It's likely that either curiosity or skepticism led you to this article, and I would agree that, for most individual investors, trading is approached in a totally speculative manner. Stock trading, in its more popular forms (Day Trading, Swing Trading, Penny Stock Speculating, etc. ) includes none of the elements that a conservative investment strategy would have at its very core: Little if any attention is given to the fundamental Quality of the equities selected. Any Diversification that exists in the portfolio is determined by chance alone and is, at best, a transient result of the selection guesswork. No attempt whatever is made to develop an increasing and dependable stream of Income. But stock trading by individual investors doesn't deserve quite as bad a “rep" as it has earned. After all, its very foundation is Profit Taking, probably the most important (and possibly the most often neglected) of the activities required for successful investment portfolio management. Unfortunately for most non-professional equity traders, loss taking is a more common occurrence.
Bond, (and other Income Security) trading is generally avoided by most non-professional traders. Obviously, it takes more investment capital to establish positions in Corporate and Municipal Bonds, Real Estate, or Government Securities than it does in Equities, and the volatility that traders thrive upon is just not a standard feature of the mundane world of debt securities. Surprisingly, most investment advisors and stock brokers have not discovered that there is a more exciting approach to Income Investing that is actually safer for investors and less inflexible in the face of changing interest rate expectation scenarios. Certainly, Wall Street financial institutions pressure their representatives to push individual new issues and/or investment products, but I think that the Market Value fixation that stretches from Wall Street to Main Street is the real culprit. Income securities need to be “valued" for long-term income growth and traded with great pleasure. . . albeit much less frequently.
Consequently, most trading is done in an Equity only environment that, by its very nature, is too speculative for most mature (in whatever sense you choose) investors. But this is not the way it needs to be. Since stock prices are likely to remain volatile in the short run and cyclical in the long run, there will always be opportunities for profit taking. [Note that it is the combination of volatility, market accessibility, universal equity ownership, and confiscatory taxation that have made “Buy ‘n Hold" a tar pit Investment strategy. ] Similarly, there are no rules against taking advantage of the cyclical nature of interest rate sensitive security prices. Trading is the world's oldest form of commercial activity, and it is unfortunate that it is treated with such disrespect by our dysfunctional tax code. It is even more unfortunate that it is looked at askance by client attorneys and brokerage firm compliance officers. . . masters of hindsight that they are.
Trading does not have to be done quickly to be productive, and it doesn't have to focus on higher risk securities to be profitable. And perhaps most importantly, it doesn't have to avoid the interest rate sensitive income securities that are so important to the long-term success of any true investment portfolio. No matter how beaten up a speculative day trader becomes, whatever profit taking experience there has been is invaluable. Once a trader/speculator is weaned off the gambling mentality that brought him to the “shock market" in the first place, he can apply his trading skills to investing and to portfolio management. The transition from trader/speculator to trader/investor requires some education. . . education that cannot be obtained from product salespersons.
Step One is to gain an appreciation of the power of Asset Allocation using the principles of The Working Capital Model. Asset Allocation is the process of dividing the portfolio into two conceptual “buckets". The first of these will contain Equity Securities, whose primary purpose is to produce growth in the form of Realized Capital Gains. The other bucket will contain various securities whose primary purpose is to produce some form of regular income. . . dividends, interest, rents, royalties, etc. The percentage allocated to each is a function of a short list of personal facts, concerns, goals, and objectives. The cost basis of the securities, absolutely not their constantly changing Market Values, must be used in all Asset Allocation calculations. Asset Allocation is a critical portfolio planning exercise that is: based on the purpose of the securities to be purchased, long term in nature, and never “rebalanced’ or altered due either to current market circumstances, hedging, or some form of market timing (which, of course, is impossible).
Market Values are used in the selection process that identifies trading candidates that will fill the buckets. . . cash from all income sources, by the way, is always “destined" for one bucket or the other, and may be held unused if no proper candidates exist. Selecting potential Equities must first be “fundamental", then “technical". . . i. e. based on the Quality of the security first, and the price second. My experience is that higher quality companies purchased at a 20% or more discount from the 52-week high, with a profit target of approximately 10% (realized as quickly as possible) is a very manageable approach. The proceeds find their way back into the “smart cash" pot for Asset Allocation according to formula. There will be times when “smart cash" grows quickly while the list of new trading candidates shrinks, but when trading candidates are all over the place, “smart cash" is replenished with a portion of every income dollar produced by both fully invested buckets! Thus, insistence upon some form of income from all securities owned makes enormous sense!
But what about trading the Income Bucket securities? Enter the Closed End Income Fund, in the form of a common stock, and in a surprising variety of income producing specialties ranging from Preferred Stocks to Oil Royalties, Treasury Securities to Municipal Bonds, and REITs to Mortgage Income. No more worries about liquidity and hidden markups. No more cash flow positioning or laddering of maturities. And best of all, no more calls of your highest yielding paper when interest rates fall. Instead, you are taking capital gains, compounding your yield, and paying your dues to the Equity Bucket. And when interest rates move back up. . . you'll have the luxury of reducing your cost basis by adding additional shares. Of course its magic. . . that's what we do here on Wall Street!
Steve Selengut http://www.sancoservices.com http://www.valuestockbuylistprogram.com Professional Portfolio Management since 1979 Author of: “The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read", and “A Millionaire's Secret Investment Strategy"