Stock and Bond Trading Powers Modern Asset Allocation
by Steve Selengut
For most individual
investors, trading is approached in a totally speculative
manner. Stock trading, in its more popular forms
(Day Trading, Swing Trading, etc.) includes none
of the elements that a conservative investment strategy
would contain: little if any attention is given to
the Quality of the equities selected; Diversification
is determined by chance alone; no attempt is made
to develop an increasing and dependable stream of
Income. But stock trading by individual investors
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 equity traders,
loss taking is a more common occurrence.
Bond, and other income security trading is generally
avoided by most non-professionals. Obviously, it
takes more investment capital to establish positions
in corporate and municipal bonds, real estate, and
government securities than it does in equities, and
the volatility that traders thrive upon is just not
a standard feature of the mundane world of income
investing. Surprisingly, most investment professionals
avoid a more exciting approach to income investing
that is actually safer for investors and less inflexible
in the face of changing interest rate expectations. Certainly,
Wall Street financial institutions pressure their
representatives to push individual new issues and/or
investment products, but I think that the market
value fixation that stretches from Wall Street to
Main Street is 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 most mature
(in whatever sense you choose) investors. But
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 does not have to be done quickly to be productive,
and it doesn't have to focus on higher risk securities
to be profitable. And perhaps most importantly, it
doesn't have to 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 off the gambling 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. Asset Allocation is 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. The cost basis of the securities
must be used in all asset allocation calculations.
Asset allocation itself is a portfolio planning exercise
that is based on the purpose of the securities to
be purchased, and long term in nature. It should
not be "rebalanced" or altered due to current market
conditions or suppositions 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 cost-based
asset allocation formula. Selecting equities must
first be fundamental, then technical... quality first,
and market price second. My trading experience is
that higher quality companies purchased at a 20%
or more discount from the 52-week high, with a profit
target of approximately 10%, is a very manageable
approach. The 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, insistence upon
some form of income from all securities owned makes
enormous sense.
What about trading the income bucket securities?
Enter the managed closed-end income fund (CEF), as
tradable 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...
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!
Steve Selengut
http://www.sancoservices.com
http://www.valuestockindex.com
Professional Portfolio Management since 1979
Author of: "The Brainwashing of the American Investor:
The Book that Wall Street Does Not Want YOU to Read",
and "A Millionaire's Secret Investment Strategy" |
Stock
Market Article Index