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A New Wall Street Line Dance

By: Steve Selengut

It matters not what lines, numbers, indices, or gurus you worship, you just can't know where the stock market is going or when it will change direction. Too much investor time and analytical effort is wasted trying to predict course corrections... even more is squandered comparing portfolio Market Values with a handful of unrelated indices and averages. If we reconcile in our minds that we can't predict the future (or change the past), we can move through the uncertainty more productively. Let's simplify portfolio performance evaluation by using information that we don't have to speculate about, and which is related to our own personal investment programs.

Every December, with visions of sugarplums dancing in their heads, investors begin to scrutinize their performance, formulate coulda's and shoulda's, and determine what to try next year. It's an annual, masochistic, right of passage. My year-end vision is different. I see a bunch of Wall Street fat cats, ROTF and LOL, while investors (and their alphabetically correct advisors) determine what to change, sell, buy, re-allocate, or adjust to make the next twelve months behave better financially than the last. What happened to that old fashioned emphasis on long-term progress toward specific goals? The use of Issue Breadth and 52-week High/Low statistics for navigation; and cyclical analysis (Peak to Peak, etc.) and economic realities as performance expectation barometers makes a lot more personal sense. And when did it become vogue to think of Investment Portfolios as sprinters in a twelve-month race with a nebulous array of indices and averages? Why are the masters of the universe rolling on the floor in laughter? They can visualize your annual performance agitation ritual producing fee generating transactions in all conceivable directions. An unhappy investor is Wall Street's best friend, and by emphasizing short-term results and creating a superbowlesque environment, they guarantee that the vast majority of investors will be unhappy about something, all of the time.

Your portfolio should be as unique as you are, and I contend that a portfolio of individual securities rather than a shopping cart full of one-size-fits-all consumer products is much easier to understand and to manage. You just need to focus on two longer-range objectives:

Neither objective is directly related to the market averages, interest rate movements, or the calendar year. Thus, they protect investors from short-term, anxiety causing, events or trends while facilitating objective based performance analysis that is less frantic, less competitive, and more constructive than conventional methods. Briefly, Working Capital is the total cost basis of the securities and cash in the portfolio, and Base Income is the dividends and interest the portfolio produces. Deposits and withdrawals, capital gains and losses, each directly impact the Working Capital number, and indirectly affect Base Income growth. Securities become non-productive when they fall below Investment Grade Quality (fundamentals only, please) and/or no longer produce income. Good sense management can minimize these unpleasant experiences.

Let's develop an "all you need to know" chart that will help you manage your way to investment success (goal achievement) in a low failure rate, unemotional, environment. The chart will have four data lines, and your portfolio management objective will be to keep three of them moving upward through time. Note that a separate record of deposits and withdrawals should be maintained. If you are paying fees or commissions separately from your transactions, consider them withdrawals of Working Capital. If you don't have specific selection criteria and profit taking guidelines, develop them.

Line One is labeled "Working Capital", and an average annual growth rate between 5% and 12% would be a reasonable target, depending on Asset Allocation. [An average cannot be determined until after the end of the second year, and a longer period is recommended to allow for compounding.] This upward only line (Did you raise an eyebrow?) is increased by dividends, interest, deposits, and "realized" capital gains and decreased by withdrawals and "realized" capital losses. A new look at some widely accepted year-end behaviors might be helpful at this point. Offsetting capital gains with losses on good quality companies becomes suspect because it always results in a larger deduction from Working Capital than the tax payment itself. Similarly, avoiding securities that pay dividends is at about the same level of absurdity as marching into your boss's office and demanding a pay cut. There are two basic truths at the bottom of this:
Don't pay anyone who recommends loss taking on high quality securities. Tell them that you are helping to reduce their tax burden.

Line Two reflects "Base Income", and it too will always move upward if you are managing your Asset Allocation properly. The only exception would be a 100% Equity Allocation, where the emphasis is on a more variable source of Base Income... the dividends on a constantly changing stock portfolio. Line Three reflects historical trading results and is labeled "Net Realized Capital Gains". This total is most important during the early years of portfolio building and it will directly reflect both the security selection criteria you use, and the profit taking rules you employ. If you build a portfolio of Investment Grade securities, and apply a 5% diversification rule (always use cost basis), you will rarely have a downturn in this monitor of both your selection criteria and your profit taking discipline. Any profit is always better than any loss and, unless your selection criteria is really too conservative, there will always be something out there worth buying with the proceeds. Three 8% singles will produce a larger number than one 25% home run, and which is easier to obtain? Obviously, the growth in Line Three should accelerate in rising markets (measured by issue breadth numbers). The Base Income just keeps growing because Asset Allocation is also based on the cost basis of each security class! (Note that an unrealized gain or loss is as meaningless as the quarter-to-quarter movement of a market index. This is a decision model, and good decisions should produce net realized income.)

One other important detail No matter how conservative your selection criteria, a security or two is bound to become a loser. Don't judge this by Wall Street popularity indicators, tealeaves, or analyst opinions. Let the fundamentals (profits, S & P rating, dividend action, etc) send up the red flags. Market Value just can't be trusted for a bite-the-bullet decision... but it can help. This brings us to Line Four, a reflection of the change in "Total Portfolio Market Value" over the course of time. This line will follow an erratic path, constantly staying below "Working Capital" (Line One). If you observe the chart after a market cycle or two, you will see that lines One through Three move steadily upward regardless of what line Four is doing! BUT, you will also notice that the "lows" of Line Four begin to occur above earlier highs. It's a nice feeling since Market Value movements are not, themselves, controllable.

Line Four will rarely be above Line One, but when it begins to close the cap, a greater movement upward in Line Three (Net Realized Capital Gains) should be expected. In 100% income portfolios, it is possible for Market Value to exceed Working Capital by a slight margin, but it is more likely that you have allowed some greed into the portfolio and that profit taking opportunities are being ignored. Don't ever let this happen. Studies show rather clearly that the vast majority of unrealized gains are brought to the Schedule D as realized losses... and this includes potential profits on income securities. And, when your portfolio hits a new high watermark, look around for a security that has fallen from grace with the S & P rating system and bite that bullet.

What's different about this approach, and why isn't it more high tech? There is no mention of an index, an average, or a comparison with anything at all, and that's the way it should be. This method of looking at things will get you where you want to be without the hype that Wall Street uses to create unproductive transactions, foolish speculations, and incurable dissatisfaction. It provides a valid use for portfolio Market Value, but far from the judgmental nature Wall Street would like. It's use in this model, as both an expectation clarifier and an action indicator for the portfolio manager, on a personal level, should illuminate your light bulb. Most investors will focus on Line Four out of habit, or because they have been brainwashed by Wall Street into thinking that a lower Market Value is always bad and a higher one always good. You need to get outside of the "Market Value vs. Anything" box if you hope to achieve your goals. Cycles rarely fit the January to December mold, and are only visible in rear view mirrors anyway... but their impact on your new Line Dance is totally your tune to name.

The Market Value Line is a valuable tool. If it rises above working capital, you are missing profit opportunities. If it falls, start looking for buying opportunities. If Base Income falls, so has:
So Virginia, it really is OK if your Market Value falls in a weak stock market or in the face of higher interest rates. The important thing is to understand why it happened. If it's a surprise, then you don't really understand what is in your portfolio. You will also have to find a better way to gauge what is going on in the market. Neither the CNBC "talking heads" nor the "popular averages" are the answer. The best method of all is to track "Market Stats", i.e. Breadth Statistics, New Highs and New Lows. . If you need a "drug", this is a better one than the ones you've grown up with.

Have a nice change!

Author Bio
Steve Selengut
sanserve@aol.com
800-245-0494
www.sancoservices.com
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"

Article Source: http://www.ArticleGeek.com - Free Website Content

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