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Managing the Income Portfolio 101

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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 --- 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 income purpose investing.

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 any negotiable (tradable) security.

We can minimize the former by selecting only high quality securities and the latter by diversifying properly, and by understanding that market value changes are totally normal. What is needed is a plan of action for dealing with such fluctuations.

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 almost always improperly used within the financial community.

It’s also important to recognize, that you dont need super computers, economic scenario probabilities, inflation estimators, or 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; The Working Capital Model will help you organize, and control the content of your investment portfolio. 

Planning for Retirement should focus on the additional income needed from the investment portfolio; the asset allocation formula needed for goal achievement will depend on just three variables: the amount of investment assets you are starting with, the amount of time until retirement, and the range of interest rates currently available from investment grade securities.

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 will pretty much take care of itself. Remember, a higher market value may increase hat size, but it doesn’t pay the bills. 

Deduct any guaranteed income of any kind from your retirement income goal to estimate the amount needed 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 (5%, to 7% 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 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 --- not even close.

Asset allocation divides the investment portfolio into the two basic classes of investment securities: Equities for growth and income securities for ------. 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 wprking capital.

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 shifting.

The asset allocation formula itself is sacred, and if constructed properly, should never be altered due to conditions in either equity or income security 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 --- current market value may be more or less and it just doesn’t matter. 2) Any investment portfolio with Working Capital (cost basis) of $100,000 or more should have a minimum of 30% invested in income purpose securities, taxable or tax free, depending on the portfolio.

Tax deferred entities (all varieties of retirement programs) should house the bulk of the equity investments. This rule applies from age zero to retirement age minus five years. Under age thirty, it is a mistake to have too much of your portfolio invested for income.

3) There are only two asset allocation categories, and neither is ever described with a decimal point. All cash in the portfolio is destined for one category or the other. If it doesn't fit, it is a speculation.

4) From retirement age minus five on, the income percent needs to be adjusted upward until the “reasonable interest rate test” says that you are on target or at least in range. 5) At retirement, between 60% and 100% of your portfolio may have to be in income purpose securities.

Managing the Income Portfolio 201:

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