What Your Advisor Hasn’t Told You About Income Investing, A Q & A


One of the biggest mistakes investors make is ignoring the 'for income' portion of their investment portfolios … many don't even realize that such a thing should exist. The second biggest mistake is to look at the performance of income securities in the same way as “growth oriented” securities (stocks).

The following questions and answers assume that portfolios are built around these four major financial risk minimizers: All securities meet high quality standards, produce some form of income, are 'classically' diversified, and are sold when target earnings "Reasonable" are achieved.

1. Why should a person invest to earn income? Aren't stocks much better mechanisms for growth?

Yes, the purpose of investing in stocks is to produce "growth," but most people view growth as increasing the market value of the securities they own. I'm thinking of growth in terms of the amount of new "capital" that is created by making profits, and the composition of profits when that new capital is reinvested using a "cost-based" asset allocation .

Most advisers don't see profits with the same warm, fuzzy feeling that I do … maybe this is a tax code that treats losses more favorably than gains, or a legal system that allows people to sue counselors if hindsight suggests that a wrong turn may have been taken. Truth be told, there is no such thing as bad profit.

Most people wouldn't believe that over the past 20 years, a 100% income portfolio would have "outperformed" the top three market averages in "total return" … using a payout number as the conservative 4% annual: The percentage of earnings per year:

NASDAQ = 1.93%; S&P 500 = 4.30%; DJIA = 5.7%; 4% Closed Fund Portfolio (CEF) = 6.1%

  • * NOTE: Over the past 20 years, taxable CEFs have actually reported around 8%, tax exemptions just under 6% … and then there were all the capital gains opportunities from 2009 to 2012.

Try to look at it this way. If your wallet is generating less income than what you take out, something needs to be sold to provide the pocket money. Most financial advisers would agree that no less than 4% (payable in monthly installments) is needed in retirement … regardless of travel, grandchildren's education, and emergencies. This year alone, most of that money was supposed to come from your principal.

  • Like the basic fixed annuity program, most pension plans assume an annual reduction in capital. A “retirement loan” income program, on the other hand, leaves the capital to the heirs while increasing the annual expenses of retirees.

2. How income oriented should an investment portfolio be?

At least 30% for anyone under 50, then an increasing allowance as retirement looms larger … portfolio size and spending money needs should dictate how much of the portfolio can be risk in the stock market. Typically no more than 30% in shares for retirees. Very large portfolios could be more aggressive, but doesn't real wealth mean you no longer have to take significant financial risks?

As an added safety measure, all equity investments should be invested in value-grade, investment-grade stocks and a diverse group of CEFs of stocks, thus ensuring cash flow from the stock. entire portfolio, at all times. But the key from day one is to do all the asset allocation calculations using position cost basis instead of market value.

  • NOTE: When stock prices are very high, stock CEFs provide significant income and excellent diversification in a managed program that allows for participation in the stock market with less risk than individual stocks and significantly higher income than funds. Income mutuals and income ETFs.

Using total 'working capital' instead of current or periodic market values ​​allows the investor to know precisely where new portfolio additions (dividends, interest, deposits and trading proceeds) should be. invested. This simple step will ensure that the total income of the portfolio increases from year to year and accelerates considerably towards retirement, as the asset allocation itself becomes more conservative.

  • Asset allocation should not change based on market prognosis or interest rates; the projected income needs and the minimization of financial risks for retirement are the main issues.

3. How many different types of income securities are there, and

There are a few basic types, but there are many variations. To keep it simple, and in ascending order of risk, there are US government and agency debt, government and local government securities, corporate bonds, loans and preferred shares. These are the most common grape varieties and they generally provide a level of fixed income payable semi-annually or quarterly. (CDs and money market funds are not investments, their only risk being the “opportunity” variety.)

Variable income securities include mortgage products, REITs, equal share trusts, limited partnerships, etc. to the extent necessary for a prudent investment.

Generally, higher returns reflect higher risk in individual income securities; complicated maneuvers and adjustments increase the risk exponentially. Actual yields vary depending on the type of security, the fundamental quality of the issuer, the time to maturity and in some cases the conditions in a particular industry … and, well sure, the IRE.

4. HHow much do they pay?

Short-term interest rate expectations (IRE, rightly so), stir up the current yield pot and keep things interesting as the yields of existing securities change with "inversely proportional" price movements. Yields vary widely from type to type, and currently range between less than 1% for 'risk-free' money market funds to 10% for oil and gas MLPs and some REITs.

Corporate bonds are around 3%, preferred stocks around 5%, while most taxable CEFs generate around 8%. Tax-exempt CEFs earn around 5.5% on average.

  • A wide range of income possibilities, and there are investment products for every type of investment, grade level, and investment time imaginable … not to mention global and index opportunities. But without exception, closed-end funds bring in a lot more income than ETFs or mutual funds … it's not even close.

All types of individual bonds are expensive to buy and sell (margins on preferred bonds and new issues should not be disclosed), especially in small amounts, and it is virtually impossible. add bonds when prices drop. Preferred stocks and CEFs behave like stocks and are easy to trade as prices move in both directions (i.e., it's easy to sell for profit or to trade) ; buy more to reduce the cost base and increase efficiency).

  • During the 'financial crisis' CEF yields (tax exempt and taxable) nearly doubled … almost all of them could have been sold more than once, at 'one time' profits. year with advance interest ”, before their normal levels of 2012.

5. How do CEFs produce these higher income levels?

There are several reasons for this large differential in returns for investors.

  • CEFs are not mutual funds. They are separate investment companies that manage a portfolio of securities. Unlike mutual funds, investors buy shares of the company itself, and the number of shares is limited. Mutual funds issue an unlimited number of shares whose price is always equal to the net asset value (NAV) of the fund.

  • The price of a CEF is determined by market forces and may be higher or lower than NAV … thus, they can sometimes be purchased at a discount.

  • Mutual income funds focus on total return; The CEF's investment managers focus on producing pocket money.

  • CEF raises liquidity through an IPO and invests the proceeds in a portfolio of securities, most of the income from which will be paid out as dividends to shareholders.

  • The investment company can also issue preferred stock at a guaranteed dividend rate well below what it knows it can get in the market. (For example, they could sell a 3% redeemable preferred stock issue and invest in bonds that pay 4.5%.)

  • Finally, they trade very short-term bank loans and use the proceeds to buy longer-term securities that earn a higher interest rate. In most market scenarios, short-term rates are much lower than long-term ones, and loan terms are as short as the IRE scenario allows.

  • This 'leveraged borrowing' has nothing to do with the portfolio itself, and in a crisis, managers may stop short-term borrowing until such time as it is. a more stable interest rate environment returns.

Therefore, the actual investment portfolio contains much more income producing capital than that provided by the IPO proceeds. Shareholders receive dividends from the entire portfolio. To learn more, read my article "Investing under the dome".

6. What about annuities, stable value funds, private REITs, income ETFs, and retirement mutual funds?

Annuities have several unique characteristics, none of which make them good "investments". These are great security covers if you don't have enough capital to generate adequate income on your own. The 'variable' variety adds market risk to the equation (at an additional cost), bastardizing the original principles of fixed-amount annuity.

  • They are "the mother of all commissions".

  • They impose penalties which, in effect, lock in your money for up to ten years, depending on the size of the commission.

  • They guarantee you a minimum interest rate because they pay you back your own money over your "actuarial life expectancy" or over your actual life, whichever is longer. If you get hit by a truck, the payments stop.

  • You can pay extra (ie reduce your payments) to benefit others or to make sure your heirs get something when you die; otherwise, the insurance company receives all of the rest regardless of when you exit the program.

Stable value funds give you the lowest possible return you can get in the fixed income market:

  • They include bonds with the shortest duration to limit price volatility, so in some scenarios, they might actually earn less than money market funds. Those with slightly higher yielding paper include insurance "wrapping" that provides price stability, at an additional cost to the annuitant.

  • They are designed to reinforce Wall Street & # 39; s misguided emphasis on market value volatility, the harmless and natural personality of interest rate sensitive securities.

  • If money market rates return to "normal", these bad joke products are likely to go away.

Private REITs are “the father of all commissions,” illiquid mystery wallets, far inferior to the publicly traded variety in many ways. Take the time to read this Forbes article: "An investment choice to avoid: private REIT" by Larry Light.

Income ETFs and retirement income mutual funds are the second and third best ways to participate in the fixed income market:

  • They provide (or track prices) diversified portfolios of individual securities (or mutual funds).

  • ETFs are better because they look and feel like stocks and can be bought and sold at any time; the obvious downside to most is that they're designed to track clues, not to generate income. A few that seem to produce above a measly 4% (just for information and absolutely not a recommendation) are: BAB, BLV, PFF, PSK, and VCLT.

  • When it comes to retirement mutual funds, the most popular of all (the Vanguard VTINX) has a 30% equity component and earns less than 2% in actual pocket money.

  • There are at least a hundred "experienced" tax-free and taxable income CEFs, and at least forty equity and / or balanced CEFs that pay more than any ETF or mutual fund. investment income.

More questions and answers in Part II of this article …

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