the turn of the millennium ranged around the 4% level. (Source: I was there!)  There is a large proportion Canadians who lived through those times.  According to Statistics Canada there is roughly an equal number of young people as there are older people.  Ratio of old to young in CanadaHalf of us in Canada might consider those times ancient history (or have no interest at all in history), and the other half feel as if it was just yesterday that mortgage rates were in the double digits.

These more seasoned citizens look at the rates of return offered by the bond market and similar investment vehicles and say to themselves: “Hey, if I buy a longer term bond, I’m earning next to nothing anyway, so I’ll just put money into shorter term GIC’s and term deposits that are effectively earning nothing and avoid the risk of having my money tied up.”  Having experienced periods of rising inflation and higher real rates, they (and yes, I’m a member of that distinguished group) are inclined to wait until more generous returns come back – if they ever do come back.  And don’t forget, these same folks might actually have to spend their savings sooner rather than later suggesting that any risk of a big loss in the stock or bond market is simply untenable.

Most people when they think of Canada bonds, immediately think of Canada Savings Bonds.  They are not the same at all.  Normal Government of Canada bonds, held in mutual funds and pension plans for example, rise and fall in value as interest rates change.  Although we’ve been through a very long stretch of falling interest rates, which made bond prices steadily go up in value, there have been and will be periods when interest rates rise and people lose money in bonds.  It is smart to learn how the time value of money works and how and why bonds can make or lose money.  There is a plethora of online videos that can help you understand bond valuation and the investment in your time to learn bond dynamics is well worth the minimal effort.

The yield curve is simply a plot of interest rates corresponding to varying maturities at a point in time.  Ordinarily, we expect to earn higher returns the longer our money is lent to someone else.  GIC rates are lower when the hold period is 3 months than they are when your money is tied up for 3 years.  The same should be true for bonds.  But consider where we’ve come from:  US Treasury Dept. Yield CurvesThe graph shows the yield curves for US Treasury bonds as of October 2007 compared to the same today.  The 2007 yield curve reflects the uncertainty at that time about, well almost everything.  We didn’t know if we should accept lower rates for shorter investments or high rates for longer term bonds so the curve was somewhat flattish.  What would inflation be?  Which financial institution would be solvent?  Would the US government even be solvent?  Many questions but few answers in the midst of the financial turmoil.

The more current yield curve reflects today’s reality.  The only interest rates we can earn in the short-term are hovering close to zero, and since longer-term risk-free bonds are paying us barely one percent over inflation why assume the added risk.  If interest rates do rise from these low levels, then you will certainly lose money owning the longer-term bonds.

In a nutshell, people have doing what they should be doing – seeking shelter and waiting it out.   A side-effect of this behaviour is that our willingness to tolerate no return for lots of safety has stalled the return to financial market normality.  By stubbornly remaining in GIC’s, term deposits and money market funds we are inadvertently delaying what we desire – a decent return for taking some risk.  It’s only when money moves freely and to a large extent greedily that financial markets function properly.  This presents quite a conundrum for policy makers around the world, who’ve been praying that businesses invest in business instead of hoarding their cash, and people begin spending more and taking on more risk by investing their savings in more diverse ways.

There are many pundits who have suddenly jumped on the bandwagon predicting a stock market meltdown and impending bond market rout.  If they are right and this happens then we might finally get what we want after-the-fact; returns that compensate us fairly for inflation and risk.  In fact the stock market is suffering of late, and a shift (or rather, twist)  in the yield curve is already causing some havoc for bond managers.  The longer-term rates have declined rather than risen as expected, and mid-term bond yields have surprisingly risen – causing grief even for gurus like Bill Gross, who co-founded PIMCO and until recently managed one of the world’s largest bond portfolios.

If investors have been doing the right thing to feel secure, what should they be doing next?  Over my own lengthy career I’ve found that at some point it is important to combat inertia and begin moving in a different strategic direction.  As stock prices adjust downwards, take advantage of what happens.  The dividends paid on the increasingly lower stock prices become more attractive quickly, and remember they are taxed at preferential rates.  The world economy may continue to grow at only a snail’s pace, so why not test the waters so to speak and begin putting some funds into longer-term interest-earning bonds.  If inflation does creep up and interest rates increase some, then put even more funds to work at the higher yields.    Having done the safe thing during turbulent times, perhaps it’s time to do the smart thing.  Experience teaches us that the best time to be doing the smart thing is almost always when it is most difficult to do it.  The longer you earn nothing, the poorer you get.

 

Inside Modern Portfolio Theory – For Emperors Only

Maybe it’s just me, but when I hear “Monte Carlo”, I can’t help but think “casino”…

My previous article post dealing with the income growing opportunities of 401k account “drawdown” elicited some interesting commentary from the MPT community.

Apparently, if we apply the proper mathematical algorithms to all stock market probabilities, including all possible cash flow scenarios, we will be able to deal with 401k participant expectations better…

I can’t control the warmth and fuzziness that has taken over my financial feelings… future predictions that possibly, maybe even more often than not, can reduce my drawdown to a less painful level than otherwise, while doing nothing to boost the income generated by my portfolio is certainly bringing on a huge sigh of relief…

What!

I’m the type of investor who cringes when he hears market analysts explain how investors are “placing their bets” but how can you possibly sleep at night when you know that your 401k selections are “probably” being designed using the “Monte Carlo” algorithm subset of Modern Portfolio Theory?

Check it out if you wish, but if you aren’t rolling-on-the-floor, LOL, when you finish, have I got a new suit of clothes for you: http://en.wikipedia.org/wiki/Monte_Carlo_method

How many soontobe retirees (including myself, eventually) would even pretend to understand it. Really, a show of hands would be appreciated. How many of you think that these probability games are “investing”.

Retirement income is not (and should not be) about gambling. A fundamentally sound (i.e., quality) portfolio that generates 6% or so income (tax free, even) is easy to put together… yes, in today’s low interest rate environment.

4% to 5% in the 401k space, convertible upon rollover to the 6% variety is doable as well. You need to make a market value drawdown an opportunity to grow the income… faster.

Once the retirement income has been secured, then you can tour the world’s casinos until the excess capital is gone.

The MPT portfolio that bursts like a 4th of July “finale” in my weakened brain is reminiscent of the magical Junk Bond Portfolios of the ‘1980’s.  Don’t worry  about it, investors, we’ve put all these fundamentally speculative securities together in such a brilliant manner that the sum of the junk has been transformed into non-junk.

As of August 31st, 2014, the Vanguard Target 2015 portfolio was still 51.8% invested in the World’s Stock Markets and generating less that 2% in spending money…

Yes, it is true, the inmates really have taken over the asylum.

401k Drawdown… OMG

“Drawdown” has become the most feared word in the 401k vocabulary, just as “Total Return” has become the most worshipped phrase. OMG, how will plan participants be able to retire if their portfolio market values stop rising!

“Well, yeah,” you might say, “isn’t that what investing is all about. If you’re in the right sectors and the right funds, your drawdown will be minimized.” Well , yeah, that could be a viable drawdown minimization scenario if we had a crystal ball that could identify the “right” vehicles.

We don’t, and a litany of supportive sector correlation statistics just doesn’t change the basic facts of investment life that still are referred to respectfully by some as the “Market Cycle”.

Can you remember how easy portfolio management once was, simply by applying basic “QDI” principles to portfolio content selection and profit taking disciplines? It was a time when navigating an investment portfolio through the unpredictable, cyclical, undulations was indeed, a labor of love and respect for economic fundamentals… with strategies based on cyclical realities.

MPT charlatans, with “Frankensteinian” creativity, have transformed text-book-defined speculation into a passive sector-timing process based on probabilities… games of chance yet to be tested through any form of market correction.

In a program with no promise of income and no concern for fundamentals, is it any wonder market value drawdown is so feared.

Place today’s ETF and Mutual Fund equity content into the three Major Meltdowns of the past 30 years, and it’s likely that you’ll see the very same drawdown numbers… or worse, because of the artificial demand for a finite supply of real securities.

Drawdown happens; corrections are inevitable. The same MPT hocus pocus that, theoretically, is placing 401k dollars in the right sectors is, perversely, exacerbating the problem by blowing up the highest security price balloon ever, even higher.

Keep in mind as well, advisors and fiduciaries all, while we wonder at the brilliance of those who have created this ethereal (surreal), market fantasy land, that it is they (not you and I) that wield the fatal “pin”.

When the bubble bursts, remember these thoughts:

Drawdown minimization is accomplished by: investing only in “investment grade”, high quality, securities (fundamentally speaking); then diversifying among them sensibly within two “purpose delimited” security buckets; and regarding realized “base income” as the primary purpose of the income allocation and the secondary purpose of the equities.

With strict buy, hold, and reasonable profit-taking disciplines governing portfolio operations, drawdown minimization, continual income growth, and rapid recovery is virtually a sure thing… a sure thing that isn’t possible in a 401k environment that has kicked fundamental quality and income growth principles to the curb.

Retirement Preparation 101

Prompted by a recent article in “Financial Planning” entitled “For Retirement Portfolios, a Smarter Glidepath”… several points in the referenced “conventional wisdom” have fingernails on chalkboard quality.

The use of “stocks” in retirement to help with portfolio growth and to keep up with inflation is the first. The main thrust of a retirement program is (should be, anyway) the generation of income… closed end income funds do this better (and historically safer) than anything else.

If there is enough income (defined as more than the retiree needs for regular monthly expenses), the transition to retirement can be easy without ever being overly concerned with market value.

If a retiree spends a max 70% of the dividend and interest (“base”) income, it’s easy to grow both the portfolio market value (which you can’t spend) and the income (which you can)… thus keeping up with inflation, something we haven’t been allowed to see a glimpse of for years.

Only when there is enough income should equities even be considered in a retirement portfolio. Stocks have nothing whatsoever to do with inflation … a measure of buying power. More income dollars = more buying power. More market value tends only to encourage excessive spending.

Another myth is “today’s low interest rate environment”… totally not true in the land of income CEFs and even some income ETFs… tax free CEFs are paying (they have been for years) over 6% on average, with taxable funds paying much more.

A retirement “glide path” that increases equity exposure “to improve total return outcomes” is another dose of illogic that stems from the idea that the market price of income securities is even more important than the income the securities produce.

It just ain’t so… ever. Take the example of the financial crisis. Investors who held income CEFs (particularly the tax exempt variety) never saw a change in spending money, while the reinvestment of the “at least 30% of the income” rule mentioned above allowed them to add to their holdings… growing yield, growing income, and reducing cost basis per share.

The problem is that the search for the holy (market value) grail makes pre-retirement investors forget the purpose of their retirement portfolios (i.e., it’s the income, not the market value).

The problem this market value, total return, focus brings to the 401k space is the millions of pre-retires, appendages crossed, genuflecting frequently, praying that their market value will be stable. Somehow their standard of living will be maintained with realized income in 2% to 3% range… so let’s add more stocks, the article suggests, because they will go up in price better than income securities.

My hope is that the vast majority of Financial professionals will reject this lunacy… no matter how you slice it, higher, even stable, market value may float your boat, but it won’t produce the income needed to run it.

A wise man once defined true wealth, not as the ability to accept financial risk, but as the ability not to need to. Wise men in the 401k 3(38) fiduciary space can be found at Expand Financial and QBox Fiduciary Solutions.

Total Return: Smoke and Mirrors?

Just what is this “total return” hoop that investment managers are required to jump through? Why is it mostly just smoke and mirrors? Here’s the formula:

  • Total Income + (or -) Change in Market Value – Expenses = Total Return — the ultimate test for any investment portfolio.

Applied to income purpose portfolios, it is really close to nonsense, and confusing to most investors.

Remember John Q. Retiree? He was the guy with his chest all puffed up one year, bragging about the 12% “Total Return” on his bond portfolio. Secretly, he wondered about having only 3% in actual spending money.

A year or so later, he’s scratching his head wondering how he’s going to make ends meet with a total return that’s approaching zero. Do you think he realizes that his spending money may be higher?

What’s wrong with this thinking? How will the media compare mutual fund managers without it?

Wall Street doesn’t much care. They set the rules and define the performance rulers, and they say that income and equity investment performance can be measured with the same tools. They can’t, because their investment purposes are different.

If you want to use a ruler that applies equally well to both classes of security, just change one piece of the formula and give the new math a name that focuses on the actual purpose of income investing — the spending money.

We found this old way of looking at things within “The Working Capital Model”; the new and improved formulae are:

  • For Fixed Income Securities: Total Cash Income + Net Realized Capital Gains – Expenses = Total Spending Money!
  • For Equity Securities: Total Cash Income + Net Realized Capital Gains – Expenses = Total Spending Money!

Yes, they are the same, and divided by the amount invested, they produce a Total Realized Return number. The difference is what the investor elects to do with the spending money.

So if John Q had taken profits in year one, he could have spent more, or added to his income production. You just can’t spend (or reinvest) “Total Return”.

We’ve taken those troublesome paper profits and losses out of the equation entirely. “Unrealized” is “un-relevant” in a properly diversified portfolio comprised only of investment grade, income producing securities.

Most of you know of Bill Gross, the Fixed Income equivalent of Warren Buffett. He manages a humungous bond mutual fund, but how does he invest his own money?

According to a NYT Money and Business article by Jonathan Fuerbringer (January 11, 2004), he’s “out” of his  own Total Return fund and “in” Closed End Muni Funds paying 7.0% tax free. (Must have read “The Brainwashing of the American Investor”.)

Fuerbringer doesn’t mention the taxable variety of CEF, then yielding roughly 9%, but they certainly demand a presence in the income security bucket of tax-qualified portfolios like 401ks. Sorry, can’t do that now. The omniscient DOL says the net/net income isn’t nearly as important as the Expense Ratio….

Similarly, Mr. Gross advises against the use of the non investment grade securities (junk bonds, etc.) that many fund managers  sneak into their portfolios.

But true to form, Mr. Gross is as “Total Return” Brainwashed as the rest of the Wall Street institutional community, as he gives lip service validity to speculations in commodity futures, foreign currencies, derivatives, and TIPS.

Inflation impacts buying  power, and the only way to beat it is with higher safe income. If TIPS rise to 5%, REITS will yield 12%, and preferred stocks 9%, etc. No interest rate sensitive security is an Island!

As long as financial intellectuals remain mesmerized with total return numbers, investors will be the losers.

  • Total Return goes down when yields on individual securities go up, and vice versa. This is a good thing.
  • Total Return analysis is used to engineer market timing decisions between fixed income and equity investments, based on statements such as: “The total return on equities is likely to be greater than that on income securities during this period of rising interest rates.”

Investors have to commit to the premise that the primary purpose of income securities is income production… this requires a focus on spending money.

If these three sentences don’t make complete sense to you, you need to learn more about income purpose investing:

  • Higher interest rates are the income investor’s best friend. They produce higher levels of spending money.
  • Lower interest rates are the income investor’s best friend. They provide the opportunity to add realized capital gains to total spending money and to total working capital.
  • Changes in the market value of investment grade income securities are totally and completely irrelevant, 99% of the time.