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Stock and Bond Market Trading Powers Modern Portfolio Asset Allocation

Portfolio / Learn to Trade Feb 06, 2008 - 01:44 PM GMT

By: Steve_Selengut

Portfolio Best Financial Markets Analysis ArticleFor most individual investors, trading is approached in a totally speculative manner. Stock trading, in its more popular forms (Day Trading, Swing Trading, etc.) includes none of the elements that a conservative investment strategy would contain: little if any attention is given to the Quality of the equities selected; Diversification is determined by chance alone; no attempt is made to develop an increasing and dependable stream of Income. But stock trading by individual investors doesn't deserve quite as bad a "rep" as it has earned. After all, its very foundation is profit taking, probably the most important and most often neglected of the activities required for successful investment management. Unfortunately for most equity traders, loss taking is a more common occurrence.

Bond, and other income security trading is generally avoided by most non-professionals. Obviously, it takes more investment capital to establish positions in corporate and municipal bonds, real estate, and government securities than it does in equities, and the volatility that traders thrive upon is just not a standard feature of the mundane world of income investing. Surprisingly, most investment professionals avoid a more exciting approach to income investing that is actually safer for investors and less inflexible in the face of changing interest rate expectations.  Certainly, Wall Street financial institutions pressure their representatives to push individual new issues and/or investment products, but I think that the market value fixation that stretches from Wall Street to Main Street is the real culprit. Income securities need to be assigned a value that recognizes the safety of their income production and market value changes should only to be viewed as opportunities for increasing yield or taking rare, but wonderful, profits.

Consequently, most trading is done in an equity only environment that is too speculative for most mature (in whatever sense you choose) investors.  But this is not the way it needs to be. Since stock prices are likely to remain volatile in the short run and cyclical in the long run, there will always be opportunities for profit taking. Similarly, there are no rules against taking advantage of the cyclical nature of interest-rate-sensitive security prices.  Trading is the world's oldest form of commercial activity, and it is unfortunate that it is treated with such disrespect by our dysfunctional tax code. It is even more unfortunate that it is looked at askance by client attorneys and brokerage firm compliance officers... masters of hindsight that they are.

Trading does not have to be done quickly to be productive, and it doesn't have to focus on higher risk securities to be profitable. And perhaps most importantly, it doesn't have to avoid the interest-rate-sensitive income securities that are so important to the long-term success of any true investment portfolio. Once a trader/speculator is weaned off the gambling mentality that brought him to the shock market in the first place, he can apply his trading skills to investing and to portfolio management. The transition from trader/speculator to trader/investor requires some education... education that generally cannot be obtained from product salespersons.

Step one is to gain an appreciation of the power of Asset Allocation. Asset Allocation is the process of dividing the portfolio into two conceptual securities buckets. The primary purpose of the equity bucket is to produce growth in the form of realized capital gains. The other bucket contains securities whose primary purpose is to produce some form of regular income... dividends, interest, rents, royalties, etc. The percentage allocated to each is a function of a short list of personal facts, concerns, goals, and objectives. The cost basis of the securities must be used in all asset allocation calculations. Asset allocation itself is a portfolio planning exercise that is based on the purpose of the securities to be purchased, and long term in nature. It should not be "rebalanced" or altered due to current market conditions or suppositions about the future.

Market values are used in the selection process that identifies potential trading candidates and as the trigger mechanism for profit taking decisions.  Cash from all income sources is always destined for one bucket or the other, depending on the cost-based asset allocation formula. Selecting equities must first be fundamental, then technical... quality first, and market price second. My trading experience is that higher quality companies purchased at a 20% or more discount from the 52-week high, with a profit target of approximately 10%, is a very manageable approach.

The proceeds find their way back into the "smart cash" pot for asset allocation according to formula. There will be times when smart cash will grow quickly while the list of new trading candidates shrinks, but when trading candidates are all over the place, smart cash can only be replenished with income produced by both securities buckets. Thus, insistence upon some form of income from all securities owned makes enormous sense.

What about trading the income bucket securities? Enter the managed closed-end income fund (CEF), as tradable as any common stock, and in a surprising variety of income producing specialties ranging from preferred stocks to royalty trusts, treasuries to municipals, and REITs to mortgages. No more worries about liquidity and hidden markups. No more cash flow positioning or laddering of maturities. And best of all, no more calls of your highest yielding paper when interest rates fall. Instead, you are taking capital gains, compounding your yield, and paying your dues to the equity bucket with every transaction. And when interest rates move back up... you'll have the luxury of reducing your cost basis by adding additional shares. Of course its magic... that's what we do here on Wall Street!

By Steve Selengut
Professional Portfolio Management since 1979
Author of: "The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read", and "A Millionaire's Secret Investment Strategy"

Disclaimer : Anything presented here is simply the opinion of Steve Selengut and should not be construed as anything else. One of the fascinating things about investing is that there are so many differing approaches, theories, and strategies. We encourage you to do your homework.

Steve Selengut Archive

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