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What Your Mother Never Told You About Income Investing: Twenty Questions (1 thru 6)
Judyth Piazza Interviews Professional Investor Steve Selengut
In our last conversation, you suggested that one of the biggest mistakes investors make is ignoring the income portion of their portfolios. Let's dig a little deeper into that:
1. Why should a person invest for income, aren't equities much better growth mechanisms?
Yes, the purpose of equity investments is the production of "growth", but most people think of growth as the increase in market value of the securities they own. I think of growth in terms of the amount of new "capital" that is created by the realization of income, particularly profits, on the securities I own.
For some reason, profit taking isn't widely viewed with the same warm and fuzzy feeling that I get when I think of profits. Similarly, our incredibly dysfunctional tax code punishes investors for profiting from "capital gains" on the sale of securities --- especially the really special "short-term" variety.
If fairness in taxation is what we want in this country, we really need to begin using a consumption tax and phasing out the income variety --- that will even satisfy those who want the rich to pay more than they do now.
Sorry about the tangent --- back to income investing.
2. I can't remember hearing any other investment expert emphasize the importance of income investing the way you do. In your book "The Brainwashing of the American Investor", Chapter Five is called : "What Your Mother Never Told You About Income Investing". Can you talk about that?
Investors are a very dependent group, particularly now that most employees are responsible for directing their own saving programs for retirement. Mother Wall Street has monopolized this huge market, and nursed its children first on Mutual Funds and now on derivative betting mechanisms they call index ETFs.
ETFs are the unhealthy investment equivalent of a diet of fast food, no protein, and high energy fusion products. Designed to massage a limited understanding, instant gratification audience, these buzz word products have separated IRA, 401(k), and most non-professionals from an appreciation of the basic building blocks of investing --- stocks and bonds.
There is just no room at the Mall for the plain vanilla, but long range, thinking that goes into the development of an income producing investment portfolio. When I was a child, my father schooled me on the power of compound interest. How many of you, listening today, are fluent in compound interest tables?
3. How much of an investment portfolio should be directed to income investing?
At least 30%. Additionally, all equity investments should be in Investment Grade Value Stocks, thus assuring cash flow from the entire portfolio, all of the time. Asset allocation calculations must be based on "working capital" instead of market value.
4. Right, I get it, but please give our listeners a little more information on the "working capital" concept, and its use in asset allocation.
Simply put, working capital value is the amount that you paid for the security, i.e., the cost basis. By using cost instead of market value for diversification decisions, you prevent yourself from pouring too much money into a falling security or sector.
Additionally, you won't be tempted to stop adding to one side or the other just because market values have risen. And, there is never a need for year-end "rebalancing". Each decision is asset allocation correct from the start.
5. How many different types of income securities are there, and how much do they pay?
There are a few basic types, but the variations are many. To keep it simple, and in ascending order of risk, there are US Government and Agency Debt Instruments, State and Local Government Securities, Corporate Bonds, and Preferred Stock. These are most common varietals, and they generally provide a fixed level of income payable either semi-annually or quarterly.
Variable income securities include Mortgage Products, REITs, Income Trusts, Limited Partnerships, etc. And then there are a myriad of incomprehensible Wall Street created monstrosities with their "traunches", "hedges", and other strategies that are intended to attract more affluent investors who want to impress their buddies with their understanding of advanced finance.
Generally speaking, higher yields reflect higher risk in individual securities; complicated maneuverings and adjustments increase the risk exponentially.
Current yields vary by the type of security, the quality of the issuer, the length of time until maturity, and in some cases, conditions in a particular industry. Interest Rate Expectations, mainly short term, stir the pot and keep things interesting. Yields will vary considerably between type, and right now are between about 1/20 of 1% for no risk money market funds to between 6% and 8% for oil royalty trusts. Quite a differential.
6. Did you say 6% to 8% --- how is that possible?
It's more than possible, it's routine. Commodity based trusts have always paid higher yields than their more secure counterparts. It's a function of perceived long term risk vs. current cash flow. REITs are impacted similarly; you can imagine how much pain there was in that sector during the financial crisis.
You don't hear too much about this type of investing for what I consider to be selfish reasons on the part of many professional advisors. Similarly, Municipal Bond Closed End Funds have paid a steady rate above 6% Federally Tax Free before, during, and since the financial crisis. How many of your listeners do you think were aware of such investment opportunities?
But let's back up just a bit and consider why this important info has been withheld. It goes back to another area of "Brainwashing" --- the idea that the market value "performance" of income-purpose securities can be analyzed with the same math that is applied to equity securities --- and the lucrative business it is for the major brokerage firms to sell individual bonds and Preferred Stocks, particularly new issues.
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