Submitted by Steve Selengut
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Stock and Bond Trading Powers Modern Asset Allocation
For most investors, trading is approached in a totally speculative manner. Stock trading, in its more popular forms (day, swing, etc.) includes none of the elements of a conservative investment strategy: little attention is given to quality; diversification is a function of chance; no attempt is made to develop a dependable stream of income.
But stock trading by individuals doesn't deserve quite as bad a "rep" as it has earned. After all, its very foundation is profit taking, probably the most important and most often neglected of the activities required for successful investment management. Unfortunately for most traders, loss taking is a more common occurrence.
Bond, and other income security trading is generally avoided by non-professionals. It takes more capital to establish positions in bonds, government securities, etc., and the volatility that traders thrive upon is not a standard feature of the mundane world of income investing.
Not surprisingly, most investment professionals avoid an exciting approach to income investing that is safer for investors and quite flexible in the face of changing interest rates. Why? Mainly, because Wall Street institutions pressure their reps to push individual new issues and/or investment products --- for the high and invisible-to-consumers mark ups they generate.
But the market value fixation that stretches from Wall Street to Main Street may be the real culprit. Income securities need to be assigned a value that recognizes the safety of their income production and market value changes should only to be viewed as opportunities for increasing yield or taking rare, but wonderful, profits.
Consequently, most trading is done in an equity only environment that is too speculative for mature (in whatever sense you choose) investors. This is not the way it needs to be.
Since stock prices are likely to remain volatile in the short run and cyclical in the long run, there will always be opportunities for profit taking. Similarly, there are no rules against taking advantage of the cyclical nature of interest-rate-sensitive security prices.
Trading is the world's oldest form of commercial activity, and it is unfortunate that it is treated with such disrespect by our dysfunctional tax code. It is even more unfortunate that it is looked at askance by client attorneys and brokerage firm compliance officers --- masters of hindsight that they are.
Trading doesn't have to be done quickly to be productive, and it doesn't have to focus on higher risk securities to be profitable. And it need not avoid the interest-rate-sensitive income securities that are so important to the long-term success of any true investment portfolio.
Once a trader/speculator is weaned from the gaming mentality that brought him to the shock market in the first place, he can apply his trading skills to investing and to portfolio management. The transition from trader/speculator to trader/investor requires some education --- education that generally cannot be obtained from product salespersons.
Step one is to gain an appreciation of the power of asset allocation, the process of dividing the portfolio into two conceptual securities buckets. The primary purpose of the equity bucket is to produce growth in the form of realized capital gains. The other bucket contains securities whose primary purpose is to produce some form of regular income --- dividends, interest, rents, royalties, etc.
The percentage allocated to each is a function of a short list of personal facts, concerns, goals, and objectives.
Market Cycle Investment Management uses the cost basis of securities in all asset allocation and diversifiication calculations. Asset allocation should be a long term planning exercise that is based on the purpose of the securities to be purchased. It should not be "rebalanced" or altered due to current market conditions or guess work about the future.
Market values are used in the selection process that identifies potential trading candidates and as the trigger mechanism for profit taking decisions. Cash from all income sources is always destined for one bucket or the other, depending on the asset allocation formula. Selecting equities must first be fundamental, then technical ---quality first, market price second.
My trading approach purchases higher quality companies at a 20% or more discount from the 52-week high, with a very reasonable profit target of approximately 10%. Trading proceeds find their way back into the "smart cash" pot for asset allocation according to formula.
There will be times when smart cash will grow quickly while the list of new trading candidates shrinks, but when trading candidates are all over the place, smart cash can only be replenished with income produced by both securities buckets. Thus, an insistence on some form of income from all securities owned, in both asset buckets.
What about trading the income bucket securities? Enter the managed closed-end income fund (CEF), as tradeable as any common stock, and in a surprising variety of income producing specialties ranging from preferred stocks to royalty trusts, treasuries to municipals, and REITs to mortgages.
No more worries about liquidity and hidden markups. No more cash flow positioning or laddering of maturities. And best of all, no more calls of your highest yielding paper when interest rates fall. Instead, you are taking capital gains, compounding your yield, and paying your dues to the equity bucket with every transaction.
And when interest rates move back up (they will move back up), you'll have the luxury of reducing your cost basis by adding additional shares. Of course its magic... that's what we do here on Wall Street!