Investing For Retirement And Steady Income

David Frost // Additional Articles


November 20  

Most of the time, the core objective of many investors is to produce enough capital for retirement so that their annual living expenses can be covered by the income produced by social security, any pension income that may exist from a past employer and investment income they can derive without dipping into the principal or original capital.

With hundreds of thousands of financial professionals, companies and strategies in existence since the beginning of time, its very difficult to provide one strategy that would be appropriate for everyone. With that in mind, I will attempt to outline a methodology that can have multiple iterations and can be altered for everyone’s individual and family needs. We will call this approach “The Power of Three.”

What is it?

The power of three is an approach where you would look at your investable assets in three (3) distinct and separate categories. For the purposes of this example, we will assume that the assets will be divided into thirds (33.3% each). Of course, this can vary depending on your financial situation. The first and most important category is the risk free portion. Let’s assume we’re working with $300,000 total. The first $100,000 would be considered risk free and should be invested in a manner where you simply shouldn’t lose any money no matter what happens. This means that a portion would be in CD’s (Certificates of Deposits) that are FCIC insured, Treasury bonds, bills or notes or cold hard cash, no exceptions. Over time, these investments will earn what is called the risk free rate of return and can be very low at times of low interest rates or can be reasonable during other times. During an investing life cycle, the risk free rate has averaged about 4-5%. Today in 2010 it’s much lower. This category of investment serves multiple purposes over time. Two of the primary ones are unforeseen emergencies where you will always have cash on hand if you need it and the other is a protection against large swings and volatility in the stock or bond markets where you could lose principal value of your investments either on a temporary or permanent basis.

The second category is reserved for a little more risk and may be considered the intermediate term investment category. While not risk free, this portion of your money should stay relatively steady and earn more income and return than the first category. An example of the investments that would fit best are various types of bonds or bond funds. Diversification is important because like any other investment where there is risk, you must not place all your eggs in one basket. Different types of bonds that may be purchased are corporate bonds, municipal bonds, agency bonds, high yield bonds, international and emerging market bonds, convertible bonds and a few others that offer steady returns and should keep your principal value safe. For an added level of diversification purchasing these investments in mutual fund format can help to minimize risk. Historically, a realistic long term return in this category can be expected to come in at between 6-9%. Of course, like any other investment, there will be times of greater or lower returns. This should not be considered risk free and you may experience a loss of principal value especially during periods of rising interest rates.

The third category has been set aside for growth. This represents the category where, under this strategy you would take risk over the long term and invest this portion of your assets in the stock market. Even Though you might have heard that over the long term, the market always goes up, that may not be true depending on when you got in and what you invested in. Therefore, like any other investment, you should be very thoughtful and deliberate when considering this category. It’s not a buy and hold or buy and hope situation. You must consider what you’re investing in, how your allocating the capital and it must be managed accordingly. In our example for the last $100,000 portion, we will stay with mutual funds for an added level of diversification. Within those funds, we will allocate our monies to different types of funds just like category two (2). An example would be to invest in the following areas; Large Company Stock Fund, Small Company Stock Fund, International Stock Fund, Emerging Market Stock Fund and Technology Specific Stock Fund. Of course, this is only an example and can be adjusted in many ways to accommodate your liking.

How to manage year over year?

This certainly isn’t a set it and forget it method. When considering each of the three categories and the investments within those areas, you should at a minimum do the following:

  • Add to the investments whenever possible – pay yourself first.
  • Monitor the investments for performance at least quarterly
  • Re-balance the investments within the categories and between the categories. While there is no right or wrong formula for this portion, it makes sense to make sure your investments between and within the categories stay within the original percentages plus/minus 10 percent. For example, if the stock market out performs everything else over a period of 6 months, take some of the profits and move them into either an under performing segment of your investments or the risk free portion.

Here is a rough example of a hypothetical portfolio using mostly exchange traded funds for categories two and three.

Category 1 Risk Free

Bank CD’s To be safe, pick at least 3 different banks
Treasury Bonds, Notes or Bills
Cash – preferably in a safe, vault or buried in the back yard

Category 2 Some Risk

LQD          Long Term Corporate Bonds
JNK          High Yield Bonds
TIP           Treasury Inflation Protected Securities
VCSH       Short Term Corporate Bonds
VCIT        Intermediate Term Corporate Bonds
VMBS      Mortgage Backed Securities
EMB         Emerging Market Bonds
ISHG       International Treasury Bonds

Category 3 Stock Market Risk

VUG      Large Capitalization Growth
VB         Small Capitalization
VTI       Total Stock Market
VWO    Emerging Markets
VEU     All World except United States
VT        Total World Stock Index

This hypothetical portfolio is for illustration purposes and may not be suitable for you based on your financial needs. You decide.

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About the Author

Trading and investing in markets is second nature to some, but a mystery to others. The goal is to provide a forum where everyday people aspiring to be part time or full time traders will learn how view markets differently and profit beyond their wildest dreams.

David Frost