The Strategic IRA Investor: 6.9% For 6 Months

Includes: DPG, T, UTG, VZ
by: Steven Bavaria

What a difference a month makes. Last month, in an article pointing out how IRA investors can take advantage of market turbulence, I pointed out that my own portfolio was up by a rather modest 3.2% for the first 5 months of the year. Since then, market prices for the sort of high yielding equities, funds and bonds that I stock my IRA with have appreciated, and my end-of-June six-month return is now 6.9% (13.8% annualized). Obviously, I have no expectation of maintaining that pace of capital growth, but just pocketing the current yield on my portfolio - just under 7% - for another 6 months, will bring my annual return to about 10%, which exceeds the 7-8% bogey that I've set for myself.

Capital appreciation, of course, makes you feel good, but for most IRA investors who are still building for future retirement (or like me, are already retired but not yet tapping their IRA assets) growth in market value can be a mixed blessing. That's because while you are re-investing the current income (dividends and interest) from your existing IRA, you actually get to compound your IRA assets at a higher rate (i.e. get more additional income for every re-invested dollar) if your IRA assets are not rising in value.

I know this is counter-intuitive to many investors who may feel that the ideal thing is for their portfolio to go up constantly, but look at an example:

Suppose my IRA portfolio was $1 million and yields 7%, earning me $70,000 per year. If asset prices remain the same, and I reinvest my $70,000 earnings, then next year, I will earn 7% on $1,070,000, and have earnings of 74,900.

Suppose asset prices continue to remain steady, and I do the same thing the second year, reinvesting my $74,900 earnings in the same portfolio I already have, so my yield continues to be 7%. By the end of year 2, my portfolio is worth $1,144,900 (i.e. the original $1 million, plus the first year's earnings of $70,000, and the 2nd year's earnings of $74,900.) The third year, I do the same thing, re-investing my earnings into the same portfolio, earning a steady 7%, which now amounts to $80,143 per year. Adding that to the total will bring my portfolio to $1,225,043 at the end of 3 years. Equally or more important is the fact that my yearly income from the portfolio - which as a retiree who has to live on it someday is what I really should focus on - has now climbed to almost $86,000 per year ($1,225,043 X 7% = $85,753), from $70,000 three years earlier, as I add each year's earnings to my principal.

Simple compounding, you say; and you're right, which is the point I'm making. An IRA, because of its tax deferral feature, is basically an investment compounding machine, and the investment strategy one utilizes should reflect that and take advantage of it.

Returning to our simple example above, let us run the same numbers, but this time, we will plug some capital appreciation into the mix, assuming an annual appreciation in market value of 10%. The assets are still earning the same dividends or interest as before, but now the market is taking their price up by 10% per year. The effect, we will see, is that when we re-invest our earnings each year, they will buy fewer additional earning assets, so the compounding effect will be somewhat less over time.

We start with the same $1 million, invested in assets that yield 7%. So the first year we earn $70,000, but the original assets have increased in value by 10%, so at the end of the year, the portfolio is worth $1,100,000. The $70,000 in dividends and interest that portfolio yields represents a yield on its new market value of only 6.4% (i.e. $70,000/$1,100,000). We re-invest those earnings ($70,000) at that yield of 6.4%, earning an additional $4,480 per year, which when added to the original $70,000 per year, brings annual cash earnings up to $74,480. During year 2, our $1,170,000 of principal increases by another 10%, bringing its market value to $1,287,000, so the $74,480 earnings from it now represents a yield of only 5.8%. At the end of year 2 we re-invest the cash earnings of $74,480, bringing the market value of our portfolio at the beginning of year 3 to $1,361,480 (i.e. $1,287,000 plus the re-invested $74,480.) In year 3, we have that higher amount of principal working for us, but at a reduced yield of 5.8%, so the cash return for the year is $78,790 (versus $80,143 at this point in the earlier example.) We assume another 10% rise in market price during the year, bringing the value of the portfolio at the end of year 3 to $1,497,628; so year 3's cash return of $78,790 now represents a yield of only 5.3% against the appreciated market value. Re-investing year 3's cash income of $78,790 to the existing principal brings total assets up to $1,576,418, which will yield an annual cash return the next year at a yield of 5.3% of $83,550.

The point of this somewhat exaggerated example is to show that capital appreciation comes at a price for the income-focused investor. In our example, the $1 million portfolio that appreciated 10% per year grew to $1,576,418 after three years, with income re-invested. The "flat line" portfolio with no growth grew to only $1,225,443, again with income re-invested. However, because the no-growth portfolio was able to re-invest at lower prices each year, its cash flow compounded at a higher rate, so that by the end of three years, it was generating $85,773 in cash per year, versus only $83,550 in cash per year from the higher market value portfolio.

Obviously if we could count on a 10% market price increase every year, we wouldn't have to focus much on yield. But since we can't, I focus on the income generating capacity of my portfolio, since income is what you want to live on in retirement (or any other time.) Therefore, I manage my IRA portfolio to try to constantly increase the projected yield, and I try not to get to concerned with market downturns, which I regard as cheap re-investment opportunities. That means:

  • Re-investing my interest and dividends on "down days" if possible to get the most for my re-invested dollar
  • On the days that I am re-investing, selecting from my existing portfolio and list of pre-selected "target" investments, those holdings that happen to be down rather than up
  • Constantly sifting the portfolio to take profits on holdings that seem to be up more than usual (especially closed-end funds that rise to premiums) and to re-invest in holdings that are temporarily out-of-favor (especially closed-end funds at discounts)
  • "Pairing" various stocks, like (1) AT&T (NYSE:T) and Verizon (NYSE:VZ), (2) Reaves Utility Income Fund (NYSEMKT:UTG) and Duff & Phelps Global Utility Fund (NYSE:DPG), or (3) various floating-rate loan funds like EFT, JGC (JGC), JRO (NYSE:JRO) and PPR (NYSE:PPR), that have similar characteristics, and any of which I'm happy to have in my portfolio long-term, in order to alternate between them when and if they move in different directions for no apparent reason (This especially happens in the highly inefficient closed-end fund arena, which is why these are great holdings for long-term IRA investors.)

This is part of what I believe is a uniquely IRA-focused strategy, taking advantage of some of the distinctive qualities of IRAs as investment vehicles. Primarily because of their tax deferral characteristics, IRAs actually are perfect vehicles for a strategy that employs:

  • Frequent trading and turnover to take advantage of short-term market moves, which would not be advisable in taxable accounts because of the short-term versus long-term tax consequences
  • Preference for cash-income over capital gains for the reasons outlined above, to both:

o Maximize the internal rate of compounding generally, and

o Minimize the prices paid for assets bought with re-invested funds

Many of these are obvious investment strategies, but are not emphasized by the investment press much because there is little if any attention paid to "IRA investing" as a stand-alone investing discipline. I think it deserves more attention from financial and investment journalists, given the over $5 trillion in IRA investments. Anyone interested in some other thoughts and basic principles along these lines, please refer to this article.

Disclosure: I am long (DPG), (UTG), (NYSE:EFT), (NYSE:JQC), (JRO), (PPR).