Income investing made easy, Pt. 1Article added by Steve Selengut on February 15, 2011
Ranked: #743 (138 pts)
There's nothing like a credit crunch, combined with a meltdown in financial derivatives, a brokerage firm collapse/bailout, and an unprecedented mess in the mortgage market to make the point: income investing is just too easy. Similarly, there's nothing like real-life decision-making to drive home a much more interesting point: Income investing is incomprehensible to the average investor.
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. For example: 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,
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.
2. The amount of time until retirement, and
3. The range of interest rates currently available from investment grade securities.
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 percent to 8 percent 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’d 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 rebalancing.
The asset allocation formula itself is sacred, and if constructed properly, should never be altered due to conditions in either equity or 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.
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.
2. All investment portfolios should have a minimum of 30 percent invested in income securities.
3. From retirement age minus five years, 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.
In fact, being too smart can be a problem if you have a tendency to overanalyze things. It is helpful to establish guidelines for selecting securities, and for disposing of them. For fixed-income investing, focus on investment grade securities, with above average but not the "highest in class" yields.
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