Investing In Retirement – Generating Current Income

Today we reach the final post in the series on investing.  We have followed our young investor, Fred, from the time he was young and had little money, through his mid-life where he started to build up enough of a portfolio to begin to protect it through diversification, and then into his retirement years.  He is now starting retirement and needs to start using his retirement account to generate income for him to live on.

The goal of investing when living off of an account is to make enough income from the account to maintain the balance and live off of the interest.  There must also be a growth aspect to the account to keep the income level risiing enough to keep up with inflation.  Ideally one would like enough cash to be generated from income and dividends to meet monthly expenses. 

This used to be a fairly simple thing (provided that the account was large enough.)  One could just select a set of dividend paying stocks such as utilities, buy a few bonds, and then collect the dividend checks.  One never needed to sell stocks to raise cash or touch most of the holdings at all.  When interest rates on bonds were in the 8-10% range, and stocks paid 5-8% dividends, one could easily generate $50,000 per year on dividends and interest with a million dollar account.

Unfortunately interest rates are currently too low to generate enough income to make this strategy work.  This is because the Federal reserve has lowered interest rates to near zero due to our real-estate bubble bursting, as the Japanese did in the 1980′s when their real estate bubble burst.  Unfortunately, we’re having about the same sort of luck the Japanese did, so interest rates may stay low a long time.

If interest rates do move back up, the typical retirement investments — those that pay a good dividend — are:

1.  Utilities – Because utilities are typically not in a growth phase, but instead simply collecting money from rate payers and distributing the profits to shareholders, utilities typically pay good dividends.

2.  REITs - Real Estate Investment Trusts hold a portfolio of real estate, typically concentrated in a certain type.  For example, there are REITs that focus on office buildings, apartment buildings, shopping malls, and even cell phone towers.  These generally generate good income from rents that are passed along to shareholders.

3.  Limited Partnerships – These trade like stocks and are typically tied to some income-producing source such as a big steel ore pit or a set of oil distribution lines.  Much of the income received is passed to the partners.

4.  Preferred shares – These are special shares of stock that a company issues when it wants to raise money for some purpose.  They typically pay a large dividend and can have special features like the ability to convert to common shares at some ratio.

5. Bonds – These are loans made to companies and pay interest twice per year and at some point in the future return the principal to the lender (the bond holder).  If interest rates do spike because inflation picks up, as it did in the 1970′s, one could be set for retirement by buying into bonds paying very high rates and then holding onto them as interest rates subside.  Bonds are currently paying too low a rate right now, however, due to the low-interest rates on government securities, to be worth the investment.

Because interest rates are low, one must be more creative to earn a return from a portfolio.  Some options are:

1.  Continue to hold a set of index funds and sell some shares periodically to raise cash.  This unfortunately requires selling stock and is subject to market fluctuations, but by keeping enough cash-on-hand to cover expenses for a five-ten year period, risk can be cut substantially.

2.  Write covered-calls to generate income from stock holdings.  This requires a bit of time since positions must be resent every couple of months, but can cause any stock to generate an income.  There are also some management companies that will perform this function for the investor.  Note one must be careful to maintain sufficient diversification while employing this strategy.

3.  Buy rental properties that generate rental income.  This is not the best option since it either requires one to become a landlord/repair man or hire a manager who will take a substantial amount of the profit, but it is a way to raise an income for those who enjoy real estate.  Fortunately, rents are currently fairly high since there are so many renters.

This is part of a series of posts on How to Make Returns that Beat the Market that starts here: http://smallivy.wordpress.com/2010/08/31/a-strategy-for-market-beating-returns-in-the-stock-market-introduction/

See the rest of this series: http://smallivy.wordpress.com/category/making-market-beating-returns/

Much as I enjoy writing about investing, it doesn’t make sense unless people are reading. If you’d like to keep the articles coming, please return often and refer a friend – http://smallivy.wordpress.com.  Comments are also greatly appreciated, as is lively and friendly debate.  Also feel free to link to or reference posts – all I ask for is fair credit.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

How to Structure a Retirement Portfolio and Preserve Funds to Last Out Retirement

 Today we reach the final posts in our series on Making Market Beating Returns – Setting up a Retirement Portfolio.  Hopefully the investments of our hypothetical investor, Fred, have worked out and he now has several millions of dollars.  He is nearing retirement age and wants to be able to live on his portfolio for the rest of his years.  An employee who receives a large amount of money as a lump sum from a pension plan or a 401K plan would be in the same situation.

In retirement, the goals are to 1) preserve funds so that they last through the remainder of your life and 2) generate current income for living expenses.  We will address each of these items separately.  In today’s post we’ll address how to preserve funds.

There are actually three things that funds must be protected against in retirement.  The first is that the value of the portfolio may drop due to market fluctuations.  The second is that the portfolio be exhausted through spending before the end of one’s life.  The third is that inflation wastes away the value of the portfolio, forcing one to lower one’s standard of living. 

Protecting a portfolio against drops in value is done through 1)holding sufficient reserves in cash (money funds and CDs) to pay for near-term expenses, and 2) diversification for money not needed immediately.  Money that will be left alone for many years should be invested in assets that provide a sufficient return to make up for inflation, such as stocks, bonds, and real estate.  But because the stock market (and bond market and real estate market) has good years and bad, it is not safe to be fully invested when money will be needed for expenses.  One does not want to need to withdraw money from the stock market just after a big sell-off to pay for living expenses.  For this reason money needed for the next five years should be kept in cash instruments.  Looking at the 2008 bear market, one would have been in bad shape if one needed to sell stocks at the end of 2008 to pay for food and rent, but if funds remained invested while other cash reserves were spent the losses experienced in 2008 would have been largely erased by the strong rally of 2009.

For money not needed immediately, say money that will not be needed for the next 5-10 years, keeping these funds in cash instruments will cause spending power to be lost to inflation.  These funds should therefore be invested in common stocks, bonds, and real estate (either directly or through REITs).  These funds should be well diversified – spread over several different mutual funds, types of assets, and areas of the market - to reduce the risk of large losses in value.  The goal here is not to beat the market but instead to simple make market returns while reducing the chances of loss of capital as much as possible. 

A good rule-of thumb to prevent exhausting one’s funds is to not spend more than about 8% of the value of a portfolio during any given year.  (Note that this allows one to calculate the amount of money one needs to save up for retirement.  If one can spend up to 8% of the value of the portfolio each year,  one’s savings should be about 12 times the needed yearly income in retirement.)  To understand this withdrawal rate, assuming that the portfolio will grow at about 10-12% each year (the historical growth rate for equities), as long as no more than 8% of the portfolio is withdrawn during any given year, the return of the portfolio should be enough to provide sufficient income and make up for losses due to inflation.

An issue with the above methodology, however, is that while the average return for a diversified portfolio of stocks is 12%, this includes some great years in which the market surges 30% and some bad years when the market falls by 10-15%.  A better strategy would be therefore to:

1) Determine how much yearly income is needed for yearly expenses and start with five years worth of cash-on-hand.

 2) In years when the portfolio increases in value more than 4%, take money out any amount over the 4% growth rate.  For example, if the portfolio increases in value by 10% in a year, 6% could be withdrawn.  This would be done until ten years-worth of expenses are in cash-in-hand,

3) On years when the portfolio value is not up at least 4%, do not take any money out unless less than 3 years-worth of expenses is available in cash-in-hand.   In that case enough money would be withdrawn to regain five years’ worth of cash.

By following this strategy one would be able to sell when the market is high but still maintain enough cash-in-hand to ride out any down years.  This should keep one’s initial assets intact while providing enough income from those assets for living expenses.

Note that living expenses should include 1)health care expenses, 2) food, clothing, and utilities (hopefully shelter will be paid for), 3) upgrades and repairs to the house and purchase of cars, 4) money for any leisure activities or travel, and 5) long-term care insurance.

This is part of a series of posts on How to Make Returns that Beat the Market that starts here: http://smallivy.wordpress.com/2010/08/31/a-strategy-for-market-beating-returns-in-the-stock-market-introduction/

Link to next post in series: http://smallivy.wordpress.com/2010/09/23/investing-in-retirement-generating-current-income/

See the rest of this series: http://smallivy.wordpress.com/category/making-market-beating-returns/

Much as I enjoy writing about investing, it doesn’t make sense unless people are reading. If you’d like to keep the articles coming, please return often and refer a friend – http://smallivy.wordpress.com.  Comments are also greatly appreciated, as is lively and friendly debate.  Also feel free to link to or reference posts – all I ask for is fair credit.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

Mid-Life Investing – How to Diversify and When to Start to Diversify

 In this post I’ll continue with the steps for investing.   This is part of a series of posts on How to Make Returns that Beat the Market that starts here:

http://smallivy.wordpress.com/2010/08/31/a-strategy-for-market-beating-returns-in-the-stock-market-introduction/

Earlier posts in this series dealt with an individual in his (or her) early twenties or thirties who was just starting to invest.  This individual was being smart in his financial life – having no credit card debt, renting or buying a house with 20% down and a payment of no more than 25% of his take-home pay.  He was also putting money away regularly in his work’s 401K plan and perhaps a personal IRA on the side.  Because he had relatively little to invest, he had little to lose.  This, combined with a long time horizon that allowed for recovery from mistakes and just plain-old bad luck meant that he could be aggressive with his stock investment.

Being aggressive did not mean being foolish.  He would still invest in a way that would put the odds in his favor.  This included investing for the long-term where growth in stock price could be expected to follow the growth in intrinsic value of the stock he was buying.  Likewise, he was buying shares only in companies with steady earnings growth, good management, and room for continued growth.  He wasn’t trying to time the market or playing various games since he knew that those games were stacked against him. 

The risk he was taking was concentrating his holdings in a few great stocks rather than spreading his money out over several stocks or buying an index fund or mutual fund and just accepting market returns.  He was concentrating his investments in a few companies that he believed would outperform their peers over the long-term.  Because bad things happen to even good companies — officers steal money or cook the books, new regulations are created that hamper the business, competition emerges that takes a large amount of the company’s market share, or they drill a hole in the bottom of the ocean and kill everything in the area he is taking the risk that one of his selections could decline substantially in value.  The price of the shares of any individual company can decrease rapidly or even become worthless in a short amount of time. 

Likewise, while the entire market does not increase in value that rapidly, averaging about 10% per year, it is not uncommon for individual stocks to double or even quadruple in the period of a year.  If one is fairly good at picking stocks, one can therefore make up for one or two bad stocks that go nowhere or even disappear  with one great stock that goes up twenty-fold over a period of 10-20 years.  In the early stages, our young investor is trying to find one of these stocks to make his meager holding grow rapidly.

As this investor continues to buy shares, however, he should reach a point where he does have enough money to protect it.  He may have 5 of 6 large positions worth about $50,000-$100,000 each, with an account balance of about half a million dollars.  (One should also note that an investor who starts with a large account would apply the same strategy that follows by only investing a portion in individual stocks).  At that point he should start diversifying his holdings to reduce risk.  As stated before, diversification reduces risk because holding a basket of stocks or other investments reduces the damage done by the collapse of any one asset and  the advances by some stocks in the portfolio will offset the losses by other stocks.

The amount of security depends on two factors:  1) The number of different positions held, up to a limit of about 50-100, and 2) the amount of covariance among the holdings. 

To achieve a larger number of positions, the easiest method is to take a portion of the portfolio and put it into mutual funds.  Because their cost is low and they perform as well as most managed funds, index funds are a good choice.  To determine the amount of funds to put into index funds, simply use your age.  If you are forty, you should have about 40% of your funds in diversified mutual funds.  When you are sixty, you should have about 60% of your funds diversified into mutual funds (with about 5 years’ worth of expenses in cash as well).

The covariance is a factor that determines how the different assets you hold tend to move in the same direction.  Two holdings with a covariance of 1 would move in lock-step.  Likewise, two with a covariance of zero would move with no relationship.  Finally, two with a covariance of -1 would move in exactly opposite directions where one would go down 10% if the other went up 10%.  Ideally, covariance should be about zero aqmong the various holdings in a well diversified portfolio.

To achieve a portfolio of assets with low covariance, buy funds in different asset categories.  For example, buy a large cap fund, a small cap fund, a bond fund, an international stock fund, and a real estate fund (REIT).  One could also toss in a commodities fund in small amounts if inflation was a concern.  Buy some funds that pay a large dividend (ideally hold these in an IRA to protect yourself from taxes) and buy others that pay almost no dividend but hold a large number of growth stocks.  You can also select managed funds that try to buy based on value (an example would be a “Dogs of the Dow” fund ) and another that invests based on momentum.

In the next post we’ll look at what to do as our investor nears retirement age and need to start setting up the portfolio to live on.  Next post in series: http://smallivy.wordpress.com/2010/09/21/how-to-structure-a-retirement-portfolio-and-preserve-funds-to-last-out-retirement/

This is one of a series of posts in the category of ”Making Market Beating Returns.” See the rest of this series: http://smallivy.wordpress.com/category/making-market-beating-returns/

Much as I enjoy writing about investing, it doesn’t make sense unless people are reading. If you’d like to keep the articles coming, please return often and refer a friend – http://smallivy.wordpress.com.  Comments are also greatly appreciated, as is lively and friendly debate.  Also feel free to link to or reference posts – all I ask for is fair credit.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

Getting Started in Stock Investing – After the First Positions

 In this post I’ll continue to describe the steps for getting started in investing.  This is part of a series of posts on beating the market that starts here:

http://smallivy.wordpress.com/2010/08/31/a-strategy-for-market-beating-returns-in-the-stock-market-introduction/

In the last post I started to describe how a young person — with plenty of time to grow wealth and the time to recover from mistakes — would start investing.  Out theoretical investor, Fred, built up a set of positions in three companies he felt had a good chance of growing for the next several years.  He did this by buying 100-300 shares at a time as his chosen stocks dipped in price.  Finally after a period of time, (which could be a year or more, depending on how much extra income he had to invest), he would reach the point where he would have three significant positions in companies that he believed had good long-term growth prospects.  In this post, we’ll follow the same theme and talk about Fred’s next moves.

For each of Fred’s three positions, one of three things could have happened.  These are 1) his stock went up in price, 2) his stock went down in price, or 3) his stock stayed at about the same price.  Let’s look at how to address each of these three situations:

1) The stock went up in price

Congratulations to Fred.  The market saw the good prospects of his chosen company and decided to bid up the price.  Note that while the market price will eventually follow the increase in intrinsic value of a stock, which will grow if earnings are growing, there is no reason to believe that it will have any correlation to intrinsic value in the short-term (periods of a few months).  There may have been some favorable news that came out about the company, stocks in general may have moved up, or various traders may have been pushing the stock around for random reasons.  The fact that the stock increased in price, while nice, therefore means nothing about the correctness of the pick.

If the stock continues to grow in price, such that the value of the holding becomes much larger than that of the other two, Fred should sell off some shares and buy more of the other stocks.  Once again, the deciding factor is how much Fred is willing and able to lose — no single position should be greater than this amount.  If all three positions have reached this threshold, it is time to start looking for a fourth stock to start buying.

2) The stock went down in price 

Just as the stock going up in price was just happenstance, a decline in price is not necessarily significant.  For stocks that have gone down, Fred should examine the fundamentals of the company again to see if there is something he missed.  Likewise, he should look for any news articles that may explain the decline.  If there are any, he should determine if the effects are short-term or cause a change in the fundamentals of the company.  As long as the reasons for which he bought the stock remain, he should stay invested.

There is a temptation to buy more shares.  This process, called averaging down, is attractive because one feels that by lowering one’s cost basis, one is reducing the loss and one will make more money if the stock increases in price.  While this is an attractive option, it is best not to average down once a position of the desired size is obtained.  There may be something fundamentally wrong with the stock that was missed and averaging down will just be throwing good money after bad.

3) The stock stayed at the same price

The response to the stock staying at the same price would be the same as that for the stock going down in price.  Stay the course unless something else has changed.

In the next post, we’ll continue to follow Fred as he builds up a larger portfolio.

Next post in series: http://smallivy.wordpress.com/2010/09/19/mid-life-investing-how-to-diversify-and-when-to-start-to-diversify/

This is one of a series of posts in the category of ”Making Market Beating Returns.” See the rest of this series: http://smallivy.wordpress.com/category/making-market-beating-returns/

Much as I enjoy writing about investing, it doesn’t make sense unless people are reading. If you’d like to keep the articles coming, please return often and refer a friend – http://smallivy.wordpress.com.  Comments are also greatly appreciated, as is lively and friendly debate.  Also feel free to link to or reference posts – all I ask for is fair credit.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Getting Started in Stock Investing – The Early Life Stage

 Having built the groundwork over the last series of articles, I’ll now describe how the process would be started using a hypothetical investor, Fred.  We’ll assume that Fred is ready to start investing.  He has paid off all of his credit cards, is renting or has bought a house he can afford (no more that 25% of his take-home pay), and he is participating fully in his company retirement plans and his IRA (10-15% of his income is going to retirement).  He has then identified a certain amount of his income to use for investing.  In this article I’ll discuss how an investor, Fred, would start the process of building a portfolio.  This is a continuation of the thread on how a small investor can beat the market returns, started here:

http://smallivy.wordpress.com/2010/08/31/a-strategy-for-market-beating-returns-in-the-stock-market-introduction/

As stated in the title of this post, we’re assuming that Fred is young.  He therefore does not have a lot of wealth, but he has a reasonable income and he lives on less than he makes.  The reason Fred needs to be young is that he needs to have time to make up for mistakes and allow his holdings to grow.  If Fred were 55 and trying to save for an early retirement in seven years, his retirement plans could be greatly changed if he picked the wrong stocks and saw a sharp decline.  For our young investor, he has little money but a lot of time, so his main objective is growing wealth.  An older investor could apply the same strategy using a smaller portion of his/her portfolio to gain some extra income, but it is important that moneys needed in the near-term (5-10 years out) are kept secure in cash or cash equivalents.

Here is how Fred would start to apply the strategy.  Fred, knowing that some stock are going to grow faster than others, would select a set of stocks that have the traits that make them grow faster (namely, a steady significant earnings growth rate).  He would also use the other traits to help whittle down his list of candidates. (see “Stock Picking 101″  http://smallivy.wordpress.com/2010/03/27/stock-picking-101/ and the rest of the series: http://smallivy.wordpress.com/category/stock-picking/). 

He would find, at most the top 1-2 stocks in desirable sectors — those that have room for growth.  Good choices include technology, retail, and restaurants, but there are other industries as well.  Since Fred does not have that much to invest, he can buy shares in only his top picks.  He does not need to buy everything like he would if he had several million dollars to invest.

Fred would start off buying 100-200 shares of his top pick.  If he had several stocks he liked, he may look for one that is down a bit in price.  He then would save up some more money and buy more shares of his top pick, buying as the price dips,  until he acquired a position of about 500 shares.  He would not really be concerned about the price.  If the stock fell a bit after his initial buy, he would pick up more shares at the better price.  If the stock went up in price, he would buy more on the next dip.  The goal is to get a significant position.

Once he had the initial position, he would turn to his next pick and begin acquiring shares as he had funds.  He would then do this for a third stock.  At that point he would have three significant positions in companies that he believed had good long-term growth prospects.  In the next post, we’ll follow the same theme and talk about Fred’s next moves.

Next post in series: http://smallivy.wordpress.com/2010/09/15/getting-started-in-stock-investing-after-the-first-positions/

This is one of a series of posts in the category of ”Making Market Beating Returns.” See the rest of this series: http://smallivy.wordpress.com/category/making-market-beating-returns/

Much as I enjoy writing about investing, it doesn’t make sense unless people are reading. If you’d like to keep the articles coming, please return often and refer a friend – http://smallivy.wordpress.com.  Comments are also greatly appreciated, as is lively and friendly debate.  Also feel free to link to or reference posts – all I ask for is fair credit.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.