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July, 2006

THE 5% SOLUTION - A NEW LOOK
AT A HIGHER YIELD, LOWER RISK PORTFOLIO
by LARRY

In the April issue, I noted that "we have now gone over three years since a significant market correction. I understand there have only been a few prior times when this long a period has elapsed without a 10% or greater correction. I believe in each of the other instances such a period was followed by market pullbacks of from 10-40%. While this time may be different, I think it particularly prudent now to assure that one's assets are well allocated." Since then, over just the period 4/21/06-7/14/06 (when this was written), the broad Nasdaq index has fallen about 13%. (Lest anyone, however, think I am now good at market timing, I did not anticipate the big equity drops in 1987, 2000, or 2002 and, if the market now surges in the balance of 2006, as it well may, I won't have anticipated that either.)

Meanwhile, recent increases in the Federal Funds Rate have led both to greater yields for CDs, money market funds, plus short-term bonds and to more pressure on stock prices. None know when there may be a substantial new catastrophe as bad as or worse than those on 9/11/01 (or than Hurricanes Katrina and Rita, for that matter), but a variety of experts say we are not yet prepared for one when it occurs and that many people are quite interested in assuring such disasters are part of our nation's future. When they occur, stock markets are apt to react badly. As if these factors were not enough, higher energy prices, added instability in the Middle East, and further ongoing terrorist activity have led to significant present stress for investors.

It seems an appropriate time to reconsider means to receive a good dividend from one's total portfolio while retaining some growth potential, and yet hopefully being exposed to less risk of permanent loss to one's nest egg than in the overall stock market.



One possible approach, the 5% solution, involves five sets of asset categories, largely of increasing potential risk, but for which the total volatility is reasonably low, yet the income is relatively high (intended to be at least 5% annually). The five sets are:

  • Lower Risk Fixed Income

  • Higher Risk Fixed Income

  • Misc. "High-Yielders"

  • Lower Risk Stocks

  • Higher Risk Stocks


Here are typical assets (or asset classes) to put in each category:

I - Lower Risk Fixed Income*

Asset (or Asset Class)SymbolRecent Yield
Top-Yielding Online Bank Savings Acc't.-4.7%
Vanguard Prime Money Market FundVMMXX5.0%
Ten-Year US Treasury Notes-5.1%
Vanguard Short-Term Bond Index FundVBISX5.3%
Top-Yielding One-Year Certificates of Deposit (CDs)-5.5%

II - Higher Risk Fixed Income*

AssetSymbolRecent Yield
Vanguard GNMA FundVFIIX5.2%
Vanguard Long-Term Investment Grade Bond FundVWESX6.1%
Fidelity Floating Rate High Income FundFFRHX6.3%
Alabama Power AAA-rated Preferred SharesALZ6.4%
Pulte Homes BBB-rated Preferred SharesPHMI7.4%

III - Misc. "High-Yielders"*

AssetSymbolRecent Yield
Vanguard High-Yield Corporate Bond FundVWEHX7.5%
Cross Timber TrustCRT7.5%
Eaton Vance Senior Floating-Rate Income TrustEFT8.6%
Thornburg Mortgage REITTMA9.8%
BP Prudhoe Bay TrustBPT11.5%

IV - Lower Risk Stocks*

AssetSymbolRecent Yield
Berkshire Hathaway, Class BBRK/B0.0%
Royal Dutch Shell, Class ARDS/A3.7%
Bank of AmericaBAC4.1%
Bristol-Myers SquibbBMY4.6%
Sara Lee Corp.SLE4.8%

V - Higher Risk Stocks*

AssetSymbolRecent Yield
Pfizer, Inc.PFE4.3%
Allied CapitalALD8.3%
American Capital StrategiesACAS9.8%
MCG CapitalMCGC11.0%
Genco Shipping and TradingGSTL12.0%

(*Average of 25 sample asset yields: 6.6%)



Depending on one's particular risk averseness, income needs, or desire for greater growth, she or he can put any desired percentage of holdings into each set of lower to higher risk assets. One should have little difficulty achieving an overall 5% or better yield, while also likely enjoying some investment growth and overall portfolio volatility about the same as or below that of the major market indexes. There are no guarantees in investing, though, and each investor should do his or her own research and/or consult with a preferred financial advisor prior to such purchases.

I would recommend that the asset sets be rebalanced to within a certain threshold (such as 5%) of the desired allocation percentages about once a year or after one's equities have fallen or risen more than 5%. (Some suggest no portfolio adjustments until there has been a rise or fall of 10% or more. I think it is a matter of personal choice. Either level assures that one is selling when prices in the now increased market value set are higher or buying when those of a now decreased market value set are lower.)

Other than this periodic tweaking of the nest egg, one may hopefully just sit back and enjoy growth and income with, as the Aussies like to say, "no worries, mate." With any luck, the main concern will simply be: "What do I wish to do with all this extra income?"

Ah, would that things were that simple! In fact, since both the economic environment and individual assets may change in the intervening period, it would be well to also review one's holdings every now and then, either completely on one's own, if comfortable with the issues involved, or with assistance from a professional.

Source:
Where to Find the Best Yields. Jeffrey R. Kosnett in Kiplinger's Personal Finance, Vol. 60, No. 8, pages 43-46; August 2006.



DISCLAIMER

Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)



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