My Capital Allocation
This article was written in October 2010. With the unprecedented credit crisis still underway, I feel it is important to understand why I allocate my capital as- 40% stocks – 30% bonds – 30% cash.
As my strategy employs 40% of my capital always in stocks I like to have a strategy that I can use no matter the financial climate.
The Federal Reserve and Stocks
While the Fed is busy propping up stocks, you can also tell from company earnings where fair value is. While many companies are showing excellent earnings, those earnings have to be taken into context with everything from reducing the number of workers employed to the amount of long term debt that has been re-written by almost 75% of US companies. When factored in, the earnings picture is pretty much the same as it was in 2006.
By establishing trend lines and valuation points, it really assists me in knowing what strategy to employ when the market reaches specific levels. An investor can do the same thing with individual stocks particularly when selling naked puts. It becomes easier and easier to know when to sell puts out of the money, at the money or in the money and whether to go one month, two months or further out depending on the stock valuation.
This allows an individual investor to understand how to stay invested throughout the year, while taking into account risk. While the Fed may be propping up the market through liquidity, a lot of that liquidity has actually been reduced from various sectors of the economy and moved to others. Right now you can tell that the Fed’s main goal is keeping the long end of mortgages and credit at low rates, so that is where they are putting most of their cash as they try to force rates down and push the dollar lower. This is impacting American businesses and those of other countries.
I think people need to understand profit levels within companies. Companies like JNJ did not really benefit in sales from the Fed’s initial action, BUT they benefited by re-writing long term debt at rates far below the normal. As well the declining dollar value means many companies will show better profits on their international sales which over the last 10 years has grown substantially.
The Fed intervention has had some long term effects that will play out on the bottom line of many US companies and as a consequence stock valuations can be established to tell me as an investor at what stock price to be prepared to sell puts, accept assignment and buy stock. So despite Fed intervention, it remains very viable for investors to determine stock price valuations in many stocks, at which they would want to sell their puts and or actually step in and pick up shares.
The Importance Of Having A Plan
In my opinion, this is what investing is all about. If tomorrow we had a major scare (How about a US dollar currency crisis which I believe is coming) and the Dow Index fell 600 points overnight and a company like JNJ fell from 63 to 50 or 30, I would know exactly what strategy to employ. I would not need to sit back and think, “well maybe tomorrow it may be cheaper”. Instead I can react immediately and begin to scale into positions.
Remember how in October 2008 Warren Buffett announced he was “Buying America”. Aside from all the political hoopla, he really was not wrong. Basically he saw value in many companies, that had become undervalued in the selling. He was early as many stocks that he bought fell another 15% or more, but it turns out he was right. When interviewed Buffett laughed and said that he really is never sure of a bottom in selling, but knew the prices he wanted on his stock picks. He went on to say that anyone could be successful at investing. He explained that it takes a lot of homework and he has his goals established long before something happens and he is a very patient man. He likes to think long term. He likes to buy when there is a sale, and in October 2008 he felt that there was a big sale happening on wall street.
In my case, if I am wrong and the stock continues to collapse, I have many strategies available. I can buy back my naked puts and roll lower, buy back and close for a loss, hold and roll further out at the same strike for more premium, sell more puts even lower, accept assignment on some stock and collect the dividend and if available sell covered calls, or do a combination of a variety of option strategies.
The problem so many investors have is short term thinking. They worry that the market will collapse around them; stock valuations will plunge; they will end up holding puts on companies that they really did not want to own; to mention just 3.
Instead if investors would establish 3 funds for themselves; stocks, bonds, cash, they might be surprised at the annual results and their ability to sleep nights. The percentages I arrived at suit my investment style and my level of comfort. Every investor needs to decide on their own comfort zones. Almost always when stocks collapse, bonds rise dramatically. The investor can then cash out some of his bonds (at a profit usually) to raise cash to step back in to the stocks that are on sale. As well having some cash available all the time means the investor does not have to sell his stocks in a collapsing market, but instead can step up to the plate and buy them on sale, averaging down on his stock holdings and continuing to sell calls and puts.
Case in point – In March and into early April 2010 I was buying bonds. Stocks were in an upswing and bonds prices were moving lower. I moved back into bonds that I had sold from October 2008 to April 2009. Then recently I posted a number of articles explaining how I was selling some of my bonds. I started selling in July right through until just recently. My bonds have returned 8 to 14 percent depending on the maturity. You don’t have to be a genius to protect and grow your wealth, but you do need a plan. If the market begins to move higher this fall I will be watching bond prices. If they move lower, which I expect they will, I will again begin to buy bonds waiting for another sell off in stocks somewhere down the road.
Turn Down The Noise
I would urge investors to step back from the daily noise and look a little further out than next week or next month and realize what is actually happening around them. Unemployment in the US is at historic highs, individual and government debt is massive, housing is absolutely terrible, BUT US businesses have scaled back their employment numbers leading to bottom line returns; debt levels have been greatly reduced and long term rates have been tied in at unprecedented low rates for more than 30 years by many corporations; many have been expanding by purchasing competitors as well as expanding into other markets. A lot of businesses have a lot of cash.
The most important aspect of the recovery remains expansion and while unemployment is terrible and governments at all levels are strapped with debt, many businesses are expanding. This is a good sign. But the talking heads don’t focus on this. The old adage that bad news sells, is still true today. I believe that eventually debt levels will become manageable. Governments just like citizens have been living way beyond their means and eventually you just had to know it would end badly. To think that this will be fixed overnight is foolish. This will take decades to remedy. It’s like weight loss. If I can put on 100 pounds over 20 years, I really shouldn’t expect to lose it all within a month. It is just not realistic. But in investing, I need to be invested at all times to garner a return, and I have to be realistic.
Be Realistic In Expectations
To make 20 or 30 percent a year or more on my portfolio is just not realistic. To have those kinds of returns I would have to “throw caution to the wind” and commit all my capital and certainly pick all the right stocks and trends. Is this realistic? Not for me. So if my 40% of capital in stocks returns even 15% I am pretty pleased. Then my bonds perhaps 5 to 6 % and my cash 1 to 2 %. Added together maybe a total portfolio return of 8, 10 or 12 percent consistently every year. Some years better than others, but consistently I want that percent return. That’s a huge return which over time will build an excellent nest egg while offering better risk management.
Any Recovery Could Be Years Away
I strongly urge investors to step back from the noise. This recovery is about as bad as the recovery that began in Sep 2002 or the August 1998. Both of these were not credit crises and as such the recessions saw unemployment more in the 8% range. I believe the recovery we are in will take a longer based on past historic credit crises of other nations. The deleveraging that needs to go forward will take some time and that is why I believe it is important to establish ranges on stocks and the market. In this way I can remain invested, know what to do at different valuation levels and know when to commit fresh capital when stock or bond plunges occur.
I believe that Investing is not rocket science or luck. It is establishing goals, developing strategies and following those strategies to a profitable conclusion. I cannot accomplish that if I only look a few weeks or a month down the road. America is a great country and I believe the American story has a lot more pages to write.