How many times have you heard somebody say "it takes money to make money"? I have heard it many times. Every year in May, I start hearing it in my sleep. The markets get in a down draft and we all wonder if it's time to get into a full blown protection mode. If you have worked and managed to save and scrap some retirement savings together, then your money should be making you some money and you don't want to start losing it.
How much money should money be making?
I'm going to say it again. It should be making no more than 6% if you want to protect your capital. It's tough to get together some capital these days, unless you are a hedge fund or bank. Rising fuel, food and medical keep eating into existing and future savings. So, don't lose capital.
Let's describe capital: From my online dictionary.
Capital: n. wealth in the form of money or other assets owned by a person or organization or available or contributed for a particular purpose such as starting a company or investing.
If you have ever had money in your hands for investment, then you have had capital. This includes the money you are paid in dividends. When a dividend is paid to you and you decide to re-invest it, then it is capital used to buy more shares. On that day, it became the cost basis of a new investment. Don't lose capital, don't lose cost basis–it's the same thing.
If you are re-investing in a fund or company with a falling share price, then you are losing capital. I have heard and read about this getting justified many times by income-oriented investors. It's an ongoing and fascinating argument to me. However, in my investment management, I evaluate every dollar spent as capital.
Ways to protect your capital:
1. Cash is pretty safe.
2. Bonds can be almost as safe.
3. Wide moat, low debt, solid margin companies are advisable.
4. Regulated utilities can be counted on.
5. Defensive sectors, like food and medical.
6. Stops (learn about these)
7. Simple hedging.
With a look at 1-6 on this list, the first thing that comes to mind is that none of this stuff will generate an income that you live on. Sure a person can live off the capital and just withdraw cash as needed, and at times that can be a good idea, especially if one possesses a crystal ball. Retirees who have variable cash spending needs should keep enough cash to free themselves from the need to time the market. That is a good example of spending saved capital. However, capital that is not working and generating income and gains is losing opportunity.
Adding enough risk to a portfolio to get to 6% yield can be hair raising to say the least. A high yield investment can cut that yield and invariably lead to capital loss. An investment that performs like that will rarely, if ever, return to that higher price and return the lost capital to the investor. Please remember that if yield is replacing your capital, then you are losing opportunity as well.
Let's now take a look at the 5-Year chart for Chimera Investment Corporation (CIM):
Click to enlarge
Then, we can look at Nuveen Equity Premium Income Fund (JPZ):
And then, there is Alpine Total Dynamic Dividend Fund (AOD):
I do not see that the return of an investor's capital is anywhere in the realm of possibility for investors who have held these funds. Now I don't want to beat up on these CEFs, there are some good stretches in these charts that could have made some money for an investor, both in terms of capital and yield. I stay away from CEFs - with the exception of a VERY few zero leveraged, zero option bond funds.
For high yield, I have started to study mRIETS and BDCs. This low interest rate environment may last awhile. It has lasted for many years in Japan. So it is reasonable to look at some innovators that are using the current conditions to make some money.
Everybody is looking at Annaly Capital Management, Inc. (NLY), Main Street Capital Corporation (MAIN) and others. I have been digging into PSEC for my clients. The additions of stable price (or capital value) and high yields are attractive, rising prices here are even better. My hesitation is always due to a lack of ego. I assume that in a market this size, risk and reward go together, so while the market digests the success of these mRIETS and BDCs I will move slowly and carefully.
Capital can be strategically preserved with stop orders. I suggest stops in any risky or very profitable positions. Wal-Mart (WMT) is looking stop worthy right now if you have some profits at the $68 range. We added Walmart after the faux bribery scandal and have stopped them out at $65.
Another good way to preserve capital is the use of a few carefully selected inverse funds. I use ProShares UltraShort S&P 500 ETF (SDS) or ProShares UltraPro Short S&P 500 ETF (SPXU). A small position in these type of funds will back fill some losses. In 2008-09 these helped ease some pain. If the S&P starts getting close to the 1275 range, we will begin to use reserves for these simple hedges.
Don't lose capital, it will lose itself if you don't watch it close. Use stops, hedge when the market gets choppy and understand what your money is doing for you.
Disclosure: I am long WMT.