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, tea leaves, 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.
