Managing a portfolio
A gentle pruning
Most everyone has heard of dollar cost averaging. This is the practice of investing a steady amount of money in stocks on a regular basis, say once a month, over many years. Because stock prices are volatile, this practice has the benefit of smoothing out, or averaging, the cost over time. Sometimes the stocks will be bought when prices are high. But, just as often, the stocks will be bought when prices are low.
Investors in common stocks
My wife and I have been retired for 18 years. We rely almost exclusively on our investments for the cash to live on.
Almost all of our retirement savings are invested in common stocks. The only exception is when we go into bonds in face of a general stock market bubble. The last time we did that was in 1998. We have been essentially 100% in stocks since the fall of 2002.
When investing in stocks, some people think you should only support yourself on the dividends earned. Otherwise, they say, you will be encroaching on your capital. That, they say, is a sure recipe to run out of money.
That view is mistaken. To understand this properly, you need to understand the concept of total return investing. We can turn to Warren Buffett to explain this:
On December 10, 2001 Carol Loomis’ report on the CNNMoney website contained an essay written by Warren Buffet based on a speech he had given the previous July. (Buffett W. , 2001) It may be found at: http://money.cnn.com/magazines/fortune/fortune_archive/2001/12/10/314691/
The following are excerpts as written by Buffett:
“To report what Edgar Lawrence Smith discovered, I will quote a legendary thinker–John Maynard Keynes, who in 1925 reviewed the book, thereby putting it on the map. In his review, Keynes described ‘perhaps Mr. Smith’s most important point … and certainly his most novel point. Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back in the business. Thus, there is an element of compound interest operating in favor of a sound industrial investment.’
It was that simple. It wasn’t even news. People certainly knew that companies were not paying out 100% of their earnings. But investors hadn’t thought through the implications of the point. Here, though, was this guy Smith saying, ‘Why do stocks typically outperform bonds? A major reason is that businesses retain earnings, with these going on to generate still more earnings–and dividends, too.’”
Total return investing
Investors in common stocks earn returns in two ways. They typically receive dividends. They also take advantage of the fact that well managed businesses “retain a part of their profits and put them back in the business.” This results in capital gains.
In time, capital gains come about not because stocks become overpriced. What happens is that a well managed business will become more valuable over time and the price will reflect this. This increase in value contributes to a return on investment.
Taken together, dividends and capital gains make up the total return on the investment.
Live within your means – total return
With saving for retirement, everyone knows it’s really important to start early. Thirty or more years will go by before the savings and investments are used for retirement. This is when dollar cost averaging takes place naturally.
The next horizon to plan for is when you retire. Retirement might last for thirty years. The big question is how much of one’s retirement savings can you consume each year and not run out of money before you die.
If you invest in common stocks, the answer revolves around the total return you make on your investments. I can say that after 18 years of retirement there is no easy answer to that question. It depends on the total return you obtain from your investments. The answer I have come up with is to maximize our investment returns through careful investments in common stocks and then live within our means.
The term I have coined is, dollar price averaging, the practice of retirees selling small amounts of stocks on a regular basis to generate the cash to live on. These sales, when combined with dividends received, allow us to live off our total returns. It is the disinvestment equivalent of dollar cost averaging.
Typically, I sell enough stocks to generate about three months cash to live on. Thus, very roughly, sales take place about four times a year.
The selling is an integral part of portfolio management. In gardening terms, the selling is a light pruning. The watchword for every sale is whether it improves the overall quality, balance and diversity of the portfolio. Typically, I will sell stock in the company I consider the weakest company in the portfolio. By weakest I refer to the business of the company not the price of the shares.
Some advisors recommend holding sufficient cash to cover living expenses for, say, two years. This is foolish. It either sterilizes a substantial portion of the portfolio or causes investors to pick a time to sell that may or may not be at a good time (timing the market is bad).
Dollar cost averaging works well when saving for retirement. It happens naturally over many years. Investing a lump sum, such as an inheritance presents different issues. In retirement, investors in common stocks can sensibly follow a dollar price averaging approach to generate cash to live on.
You can reach me by email at email@example.com
I’m also on Twitter @rodneylksmith
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