August TCA Newsletter

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August TCA Newsletter - August 6, 2009

Today is a very exciting day here at Vance Capital Management! We are releasing our first Fixed Income Strategy for our Trust Company of America clients!

I spent over three years working on the three stock portfolios. This required an enormous amount of time traveling the country going to seminars, seeking out the best money managers I know, buying software, learning computer programming languages and developing the strategies that allowed us to avoid the savage downturn in 2008.

With our new Fixed Income Strategy, we can add a shorter term component for clients who may have spending needs in the next one to five years. To clarify what we are speaking of, here is an overview of how the money management process should work for most people.

The Three Boxes of Portfolio Management

Almost everyone should segment their available spendable capital into three boxes (See diagram below). Box #1 is for Short Term needs which we define as money you may need in the next year. This is usually for emergencies and opportunities. This is an expanded concept of having 3-6 months of expenses set aside for emergencies, an axiom that the best financial advisors strongly recommend. We add short term opportunities as well. That means you would use Box #1 for that special trip that is deeply discounted or a great sale on sofas or bedroom furniture.

The instruments used consist of cash in your jeans, checking accounts, money market accounts, Certificates of Deposit (CDs) and gold. All five of these have one fundamental characteristic and that is there is no loss of principal if you spend it. Gold is a bit different in that it tracks inflation and can therefore also be thought of as a long term holding but it is still cash, it is still money, and it is not an "investment." Today, 1% - 3% is about average for cash reserve accounts. If you don't have this category covered, we can help. The bank we work with pledges to keep their CD rates in the top 5% of banks nationwide. Our money market accounts are the best and safest we can find.

The problem with Box #1 (with the exception of gold) is you are guaranteed to lose money every single day of your life. Yes, that is right! You are guaranteed a loss. The reason is all of these will pay less interest than the cost of inflation and taxes. Many bemoan the "good old days" when CDs paid 15%. To those folks, we would say: look at the facts. Inflation was running at 18% and you paid taxes on the interest so you most likely lost a whopping 8% in purchasing power. Yet, we all need Box #1 but only for the right reasons. If you need help in determining how much to set aside and where, call us for a meeting so we can help. The most important characteristic of a financially sound family is a good, well thought out cash reserve strategy!

The next box is Box #2 which is for Medium Term needs. This assumes a goal or potential need in the next 1-5 years. Those who are more aggressive would put aside three years while the more conservative folks would do five years.

Medium term goals would include buying a car, fixing or remodeling your home, saving for a down payment on a major purchase, education funding, short term retirement needs or other large purchases desired or expected in a 1-5 year period.

Normally, you would use Fixed Income and Bond investments. This would include longer term Treasury bonds, corporate bonds, high yield bonds, inflation protected bonds, bond mutual funds, preferred stocks and more. Fortunately, Fixed Income will usually just keep up with inflation but often it will not keep up with taxes. We should expect to get between 4% and 8% per year in bond or fixed income holdings.

By the way, bonds are fixed income but not all fixed income is a bond. It could be a preferred stock or note payable for example. Fixed Income is something that pays interest or a dividend and is where you loan money to a bank, corporation or other entity. I call it "loanership." The nice thing about fixed income is the returns are often relatively stable. We say relatively stable because bonds can fluctuate in value. A note payable or preferred stock can fluctuate but they don't usually fluctuate nearly as much as stocks. Hence the 1-5 year goal timeframe because fixed income will usually tend to smooth out over a 1-2 year period if it does drop. This happened from September 2008 to March 2009.

Bonds and Fixed Income make a nice complement to one's portfolio because they often move differently than stocks and equities. In 2008, when stocks were hammered, there were a few bond categories that were positive. By combining stocks and bonds, many investors are able to enjoy more stable returns over time. Again, the secret is to combine assets based on future income needs.

Box #3 is our last category. This is for goals over five years. This is where the serious money is made but it is almost never made unless people are patient and disciplined. This is for the stock investors and real estate investors. These are the only categories that really do well over time and will usually outperform taxes and inflation.

These markets are wicked to the impatient and faint of heart. Occasionally we have periods like the 1990's where it seemed to have just gone straight up for 10 years. In reality, 1994 was an off year but it was only down about 2%. Since 2000, the financial markets have been much more volatile but there are rewards for those who play by the rules and are patient. The way to be patient and disciplined is to make sure you have boxes #1 and #2 well thought out. If the game plan is sensible then a person can feel free to let the markets go through their gyrations and not lose sleep.

Surprisingly enough, we have people who are scared of losing their retirement plan that they will not touch for 20 years but want to invest in the stock market for a short term goal. We regularly have folks ask us to invest in the stock market for a house or car purchase 6-12 months in the future. This is very bad money management!

The reason for the five year goal for stock and real estate investments is because of the economy. Stocks represent ownership of businesses. In other words, if you own stocks or stock mutual funds then you are an owner of that company! I call that "ownership." Question: is "ownership" more profitable or is "loanership" more profitable? Answer: Almost always, the answer is "ownership" because you participate in the growth of the firm whereas with bonds and "loanership" you just get the income.

If the economy is struggling, stocks can drop. As the economy picks up then the stock prices will rise. Since we have no way of ever knowing when things turn around, we have to encourage people to stay the course based on goals and needs. Can a person lose all their money in the stock market? Sure but if you own a mutual fund all the companies (usually 100-200) have to go bankrupt. And it pretty much needs to happen on the same day! Could a real estate investment become worthless? Sure, just let it burn down without insurance but you can still sell the land! In other words, good investments of all kinds must be treated properly to avoid the anxiety and disappointments that many people experience.

In summary, almost every investor who is unsuccessful has brought on the problems because of poor planning, patience and discipline. In addition, they fail to follow the sound money management principles that we preach. Unfortunately, a money manager cannot make people rich; people grow their own wealth during their working years. A money manager's best contribution to any family is to help them understand the basic tenets, strategize distributions, plan their future, grow their wealth over time and manage their expectations. Again, if you are not following some of these principles it is time for a fiscal fitness checkup! Just call for a meeting. (Note: there is a nominal fee for the Fiscal Fitness Checkup)

Fixed Income Strategy and Purpose:

The purpose of this strategy is to offer a pure fixed income/bond strategy to help diversify stock portfolios. Fixed income tends to be more stable in normal years than stocks and therefore can be a desirable addition for many client portfolios. Furthermore, fixed income can generate dividends that can be used to supplement income needs. The income generated will often be far superior to the income generated by stocks.

The Fixed Income Strategy is therefore designed to be the Box #2 or it can be useful for those people who have no future income needs and can afford to be more conservative. We find that too many people want to be conservative and have no ability for their money to outlive them. They prefer to take no risk and run out of money than to take some risks and have a chance of staying afloat longer. This is contrary to common sense and good financial management but nonetheless is a very, very common malady.

For many clients, the Fixed Income Strategy is a missing link. It will give greater diversification to a portfolio plus it can be a portion that pays out income when needed. This will allow the greater wealth to grow over the long term and provide more peace of mind.

Methodology and Discipline:

This portfolio, while all fixed income, will take positions for both longs and shorts. If, for example, the bond market is weak, we will buy inverse positions. This will typically only happen during a rising interest rate environment. Rising interest rates are deadly for the bond market and occur when inflation is a threat.

The universe of fixed income that we can invest in includes but is not limited to:

1) Short term bonds: 1-3 years

2) Medium term bonds: 3-7 years

3) Long term bonds: 10 years plus

4) High yield bonds

5) GNMA bonds

6) Mortgage backed bonds

7) International bonds

8) Preferred stocks which mimic bonds

9) Multi-sector bonds

10) Inflation protected bonds

11) Corporate bonds

12) Floating rate bonds

13) Convertible bonds

Due to the nature of bonds, we do not expect to experience the high volume of trading that often occurs with stocks. We expect that the number of changes per year will be minimal. While it is impossible to know for sure, it will most likely be less than one change per month or about 10-12 per year. For fixed income, fewer changes are better.

The frequency of trading is completely dependent on the bond market, the performance of managers, the other opportunities available and our worldwide economic forecasts. Changes are based on those variables as well as modifying the allocations from time-to-time which includes rebalancing.

Goal:

The expected goal is a total return of 4% to 8% per year.

Sample Investments (actual portfolio as of 8/3/09):

1) Corporate Bonds: LQD 5% Corporate

2) Duff & Phelps Utility Corp: DUC 5% Multi-Sector

3) Pimco Foreign Unhedged PFUAX 4% Foreign Bonds

4) TIPS Bonds: TIP 14% Inflation Protected

5) Vanguard Short Term Bonds: BSV 20% Short Term Bonds

6) Pioneer High Income: PHT 3% High Yield Bonds

7) Buffalo High Yield: BUFHX 3% High Yield Bonds

8) Evergreen Income: EAD 4% High Yield Bonds

9) Pimco Total Return: PTTDX 5% Medium Term Bonds

10) Templeton Emerging Mkts TEI 3% International Bonds

11) Templeton Global Income: GIM 5% International Bonds

12) Loomis Sayles Bond: LSBRX 10% Multi-Sector Bonds

13) Blackrock Income: BKT 5% Medium Term Bonds

14) Blackrock Floating Inc: BGT 7% Floating Rate Bonds

15) S&P U.S. Preferred Stock Index PFF 5% Preferred

16) Short Term 1-3 Year Treasury SHY 2% Short Term Bonds

Sample Portfolio:

Performance:

Below is a chart of the above portfolio from October 1, 2007 to July 31, 2009. This portfolio (green line) is the one above but is static and it does not show any changes during that time. It is an illustration only. This shows a total return during that time of 11.20% or 5.96% annually. The red line is the S&P 500 and during the same time period it was down -36.17%.

Notice that the green line is much less volatile than the stock market. Also notice that it is not without its rockiness if there are market disruptions. I point this out to again show that patience is important but also that the recovery period was only 6 months and not the 5-7 years that the stock market can take. In fact, it took exactly 5 years for the stock market to recover from the dot.com debacle in 2000-2002. Fixed Income portfolios are usually not as volatile but then again, the threat of a world banking system collapse is not a normal event either!

Conclusion:

This will be a very important component for many investor portfolios. It adds a needed addition for many people who may have short term needs, want to be more conservative in a rocky market, or simply are not willing to participate in other financial markets. For investors who like the idea of having a "balanced portfolio", utilizing 40% Fixed Income helps to stabilize the other 60% which would be stocks. Other percentage allocations would be dependent on variables such as future income needs, tax consequences, capital gains and more.

If you would like to consider this for part or your entire portfolio, please email or call for an appointment. Please understand that if you come in for a meeting that we could have a very long waiting list so email is better. Appointments will be on a first come, first served basis. When I say we could have a long waiting list, what I mean is this: if I do nothing but meet with every client to discuss this then it would take over six months to meet with everyone!

We are excited to be able to continually improve our offerings that are designed to meet the needs of all investors. We are continuing to work on other model strategies to meet a variety of other needs. Many thanks to all of you; we really appreciate you!

August TCA Newsletter - August 6, 2009

'Vance on Finance'

'Monthly Client Newsletter'

'The Vance Advance'

'Portfolio Update'