A New Wall Street Line Dance
It matters not what lines, numbers, indices, or gurus you
worship, you just can't know where the stock market is going or
when it will change direction. Too much investor time and
analytical effort is wasted trying to predict course
corrections... even more is squandered comparing portfolio
Market Values with a handful of unrelated indices and averages.
If we reconcile in our minds that we can't predict the future
(or change the past), we can move through the uncertainty more
productively. Let's simplify portfolio performance evaluation by
using information that we don't have to speculate about, and
which is related to our own personal investment programs.
Every December, with visions of sugarplums dancing in their
heads, investors begin to scrutinize their performance,
formulate coulda's and shoulda's, and determine what to try next
year. It's an annual, masochistic, right of passage. My year-end
vision is different. I see a bunch of Wall Street fat cats, ROTF
and LOL, while investors (and their alphabetically correct
advisors) determine what to change, sell, buy, re-allocate, or
adjust to make the next twelve months behave better financially
than the last. What happened to that old fashioned emphasis on
long-term progress toward specific goals? The use of Issue
Breadth and 52-week High/Low statistics for navigation; and
cyclical analysis (Peak to Peak, etc.) and economic realities as
performance expectation barometers makes a lot more personal
sense. And when did it become vogue to think of Investment
Portfolios as sprinters in a twelve-month race with a nebulous
array of indices and averages? Why are the masters of the
universe rolling on the floor in laughter? They can visualize
your annual performance agitation ritual producing fee
generating transactions in all conceivable directions. An
unhappy investor is Wall Street's best friend, and by
emphasizing short-term results and creating a superbowlesque
environment, they guarantee that the vast majority of investors
will be unhappy about something, all of the time.
Your portfolio should be as unique as you are, and I contend
that a portfolio of individual securities rather than a shopping
cart full of one-size-fits-all consumer products is much easier
to understand and to manage. You just need to focus on two
longer-range objectives: (1) growing productive Working Capital,
and (2) increasing Base Income. Neither objective is directly
related to the market averages, interest rate movements, or the
calendar year. Thus, they protect investors from short-term,
anxiety causing, events or trends while facilitating objective
based performance analysis that is less frantic, less
competitive, and more constructive than conventional methods.
Briefly, Working Capital is the total cost basis of the
securities and cash in the portfolio, and Base Income is the
dividends and interest the portfolio produces. Deposits and
withdrawals, capital gains and losses, each directly impact the
Working Capital number, and indirectly affect Base Income
growth. Securities become non-productive when they fall below
Investment Grade Quality (fundamentals only, please) and/or no
longer produce income. Good sense management can minimize these
unpleasant experiences.
Let's develop an "all you need to know" chart that will help
you manage your way to investment success (goal achievement) in
a low failure rate, unemotional, environment. The chart will
have four data lines, and your portfolio management objective
will be to keep three of them moving upward through time. Note
that a separate record of deposits and withdrawals should be
maintained. If you are paying fees or commissions separately
from your transactions, consider them withdrawals of Working
Capital. If you don't have specific selection criteria and
profit taking guidelines, develop them.
Line One is labeled "Working Capital", and an average annual
growth rate between 5% and 12% would be a reasonable target,
depending on Asset Allocation. [An average cannot be determined
until after the end of the second year, and a longer period is
recommended to allow for compounding.] This upward only line
(Did you raise an eyebrow?) is increased by dividends, interest,
deposits, and "realized" capital gains and decreased by
withdrawals and "realized" capital losses. A new look at some
widely accepted year-end behaviors might be helpful at this
point. Offsetting capital gains with losses on good quality
companies becomes suspect because it always results in a larger
deduction from Working Capital than the tax payment itself.
Similarly, avoiding securities that pay dividends is at about
the same level of absurdity as marching into your boss's office
and demanding a pay cut. There are two basic truths at the
bottom of this: (1) You just can't make too much money, and (2)
there's no such thing as a bad profit. Don't pay anyone who
recommends loss taking on high quality securities. Tell them
that you are helping to reduce their tax burden.
Line Two reflects "Base Income", and it too will always move
upward if you are managing your Asset Allocation properly. The
only exception would be a 100% Equity Allocation, where the
emphasis is on a more variable source of Base Income... the
dividends on a constantly changing stock portfolio. Line Three
reflects historical trading results and is labeled "Net Realized
Capital Gains". This total is most important during the early
years of portfolio building and it will directly reflect both
the security selection criteria you use, and the profit taking
rules you employ. If you build a portfolio of Investment Grade
securities, and apply a 5% diversification rule (always use cost
basis), you will rarely have a downturn in this monitor of both
your selection criteria and your profit taking discipline. Any
profit is always better than any loss and, unless your selection
criteria is really too conservative, there will always be
something out there worth buying with the proceeds. Three 8%
singles will produce a larger number than one 25% home run, and
which is easier to obtain? Obviously, the growth in Line Three
should accelerate in rising markets (measured by issue breadth
numbers). The Base Income just keeps growing because Asset
Allocation is also based on the cost basis of each security
class! [Note that an unrealized gain or loss is as meaningless
as the quarter-to-quarter movement of a market index. This is a
decision model, and good decisions should produce net realized
income.]
One other important detail No matter how conservative your
selection criteria, a security or two is bound to become a
loser. Don't judge this by Wall Street popularity indicators,
tealeaves, or analyst opinions. Let the fundamentals (profits, S
& P rating, dividend action, etc) send up the red flags. Market
Value just can't be trusted for a bite-the-bullet decision...
but it can help. This brings us to Line Four, a reflection of
the change in "Total Portfolio Market Value" over the course of
time. This line will follow an erratic path, constantly staying
below "Working Capital" (Line One). If you observe the chart
after a market cycle or two, you will see that lines One through
Three move steadily upward regardless of what line Four is
doing! BUT, you will also notice that the "lows" of Line Four
begin to occur above earlier highs. It's a nice feeling since
Market Value movements are not, themselves, controllable.
Line Four will rarely be above Line One, but when it begins to
close the cap, a greater movement upward in Line Three (Net
Realized Capital Gains) should be expected. In 100% income
portfolios, it is possible for Market Value to exceed Working
Capital by a slight margin, but it is more likely that you have
allowed some greed into the portfolio and that profit taking
opportunities are being ignored. Don't ever let this happen.
Studies show rather clearly that the vast majority of unrealized
gains are brought to the Schedule D as realized losses... and
this includes potential profits on income securities. And, when
your portfolio hits a new high watermark, look around for a
security that has fallen from grace with the S & P rating system
and bite that bullet.
What's different about this approach, and why isn't it more high
tech? There is no mention of an index, an average, or a
comparison with anything at all, and that's the way it should
be. This method of looking at things will get you where you want
to be without the hype that Wall Street uses to create
unproductive transactions, foolish speculations, and incurable
dissatisfaction. It provides a valid use for portfolio Market
Value, but far from the judgmental nature Wall Street would
like. It's use in this model, as both an expectation clarifier
and an action indicator for the portfolio manager, on a personal
level, should illuminate your light bulb. Most investors will
focus on Line Four out of habit, or because they have been
brainwashed by Wall Street into thinking that a lower Market
Value is always bad and a higher one always good. You need to
get outside of the "Market Value vs. Anything" box if you hope
to achieve your goals. Cycles rarely fit the January to December
mold, and are only visible in rear view mirrors anyway... but
their impact on your new Line Dance is totally your tune to
name.
The Market Value Line is a valuable tool. If it rises above
working capital, you are missing profit opportunities. If it
falls, start looking for buying opportunities. If Base Income
falls, so has: (1) the quality of your holdings, or (2) you have
changed your asset allocation for some (possibly inappropriate)
reason, etc. So Virginia, it really is OK if your Market Value
falls in a weak stock market or in the face of higher interest
rates. The important thing is to understand why it happened. If
it's a surprise, then you don't really understand what is in
your portfolio. You will also have to find a better way to gauge
what is going on in the market. Neither the CNBC "talking heads"
nor the "popular averages" are the answer. The best method of
all is to track "Market Stats", i.e. Breadth Statistics, New
Highs and New Lows. . If you need a "drug", this is a better one
than the ones you've grown up with. Have a nice change!