Last week, we talked about five rules every income investor should follow in building their retirement program. Today, I want to expand on this subject a bit more and give you four rules that will take us to the next logical step — actually protecting the overall equity in your portfolio. These rules are designed to help you weather stock market ups and downs and to help you adjust your portfolio's exposure to risk as you progress toward your retirement years.
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But first, a brief word about portfolio equity protection. When you seek protection for your home or automobile from theft or other possible threats, you go to the professionals in that field and make a review of the products offered to help satisfy your concerns. You will likely look at a wide array of products offered. But in the end you are looking for devices that give warnings of intrusion either at a distance from your property (usually called perimeter warning devices) or those that only provide warning only when the home or auto is directly tampered with in an attempt to find entry.
Seeking portfolio protection is very much like seeking protection for your home or auto. You can decide to use methods that will give you a very early warning (say a decline in the Dow of 7 — 8 percent) and then set in motion the rules that you have predetermined to follow if such an event occur, or you can select rules to set in motion only when a greater decline (say a decline in the Dow of 17 — 20 percent) occurs. What I will be offering to you today is designed to be helpful regardless of the level of "threat" that occurs. These are what I call "universal" rules. If you wish to add additional rules that are more specific to your retirement plan, that is certainly appropriate. But, the four rules below, if ever broken, should be the front-line alert guards signaling you that there is a problem which needs to be addressed to protect your portfolio equity.
That said, let us talk about the FOUR RULES in detail.
Rule #1: Your age should dictate how much risk you should take in your portfolio. It is ALWAYS a question of risk-taking. Stocks are mainly for growth of equity and bonds are generally for income and safety of principal. Therefore, the first look at your portfolio should always be the balance in your portfolio between stocks and bonds. To put it in very simple terms, a higher percentage of stock investments means more risk to equity, a higher percentage of bond investments means less risk to equity.
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Several weeks ago, I gave you a very good guide to age and portfolio risk levels you should follow when building your portfolio. The title of the article was "Two Rules for Income Investing." Let me repeat a prime rule from that article. Don't ever put all or even a very large part of your investments solely in, let's say, stocks representing technology, or international stocks, or health-care stocks, etc. Why? If these areas get hit by massive selling, your portfolio will also be hit by massive equity losses. A good example of this was the 2000-2001 sell-off in the technology stocks. Many investors lost very large parts of their equity from not following this rule. Your lesson from that event should be to view history as most valuable teacher.
Rule #2: Having decided to have a mix of stocks and bonds in your portfolio, let us focus first on the stocks portion. Your stock investments should represent a minimum of 7-8 industry sectors. What is a sector? Well, for example, health-care, transportation, food, retail, technology, insurance, etc. A good place to find a more complete list is to go to any one of a number of web sites that pop up when you use a search engine with the words "stock sectors." Then, use these five points as your guides:
- Try and select sectors with which you are familiar. These may be ones allied with the business you are in, or industries that are the dominate employers in your area, or even industries you often use, such as healthcare or food.
- Select sectors that include some very large companies with a long history. These large companies are ideal as foundations in your portfolio for a long term investment strategy of growth and income from dividends.
- Try and keep away from using two closely similar type sectors in your portfolio, such as drugs and healthcare stocks, for example.
After selecting the sectors in which you want to invest, select one company from each sector as your final stock selection. These stocks should make up 75 percent of your total stock investments. Once each year, or in stock sell-offs that you consider unusual, review the stock selection you have made to be sure the growth and dividend histories remain as stable as possible and that the industry remains a good investment. If adjustments seem warranted, make them. Keep your portfolio abreast of the times. Remember, buggy whips were great in 1890, but not in 1920.
- The 25 percent balance of your investments in the stock portion should be made up of no-load mutual funds. Invest in funds that have a long history of growth in good times and a minimum of decline when stock markets have declined. Sectors are not the prime considerations here. We are interested in mutual funds that have good, long histories. These act as a back-up cushion in down markets and the fund managers do all the work of yearly and emergency review for you.
Rule #3: The bond portion of your portfolio should represent only BA rated bonds or better when you are under 50 and only A rated or better when you are over 50 years of age. Ratings are maintained on all bonds ever issued, so your broker can provide you the exact rating when you purchase the bond. Here, also, check once each year to be sure that your bond rating is stable. If it falls below the appropriate level, sell the bond and reinvest in better rated bonds.
Bond all have "maturity" dates, that is, the date the bond loan is paid back in cash to the holder of the bond. Generally, you should invest in 10-year bonds before age 50 and 5-10 year bonds if you are over 50. When you reach age 60-62, consider moving to all Treasury bonds (the safest bond investment) for your portfolio and continue to apply the 5-10 year rule here, as well.
As for interest rates, you will be somewhat constrained by the prevailing bond rates at the time you buy your bonds, but shop around for the best interest rate available And also shop around for the lowest commission and fee rates that brokers will offer. Be wary if the interest rate offered is above the generally prevailing rates available, as this is often a warning sign that the issue may be suffering some sort of problem. This applies to all but the Treasury issues, of course.
Rule #4: Do all your own analysis and all your own purchasing of stocks and bonds. There is nothing like begin involved at the "grass-roots" level of analysis and purchasing of your portfolio holdings to give you control and that sense of well being when it comes to your portfolio's health. In good market times you will benefit from knowing you have made good choices for your portfolio. And in down market times, it will be a major comfort that you have a portfolio that, while it may suffer a bit, won't fall apart and leave you with huge losses.
Now, if you feel the need to hire a consultant to help you, I have no quarrel with this at all. BUT — never let any consultant do your buying of stocks or bonds. If you hire a consultant, ask for written analysis of why he recommends a specific stock or bond, but ALWAYS make the purchase yourself and ask questions of the broker when you do. Is the broker allied to the consultant in any way? Does the consultant get any commission from the fact that you are buying the stock or bond from the broker? Is there any current broker analyst report on the stock or bond you are about to buy? If so, get a copy before you make the purchase and study it for yourself. BE INVOLVED!! BE ALERT!! When retirement comes, having been involved will give you a good grasp of what to do in the retirement years to maintain the good health of your portfolio.
Well, that's it for this week. Hope you find our four rules of help. And remember, you keeping touch. I do. See you next week.
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