Submitted by The Investment Shadow
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Cruise Control Hedging: The Basics of Investing
Apart from the considerations discussed in the previous article, risk of loss in an equity investment is generally greater than risk of loss in any debt instrument. The potential reward from each is just the opposite, and that's where all the excitement begins.
Do we risk more to obtain a greater realized return, or do we risk less trying to preserve capital? Keep in mind that investment capital is a measure of cost, not of market value, and that the only real loss is a realized loss.
Typically, the older the investor, the more boring or income focused the portfolio should be --- minimizing the overall risk. But it's difficult to actively manage risk in "open end" mutual funds or unmanaged ETFs.
Risk minimization requires the identification of what's inside a portfolio. Risk control requires decision-making about the content. Risk management requires selection from a universe of securities that meet a known set of quality standards.
Product owners assume the added "fear and greed" risk of the general population, while fund mangers stand aside and mumble about the opportunities lost in either direction.
Without a risk sensitive menu to select from, 401k participants need to minimize risk by: avoiding the poor diversification that may be a requirement of their plan, and developing outside income portfolios with disposable income above the employer matching contribution.
The most important management action focused on risk minimization in any program is the asset allocation plan. The plan separates investment capital into two buckets (Equity and Income) based on cost, not market value. No portfolio should have less than 30% in the income bucket, 40% seems to be the most effective number, long term.
No investment plan should be developed "tax" or "cost" first. Risk minimization comes first, then tax minimization, if possible. Finally, transaction cost minimization may be considered only if you are qualified to run your program yourself.
A cost based asset allocation approach (Google "working capital model - Selengut") assures growing levels of "base income" throughout the portfolio development process and, possibly, into retirement. Income growth is the only real hedge against that other economic risk, inflation --- a buying power problem that has nothing to do with the market value of the income producing assets.
Minimizing investment risk is done best through the use of disciplined sets of rules for the various operations involved in managing a portfolio. Strict rules need to be developed for security selection, three types of diversification, income production, and profit taking.
Forget the Wall Street product menagerie. You needn't be interested in massaging market value to take the sting out of cyclical market change. The plan is to take advantage of these changes as they unwind around us over time, and when they occur unexpectedly, causing short-term disruptions and dislocations.
In the securities markets (stocks and bonds), the real risk of loss can be minimized without products and futures speculations, without commodities and hedge funds, and without the "ageda" most people experience throughout their investment lifetimes.
The old fashioned principles of investing: Quality, Diversification, and Income, plus disciplined, targeted, Profit Taking are the only hedges an investment portfolio needs to assure long-term productivity. Conveniently, QDI+PT applies equally well to both growth and income securities.
"Q" is for quality. If you study the long-term behavior of Investment Grade Value Stocks, and high quality income CEFs, you'll discover that they hedge themselves quite effectively.
Risk is wrung out of portfolios by investing only in S & P, B+ or better rated, dividend paying, and historically profitable companies and only when their prices are well below 52-week highs.
Click for Details --> Ten Risk Minimizers <--
"D" is for diversification. Positions must never exceed 5% of total working capital (i.e., the total cost basis) and positions should never start at maximum exposure. You want to be able to buy more at lower prices.
Similar diversification rules apply to industry exposure and global diversification through the use of the mainly world class companies in the investment grade quality categories.
"I" is for income. Own no security that does not pay regular dividends or interest. Dividends are a quality indicator in equities. In the income "bucket", seek out above average yields while avoiding those that seem either too high or too low.
Managed closed end funds do it best and provide easy "PT" and "buy more" opportunities. Buy established CEFs with long term payment records.
"PT" is for profit taking. Absolutely always smile and take your profits willingly, net/net 7% to 10% (dependent upon available reinvestment possibilities and security class), and never, ever, look back. Trading this same body of securities, again and again, has been shown to sustain growth of capital and income consistently in a relatively low risk environment.
In the recent financial crisis, a very small percentage of (I bought my house to live in) homeowners stopped paying on their mortgages. Still, the hysteria over the bursting housing bubble (i.e., lower market values) led to financial institution road-kill because of ridiculous accounting rules.
When the dot-come bubble destroyed "new economy" gladiators in a gory spectacle destined to repeat itself over time, what investment portfolios cheered unscathed from the coliseum bleachers?
If you reduce the amount of betting in your portfolio (and throw out politicians who don't have a clue about the workings of free markets) you can safely navigate even the choppiest seas that the market, interest rate, and economic cycles roll your way.
The tide-like change of market values is the normal order of things, and until we embrace the cyclical nature of markets, all markets, our disappointment and disillusionment will continue. Portfolio market values will reflect where we are within the various cycles.
Interest rate sensitive securities (all bonds, government securities, preferred stocks, and relatively high dividend equities) vary inversely with interest rate expectations, most of the time.
Where we are in the interest rate cycle is fairly easy to determine, and you need to position yourself to take advantage of the higher rates that will sneak into the economic formula as the cycle moves further and further from its recent lows.
How do we prepare for higher interest rates? By designing the income bucket of the portfolio so that it refills itself with at least 30% of total portfolio realized income, and by owning income generating securities in a form that is easy to add to.
The next article presents ten, time-tested, live portfolio risk minimizers.