The Financial Lexicon October, 2013

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1 THE INSIDER S GUIDE TO INCOME INVESTING The Financial Lexicon October, 2013 In this document, I explore the idea of income investing, explaining what it is and outlining why various assets classes and asset class categories might be included in an income-focused investor s portfolio. I will also discuss the types of things income-focused investors should concern themselves with from a macro-picture view.

2 Introduction to Income Investing Over the course of an investing lifetime, many people will likely experience changing investment goals, risk tolerances, and time horizons. During the investing journey, especially in its latter stages, many investors shift their focus to income generation rather than capital appreciation. But people in their early years of investing can also benefit from income-focused investing. By collecting after tax, above-inflation income from investments providing significant principal protection and reinvesting that income in securities also providing after tax, above-inflation income, with significant principal protection, investors can grow their wealth in a methodical way over extended periods of time. Such a strategy might prove especially fruitful in an economic- and inflationary-environment that one can reasonably expect to be slow or below historical trends. What specifically is the crux of income investing? Income investing involves focusing your efforts on creating diversified streams of income with as little risk to principal as you feel is possible in order to sustain your purchasing power over time. Income investing involves using your money to create more money in a way that is much more predictable than putting all your eggs in one or two baskets and hoping they grow over time. While it is true that strictly focusing on capital appreciation over income can reap far greater rewards, income-focused investing brings with it greater predictability and greater certainty than capital-appreciation-focused investing does. I do not believe one can ever achieve 100% certainty when investing. But a strategy that makes planning for the future more predictable will likely be an attractive option to many investors. With that said, there is a role in the income-investor s portfolio for some securities that both provide income and theoretically allow for unlimited capital appreciation. I will address those securities shortly. But first, I would like to comment on macro-economic considerations. The Macro Picture What Should Be the Income Investor s Focus? The two greatest risks to the income investor are credit risk and inflation. Making sure your portfolio is adequately diversified can help you manage these risks, and following the broader macro environment can help you monitor these risks. In terms of credit risk, a weak economic environment will bring with it challenges for businesses that could result in greater rates of debt defaults and very weak stock prices. For a broad

3 sense (not company-specific sense) of how the economy is trending, I like to monitor the labor market, manufacturing indices, retail sales, durable goods order, consumer credit, and housing market data. I also keep my eye out for other pieces of information that help build a well-rounded, realistic view of the economy. Concerning inflation, an investor whose portfolio is heavily weighted toward fixed income, even if the yield is quite attractive, runs the risk of longer bouts of moderate-to-high inflation eroding the purchasing power of his or her investments. Inflation that remains contained at lower levels makes it easier for income-focused investors to generate after tax, real returns from their income streams. In terms of monitoring inflation and the potential for inflation, I like to monitor wages, income, consumer and producer prices, and again, consumer credit. Of course, as someone interested in fixed-income, I also monitor interest rates. But in my experience, the bond market has yet to tell me something I didn t already know about inflation. Therefore, I monitor interest rates more from the perspective of looking for investment opportunities rather than for unique insights into current and potential future inflation trends. Also, the health of the labor market can provide clues as to how future wage growth may trend. Individual Common Stocks There should be well-thought-out reasons for why each and every security deserves a place in your portfolio. Regarding individual common stocks, the primary reason I own them is for the potential dividend growth. A secondary reason is for the potential capital appreciation. I like to think of companies that have a history of raising dividends on a regular basis as providing an income stream similar to that of a variable-rate bond except the rate, in many cases, rarely goes down. Notice that I didn t say I view my dividend stocks as bond replacements. I know that calling certain dividendpaying equities bond replacements became popular in the financial community in recent years. But common stocks carry risks that in my opinion do not make them suitable bond replacements. If you believe you should have X amount allocated to bonds, then X amount should be allocated to bonds, not bond replacements.

4 Why exactly does dividend growth provide an income stream similar to a variable-rate bond? This is because with each successive dividend increase, the investor s yield on cost increases. If you purchased XYZ stock for $50 per share, and, at the time of purchase, XYZ was paying a $1.50 annual dividend, your yield on cost and the stock s dividend yield would be the same, 3%. Fast forward 10 years, and XYZ is paying a $2.50 annual dividend. The $2.50 dividend means your yield on cost (your cost is $50 per share) grew from 3% to 5%. Let s jump another 15 years into the future, and XYZ is paying $6 per share in annual dividends. Over the course of 25 years, your yield on cost would have grown from 3% to 12%. Of course, things don t always work out that way. And it is the risk of things not working that needs to be carefully managed within an incomefocused portfolio. A secondary benefit to owning individual common stocks in an income-focused portfolio is capital appreciation. To guard against the risk of potential future inflation, it is necessary to have a component of the portfolio that should benefit over time from rising prices. But it is also necessary to not forget that capital appreciation is a secondary concern. Should you get too aggressive in your stock selections, it could harm your portfolio. When managing my allocation to individual common stocks as part of my income-focused portfolio (distinct from my trading portfolio), I do my best to ensure that one or more of the following three things do not occur: (1) the portfolio is overly exposed to equities, creating the risk of the next bear market causing me significant hardship/changes to my standard of living, (2) one or more of my individual stock selections goes terribly wrong, offsetting the benefits to my portfolio provided by the other individual stocks, and (3) my allocation to stocks underperforms the broader stock market indices over extended periods of time. Notice that in (3), I stated my allocation to stocks, rather than my allocation to individual stocks. I own stocks in order to capture dividend growth and as one method of helping to maintain the purchasing power of my investments. And in case the allocation to individual stocks provides sufficient dividend growth but underperforms broader-market indices, I also have an allocation to equity index funds. The primary purpose of also allocating money to broader-market indices is to ensure that the correlation between my equity portfolio and the broader-market remains no lower than a minimum acceptable level.

5 Equity Funds As I stated above, the primary purpose of investing in equity indices within my income-focused portfolio is to maintain certain minimum correlations with the broader market. If one of the reasons I am investing in stocks is to protect my purchasing power, then I want to make sure that at least some of my equity portfolio is guaranteed to be correlated with broader-market indices. And the way to do that is to purchase equity funds that track broad-market indices. Furthermore, when purchasing equity funds, pay careful attention to all the fees and costs associated with those funds. Fees can vary greatly across different funds and fund families. Additionally, I would like to point out that investors can also realize rising yields on cost when investing in equity funds over extended periods of time. But given the extremely unimpressive yields that most broad-market equity indices currently offer, it will take a while for your yield on cost to reach levels that many income-focused investors would consider exciting. Concerning Common Stocks, Keep This in Mind Individual common stocks and equity funds have a role to play in the income-focused investor s portfolio because of the potential for dividend growth and capital appreciation to protect purchasing power over time. But investors should remember that common stocks are at the bottom of the capital structure for a reason. An investment in common stocks carries certain risks (and rewards) that other parts of the capital structure do not carry. While it has been historically true that stocks outperform other asset classes over very long periods of time, it is important to remember that each of us has very defined time horizons. Each of us runs the risk of growing old at an unfortunate time in stock market history. How much you are willing to risk that your time horizon won t correspond with an unfortunate time in stock market history will help shape your allocation to stocks within your income-focused portfolio. Moreover, bear in mind that stocks aren t the only game in town. Bonds are also an important component of any diversified income-focused portfolio.

6 Individual Bonds When it comes to investing in bonds, my preference is to create a diversified portfolio of individual bonds with the intention of holding those bonds to maturity. I might not always hold the bonds to maturity. But the original intention is to do so. Nowadays, commissions and minimum purchase requirements are low enough that a few hundred thousand dollars should be sufficient to build a stable portfolio of individual bonds providing a real, after-tax yield, without assuming an unreasonable amount of credit risk. Some investors may scoff at the notion of realizing a positive inflation-adjusted, after-tax yield in today s interest-rate environment. But just because that is difficult to achieve in one part of the bond market (Treasuries, for example) does not mean it can t be found in other parts (corporate bonds and municipal bonds, for example). Perhaps the biggest reason I prefer individual bonds over bond funds is because absent a default by the issuer, the bond will mature at 100 cents on the dollar. The same cannot be said for most (but not all) bond funds. The additional predictability that principal protection in the form of holding to maturity brings for portfolio planning purposes is something I find quite compelling. Other reasons I tend to favor individual bond investing over purchasing bond funds is the ability to manage which companies you have exposure to and the ability to manage the maturity profile of the portfolio. Bond Funds If you decide to go the bond fund route, you will have the choice of investing in defined-maturity funds (not that many currently available) or more traditional funds. Defined-maturity funds are supposed to give investors access to a diversified portfolio of bonds while also having a set maturity date, like an individual bond does. Traditional bond funds do not have defined maturities and therefore have more interest rate risk over extended periods of time. Additionally, traditional bond funds tend to maintain relatively constant durations, whereas individual bonds and defined-maturity funds have declining durations over time. Although I am not a huge fan of bond funds, I can think of two reasons why I might purchase one: First, if I want exposure to a particular part of the bond market but am uncomfortable buying individual bonds in or unable to adequately diversify in that part of the market. Second, if I can

7 purchase a fund with a low/short duration at an attractive price (enough to provide what I consider a margin of safety). Other than that, I am generally not interested in using bond funds to build fixed-income exposure in my portfolio. Additional Thoughts on Bonds In order to maintain sufficient principal protection in the income-focused investor s portfolio, an allocation to bonds is prudent. The allocation need not necessarily be focused on any one part of the market (Treasures, corporates, munis, sovereigns, etc.). All of us will have different preferences and different allocations. But the one thing that should remain constant across all types of investors is that when building a diversified bond allocation within an income-focused portfolio, the importance of obtaining an inflation-adjusted, after-tax yield should not be understated. Investors using bonds to grow their portfolios can reinvest that inflation-adjusted, after-tax income into more securities with real yields, thereby maintaining consistently high returns from their bond allocations (the word high is relative to the asset class under discussion). On the other hand, investors living off their portfolios need real yields in order to secure returns that help slow the pace of withdrawals from their accounts or buy them time before withdrawals become necessary. Finally, as I mentioned earlier, while it has been historically true that stocks outperform other asset classes over very long periods of time, it is important to remember that each of us has very defined time horizons. Furthermore, when thinking through how much of your income-focused portfolio to allocate to bonds versus stocks, keep in mind that each of us runs the risk of growing old at an unfortunate time in stock market history. How much you are willing to risk that your time horizon won t correspond with an unfortunate time in stock market history will help shape your allocation within your income-focused portfolio.

8 Looking Beyond Stocks and Bonds Preferred Stocks Sitting just above common stocks on the capital structure are preferred stocks. Preferred stocks are a hybrid-type security with features similar to both common stocks and bonds. Investors looking for higher yields than the common stock and bonds of a particular company pay often find those yields in preferreds. Every public company does not offer preferred stock, so your options are somewhat limited. But many REITs, utilities, and financials do. For investors looking to build annuity-like income streams, the yields offered by many preferreds can be quite enticing. Exchange-Traded Debt In a recent article, Exchange-Traded Debt A Different Breed of Bonds, I noted several features of exchange-traded debt that makes it unique. Unlike traditional bonds, debt traded on an exchange does not have to be purchased in increments of $1,000, and there are no minimum purchase requirements. On the other hand, exchange-traded debt usually has very long-dated maturities and call features that are less favorable than more traditional bonds. Additionally, exchange-traded debt is further up the capital structure than preferred stock and pays yields that are generally in line with what one would expect from preferreds. Again, investors looking to build annuity-like income streams without needing to touch their principal often can find attractive opportunities in the exchange-traded debt space. Options Despite their reputation for being inherently risky products, there are certain options strategies that are suitable for most investors and help enhance a portfolio s income-generating capabilities. Two such strategies are selling puts and selling covered calls. By using these strategies to methodically collect small amounts of income on a regular basis over extended periods of time, you can increase your portfolio s income stream in a meaningful way. If you want to learn more about options, including selling puts, selling covered calls, and other strategies, you can do so in my book, Options Strategies Every Investor Should Know.

9 Real Estate The illiquidity, leverage, and generally high minimum investments often required for physical real estate investing keeps many people from acquiring portfolios of properties in their lifetimes. If you are one of the fortunate ones, you can certainly collect steady cash flows from rental income. For everyone else, there is always REITs. Regarding equity REITs, investors have plenty of choices in which to invest. This includes both common stocks and preferred stocks. If you are an income investor and someone interested in protecting purchasing power over time, it may behoove you to have exposure to the real estate cash flows of a variety of public REITs. Conclusion If your investment focus involves creating diversified streams of income with as little risk to principal as you feel is possible in order to sustain your purchasing power over time, then my monthly newsletter Income Investing Insider is for you. The newsletter will include a monthly macro discussion and my views of the current investing environment. It will also include ideas of various securities that might serve the income-focused investor well. Those securities will come from across the broad spectrum of assets discussed in this document. If you are serious about income investing and interested in subscribing to Income Investing Insider, you can do so here.

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