The only real loss is a realized loss
by Steve SelengutMr. Selengut is a private investor and a contributor to LIFE&Health Advisor. He is the author of the book ‘The Brainwashing of the American Investor: The book that Wall Street does not want you to read.’ He can be reached at [email protected].
Apart from these important peripheral considerations, the risk of loss in any equity investment is generally greater than the risk of loss in any debt related instrument. The potential reward from each type is just the opposite, and that’s where all the excitement begins.
Do we risk more for the chance of a greater return, or do we risk less and try to preserve our investment capital? Keeping in mind that investment capital is a measure of cost, not of market value, and that the only real loss is a realized loss.
Typically, the older the investor, the more boring or income focused the portfolio should be — minimizing the overall level of risk. But it’s difficult to actively minimize or manage your risk in the “open end” mutual fund or passively managed ETF marketplaces.
What’s in your portfolio?
Risk minimization requires the identification of what’s inside a portfolio. Risk control requires decision-making by the owner of the investment assets. Risk management requires a selection process from a universe of securities that meet a known set of qualitative standards.
Product owners assume the added “fear and greed” risk of the general population, while their fund mangers stand aside and mumble about the opportunities lost in either direction.
Without a risk sensitive menu to select from, 401(k) participants need to minimize risk by: (a) avoiding the poor diversification that may be a requirement of their plan, and (b) developing outside income portfolios with any investable income above the employer matching contribution.
The first and most important management action focused on risk minimization in any “program” is the development of an asset allocation plan. The plan separates “liquid” investment assets into two buckets (Equity and Income) based on cost, not market value. No portfolio should have less than 30% in the income bucket — no ifs, ands, or buts.
And no investment plan should be developed “tax” or “cost” first. Risk minimization comes first, and then tax minimization if possible. Finally, transaction cost minimization can be considered if you are qualified to run your program yourself.
A cost based asset allocation approach (Working Capital Model) assures growing levels of “base income” throughout the portfolio development process and, possibly, into retirement. Income growth, by the way, is the only real hedge against that other economic risk, inflation — a buying power problem that has nothing to do with the market value of the income producing assets.
Minimizing investment risk is done best through the use of disciplined sets of rules for the various operations involved in managing a portfolio. Strict rules need to be developed for security selection, three types of diversification, income production, and for profit taking.
Taking advantage of change
Forget the Wall Street “I-can-fix-that” product menagerie. We’re not interested in massaging our market value to take the sting out of cyclical market value changes. Our plan is to take advantage of these changes as they unwind around us over time, and when they occur unexpectedly, causing short-term disruptions and dislocations.
In the securities markets (stocks and bonds), the real risk of loss can be minimized without products and futures speculations, without commodities and hedge funds, and without the ageda that most people experience throughout their investment lifetimes.
The old fashioned principles of investing: Quality, Diversification, and Income, plus disciplined, targeted, Profit Taking are the only hedges an investment portfolio needs to assure long-term success. Conveniently, the QDI+PT applies equally well to both classes of investment securities.
“Q” is for quality
If you study the long-term behavior of Investment Grade Value Stocks, and high quality income CEFs, you’ll discover that they hedge themselves quite effectively.
Risk is wrung out of portfolios by investing only in S & P, B+ or better rated, dividend paying, and historically profitable companies and then only when their equity prices are well below their 52-week highs.
“D” is for diversification
Absolutely never allow any position in your portfolio to exceed 5% of total portfolio working capital (i.e., the total cost basis) and never start a position anywhere near maximum exposure. You want to be able to buy more at lower prices.
Similar diversification rules apply to industry exposure and global diversification through the use of the mainly world class companies in the investment grade quality categories.
“I” is for income
Own no security that does not pay regular, dependable, dividends or interest. Regular and growing dividends are a quality indicator in equities. In the income “bucket”, seek out above average yields while avoiding those that seem either too high or two low.
Managed closed end funds do it best and provide easy “PT” and “buy more” opportunities. Buy established CEFs with long term “income” (not ROC) payment records.
“PT” is for profit taking
Absolutely always smile and take your profits willingly, net/net 7% to 10% (dependent upon available reinvestment possibilities and security class), and never, ever, look back. Trading this same body of securities, again and again, has been shown to sustain growth of capital and income consistently in a relatively low risk environment.
Market Cycle Investment Management With Ten Time Tested Risk Minimizers
In the recent financial crisis, a very small percentage of (I bought my house to live in) homeowners stopped paying on their mortgages. Still, the hysteria over the bursting housing bubble (i.e., lower market values) led to financial institution road-kill because of ridiculous accounting rules.
When the dot-come bubble destroyed “new economy” gladiators in a gory spectacle destined to repeat itself over time, what investment portfolios cheered unscathed from the coliseum bleachers?
If you reduce the amount of betting in your portfolio (and throw out politicians who don’t have a clue about the workings of free markets) you can safely navigate even the choppiest seas that the market, interest rate, and economic cycles roll your way.
The tide-like change of market values is the normal order of things, and until we embrace the cyclical nature of markets, all markets, our disappointment and disillusionment will continue. Portfolio market values will reflect where we are within the various cycles.
Interest rate sensitive securities (all bonds, government securities, preferred stocks, and relatively high dividend equities) vary inversely with interest rate expectations, most of the time.
Where we are in the interest rate cycle is fairly easy to determine, and you need to position yourself to take advantage of the higher rates that will sneak into the economic formula as the cycle moves further and further from its recent lows.
How do we prepare for higher interest rates? By designing the income bucket of the portfolio so that it refills itself with at least 30% of total portfolio realized income, and by owning income generating securities in a form that is easy to add to.