Tag Archives: opinion

PKW: Does It Outperform Because Of Strategy Or Sector Allocation?

Summary The PKW portfolio is built to take advantage of companies that are repurchasing shares. Over the last several years PKW has performed very well. The holdings are fairly concentrated but a focus on sectors with more buybacks could indicate less exposure to price based competition. My concern about the sector allocations is that they feel exposed to recessionary problems. If I was going to use PKW, I would want to include a heavy position in a long term treasury ETF to offset the risk in the portfolio. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. I’m working on building a new portfolio and I’m going to be analyzing several of the ETFs that I am considering for my personal portfolio. One of the funds that I’m considering is the PowerShares Buyback Achievers Portfolio ETF (NYSEARCA: PKW ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Expense Ratio The expense ratio on the fund is arguably the largest drawback. At .68%, the expense ratio eats into the long term value that can be generated by the fund. If it continues to outperform the market that won’t be a problem, but that feels like a dangerous bet on the system continuing to work. If it does, then all economic theories based on efficient markets should be called into question. Largest Holdings The largest holdings represent very material portions of the ETF. The analysis of the portfolio is further complicated by the potential for substantial amounts of turnover within the ETF which may cause the holdings and sector allocations to change materially over time. When they change, the risk profile also changes. The ten largest holdings are included in the chart below: Heavy allocations to both Home Depot (NYSE: HD ) and Lowe’s (NYSE: LOW ) are interesting. If both companies are heavily committed to using their cash for buybacks rather than expanding competition against each other, it could be a favorable sign for both companies and help them see boosts in earnings. While I’ve been critical of industries that are destroying margins through excessive competition, seeing Lowe’s and Home Depot together seems like a positive sign. Of course, the companies will also be heavily influenced by other factors such as demand for their goods which will be tied to other factors in the economy. Sectors The sector allocation is heavily focused on consumer discretionary while staples are extremely low. Health care and utilities are also fairly light weight which leaves me concerned about how the portfolio would fair if the economy slipped substantially. I love how well the ETF has performed, but I’m wondering how much of that is a function of their methodology and how much is simply a measure of sector allocation during a period of low interest rates with expanding GDP and high corporate profits relative to total GDP. Building the Portfolio This hypothetical portfolio has a slightly aggressive allocation for the middle aged investor. Only 30% of the total portfolio value is placed in bonds and a third of that bond allocation is given to emerging market bonds. However, another 10% of the portfolio is given to preferred shares and 10% is given to a minimum volatility fund that has proven to be fairly stable. Within the bond portfolio, the portion of bonds that are not from emerging markets are high quality medium term treasury securities that show a negative correlation to most equity assets. The result is a portfolio that is substantially less volatile than what most investors would build for themselves. For a younger investor with a high risk tolerance this may be significantly more conservative than they would need. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. (click to enlarge) A quick rundown of the portfolio The two bond funds in the portfolio are the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEARCA: EMB ) for higher yielding debt from emerging markets and the i Shares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) for medium term treasury debt. IEF should be useful for the highly negative correlation it provides relative to the equity positions. EMB on the other hand is attempting to produce more current income with less duration risk by taking on some risk from investing in emerging markets. The position in the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ) offers investors substantially lower volatility with a beta of only .7 which makes the fund an excellent fit for many investors. It won’t climb as fast as the rest of the market, but it also does better at resisting drawdowns. It may not be “exciting”, but there are plenty of other areas to find “excitement” in life. Wondering if your retirement account is going to implode should not be a source of excitement. The position in makes the portfolio overweight on companies that are performing buybacks. The strategy has produced surprisingly solid returns over the sample period. I wouldn’t normally consider this as a necessary exposure for investors, but it seemed like an interesting one to include and with a very high correlation to SPY and similar levels of volatility it has little impact on the numbers for the rest of the portfolio. The core of the portfolio comes from simple exposure to the S&P 500 via the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), though I would suggest that investors creating a new portfolio and not tied into an ETF for that large domestic position should consider the alternative by Vanguard’s Vanguard S&P 500 ETF (NYSEARCA: VOO ) which offers similar holdings and a lower expense ratio. I have yet to see any good argument for not using or another very similar fund as the core of a portfolio. In this piece I’m using SPY because some investors with a very long history of selling SPY may not want to trigger the capital gains tax on selling the position and thus choose to continue holding SPY rather than the alternatives with lower expense ratios. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. To make it easier to analyze how risky each holding would be in the context of the portfolio, I have most of these holdings weighted at a simple 10%. Because of IEF’s heavy negative correlation, it receives a weighting of 20%. Since SPY is used as the core of the portfolio, it merits a weighting of 40%. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the S&P 500. Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. Conclusion PKW has a high correlation to the S&P 500 and a similar level of volatility. When looking at the max drawdowns, it appears that during periods when the market shows fear the portfolio is more exposed to taking a hit. While I’m thoroughly impressed with the performance the ETF has shown, I am not buying into the theory that it will continue to outperform the market. I get the feeling that a really solid extended negative period for the market (rather than one week or so of free falling) could put a major dent into the portfolio. If I was going to build a portfolio with a large position in PKW, I would want to include a very material position in a long term treasury ETF for the negative correlation at -.42. The negative correlation would provide a better chance of gaining on the treasury ETF if fear or a recession took hold of the market and the underlying holdings began to suffer large setbacks. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.

UBS ETRACS Monthly Pay 2X Leveraged Closed End Fund ETN: A Pragmatic Approach

Summary Some say that CEFL price will always drop, so it is better not to be tempted by the high yield; others say that CEFL will never recover. In my opinion, those that will be patient enough to reap the high distributions over a long period of time will be highly rewarded. The CEFL premium over the YieldShares High Income ETF more than compensates the added risks. This article is a sequel to my previous one, UBS ETRACS Monthly Pay 2x leverage Mortgage REIT ETN: A Pragmatic Approach ( here ). So I will short the presentation. I bought the UBS ETRACS Monthly Pay 2xLeveraged Closed – End Fund ETN ( CEFL) shares April 7, 2014 at $27.42 for less than 5% of a non-taxable account. The purpose of this article is to evaluate if CEFL is a sound long term investment or not. And more precisely to answer the nagging question: will it recover? Because as we know, it closed at $16.92 on September 4th; a severe 38.3% decrease since my purchase. I remember a comment from some months ago stating that “CEFL will never recover.” More recently, a commentator on SA wrote: “CEFL has a problem that means its price will always drop, so don’t get tempted by CEFL.” To address that problem I will use the same computation model as the one in the UBS Pricing supplement. And I will try to evaluate what type of growth would be needed to ‘recover’ from today depth. I will then analyse the ISE High Income™ Index (the “Index”) to evaluate what type of growth could be achievable over the long term. I will make also some assumptions on the LIBOR rate evolution. And, finally, I will try to evaluate what type of return on investment (NYSE: ROI ) could be expected over a ten year time frame. (Note: Please refer to the UBS Pricing supplement ( here ) for examples of the computation model, definitions, risks description and more details) The growth model. The marginal cost, while different from MORL, is comprised of the same three elements: one variable, the LIBOR rate, and two fixed, the financing spread and the tracking rate I have already stated that, for some reasons that I have not yet fully understood, the MORL price is tied to the Indicative value as computed by UBS (before accrued fees). It is the same thing with CEFL. In fact the correlation is almost perfect at 0.9984; meaning that practically all the variations of the CEFL closing market price are induced by the variations of the Indicative value and not the reverse as we could expect. In those ETNs there is no meaningful discount or premium over the Indicative value. This is a key element for those willing to trade heavily this stock. Consequently, as the Indicative value is directly tied to the Index variations we are left with only two variables: The Index variations and the LIBOR rate variations. I have also explained in my previous article how the Principal amount (Indicative value less accrued fees) depends on the sequence and the variation of positive and negative Index months during a given period. So there is no curse that the CEFL price will always go down; it depends on the evolution of the Index and of the Libor rate. In this section I just want to show that, taking into account reasonable assumptions, CEFL can grow over time. And for that I will use my own case. Could I recoup my initial purchase price? Of course, if we want to consider the possibility of a CEFL growth, we have to place ourselves in the context of a positive Index growth trend over the long term. If not, if we think that the Index will ALWAYS trend down over the long term, for sure CEFL will go down much faster. There is no need to go further; end of the case. So, if we assume an Index positive growth trend over the long term that means that during that period the positive months will outgrow the negative ones by the net growth rate. But, as we saw in my previous article, this positive growth rate must be above ½ of the marginal cost, if not the Principal amount could still decline inexorably. The sequence of monthly Index increases and decreases is also of great importance to determine the Principal Amount (i.e. Indicative Value less accrued fees). But as it is impossible to forecast the sequences, we will make the hypothesis that a positive month will be followed by a negative month but of lesser amplitude. The increase and decrease rates will be set so that the end Index level will achieve the net Index growth rate over the given period. Having run plenty of simulations this looks a good approximation. So, let us assume, for the sake of it, that we have a LIBOR rate of 0.90% (three times more than actually), an average Index growth rate of 4.3% per year, a base Index at 71.60 and a base price of $16.92 (September 4th value), the model shows that I can recoup my purchase price of $27.42 in 8 years with an upside multiplier of 1.57. If the Libor rate were at 0.30% and the Index growth rate at 6%, my payback could be advanced to 5 years with an upside multiplier of 1.86. So yes, depending of the variables evolution, the CEFL market price could regain its April 7, 2014 prices, but it will take a long time for the reason we have already stated that the decline is always faster than the rise. We will see in the next section what kind of Index growth rate we can anticipate over the long term. The ISE High Income Index Evolution 2.1 Historical background The ISE High Income Index (The Index; YLDA) was launched on December 31, 2003 with a 100 basis. We can see its evolution here From the beginning of 2004 to mid-2007 it increased 22%. Then it went down 60% to a low of 47 in November 2008 and of 50 in March 2009. By the end of 2009, it climbed back to 88 for a 76% increase. During all 2010 and 2011 it stayed range bound in between 80 and 90. It stayed there up until the announcement of the Taper in mid-2014. It started to decline since then to finish at 71.6 September 4th; a 24% decline since the mid-July 2014. Strangely, it is exactly the same pattern than with MORT. When the economic growth is strong the high interest rates are not a detrimental factor. But when the economic growth is tepid the interest rates are of major importance as if the financial spread were the only source of profitability. 2.2 The Index built I do not want to repeat all the methodology of the Index. I refer the reader to the Solactive Guide. I just want to emphasize one thing. The funds are ranked by descending yield (from the highest to the lowest) and by ascending premium/discount to NAV (from the lowest discount to the highest premium). In the Solactive Guide there is no indication on the yield calculation method. Because the Index is not computed on the NAV but on the market price we assume it is some sort of dividend annualization on the closing market price at the calculation date. For the discount, we assume that it is the one at the calculation date. So, in effect, the Index is selecting the funds with the highest yield and with the highest discount. This is of major importance. On one hand we can say that the funds have a high yield because they have a low price due to a very high discount; not a good combination. On the other hand, we can say that those funds have a great growth potential in reducing their very high discount; a more attractive combination. In fact, the price/discount relationship is based on the NAV evolution and the factual financial situation (i.e. NII, Capital appreciation, dividends, fees) AND the overall sector and market perception. The important point here is that the Index is not computed on the funds NAV but on their market price. So there is no direct relation in between the NAV of the funds and the Index. There is only an indirect relation through the premium/discount of each fund. 2.3 The recent Index decline As we saw in the historical background, the Index suffered a sharp decline of more than 24% since mid-July 2014. This is not surprising. It had been a great worst case scenario. Think about it; the Taper, then the end of ZIRP, then the energy crisis, then the China crisis, etc., etc. Look at the Index components: High yield debt, emerging market debt, global real estate, energy debt, convertible options, high leverage, etc., etc. Take the High yield components; there are some great funds here with great management as Double Line Income Solutions (NYSE: DSL ), Eaton Vance Limited Duration Income fund (NYSEMKT: EVV ) and several other similar funds. But the market is assimilating them to ‘junk’ without differentiating in between pure ‘garbage’ and legitimate, genuine, debt. In the actual conjuncture since mid-july 2014, the market is overreacting. The discount rate of most of the fund soared with Zscores greater than -2.0. For several funds the increase in the discount rate has been two times more than the NAV decrease. I would say that the discount of most of the funds is, at this moment, 50% overvalued. 2.4 Index component changes The Index has an annual review in December of each year. Component changes are made after the close on the last trading day in December and become effective on the next trading days. But the changes are announced on ISE website at least five days prior to the effective date. And that could cause a problem detrimental to the Index in depreciating the price of the component removed (to be sold) and increasing the price of the component added (to be purchased). More important than that is the shift, if any, in the core composition of the Index. Will it get more debt funds or more equity funds, more or less discount and yield, more or less American or Global funds, etc. In other words, will the Index exacerbate the finishing year weakness or, to the contrary will provide room for growth in the coming year? Projections 3.1 The index growth I fully recognize that, due to the fact the Index component funds pay a very large portion of their available income and appreciation as distribution there is not much left for the NAV growth. Consequently, even if we get a snap-back of the discount in the next 12 to 16 months, it is hard to envision that all the funds prices will trade at a premium in the future. Necessarily, we need a base NAV growth of the funds if we want to achieve sustainable components market prices growth and consequently Index growth. This kind of NAV growth is only possible in growing economy conditions with an accommodative interest rates structure. Only those conditions can give the funds the extra margin they would need to grow their NAV while serving a hefty distribution on their market price. 3.2 The US and Global economy growth I know the past years economic growth has not been stellar. It is cliché to say that the American economy is changing. Unless there come disruptive major innovations, the rate of growth will remain relatively low for the next 10 years. And that is in forgiving major, dramatic risks that I will address in Section 5. But, one think I am sure, is that the American economy is not entering a prolonged period of recession or, to say it bluntly, a constant economic decline. On a long term basis it will continue to grow, perhaps slowly, but to grow nevertheless. Just the demographic pressure plus some inflation and a bit of organic growth will be enough to generate an average 3.5 – 4% annual growth rate over the next ten year. With such a modest growth, normally the interest rates structure should stay accommodative over the long term notwithstanding some sharp adjustments to get out of the actual ZIRP policy. By accommodative, I mean that the Effective Federal Funds Rate should stay around 2 – 2.5% on average for the period and that the rate structure should adjust accordingly (the yield curve should steepen). 3.3 The Index growth rate This long term economic trend should be favorable for the CEFs to increase their assets appreciation and their NII while maintaining their distribution thus increasing slightly but regularly their NAV while decreasing their discount and increasing their price. In this context, and I will talk about the uncertainties in the Section 5, I think the Index will grow at least 3% – 3.5% per year, on average, during the next ten years from my purchase date of April 2014. This growth should put the Index around 120 by April 2024. For the short term, I think that the Index will continue to decrease until the end of the year and the beginning of the next (2016). It has to go through the year end fiscal sales, the December 2015 components review and the normalization of the FED monetary policy. That is a lot of headwinds. But, after that, it should start to recover. The CEFs discount will abate, the assets valuation will start to rise and within 1 or 2 years the Index should revert to the 90 level from the actual 71.60 one; a 25% increase. It should then continue en route to the level 100 in the next 2 to 3 years and continue to 120 until the end of April 2014. 3.4 The LIBOR rate As saw earlier the LIBOR rate is an important variable of the computation model. Over the long term, the rate should increase a lot from the actual low of 0.3330% for the USD LIBOR 3 months. Based on my forecast of a 2.5% average effective Federal Funds rate during the ten years period to April 2014, I cannot put the LIBOR rate at less than 3.0%. I know it is a lot of increase from the actual rate, but just look at the historical data since 2000 to be convinced that 3.0% is a minimum. 3.4 The Index and CEFL dividends High distribution is always stated as the primary goal of CEFs. Capital appreciation comes as a second objective. According to Morningstar the average CEF had a distribution rate of 6.72% in 2014. Actually, according to Left Banker ( here ), “the average distribution yield are in the 8%-9% range for taxable funds.” In fact the nominal distribution stayed about the same while the price dropped 20% thus increasing mathematically the yield percentage. (Note: for the CEF funds we can use the terms ‘dividends’ or ‘distributions’ indifferently, but for CEFL we should use the term ‘distributions’ as they are assimilated to interest income for tax purpose; in taxable accounts) On the short term, it is expected that funds nominal dividends will decrease inducing a sharp price reduction so maintaining in effect the same 8%-9% yield percentage. On the long term, however, as I forecast a 3% – 3.5% Index growth rate, I think that the yield percentage will decrease to 7% all sectors combined. But due to the Index growth rate, the number of components shares detained in the CEFL shadow fund will increase by half the growth rate in order to maintain the 2:1 leverage ratio. That means I will take 15.5% ( 2 x 7% + (0.5 * 3%) as the average yield percentage over the 10 years period ending April 2024. This average long term yield cannot be compared with the Current annualized yield computed by UBS,(actually 21.60% (here) or the ‘spot’ yield computed by Professor Lance Bronfman based on September distribution of 23.2% ( here) . Projections and ROI computation 4.1 For the ten years from April 2014 Based on my Index growth rate and my LIBOR estimation during this period my computation model gives me an Index at 124 and a CEFL Principal value at $34.50 for an average compounded growth rate of 2.3%. The around 1.0% differential in between the Index growth and the CEFL growth is the leverage cost. 4.2 For the 104 months from September 2015 to April 2024 If we take the September 4th price of $16.92, which should be close to a bottom, the Index growth rate will be much steeper. But that will not change my end forecast of $34.50 in April 2024 nor my nominal base distributions ($ per share). The growth rate will then be around 8.5% and that will change considerably the ROI as we will see. 4.3 The ROI for the ten years April 2014 – April 2024. So based on a 2.3% CEFL compounded growth rate, a 15.5% distribution yield and a 3% USD 3 months LIBOR, the ROI will come out at around 17.25% per year. 4.4 The ROI for the 104 months from September 2015 to April 2024 Based on a 8.5% growth rate, while keeping the same nominal distribution than the 10 years case (but a 17.0% effective yield), the ROI will come out to 21.0% per year for a 104 months period. So, it may be an excellent investment opportunity to wait for the real bottom in 2016. 4.5 Comparison with the YieldShares High Income ETF (NYSEARCA: YYY ) YieldShares High Income ETF tracks the same Index than CEFL but without the benefit of the 2X leverage. If I take the exact same variables for YYY than for CEFL, Index growth rate 3.5%, CEFs average dividends 7.0%, same period April 7, 2014 to April 7, 2024, the YYY ROI calculated on the same basis and the same way will come to 9.0% per year. The differential of 8.25% in between 17.25% and 9.0% is in fact the risk premium for the added risks and uncertainties of CEFL over YYY. Uncertainties and risks 5.1 Uncertainties My linear Index growth rate of 3.0 – 3.5% over ten years is, in my opinion, the most probable least square average growth rate amidst an infinity of possible combinations within two standard-deviations due to changing economic conditions. And that, without talking about the possible ‘black swans’ I let everyone imagine. The effective Index level could vary +/- 20% around the linear trend meaning that we could have variations of – 33.3% from top to bottom and of + 50.0% from bottom to top over a 1 or 2 years cycle. That means the effective CEFL price could decrease by 66.6% from top to bottom or increase by 100.0% from bottom to top during such a cycle (assuming a 2:1 multiplier for convenience). So better to be prepared for a lot of volatility. As for the LIBOR rate it could stay under 1.0% for a prolonged period of time or could jump to 5.0% if the Fed monetary policy tightens to control inflation. Over a 10 years period an average 3.0% is in concordance with a Fed ‘normal’ monetary policy. Concerning the distribution, I am not so worried because the effective nominal distribution is forecasted to increase only from $4.35 to $5.34 per share over the 10 years period. Historically this is not very much. The discounted cash-flow method is a big help in confronting those uncertainties because the farther we are advanced in the period the more the present value minimize the errors. 5.2 The risks UBS details at length the various risks involved with CEFL. And I refer the reader to the Product Supplement for more details. There are two more specific risks to CEFL the agency riskthe early redemption risk The UBS is certainly a great bank. But as all the big banks it is not immune to have problems. I let everyone makes his/her own judgement. UBS can call an early redemption 1/ if, at any time, the Indicative value equals $5.00 or less and 2/ if, at any time, the indicative value decreases 60% from the closing indicative value on the previous Monthly Valuation Date. Those two conditions would have been met during the last 2008-2009 recession. Again I let everyone makes his/her own judgement on the probability that a similar recession could occur before 2024. Final points I am a private long term investor. I invest in securities as I would in business. The 17.25% CEFL ROI cannot come without extra risks. And I accept them But, in consideration of those risks, I am not prepared to increase my CEFL holdings nor to reinvest my distributions, as tempting as it could be. The CEFL risk premium over YYY, close to 50%, is worth more than the extra risk. So I prefer to keep CEFL over YYY. I have nothing to sell or to promote. I am just interested in contributing in a better understanding of this very complex product, CEFL. I welcome your comments. Disclosure: I am/we are long CEFL, MORL, BDCL, DVHL. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

How I Created My Portfolio Over A Lifetime – Part I

Summary Introduction. Three ways to build a portfolio. What types of assets to include. Patience and income have been the keys to my long-term success. Conclusion. Introduction Obviously, there are many ways to construct a portfolio and allocate funds across different classes of assets. The method described here is how I do it. Having a set of principles and specific goals helps me to stay on the right path, and I hope my explanation will help readers to formulate a system of investing that works for them. The methods I use as described in this and articles to follow are meant to provide a flexible set of guidelines that can be modified to fit any investor’s needs. If you are just starting out on your lifetime investment adventure, it is important to establish a plan with reasonable, achievable goals and intermediate milestones. I focus on the next milestone to alleviate the frustration that can creep in upon setbacks (which are a natural part of investing). Each milestone is within reach in just a few years, so it is always achievable. Once a milestone is achieved, I just plod on toward the next one. When I was in my 20s and just out of college, I started out with a goal to save $25,000. Back then (in the 1970s), that was a lot of money. I attainted that goal within four years after graduating. The next goals was to double it to $50,000; then $100,000; and each milestone thereafter was to hit the next $100,000. The great thing about having a plan and sticking to it is that it gets easier to achieve each new milestone, especially after hitting $300,000, because you are not doing it all alone. Your money is working for you, too. Or, at least, it should be if you are doing it right. I have to admit here that I strayed from the path a couple of times and got behind. I still had a lot to learn. I was good at saving, but the investing part was not working as well as I had hoped. Initially, I was accepting more risk than I needed to in the hope that I could achieve those milestones faster. In contrast to the now-famous quote of Mr. Gecko from the movie “Wall Street,” greed is not good for most investors. It generally gets in the way of consistency. When you win, you win big; but when you lose, you lose big! If an investment loses 50 percent of its value, it require a 100 percent gain just to get back to even. So, it took me more than a decade to realize what I was doing wrong. Then I read an excerpt from a study that showed how 40 percent of the total return of the S&P 500 had come from dividends when measured over the very long term (as in a lifetime, or 30-50 years of saving and investing). Suddenly it dawned on me that by looking solely for appreciation, I might be missing as much as 40 percent of the potential that the stock market had to offer me. That was revolutionary and so began my investment approach evolution. One other thing happened during my formational period. A married couple with a new baby, friends of mine, came to me with a question: If I had a baby (which I did not at the time) and wanted to put away money for his/her college education, how would I invest it? This is way before 529 plans, so that was not an option. It was also during the early 1980s when interest rates were sky high (like 15 percent for 30-year Treasuries). They didn’t want to invest in stocks. So, I suggested that they invest in zero coupon treasury bonds, then referred to as CATS. They did. I didn’t. They are happy. I am sad. They were able to lock in a 12 percent yield. By the time their baby turned 18 years of age, they were able to sell the bonds they originally bought at a price of $25,000 for well over $200,000. Of course, they had to pay taxes on the interest each year as it accumulated, and then they paid capital gains on the amount of appreciation above the accumulated interest, but that was well worth it. If they had held those bonds for the full 30-year term they would have accumulated nearly $750,000. This sort of investment return is not achievable in today’s environment of artificially low interest rates. But the pendulum always swings and often to extremes, so be ready to jump on the opportunities that are available when they come. The point to all this “experience” chatter is to frame the answer to why I invest the way I do. I invest with a long-term time horizon, even now at age 66. I need my money to last for at least another 20 years for me and my wife. I would also like to leave a nice nest eggs for our two children. Thus, my horizon extends beyond my own lifetime. That is, by definition, long term. And that is how I invest: for the long term and for a rising stream of future income for me, my wife and our children long after we are gone. What is your time horizon? Think about that and make sure you define it well. You are not just investing for when you begin your retirement, but for at least another 20-30 years or more after. Make sure your goals align with those needs. Three ways to build a portfolio There are basically three ways to invest for the long term, in my opinion. This, of course, is predicated on a strategy of buy-and-hold for the long term. If you are trading in and out of stocks like I did before I learned my lessons, there are many other methods and systems to follow, none of which will be mentioned in this article. Sorry, but I am what I am. Buy on the dips Dollar cost averaging Buy only after a bear market Of the three listed above, I mostly use the latter. That is why I wrote a lot of articles until about two years ago when valuations were still cheap, and also why I have not been writing as much for the last two years, as valuations rose to historically dear levels. I am not predicting a crash, although a bear market does seem overdue at this point. We are in the middle of a correction, and I have no idea whether it will turn into a bear market or if the markets will recover to set new records. That is a discussion for another place. But I am collecting my dividends and interest, accumulating cash for the next great opportunity when it does finally come. Buying on the dips has worked wonderfully for investors since March 2009. It is a great way to systematically add quality stocks to a portfolio when valuations are below historical averages. Whenever the stock of a great company slips by more than ten percent (or whatever percent seems appropriate for that stock), buy some more. It is simple and it works during a bull market. But it does not work so well during a bear market. That should be obvious. If a stock falls ten percent and one buys, then it falls another ten percent and one buys, and then it falls some more and more, it can get nerve wracking and one may begin to question their own actions. The long-term investor will be fine over the very long term, but he/she may suffer losses in the short to intermediate term. The market will recover and, assuming the investor has bought high-quality stocks, so will the portfolio. The dividends will just keep on being paid, adding more cash to be invested to create more income. There is really nothing wrong with this method. Dollar cost averaging works in a similar fashion but with a twist. The investor continues to invest the same amount at specific intervals. When the stock is high, one receives fewer shares. When the stock is low, one receives more shares. It is a method that is simple because it takes most of the decision-making about when to invest out of the equation. It does not really optimize investment return, though. And it is also reliant on buying quality companies to hold for the very long term. Even the best companies go through difficult times, but the best of the best evolve with the times and find a way to right the ship. Selectivity is always a key to investing. Why do I generally buy only after a bear market? The simple answer is I like the lowest cost basis I can get. To expand on that answer a little: I prefer to not use trailing stops, so I buy at prices that only come along very infrequently. Why do I not use trailing stops, you ask? Because with high frequency traders [HFT] able to move the markets at the blink of an eye and with the creation of exchange traded funds, the chances of getting an order filled way below the stop prices is way too high. I have friends who got stopped out of long held positions at losses of 30 percent or more on the day of the flash crash on May 6, 2010, even though the trailing stops they used were set at no more than ten percent below the opening price that day. The Dow Industrials Index (DJIA) fell about 600 points in about five minutes and was down nearly 9 percent at its lowest point, only to spring back, recovering most of the loss for the day. There is more to this than HFTs at work here, but that is an explanation for another time or this article will become way too long. I will discuss these varying methods in greater detail in another article with examples included for comparison. What types of assets to include The simple answer is “everything.” The purpose is to achieve diversification. I will explain the purpose and my goals for diversification in another article. The basic rule is that by diversifying across different asset classes, an investor reduces the risk of having everything in a portfolio fall in value at the same time since some assets often move counter to one another. These are the types of assets that I own: Individual stocks ETFs Individual bonds (corporate, municipals, federal government issued or backed) Bond funds Real Estate rental properties Precious metals Should everyone own everything? Not necessarily. I will always maintain that the more one has, the more diversification one needs to hold onto one’s capital. There is also the very real need to be familiar with each class of assets in which one invests. Always stick with what you understand. That is probably the most basic rule of investing, and possibly the best advice I can give to someone starting out. The next piece of wisdom is to never stop learning. By expanding what you know, you will open up new opportunities. It may take years to achieve a level of comfort necessary to actually add a new class of assets to your investment portfolio, but the patience and time it takes to gain the knowledge are worth the wait. As you understand more about each asset, you will also understand that there are better times to invest in each one. Recognizing the best time to invest in a particular asset is important. It also requires patience, a theme you will read throughout many of my articles. Of course, it is possible to invest in just stocks and bonds and cover most of the bases. To get exposure to real estate, one can invest in real estate investment trusts (REITs). To gain exposure to precious metals, one could own gold or silver mining stocks, streamers or ETFs. To gain exposure to bonds, one can invest in bond funds or closed-end funds [CEFs]. There are both benefits and drawbacks to each method of gaining exposure. I intend to get into those issues in another article in this series as well. Promises, promises. I want to spend more time explaining how I allocate my portfolio and how I adjust my allocations across various asset classes in greater detail, but that will need to happen in the next article or two in this series. Again, I am trying to keep the length of each article down to a reasonable level. Patience and Income are the keys to long-term success This is my guiding principle. It may not be yours and that is fine, too. But as I realized that owning assets that pay me to hold them can provide me with more cash to invest, I was hooked. Once I realized that there are companies that increase dividends every year, I never looked back. This worked to perfection in the beginning. Then came the first major stock market correction of my investing life, 1987. It was fast. It was brutal. It unnerved me. That is when I learned about diversifying across asset classes. It also reminded me of how well my friends were doing with their CATS bonds so far. I realized that I needed to do something different if I wanted to protect that which I had worked so hard to accumulate. I have a great story to relay to you about real estate, but I think it will require an entire article to do it justice. I now have income streams coming in from multiple sources, and the income rises each year. I plan to keep that as my short-term goal each year going forward. It really helps to focus on the income side of the portfolio during volatile market gyrations. The value can go up or down in the short term, but as long as the income keeps rising, I can feel good about what I am doing. The longer I do it, the more confident I am in what and how I am doing it. Conclusion If you want to be a millionaire, you need to invest like one. Wealthy people do not need the income from investments so they do not need to invest unless there are bargains available. Think about that for a moment. There are bargains available most of the time in one asset class or another. The key is to identify which one offers the best long-term value at any given time. People who are not wealthy feel like they need to keep all of their cash invested all of the time. That is not how Warren Buffett does it. He likes to always have large amounts of cash available at all times. Have you ever wondered why? It is really simple. He likes having cash available for when a bargain appears. He does not invest just to keep his money working. He invests when he identifies a long-term value opportunity that only comes around infrequently. Buffett considers cash as an option on the future. If you have followed his quotes for very long, you will recognize this concept. What he means is that great investing opportunities will always present themselves at some time in the future if one is patient and persistent enough to wait for their appearance. There is so much more I want to cover, so I will try to submit at least two articles a week in the series for the next few weeks or until I feel most of what I want to write has been written. Until next time, do not rely on luck; rely on wisdom and hard work. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.