(From about 2010-2016, I spent most days scouring the markets for asset bargains and then used those “found” bargains to construct income portfolios for retirees or pre-retirees. What follows are some of the key insights I gained during that period as a bond trader and portfolio manager.)
A day in the life of “The Wizard”…
“I need a bond ladder that generates 5% tax-free income to show to this prospective client!”
This was the typical refrain during my tenure as “The Wizard” as I was called then. Why “The Wizard”? Well, because I had a knack for finding the most unbelievable bargains when it came to municipal bonds. All I needed was a Bloomberg terminal and a few hours. I’d get on the phone and work my magic. It wasn’t really “magic” but my efforts were delivering double-digit returns in a bull market for bonds. Low-interest rates were my friend. And so was market volatility, which played a significant role in scaring retail investors into selling their mutual fund holdings which in turn caused large mutual fund managers to flood the market with inventory at fire-sale prices.
Having studied the financial markets for close to 20 years now, I’ve seen a lot. My takeaway is that I’m no longer surprised that many servants of the financial industry constantly search for the next best investment strategy. For starters, passive investment strategies (AKA “indexing”) can be subject to many flaws. Possibly the most glaring is that you get less than 100% of market upside and more than 100% of the market downside (because of fees to implement). Most people use passive strategies to save on costs, without considering the implicit costs of the strategy–most of which relate to volatility. On the other end of the spectrum are actively managed strategies, which are difficult and expensive to implement and maintain. Suffice to say, if you’re reading this, you may not have the time it takes to be a proficient active trader. Notwithstanding, trying to compete with well-funded institutions which trade in milliseconds.
Key Insight: Joe Blow Investor can’t beat the market with active trading…
After twenty years as a student of financial markets, I’ve learned that the chips are stacked against Joe Blow investor. Rather than being a matter of smarts or financial savvy, it’s really a matter of available tools. The average investor is generally no match for the tools available at even the smallest asset management firms. Since this is the case, all the evidence points to not trying to “beat” the collective market with active trading. (Most investors know this, but some still attempt this bold challenge.) It’s akin to trying to take a freshly killed gazelle from a lion.
If you’ve ever watched an animal bold and desperate enough to try this, it doesn’t end well for them. So what strategy should investors employ to deliver consistent total returns? I can confidently say, “there are no silver bullets”. However, what I’m calling the “Be the Bank” investment strategy can consistently deliver on the objective of total return.
Key Insight: You should instead focus on creating spendable cash flow…
In portfolio creation, the end goal is total return (i.e. growth of capital). This can happen in three ways…
- Change in price (aka “growth”)- Simply put you buy at $10 and it goes up to $20.
- Income (aka “cash flow”)- For stocks, these are dividends, for bonds its called coupons. Any form of payment you receive for holding the asset.
- Interest on Income (aka “compound interest”) – This is affectionately referred to as the 8th wonder of the world sometimes because of its power. This is when your income earns income.
The total return for a portfolio is composed of all of these. And of the three, income is arguably the most controllable and reliable. (If you find anyone that can predict the direction of price for any asset, give me a call.) Growth is great, but income-producing assets in a portfolio are more reliable when it comes to predicting total return. Using assets that have legal contracts or a long history of consistent payments are excellent proofs to determine reliability. This is why most pension programs hold bonds or fixed income in their portfolios in order to “match-up” fixed liabilities associated with pension payments. A bond’s coupon payment to the holder is a legal contract that is enforceable unlike dividend payments from stocks.
Key Insight: After all, trying to find growth is expensive (and overrated)…
If I had a dime for every phone call I received asking me about “XYZ” stock, I could put my great, great grandchildren through college (I’m not kidding!)
My observation is that the preoccupation with the “growth” component of total return has made (but mostly lost) many millions of dollars for investors. (Don’t believe me? Just Google ”Dotcom crash”.)
Here’s a real story from my trading days (some information removed to protect the innocent)…
“Hey Dominique, how you doing today”
“Oh, I’m fine Mr. ______. How can I help?”
“Can you look up a stock for me?”
“Sure what’s the ticker?”
“Ok. So you know Mr. ______, this is a penny stock? It’s really outside the scope of the investment strategy we’ve created for you.”
“Yeah I know, but I’ve been reading up on it and it has some technology that is going to change the way we use light bulbs. You won’t have to change your light bulbs but once every 5 years or so.”
“Well you realize that this company hasn’t turned a profit yet.”
“ I know, but they will. I’m telling you _________ has the market cornered on this technology. So I want to buy $10,000 worth. How many shares is that?”
You can probably guess how that story ended. Suffice to say, he’s not any closer to being a millionaire today than he was then.
Although I understand it…the growth story is sexy and salacious. It’s fun to talk about at dinner parties or on the golf course. The income story–not so much. It’s boring. It’s predictable–but it works.
Key Insight: Cash is king–that’s why people like real estate…
The main problem with real estate is scale though. If you don’t have the capital to purchase commercial real estate, you have to get into retail. And that means your income source just became “not-so-passive”. Having owned real estate before, I’ve lived this pain. No matter how much of a mogul you are, you need renters to make the investment work. Empty properties are just liabilities for real estate investors. Since renters are people too, a down real estate market usually means that your renter will want to “downsize”. Translation. You essentially take a pay cut by either lowering your rents or worse, spend your precious time finding another renter.
On the contrary, an income-focused investment strategy usually survives down markets with very little or no change to the level of income. I remember holding bonds in a portfolio that dropped more than 15% in price, but every six months the coupon payments were deposited into the account–just like clockwork. The same for other cash-flowing investments. This phenomenon also has the extra benefit of using that cash flow to buy additional shares in the down market.