A New Wall Street Line Dance

That does not mean what lines, numbers, indices, or gurus you worship, you just can not 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's market value with a handful of unrelated indices and averages. If we reconcile in our minds that we can not 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 need not speculate about who is related to our own personal investment programs.

Each year in December, with visions of sugar plums dancing in their heads, investors begin to scrutinize their performance, formulate coulda's and shoulda's, and decide what to try next year. It is an annual, masochistic, right of passage. Our year-end vision is different. We see a lot of Wall Street fat cats, ROTF and LOL, while investors (and their alphabetically correct advisors) determine what to modify, sell, buy, redistribute, 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 against specific goals? The use of Issue Breadth and 52-week High / Low statistics for navigation and cyclical analysis (from tip to tip, etc.) and economic realities, as performance expectation barometers do a lot more personal sense. And since it had become fashionable 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 creates transactions in all conceivable directions. An unhappy investor is Wall Street's best friend, and by emphasizing short-term results and creating an environment superbowlesque, they ensure that the vast majority of investors will be unhappy about something, all the time.

Your portfolio should be as unique as you are, and we argue that a portfolio of individual securities rather than a cart full of one-size-fits-all consumer products is much easier to understand and administer. You only need to focus on two longer-range goals:

(1) growing productive Working Capital, and

(2) increasing Base Income

Neither objective is directly related to the market averages, interest rate movements, or the calendar year. Thus, they protect investors from short-term, anxiety causes, events or trends while facilitating objective based performance analysis that is less frantic, less competitive and more constructive than conventional methods. Maps, Working Capital is the total cost basis of 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 us 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 graph has 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 pay fees or commissions separately from your transactions, consider them withdrawals of working capital. If you do not have specific eligibility criteria and profit taking guidelines, develop them.

Line One is labeled "Working Capital", and an average annual growth rate of between 5% and 12% would be a reasonable target, depending on Asset Allocation. [An average can not be determined until after the end of the second year, and a longer period, it is recommended to allow for mixing.] This upward only line (Do you raise an eyebrow?) Increased by dividends, interest, deposits, and "unrealized" capital gains and decreased by withdrawals and "clear" losses. A new look at some widely accepted year-end behavior can be useful at this point. Offsetting gains with losses on good quality companies 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 demands a pay cut. There are two basic truths at the bottom of this:

(1) You just can not make too much money, and

(2) there is no such thing as a bad result

Do not 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 will always move upward if you manage your asset allocation properly. The only exception would be a 100% Equity Allocation, with its emphasis on a more variable source of Base Income ... yield of a constantly changing stock portfolio. Line Three reflects historical trading results and is labeled "Net unrealized capital gains". This figure is the most important in the early years of portfolio building and it will directly reflect both 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 the 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 no 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, which is easier to achieve? Of course, if growth in Line Three accelerate in rising markets (measured by issue breadth numbers). 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-on-quarter movement of a market index. It is a decision model, and good decisions should produce net realized income.)

Another important detail No matter how conservative your selection criteria, a security or two is bound to be a loser. Do not judge this by Wall Street popularity indicators, leaves, or analyst opinions. Let the fundamentals (profits, S & P rating, dividend action, etc) send the red flag. Market price just can not trust a bid-to-point resolution ... but it can help. This brings us to Line Four, a reflection of changes in "total portfolio market value over time. This line will follow an erratic path, constantly staying in "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 do! BUT, you will also notice that the "lows" of Line Four begin to occur above earlier levels. It's a nice feeling when Market Value movements are not themselves accountable.

Line Four will rarely be above Line One, but when it starts to close the lid, 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 small margin, but it is more likely that you have allowed some greed into the portfolio and that profit taking opportunities are being ignored. Do not ever let this happen. Research shows quite clearly that the vast majority of unrealized gains are brought to Schedule D realized losses ... and this includes potential profits on income. And when your portfolio hits a new high watermark, look for a security that has fallen into disfavor with the S & P rating system and bite that bullet.

What is different about this approach, and why is it not more high tech? There is no mention of an index, an average, or a comparison with anything, and this is 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's 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 to believe that a lower market value is always bad and always a greater good. You need to go beyond "market vs. Anything" box if you hope to achieve your goals. Cycles rarely match from January to December mold, and are visible only in retrospect 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, then:

(1) the quality of your holdings, or

(2) you have changed your asset allocation for some (possibly inappropriate) reason, etc.

So Virginia, it really is OK if your market is in a weak stock market or in the face of higher interest rates. It is important to understand why it happened. If it is a surprise, so you do not really understand what is in your portfolio. You will also need to find a better way to measure what is happening in the market. Neither the CNBC "Talking Heads" or "popular averages" are the answer. The best method of all is to trace "Market Stats", i.e. Breadth Statistics, New highs and New lows. . If you need a "substance", this is better than the ones you grew up with.

Have a nice change!