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Posts Tagged ‘tactical investing’

Whatever your retirement dreams, they can still be made a reality.  It just depends on how you plan and manage your resources. On any journey it helps to have an idea where you’re going, how you plan to travel and what you want to do when you get there.

If this sounds like a vacation, well, it should. Most people invest more time planning a vacation than something like retirement.  And if you think of retirement as the Next Act in your life and approach it properly, you won’t be so easily bored or run out of money to continue the journey or get lost and make poor money decisions along the way.

It’s How You Manage It That Counts

How much you need really depends on the lifestyle you expect to have.  And it’s not necessarily true that your expenses drop in retirement. Assuming you have an idea of what your annual expenses might be in today’s dollars, you now have a target to shoot for in your planning and investing.

Add up the income from the sources you expect in retirement.  This can include Social Security benefits (the system is solvent for at least 25 years), any pensions (if you’re lucky to have such an employer-sponsored plan) and any income from jobs or that new career.

Endowment Spending: Pretend You’re Like Harvard or Yale

Consider adopting the same approach that keeps large organizations and endowments running.  They plan on being around a long time so they target a spending rate that allows the organization to sustain itself.

1. Figure Out Your Gap:  Take your budget, subtract the expected income sources and use the result as your target for your withdrawals. Keep this number at no more than 4%-5% of your total investment portfolio.

2. Use a Blended Approach: Each year look at increasing or decreasing your withdrawals based on 90% of the prior year rate and 10% on the investment portfolio’s performance.  If it goes up, you get a raise.  If investment values go down, you have to tighten your belt.  This works well in times of inflation to help you maintain your lifestyle.

3. Stay Invested:  You may feel tempted to bail from the stock market.  But despite the roller coaster we’ve had, it is still prudent to have a portion allocated to equities.  Considering that people are living longer, you may want to use this rule of thumb for your allocation to stocks: 128 minus your age.

If you think that the stock market is scary because it is prone to periods of wild swings, consider the risk that inflation will have on your buying power.  Bonds and CDs alone historically do not keep pace with inflation and only investments in equities have demonstrated this capability.

But invest smart. While asset allocation makes sense, you don’t have to be wedded to “buy-and-hold” and accept being bounced around like a yo-yo.  Your core allocation can be supplemented with more tactical or defensive investments.  And you can change up the mix of equities to dampen the roller coaster effects.  Consider including equities from large companies that pay dividends.  And add asset classes that are not tied to the ups and downs of the major market indexes.  These alternatives will change over time but the defensive ring around your core should be reevaluated from time to time to add things like commodities (oil, agriculture products), commodity producers (mining companies), distribution companies (pipelines), convertible bonds and managed futures.

4. Invest for Income: Don’t rely simply on bonds which have their own set of risks compared to stocks. (Think credit default risk or the impact of higher interest rates on your bond’s fixed income coupon).

Mix up your bond holdings to take advantage of the different characteristics that different types of bonds have. To protect against the negative impact of higher interest rates, consider corporate floating rate notes or a mutual fund that includes them.  By adding Hi-Yield bonds to the mix you’ll also provide some protection against eventual higher interest rates. While called junk bonds for a reason, they may not be as risky as one might think at first glance. Add Treasury Inflation Protected Securities (TIPS) that are backed by the full faith and credit of the US government.  Add in the bonds from emerging countries.  While there is currency risk, many of these countries do not have the same structural deficit or economic issues that the US and developed countries have.  Many learned their lessons from the debt crises of the late 1990s and did not invest in the exotic bonds created by financial engineers on Wall Street.

Include dividend-paying stocks or stock mutual funds in your mix.  Large foreign firms are great sources of dividends. Unlike the US, there are more companies in Europe that tend to pay out dividends. And they pay out monthly instead of quarterly like here in the US.  Balance this out with hybrid investments like convertible bonds that pay interest and offer upside appreciation.

5. Build a Safety Net: To sleep well at night use a bucket approach dipping into the investment bucket to refill the reserve that should have 2 years of expenses in near cash investments: savings, laddered CDs and fixed annuities.

Yes, I did say annuities.  This safety net is supported by three legs so you’re not putting all your eggs into annuities much less all into an annuity of a certain term. For many this may be a dirty word.  But the best way to sleep well at night is to know that your “must have” expenses are covered.  You can get relatively low cost fixed annuities without all the bells, whistles and complexity of other types of annuities.  (While tempting, I would tend to pass on “bonus” annuities because of the long schedule of surrender charges). You can stagger their terms (1-year, 2-year, 3-year and 5-year) just like CDs.  To minimize exposure to any one insurer, you should also consider spreading them around to more than one well-rated insurance carrier.

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After the Dow Industrials reached their peak on October 9, 2007, there was a long, painful decline to the trough reached on March 9, 2009.  During that time the DJIA lost 54% but was followed by a rally of 70%. Even with this spectacular run up through 2009, the index never reached it peak. While closer now after a good 2010 it, the peak is still a long climb up the mountain.  In fact, to break even from a 50+% loss requires a disproportionate increase (more than 100%) just to “get back to where you once belonged” as the classic rock song lyrics said.

Investors Win By Not Losing

As this roller coaster shows, its easier to keep what you have than try to rebuild it.  Unfortunately, after such volatility, investors tend to flee to places that are perceived to be safe.  For most that has created a flight to bonds. While investors think of risk as “loss of capital” the traditional views of risk continue to be turned on their head. Sure, you could stash your money away in a money market or under the mattress but what kind of return will that produce?  Will you have enough to eat more than dog food in retirement?

A recent documentary on the disaster at Pompeii and Herculaneum shows how many townspeople fled to the concrete tunnels near the wharves.  Considered a safe place, it ended up as a tomb to more than 300 skeletal remains. These hopeful survivors were trapped by the lava flows which sealed up the tunnels where they had fled.

In many ways, investors fleeing the danger of the markets by shifting to government bonds could be dooming themselves to a similar fate as the Pompeians.

The returns from “safe” Treasuries are pathetic.  Huge investor appetite has driven up to demand and helped lower the yields offered.  A backlash could hurt investors when interest rates rise as they inevitably have to.

If the goal is to preserve capital and avoid dangers, it shouldn’t matter to an investor what asset class is used.  (It’s Halloween.  Watch any scary movie and when the hapless victim is trapped he/she could care less whether the guy in the hockey mask is stopped by a dump truck or an arrow).

In much the same way, we should be looking at other ways to conserve capital.

Carrying Junk Around

Say “junk bonds” to someone and they may be thinking about Michael Milken in the 1980s or businesses on the brink of bankruptcy.  While these bonds are issued by companies with lower credit ratings, they offer a very good alternative to “safe” Government bonds. The point of diversification is to not put all your eggs in one basket.  Today most investors are torn between a savings account paying practically no interest or reaching for yield using alternatives.

The bond market prices the risks of bonds every day.  Currently, the bond market is pricing in a possibility of 6% default risk on junk bonds as a group.  That’s down from its historic number. Some individual bonds of companies may certainly be higher but as a group that’s not a bad number.  Some analysts at JP Morgan Chase have even estimated that the default risk for 2011 is as low as 1.4%.

Why so low? The projected default risk is low in part because companies are showing their highest level of profits in years.  They have shed workers, squeezed productivity gains from those remaining and taken over market share as weaker competitors have failed. The prospects for these companies look even better considering that as a recession ends company cash flows improve.  This means more cash available to service debt. And as these companies improve so too will their credit ratings leading to lower interest rates that they can get when they refinance their debts just like any homeowner would who has an improved credit score.

Avoiding the Danger of a Secular Bear

In a secular bear market, there are rally periods while the markets as a whole may languish or sometimes drop.  During the secular bear from 1/1/1965 to 12/31/1985, a Buy and Hold bond investor would have been whipsawed but ending up gaining about 1 basis point (or 0.01%)  per year for 20 years.  Not a lot of payback for the sometimes stomach-churning ride over that time.

A More Tactical Approach to Risk Management

Not all bonds are the same.  There are government bonds, municipal bonds, US investment grade corporate bonds, US hi-yield/junk bonds, convertible bonds, bonds from overseas and bonds from emerging markets.  Just like every homeowner applying for a mortgage is different and has to go through different underwriting,  the characteristics of all these bonds are different as well.

For instance, hi-yield bonds are more likely subject to credit risk.  Since the rates on these types of bonds are higher than that found on a Government bond or investment grade corporate bond, they are not so sensitive to changes in interest rates.  On the other hand, Government bonds are more sensitive to interest rate risk and the perceptions about expected inflation or the impact of monetary and fiscal policy on future interest rates.

Since these two bond categories are influenced by different factors, they tend to not be correlated meaning that they don’t move in lock-step: When one is zigging the other is probably zagging in the opposite direction.

A key way to reduce risk and potentially increase returns when dealing with bonds is to rotate among the different bond types.  Sometimes the market conditions favor one flavor of bonds over another.  At other times it’s better to reduce all bond types and shift to cash or money markets.

Simply buying and holding means that gains made in one period may be taken away by another. If you’re able to make gains and take them off the table from time to time, you’ll have less money at risk and greater opportunities at preserving capital for the long term.

In the chart below, you can see that buying each of these major bond indexes can produce widely different results.  For nearly the same risk level (as measured by the standard deviation), US High Yield long term bonds have a clearly higher overall return and higher return during periods of higher interest rates than the long-term US Treasury index.

Bottom Line

Investors seeking ways to add income to their portfolio and reduce risk of loss to their capital really need to consider alternatives to buying and holding.  Rotating among these different bond asset types may reduce the overall volatility to the portfolio and preserve capital for the long term.

If you don’t want to end up like the victims of Mount Vesuvius and be buried by a “safe” move, you should open your minds to understand all the risks and ways to manage them.

Figure 1 (Source: BTS Asset Management Presentation/Nataxis Global Assoc, 10/27/2010)

Bond Index Annualized ReturnNov 1992 – Aug 2009 Standard Deviation (measure of risk) Annual Return During Rising Rate Period
BarCap US High Yield Long 10.45% 10.94 6.75%
BarCap US Corp Baa Investment Grade 6.97% 6.31 1.75%
BarCap US Aggregate Bond 6.46% 3.82 1.31%
BarCap LT US Treasury 8.11% 9.28 -0.40%

Figure 2 (Source: BTS Asset Management Presentation, 10/27/2010)

Bond Sector Credit Risk Interest Rate Risk Currency Risk
US High Yield High Low None
International Developed Market Low Medium High
Long-term US Government None High None
Emerging Market High Low High
US Municipal Low High None
US Investment Grade Corporate Low High None

Figure 3 (Source: BTS Asset Management Presentation, 10/27/2010)

CAPITAL PRESERVATION KEY to LONG-TERM SUCCESS
Loss Gain Needed to Get Back to Break Even

(15%)

+ 18%

(20%)

+ 25%

(30%) + 43%

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