Managing the Income Portfolio

The reason people assume the risks of investing in the first place is the prospect of achieving a higher rate of return than is attainable in a risk-free...

Posted by Admin - April 25, 2022

The reason people assume the risks of investing in the first place is the prospect of achieving a higher rate of return than is attainable in a risk-free environment, i.e., an FDIC-insured bank account. Risk comes in various forms, but the average investor's primary concerns are "credit" and "market" risk… mainly when investing for income. Credit risk involves the ability of corporations, government entities, and even individuals to make good on their financial commitments; market risk refers to the certainty that there will be changes in the Market Value of the selected securities. We can minimize the former by selecting only high-quality (investment grade) securities and the latter by diversifying properly, understanding that Market Value changes are expected, and having a plan of action for dealing with such fluctuations. (What does the bank do to get the amount of interest it guarantees to depositors? What does it do in response to higher or lower market interest rate expectations?)

The K. I. S. S. Principle needs to be at the foundation of your Investment Plan; an emphasis on Working Capital will help you Organize and Control your investment portfolio. You don't have to be a professional Investment Manager to manage your investment portfolio professionally. Still, it would be best if you had to have a long-term plan and know something about Asset Allocation… a portfolio organization tool that is often misunderstood and almost always improperly used within the financial community. It's important to recognize, as well, that you do not need a fancy computer program or a polished presentation with economic scenarios, inflation estimators, and stock market projections to get yourself lined up properly with your target. It would be best to have common sense, reasonable expectations, patience, discipline, soft hands, and an oversized driver.

Planning for retirement should focus on the additional income needed from the investment portfolio. The Asset Allocation formula [relax, 8th-grade math is plenty] required for goal achievement will depend on just three variables:

  1. The number of liquid investment assets you are starting with.
  2. The amount of time until retirement.
  3. The range of interest rates currently available from Investment Grade Securities.

This can be a relatively simple process if you don't allow the "engineer" gene to take control. Even if you are young, you need to stop smoking heavily and develop a growing stream of income… if you keep the income growing, the Market Value growth (that you are expected to worship) will sustain itself. Remember, a higher Market Value may increase hat size, but it doesn't pay the bills.

Liquid personal and retirement plan assets only. First, deduct any guaranteed pension income from your retirement income goal to estimate the amount needed just from the investment portfolio. Don't worry about inflation at this stage. Next, determine the total Market Value of your investment portfolios, including company plans, IRAs, H-bonds… everything, except the house, boat, jewelry, etc. This total is then multiplied by a range of reasonable interest rates (6% to 8% right now), and hopefully, one of the resulting numbers will be close to the target amount you came up with a moment ago. If you are within a few years of retirement age, they better be! For sure, this process will give you a clear idea of where you stand, and that, in and of itself, is worth the effort. 

Organizing the portfolio involves deciding upon an appropriate Asset Allocation, which requires discussion. Asset Allocation is the most important and frequently misunderstood concept in the investment lexicon. The most basic confusion is the idea that diversification and Asset Allocation are the same. Asset Allocation divides the investment portfolio into the two basic classes of investment securities: Stocks/Equities and Bonds/Income Securities. Most Investment Grade securities fit comfortably into one of these two classes. Diversification is a risk reduction technique that strictly controls the size of individual holdings as a percent of total assets. A second misconception describes Asset Allocation as a sophisticated technique used to soften the bottom-line impact of movements in stock and bond prices and a process that automatically (and foolishly) moves investment dollars from a weakening asset classification to a stronger one, a subtle "market timing" device.

 Finally, the Asset Allocation Formula is often misused to superimpose a useful investment planning tool on speculative strategies that have no merits, such as annual portfolio repositioning, market timing adjustments, and Mutual Fund shifting. The Asset Allocation formula itself is sacred and, if constructed properly, should never be altered due to conditions in either Equity or Fixed Income markets. Changes in the investor's situation, goals, and objectives are the only issues allowed into the Asset Allocation decision-making process. 

Here are a few basic Asset Allocation Guidelines: (1) All Asset Allocation decisions are based on the securities' cost basis. The current Market Value may be more or less, and it just doesn't matter. (2) Any investment portfolio with a Cost Basis of $100,000 or more should have a minimum of 30% invested in Income Securities, either taxable or tax-free, depending on the nature of the portfolio. Tax-deferred entities (all varieties of retirement programs) should house the bulk of the Equity Investments. This rule applies from age 0 to Retirement Age – 5 years. Underage 30, it is a mistake to have too much of your portfolio in Income Securities. (3) There are only two Asset Allocation Categories, and neither is ever described with a decimal point. All cash in the portfolio is destined for one category or the other. (4) From Retirement Age – 5 on, the Income Allocation needs to be adjusted upward until the "reasonable interest rate test" says that you are on target or at least in range. (5) At retirement, between 60% and 100% of your portfolio may have to be in Income Generating Securities.

Investing is a long-term, personal, goal-orientated, non-competitive, hands-on decision-making process that does not require advanced degrees or a rocket scientist IQ. Controlling or Implementing the Investment Plan will be accomplished best by those least emotional, most decisive, naturally calm, patient, generally conservative (not politically), and self-actualized. Being too bright can be a problem if you tend to overanalyze things. It is helpful to establish guidelines for selecting securities and disposing of them. For example, limit Equity involvement to Investment Grade, NYSE, dividend-paying, profitable, and widely held companies. Please don't buy any stock unless it is down at least 20% from its 52-week high and limits individual equity holdings to less than 5% of the total portfolio. Take a reasonable profit (10% as a target) as frequently as possible. With a 40% Income Allocation, 40% of gains and dividends would be allocated to Income Securities.


For Fixed Income, focus on Investment Grade securities with above-average but not "highest in class" yields. With Variable Income securities, avoid purchasing near 52-week highs and keep individual holdings below 5%. Keep individual Preferred Stocks and Bonds well below 5% as well. Depending on the type, closed-End Fund positions may be slightly higher than 5%. Take a reasonable profit (more than one year's income for starters) as soon as possible. With a 60% Equity Allocation, 60% of profits and interest would be allocated to stocks.

Monitoring Investment Performance the Wall Street way is inappropriate and problematic for goal-orientated investors. It purposely focuses on short-term dislocations and uncontrollable cyclical changes, producing constant disappointment and encouraging inappropriate transactional responses to natural and harmless events. Coupled with a Media that thrives on sensationalizing anything outrageously positive or negative (Google and Enron, Peter Lynch and Martha Stewart, for example), it becomes challenging to stay the course with any plan as environmental conditions change. First greed, then fears, new products replacing old, and always the promise of something better when, in fact, the dull and old-fashioned basic investment principles still get the job done. Remember, your unhappiness is Wall Street's most coveted asset. Don't humor them, and protect yourself. Base your performance evaluation efforts on goal achievement… yours, not theirs. Based on the three primary objectives we've been talking about: Growth of Base Income, Profit Production from Trading, and Overall Growth in Working Capital.

Your long-range comfort demands regularly increasing income, no matter how you slice it. Base Income includes the dividends and interest produced by your portfolio without the realized capital gains that should be the more significant number much of the time. Using your total portfolio cost basis as the benchmark makes it easy to determine where to accumulate cash. Since a portion of every dollar added to the portfolio is reallocated to income production, you are assured of increasing the total annually. If Market Value is used for this analysis, you could be pouring too much money into a falling stock market to the detriment of your long-range income objectives.

Profit Production is the happy face of market value volatility, a natural attribute of all securities. To realize a profit, you must be able to sell the securities that most investment strategists (and accountants) want you to marry up with! Successful investors learn to sell the ones they love, and the more frequently (yes, short term), the better. This is called trading, and it is not a four-letter word. When you can get yourself to the point where you think of the securities you own as high-quality inventory on the shelves of your portfolio boutique, you have arrived. You won't see WalMart holding out for higher prices than their standard markup, and neither should you. Reduce the markup on slower movers, sell damaged goods you've held too long at a loss if you have to, and, in the thick of it all, try to anticipate what your standard Wall Street Account Statement is going to show you a portfolio of equity securities that have not yet achieved their profit goals and are probably in negative Market Value territory because you've sold the winners and replaced them with new inventory… compounding the earning power! Similarly, you'll see a diversified group of income earners chastised for following their natural tendencies (this year) at lower prices, which will help you increase your portfolio yield and overall cash flow. If you see big plus signs, you are not managing the portfolio properly.

Working Capital Growth (total portfolio cost basis) happens at a rate somewhere between the average return on the Income Securities in the portfolio and the total realized gain on the Equity portion of the portfolio. It will be higher with larger Equity allocations because frequent trading produces a higher rate of return than the more secure positions in the Income allocation. But, and this is too big a but to ignore as you approach retirement, trading profits are not guaranteed. The risk of loss (although minimized with a sensible selection process) is more significant than with Income Securities. The Asset Allocation moves from a greater to a lesser Equity percentage as you approach retirement.

So is there such a thing as an Income Portfolio that needs to be managed? Or are we just dealing with an investment portfolio that needs its Asset Allocation occasionally tweaked as we approach the time in life when it has to provide the yacht and the gas money to run it? By using Cost Basis (Working Capital) as the number that needs growing, accepting trading as an acceptable, even conservative, approach to portfolio management, and focusing on developing income instead of ego, this whole retirement investing thing becomes significantly less scary. So now you can focus on changing the tax code, reducing health care costs, saving Social Security, and spoiling the grandchildren.