long term investment portfolio

[Snoopy]

One point I've found is that extra caution is needed to keep a fairly generous cash portion for an investor who is reliant on income from a portfolio. For an investor with a $500k portfolio and 20% of it in cash, spending $30k per year can really hinder the effectiveness of a re-balancing strategy. Not sure there are any really good mechanical strategies to get around this, but having insufficient cash to reinvest near the bottom can destroy the hard work of many years. For example, if the $400k was in shares and the market crashed 40% in a year, then (assuming a steady downtrend), the client would end the year with about $62k in cash and $248k in shares, but would have only transferred about $8k across into shares through re-balancing, with just $2k going in at the bottom i.e there is not much ability for re-balancing to recover funds for them, other than to throw caution to the winds and plough the remaining cash into shares at the bottom. Anyone in this position would either need to be prepared to hold a lot more cash or put the time and effort in to a much more active strategy rather than a mechanical re-balancing system.

There are a few underlying assumptions in Lizard's post here that I think are worth questioning.

Looked at 'in total', spending $30,000 from a total investment portfolio of $500,000 is spending your portfolio proceeds at a rate of 6% per year. That requires a 'gross' income yield of somewhere just north of 8%. Not unreasonable. But over the business cycle getting a portfolio to achieve that without undue capital risk would be a challenge.

'Cash' is agnostic about where it comes from. Interest from a term deposit, or a sudden 'cash' windfall from an unexpected company takeover, can both be equally adept at paying the grocery bill or one of life's little treats. So IMO what our $500,000 nest egg owner needs to focus on is certainty of cashflow.

The last couple of business cycles in New Zealand have seen term deposit interest rates cycle between something like 7.5% and 3.9%. With $500,000 in capital that equates to a gross income fluctuation of between $19,500 and $37,500. I believe this kind of fluctuation would be barely acceptable. And that means people looking for 'steady income' need a far more sophisticated strategy than just 'term deposits', which is as Lizard suggests.

One option could be to go for very long dated company bonds. But these are only as sound as the underlying company that creates them. In New Zealand you can offer to get a similar gross yield if you buy the underlying company's share on the NZX directly. Or you could try long dated bank term deposits. But the problem here is the break fee should you suddenly decide you need your capital back.

IME the fluctuations from dividends throughout the business cycle are far less than the fluctuations from term deposits. That's because many directors are loathe to cut dividends through a business downturn they perceive as temporary. Having a solid dividend paying portfolio is usually less volatile from an income perspective rolling over term deposit investments. It is possible to decrease this volatility still further by:

1/ Investing in modestly geared utilities,
2/ Having paired concurrent investments like 'a good exporter' and 'a good importer'
3/ Investing in companies that are geograhically spread.
4/ Investing in companies that have a well run yet diversified product or service mix.

Such a portfolio will tend to not mimic the business cycle, an advantage to the fixed capital investor.

Finally the need for a steady income can be to some extent mitigated by investing in a company that allows you to 'living expense hedge'. For example owning power company shares may take some of the worry out of potential high power bills in day to day living.

With a portfolio of shares structered as above , I have found that there is no 'cash pinch' at the bottom of the business cycle, of the kind Lizard hints is inevitable.

SNOOPY