Di.worse.ified?

I read somewhere that if something you own isn't going down, you're not truly diversified. The logic being that if everything you own goes up at the same time, your portfolio is too correlated to be called diversified.

By that test I'm definitely diversified. With the S&P up over 8% so far this year, my best example of diversification seems to be long Treasury bonds, which are down about 20%. Over other time periods recently, I've seen diversification work its magic on REITS, energy shares and other assets.

But long T-Bonds were about the only asset class with big positive returns in 2008, gaining about 30%. And REITS made real gains in 2006, over 35%, while energy shares climbed double digits in the first half of 2008, at a time the S&P was sinking double digits.

And despite their troubles, T-Bonds, quality REITS and blue chip energy stocks are generating interest and dividends that often exceed the 4% or so an income investor might need to withdraw from a pummeled mutual fund account. (For more, see "Monte Carlo Mojo" posted here July 15, 2009).

So it's low sweat: if you want to live on your portfolio, diversification, dividends and interest can be your best friends, even when (maybe especially when) everything isn't going up.

For more on the friendliness of dividends and interest, see "Two Pounds of Chopped Livin'" (posted here July 21, 2009). For some classic investment reading (and a reminder of the original meaning of 'diworseification' ) dust off a copy of Peter Lynch's book One Up on Wall Street.

Background links:

http://news.morningstar.com/index/indexReturn.html

http://www.amazon.com/One-Wall-Street-Already-Miniature/dp/0762409819/ref=sr_1_1?ie=UTF8&s=books&qid=1248720372&sr=1-1

Cat on a Cold Stove

Mark Twain famously wrote that a cat who sits on a hot stove won't ever do it again, but it won't sit on a cold stove either.

And so it goes with many investors, burned butts still skeptical that a bull market is underway right now. True, much of the economy has a certain stink, especially employment. But bull markets launch in such stink, because markets sniff out what's coming next.

Bull market or not, I'm sticking with a 'low sweat' investing approach: a diversified mix of high quality fixed income investments and stocks with rising dividends.

For investors living on their portfolios (or planning to) this low sweat approach offers a giant advantage: you can wait patiently for a bad market to recover because interest and dividend cash keep rolling in, even when the market is burning your butt. So whether the next stove is hot or cold, your investments wait in your account, ready to rise when the market does.

I've been investing this way since the bear market of 2000-2002 and it has served me very well. For more, see "Monte Carlo Mojo" (posted here July 15, 2009) and "Two Pounds of Chopped Livin'" (July 21, 2009).

Background link:

www.latimes.com/business/la-fi-cover12-2009jul12,0,1258839.column

Two Pounds of Chopped Livin'

"Monte Carlo Mojo" (posted here July 15) said using mutual fund withdrawals as the primary means of living on a portfolio is 'Russian Roulette, Monte Carlo style,' advocating instead 'low sweat' investing in high quality fixed income investments and stocks with rising dividends.

But let's face the ugly facts in the mirror, dividends have taken a pounding, chopped even by companies with decades of dividend growth. Yet amid what Morningstar called the worst period for dividend cuts since 1938, investors living on their portfolios (or planning to) are still better off with the low sweat approach.

To illustrate, total returns for the Morningstar category 'Moderate Allocation' (a.k.a 'Balanced Funds,' which combine stocks and bonds, making a fair proxy for a typical experience with a mix of stock and bond funds) dropped on average 28% in 2008, then gained about 7% through June 2009. So if a level headed investor withdrawing 4% in 2007 wanted to maintain that prudent 4% long term withdrawal rate, it meant taking a 28% income cut for 2008, and only a small improvement to 26% less income by June 2009.

Worse yet for investors who needed to maintain that 2007 income level. They'd have to increase their withdrawal percentage to about 5.5% of their shriveled portfolio, increasing to as much as 1 in 3 the chance of going flat broke in retirement, even with a traditional mix of stock and bond funds. Hairy scary stuff.

And how would low sweat investing compare? Diversified portfolios of stocks with a history of rising dividends (illustrated here by ETF tickers PFM, SDY and VIG) show a 2008 dividend cut of 2% for PFM but increases of 12% for SDY and nearly 18% for VIG. Low sweat so far, though 2009 gets nasty: cuts through June of 38% (PFM) and 19% (SDY) but a 1% increase for VIG.

These big 2009 dividend cuts affect just the stocks in an investor's portfolio, not all of it. So in a typical allocation (where less than half the total income is from stocks and the rest is from high quality bonds or 'level income' bond ETFs such as BLV) the investor's income is steady or higher in 2008, then most likely down 5% to maybe 15% by June 2009.

Chopped livin' but not nearly the poundin'.

Background links:

https://retirementplans.vanguard.com/VGApp/pe/pubeducation/calculators/RetirementNestEggCalc.jsf

http://quicktake.morningstar.com/FundNet/TotalReturns.aspx?symbol=VBINX&country=USA

http://www.etfconnect.com/select/fundpages/etf_funds.asp?MFID=150190

http://www.etfconnect.com/select/fundpages/fixed_etf.asp?MFID=176475

Monte Carlo Mojo

For people living on their portfolios (or planning to), those 'Monte Carlo' percentages showing how likely it is you'll run out of money can be scary stuff. Invest in a mix of stock and bond mutual funds, take out 4% to 5% for 20 or 30 years and there's an X% chance you'll be on your last dime before you're on your last calendar page.

This happens even if the funds' average annual gains exceed the 4% to 5% being withdrawn because mutual fund withdrawal strategies are based on selling shares, and withdrawal selling at bear market prices bleeds your capital until there's just not enough left.

That is the mutual fund investor's withdrawal dilemma:  A big portfolio drop means a big income cut, or a fatal increase in the withdrawal rate. And while a cash reserve is a good first-aid kit for a garden variety down market, it's not the CPR needed for a multiyear mega bear (more on this later).

But it's all low sweat (investing is never 'no sweat') if a big part your living expenses comes from high quality fixed income investments and stocks with rising dividends. You collect interest and dividends without having to sell into a nasty market, and the dividend increases help offset inflation. You're taking some risks, sure, but running out of money isn't one of them.

I don't advocate avoiding mutual funds entirely, by the way, providing they are only a secondary or discretionary source of income. Mutual funds are excellent for indexing, diversifying into certain asset classes and investing styles, and averaging cash into and out of the market. But as a primary source of living expenses they are Russian Roulette, Monte Carlo style.

In future posts I'll discuss how different types of assets, including cash reserves, make for low sweat investing, and also track a simple portfolio that pays 4% to 5%, gives annual inflation increases, and won't ever go broke. But next up: how dividend cuts compare with Monte Carlo risk.

Background link:

https//retirementplans.vanguard.com/VGApp/pe/pubeducation/calculators/RetirementNestEggCalc.jsf 

A Rollicking Look at Risk

If you've ever thought of risk as dipping a toe back in the market, check out Robert P. Smith's new book Riches Among the Ruins: Adventures in the Dark Corners of the Global Economy.

Dodging death squads, bandits, mobsters and insurgent IEDs, Smith made a fortune trading obscure emerging market debt with his 'boots on the ground' in 1980's El Salvador and Nigeria, newly capitalist Russia, and war-torn Iraq, among others.

Financial adventurer Smith sums things up nicely with his description of post Soviet Russia:

"It was one of the most chaotic, confusing, corrupt and often murderous economic transformations to ever unfold. In short, it constituted the perfect conditions for me to visit and do some business."

Riches Among the Ruins is a rip-roaring summer read filled with tales from the far edge of risk.

Background link:

www.amazon.com/Robert-P.-Smith/e/B001JS9P9O/ref=ntt_athr_dp_pel_1

Low Sweat 101

Investing is never 'no sweat' -- especially if you're living on your portfolio, or plan to shortly.

Even if you love investing, like I do, a bad market can mean a bad case of the night willies (and sometimes the day willies, too). Even low maintenance index funds have betrayed investors living on their portfolios (or planning to): 50% down means 50% less cash withdrawal, or else doubling your withdrawal rate. That's the serious willies.

So how about some 'low sweat' investing? A high quality, well-diversified portfolio whose dividends and income grow year after year to offset inflation? I've been investing this way since the bear market of 2000-2002 and it has served me very well. I'll be blogging more about low sweat investing in the days to come. Thanks for visiting.