Investment strategies for individuals are definitely not "one size
fits all". The right strategy for each individual depends upon their
specific circumstances, most importantly, each client's:
Tax situation One of the most effective ways
to increase investment return is to manage the tax impact of investment
strategies. Through careful financial planning and tax aware portfolio
management, taxes on ordinary income can often be deferred or
converted in to lower rates capital gains. This can often increase
net returns by 25% or more – without any increase in investment
risk.
Time Horizon Modern Portfolio theory forms the basis of asset allocation
strategies for long investment horizons. That theory states that
over longer periods of time, stock investors are rewarded with
additional return over fixed income investors due to a risk premium.
And if one looks at longer periods of time, that premium has existed
in the majority of time periods over 5 years in length. But the
minority of periods where that risk premium is not existent or
even negative, can pose major problems for retired investors in
particular. Due to the fact that they are no longer making new
contributions to their savings, and often have no way of doing
so, the short term undependability of stocks can threaten their
financial security. One of the most common mistakes in planning
for investors with short time horizons is to make decisions based
solely on long term average returns. This is not to say that
retired investors should not own stocks. Most do have some portion
of their portfolios in stocks – but those stocks are included
for the portion of their accounts set aside for long term growth.
Cash flow needs Each portion of a portfolio should have a specific purpose.
And while it is acceptable to estimate the probability of generating
an overall portfolio return using the long term averages of the
investment markets, using an assumed rate of capital appreciation
or average returns to generate current cash flow is irresponsible.
Short term cash flow must come from either cash investments such
as money market funds, or fixed income investments such as bonds
or other dividend paying investments such as REITs, preferred
stocks, or corporate debentures.
Underlying all portfolios is the basic decision of how much to
allocate to three major investment categories:
Cash (Liquidity) Cash investments including money
market funds, stable value funds, ultra-short term bond funds,
short term CDs and T-Bills are included in this category. The
primary purpose of cash in a portfolio is to provide liquidity
for distributions to the client. Secondary purposes may be to
provide short term protection against market declines and to provide
the liquidity needed to buy fixed income or equity securities.
Fixed Income (Current Income) Bonds, long-term CDs, REITS, preferred stocks, and debentures
may be included in this category. The primary purpose of fixed
income is to provide a flow of income into the Cash segment –
which then flows out for distributions. Secondary purposes of
fixed income may be to hedge against stock volatility and to earn
capital appreciation from declines in interest rates.
Stocks (Long Term Capital Appreciation)
Diversified portfolios of index and actively managed mutual
funds whose primary purpose is to provide growth over longer periods
of time (5 plus years).
The relative proportion of each investment category is dependent
upon the primary three factors: Tax Situation, Time Horizon and
Cash Flow needs.
Investment Category Examples
The following are examples of how these investment categories interact
for three sample individual investors:
Investor 1: Pre-Retirement
This investor could be in their 20's to early 50's with any need
for distributions or income at least 10 years in the future. It
could also be for an account that may either have no or little need
for any income distributions within a 10-year period and/or needs
to be managed in a tax sensitive manner strictly for capital appreciation.
In this type of situation, stocks are relied upon for the most
of the "heavy lifting" in the portfolio as such, typically compose
80% to 95% of the account. Although some of the stocks held may
generate dividend income, the portfolio strategy matches the long
term time horizon of the investor with the long Šterm return premium
offered by stocks. Cash and fixed income play a relatively minor
role in the portfolio – mainly for short term tactical reasons.
Investor 2: Near Retirement This investor could be in their early 50's to 60's in the process
of transitioning into either retirement or significant distribution
needs within 5 to 10 years. Stocks are often still a significant
portion of the portfolio, composing 50% to 70% of the account. This
is due to the fact that even after distributions commence, the account
will require capital appreciation to meet longer term objectives.
Within 3- 5 years of retirement, however, the client begins to identify
their income needs and post-retirement budgets. Those estimates
lead to a withdrawal plan and the income generation needed to meet
those needs. Therefore, a fixed income portfolio begins to be purchased
that targets specific amounts of cash flow. By the time the client
actually reaches the point of retirement or distribution needs,
the income generation is in place to generate those dollars.
Investor 3: At Retirement The retired investor faces significant challenges
and risks. The time period of retirement may be long, yet the
retired investor cannot depend upon long term averages to meet their
investment goals.
History has shown that a standard asset allocation portfolio of
about 50% stocks, 40% bonds and 10% cash averaged about an 8% return
from 1996 to 2003. History has also shown that the majority of all
5 and 10 year periods studied delivered average returns at or above
this average return figure, and that the longer the time frame of
the periods studied, the less risk this type of portfolio exhibited.
But the key word is "majority". Projecting long term return averages
to estimate returns for a retirement income strategy is seriously
flawed. This is because a retired investor that gets caught up in
one of the "minority" periods, where the capital appreciation of
the stock market is not present, may run into significant problems.
For retirees that wish to withdraw more than 3% of their portfolio
annually, a standard asset allocation model dependent upon long
term average returns will not work. For a retired investor needing
higher amounts of cash flow, the emphasis on stock market appreciation
must be reduced.
Fortress's Yield Driven Allocation Strategy
uses the following strategy for retired investors:
1.
A monthly income figure is determined
based upon a distribution planning model.
2.
At least 12 months of that monthly income
is set aside in Cash.
3.
A fixed income portfolio is designed
to meet the specific monthly income figure. The dividends and
interest from the fixed income investments are swept into the
cash account and transferred into the client's checking account.
4.
Excess asset amounts are invested in
an index based stock portfolio designed to generate capital
appreciation within a 10 year cycle.
5.
As capital appreciation occurs within
the stock portfolio, profits are taken and used to purchase
more fixed income investments. This has the effect of giving
the client a "raise".
