Balanced Diet Investing
Your grandmother may have told you to "eat a balanced diet if you want to be healthy." Well, "healthy" investing works in much the same way although the "diet" consists of stocks, bonds, ETFs, commodities, mutual funds, options, limited partnerships, derivitives, and unit trusts among others. The list of investment choices is virtually endless and their permutations run into the zillions.
As if this isn't enough of a problem, the literature on each choice makes it look like the virtual paragon of investments. They're touted as perfect, safe, inflation-proof, secure, and flexible.
Take mutual funds for example. According to each fund's literature, its three-, five- and 10-year track record always looks great. You're inundated with Lipper and Morningstar reports proving whatever point the fund wants to make.
Limited partnership literature and stock research reports do the same. When have you ever received a tip on a bad stock?
Next in line is how great the trendy asset-management strategies are. Sweep accounts, asset allocation accounts, wrap accounts, index accounts and others all receive the same hype. So what's an investor to do?
Well grandma's "balanced diet" comprises four basic food groups. In investment and portfolio management, whether it's for your personal account or your retirement account, there are also four basic "food groups." If you know them and how to use them, you're halfway home. These groups (not the component ingredients, which are stocks, bonds, mutual funds, etc.) are capital preservation, income preservation, capital appreciation, and income appreciation.
The most easily understood group is capital appreciation. With this one, we can all take the Will Rogers attitude of not being as concerned with the "return on our principle but with the return of our principle." Common examples are certificates of deposit, short-term government bonds and money markets.
With income preservation, we want a stable return on our investment for long periods of time. We don't want our savings to take any pay cuts. Examples here are long-term bonds and annuities, which allow us to lock in long-term rates.
We want our core savings to increase in absolute dollars in capital appreciation. This can be achieved by investing in things like quality "blue chips," growth stocks and real estate.
Income appreciation is the last and least understood group. Here, we want our cash income to increase in absolute dollars, by making investments that have proven track records of consistent dividend or income increases. We might use utilities, real estate or high-dividend-paying "blue-chip" stocks for this purpose. The goal here is cash pay raises in absolute dollars (not just compounding, which is "simply" re-investing).
The purpose of income appreciation-type investments is to keep us in pace with -- and hopefully ahead of -- inflation. Bonds, CDs and fixed-income investments can't do this. Lock in 10% on $10,000 today for 10 years and you obviously get $1,000 per year. This may be fine in 2006, but in 10 years, that same $1,000 per year won't look so fine. Even at the government's ficticious "only 3 percent simple inflation," you've lost 30 percent of your purchasing power (10 years times 3 percent). And just as your income stream lost 30 percent of its purchasing power, so did your principal!
Confusingly, of all these investing "food groups," there is no best choice. Focusing on one or two is like eating only steaks and potatoes. So your grandma was right about a balanced diet!
Here's a case analysis illustrating the best use of the four groups. Assume we have either a typical 40-year old or a typical company retirement plan. Their needs are remarkably alike. They both need and want a portfolio that provides various amounts of capital preservation, income preservation, capital appreciation and income apppreciation.
If the investor wants to follow just the income preservation and capital preservation routes, a core portfolio could consist of bonds that mature at different times. If, on the other hand, the goal is capital appreciation and income appreciation, the portfolio could possibly focus on blue-chip stocks and utilities. Or it's possible that an investor could adopt a middle-of-the-road approach and go with 25 percent in each group.
Finally, what we need to learn from all of this is that an investor has to understand that it's not only what you own but why you own it that really matters. He or she also needs to realize that virtually every investment falls into one of these four groups for analysis and applicability.
Managing your personal portfolio is an evolving, dynamic process. There is no one perfect system, but there are general guidelines that make life a lot easier. Obviously, nothing beats ongoing reviews of your portfolio, coupled with thoughtful examination of the actual selections that you place in your portfolio in the first place.
* * * * *
As if this isn't enough of a problem, the literature on each choice makes it look like the virtual paragon of investments. They're touted as perfect, safe, inflation-proof, secure, and flexible.
Take mutual funds for example. According to each fund's literature, its three-, five- and 10-year track record always looks great. You're inundated with Lipper and Morningstar reports proving whatever point the fund wants to make.
Limited partnership literature and stock research reports do the same. When have you ever received a tip on a bad stock?
Next in line is how great the trendy asset-management strategies are. Sweep accounts, asset allocation accounts, wrap accounts, index accounts and others all receive the same hype. So what's an investor to do?
Well grandma's "balanced diet" comprises four basic food groups. In investment and portfolio management, whether it's for your personal account or your retirement account, there are also four basic "food groups." If you know them and how to use them, you're halfway home. These groups (not the component ingredients, which are stocks, bonds, mutual funds, etc.) are capital preservation, income preservation, capital appreciation, and income appreciation.
The most easily understood group is capital appreciation. With this one, we can all take the Will Rogers attitude of not being as concerned with the "return on our principle but with the return of our principle." Common examples are certificates of deposit, short-term government bonds and money markets.
With income preservation, we want a stable return on our investment for long periods of time. We don't want our savings to take any pay cuts. Examples here are long-term bonds and annuities, which allow us to lock in long-term rates.
We want our core savings to increase in absolute dollars in capital appreciation. This can be achieved by investing in things like quality "blue chips," growth stocks and real estate.
Income appreciation is the last and least understood group. Here, we want our cash income to increase in absolute dollars, by making investments that have proven track records of consistent dividend or income increases. We might use utilities, real estate or high-dividend-paying "blue-chip" stocks for this purpose. The goal here is cash pay raises in absolute dollars (not just compounding, which is "simply" re-investing).
The purpose of income appreciation-type investments is to keep us in pace with -- and hopefully ahead of -- inflation. Bonds, CDs and fixed-income investments can't do this. Lock in 10% on $10,000 today for 10 years and you obviously get $1,000 per year. This may be fine in 2006, but in 10 years, that same $1,000 per year won't look so fine. Even at the government's ficticious "only 3 percent simple inflation," you've lost 30 percent of your purchasing power (10 years times 3 percent). And just as your income stream lost 30 percent of its purchasing power, so did your principal!
Confusingly, of all these investing "food groups," there is no best choice. Focusing on one or two is like eating only steaks and potatoes. So your grandma was right about a balanced diet!
Here's a case analysis illustrating the best use of the four groups. Assume we have either a typical 40-year old or a typical company retirement plan. Their needs are remarkably alike. They both need and want a portfolio that provides various amounts of capital preservation, income preservation, capital appreciation and income apppreciation.
If the investor wants to follow just the income preservation and capital preservation routes, a core portfolio could consist of bonds that mature at different times. If, on the other hand, the goal is capital appreciation and income appreciation, the portfolio could possibly focus on blue-chip stocks and utilities. Or it's possible that an investor could adopt a middle-of-the-road approach and go with 25 percent in each group.
Finally, what we need to learn from all of this is that an investor has to understand that it's not only what you own but why you own it that really matters. He or she also needs to realize that virtually every investment falls into one of these four groups for analysis and applicability.
Managing your personal portfolio is an evolving, dynamic process. There is no one perfect system, but there are general guidelines that make life a lot easier. Obviously, nothing beats ongoing reviews of your portfolio, coupled with thoughtful examination of the actual selections that you place in your portfolio in the first place.
* * * * *
posted by Bob Moser at
6:27 PM
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