- Investing in broad market indexes at regular intervals can be a reasonable long-term strategy, especially for younger investors.
- However, with index investing, there's no escape from a roller coaster ride. For most people, especially retirees, it's very difficult to tolerate large and deep drawdowns.
- Retirees and conservative investors need income, growth to meet inflation, and most importantly, conservation of capital. Early last year, we introduced the concept of the Near-Perfect Portfolio (NPP), which tries to do exactly that.
- In brief, the NPP tries to avoid the pitfalls of index investing. Principles of NPP revolve around sustainable income, low drawdowns, capital preservation, and reasonable growth over the long term.
- Looking for a portfolio of ideas like this one? Members of High Income DIY Portfolios get exclusive access to our model portfolio. Learn More »
Investing in broad market indexes at regular intervals can be a reasonable long-term strategy, especially for younger investors who have many years before they would need income. It is even recommended by Oracle of Omaha, Warren Buffett. If you are not particularly inclined to invest in individual stocks and can ignore the ups and downs of the market without panic selling, the above strategy can deliver reasonable results. In fact, if you are investing on auto-pilot with every paycheck or any other interval, you are buying high as well as low, using the benefits of dollar-cost-average.
However, the main problem with the above strategy is that so many folks cannot tolerate the roller-coaster ride of the stock market and resort to panic selling exactly at the wrong time in the hopes of getting back later. On the other hand, income investors, including retirees who live off that income, have a different problem. Since they need to withdraw income on a regular basis, they may be forced to sell when the prices are low. Even if they do not withdraw income, more than likely, they are not adding any fresh money to take advantage of low prices. Retirees can also face the problem of sequential risk if the market happens to go into a deep correction for multiple years in the early phase of retirement.
If you are an income investor and don't like the roller-coaster ride of the stock market and rather sleep well even during the depth of a correction, the NPP strategy described in this article is for you. If you are a retiree or near-retiree and want to avoid the sequential risk of the stock market, in our opinion, the NPP strategy can do wonders for you. If you are nearing 50 or already 50-plus and believe that low volatility leads to higher returns in the long-term (and vice versa), then again, the NPP strategy may be the right fit for you.
Early last year, we wrote an article on SA about a portfolio strategy that we like to call NPP (Near-Perfect Portfolio) strategy. Since nothing is perfect, especially so in the investment world, hence the name Near-Perfect Portfolio. We admit the name still may appear to be a bit over the top, but the underlying premise and goals fit the name. Generally, we're looking for a strategy that performs reasonably well during the bull markets, preserves capital when the market throws a fit or performs poorly, and provides a decent enough income stream on a consistent basis. This is the basis of the Near-Perfect Portfolio.
We follow the NPP strategy in our Marketplace service "High-Income DIY," but from time to time, we provide updates and progress of the NPP portfolio here on SA public platform. As usual, we will provide an overview of the performance and broad comparison of our NPP portfolio vis-à-vis the S&P500 since January 2020. The past 18 months have seen an incredible roller-coaster ride for the broader market. We started the year 2020 with a strong booming economy, low unemployment, and a stock market that was breaking new records. Then came the pandemic that resulted in worldwide economic shutdowns. At the peak of the panic, the S&P500 lost nearly 30%, while Dow Jones Industrials fared even worse. Almost overnight, the economy and the stock market were in the dumps, and millions lost their jobs. If you were a retiree and suddenly your retirement accounts tumbled from a million dollars to $650,000, it was certainly not a good feeling. However, the stock market had a rather quick recovery in spite of a struggling economy, to the surprise of most market participants. Folks who panicked near the bottom and sold their stock positions probably never got a chance to get back in. Now, a year and a half later, the stock market is in a new bull market and has been topping the previous records almost every month.
However, recently, it has faced some headwinds, and there is a lot of fear of some form of correction in the months ahead. After many decades of low inflation, we are seeing high inflation. In spite of the Fed's talk of the transitory nature of this inflation, there is a general perception that inflation may be here to stay and may even get out of control. The Fed may have some tools to fight inflation, but are they really sufficient? Inflation is the biggest threat to retirees and folks who are on a fixed income. Another problem is that the valuations of most asset classes are very rich. This is the reason that many believe the market returns in the next ten years will be sub-optimal, if not negative.
With all that said, it boils down to one simple question. Do we really want to constantly go through these ups and downs of the stock market and worry about the value of our portfolio on a daily or weekly basis? Or is there a better alternative, where a conservative investor or a retiree could have low volatility, minimal drawdowns, consistent income but still could enjoy the fruits of a rising market if that continues? This is exactly the objective of this comparative analysis of the NPP portfolio and the broader market indexes like the S&P 500.
What's a Near-Perfect Portfolio?
Here's some background. No portfolio can be perfect because it cannot meet all of its stated objectives in every situation or all the time. However, even if we could meet 80% of our objectives, 80% of the time, we should do pretty well. It's not about outperforming or beating the market all the time but meeting the investors' pre-determined goals and expectations.
It's not possible for anyone to predict what the markets are going to do tomorrow, next month, or six months down the line. So, we do not believe in chasing the market. Rather, we look for strategies that produce low volatility, preserve capital, provide a decent income and reasonable total returns over the long term. In our view, these are the outcomes that most retirees or conservative investors would want as well. They cannot afford large or deep drawdowns in their portfolios because they do not have the luxury of time. Also, most retirees need their portfolios to provide a consistent stream of reliable income. The S&P 500 provides a lowly 1.3% yield today, so index investing would not be ideal from an income perspective. In addition, as explained earlier, the extraordinary streak of high performance of the S&P 500 during the past 12 years is unlikely to continue in the next decade.
So, what should a retiree or anyone 50 years of age or older do? What's the best way to manage a stock portfolio and still sleep well at night? How can you preserve your capital, earn roughly 5% income (if you need to withdraw), and at the same time grow your investments to get a long-term total return of roughly 10%? Sounds like a tall target? We believe it's possible to achieve all of these three goals by adopting what we like to call a Near-Perfect Portfolio strategy. To summarize, we expect our Near-Perfect Portfolio to achieve these three objectives:
• Preserve capital by limiting the drawdowns to less than 20%.
• Provide a consistent income of roughly 5% to those who need to withdraw.
• Grow the capital for the long term at an annualized rate of 10% or better (including the income).
We must caution that these strategies need some work on an ongoing basis and may not suit highly passive investors. In addition, they require patience.
The Importance of Diversification:
The importance of the need to diversify cannot be overstated, especially for older investors. Sure, you can always find some investors who have done pretty well with highly concentrated portfolios. Warren Buffett famously said that "diversification is protection against ignorance." But then, most people aren't astute investors like Warren Buffett. So, the question is how to diversify and how much to invest in various types of assets or strategies. It's rather a complex topic. First, we need to diversify our stock holdings among different sectors or industry segments of the economy. But that alone may not be enough if you want to avoid volatility since the stock market is inherently volatile. High volatility brings in all kinds of emotions and issues, including fear, selling at the wrong time, fear of missing out, and above all, overall low performance. So, as a second step, we recommend diversifying in terms of types of investment strategies. We try to combine strategies that are likely to perform in divergent ways under different market conditions. This helps bring down the portfolio volatility and improve overall performance. The NPP portfolio combines monthly rotational strategies with some buy-and-hold DGI (dividend growth investing) and high-income strategies to perform well in different market conditions.
Performance Behavior of NPP Strategy During Bull & Bear Markets
Before we go any further, it may be beneficial to discuss how our rotational and buy-and-hold portfolios have performed in real-time starting last year. The beginning of the year 2020 is a good point for such a comparison because of the wild swings that we have seen in stocks during the past 21 months. Moreover, this will demonstrate how rotational portfolios can act as a counterbalance to buy-and-hold portfolios during times of crisis. We run and manage many such rotational portfolios and three buy-and-hold portfolios. Below, we provide the real-time year-to-date performance of such portfolios:
Note: All the tables and charts included in this article are sourced from Author's work unless specified otherwise underneath the image. The stock market data, wherever used, is sourced from public websites like Yahoo Finance, Google Finance, Morningstar.com, etc.
As you can see from the above chart, these Rotational portfolios behaved exceptionally well during the downturn last year and also during most of the recovery. Most of them stayed positive all the time. None of them ever fell below -5%, compared to -30% to -35% for the broader market.
At the worst point during the panic in March 2020, the NPP portfolio as an average (of eight portfolios) was actually 1% positive, compared to more than 30% loss in market indexes. Also, it's important to note that NPP recovered much faster in the initial stages compared to market indexes. Obviously, the S&P 500 has done very well in the year 2021 and overtaken the return from Rotational portfolios slightly. But if history is any guide, the S&P 500 is not likely to repeat its recent performance in the next few years.
The buy-and-hold portfolios performed mostly in line with the broader market. However, our technology portfolio (10-bagger) performed exceptionally well during the recovery. DGI-Core portfolio more or less mirrored the broader market but has lagged a bit. Nonetheless, there's a significant advantage of the DGI portfolio over the market index. This portfolio provides a much more significant income (yield) than the S&P 500.
The high-income portfolio, "8%-Income CEF," was a laggard at the market bottom and was slow to recover. However, it has caught up in 2021. Moreover, it was never a laggard on the income front.
Combined Portfolio (NPP) Performance:
From the above charts, it's easy to see that rotational portfolios and buy-and-hold portfolios behaved quite the opposite to each other during the panic and also during the recovery. So, it may be fair to conclude that combining them would make a less volatile and more balanced portfolio. Let's assume we had our overall portfolio (Near-Perfect Portfolio) that was invested in the following proportions prior to going into last year's crisis, and let's see how it would have fared.
Note: The optional bucket can be a cash-like bucket for highly conservative investors, while young investors could invest this money in the high-growth tech bucket.
Chart-3: The Combined NPP portfolio vs. S&P500
You can see in the above chart that the NPP (combined) lost less than 15% compared to 30% plus of the broader market.
How to Structure a Three-Basket NPP Portfolio
With every write-up, we like to present an actionable strategy to our readers that they can analyze, do their due diligence, and possibly adopt if it suits their personal situation. We provide below a sample NPP portfolio, complete with its three components. At times, there may be some repetition, but we feel new readers could benefit from this greatly.
The idea here is to provide the basic framework. You do not have to follow the strategy exactly as it's laid out here; rather, use these ideas in a manner that suits you based on your own unique situation. For example, the younger and more aggressive investors could include a fourth bucket for "Technology and Innovation" stocks, allocating 10% of the portfolio capital. However, the most conservative investors could instead use this fourth bucket as a cash-like investment.
It takes time to build confidence and conviction in any new strategy. So it's highly recommended that one should move to any new strategy on a gradual basis over a period of time by adding in small lots rather than all in one go.
We would outline below a portfolio of three buckets if someone was to invest today. The fourth bucket would be optional based on the individual situation and thus not included here.
Bucket 1: DGI-Core
We believe that a diversified DGI (Dividend Growth Investing) portfolio should hold roughly 15-25 stocks. We like to invest in individual stocks, and that's what we are going to focus on here. However, more passive investors could make this portfolio entirely of some select dividend ETFs (Exchange Traded Funds). For our sample portfolio presented below, we will look for companies that are large-cap, relatively safe, and have solid dividend records. Most of them will likely provide a high level of resistance to downward pressure in an outright panic situation. We will present 15 such stocks based on our past research, current dividend payouts, and relative dividend safety.
• Long-term investments 3%-4% dividend income
• Long-term total return in line with the broader market
• Drawdowns to be about 70% of the broader market
In this bucket, we will invest roughly 35%-40% of the total investable funds. It will be our core investments in solid, blue-chip dividend stocks. It's relatively easy to structure and form this bucket. However, we must put emphasis on diversifying among various sectors and industry segments of the economy. A selection of roughly 15-25 stocks could provide more than enough diversification.
A Sample DGI Portfolio:
For this part of the portfolio, our focus is to select stocks that tend to do well in both good times and during recessions/corrections. This is especially important if you are a retiree.
AbbVie Inc. (ABBV), Automatic Data Processing (ADP), Amgen (AMGN), Clorox (CLX), Digital Realty (DLR), Fastenal (FAST), Home Depot (HD), Johnson & Johnson (JNJ), Kimberly-Clark (KMB), Lockheed Martin (LMT), McDonald's (MCD), Altria (MO), NextEra Energy (NEE), Texas Instruments (TXN), and Verizon (VZ).
The average yield from this group of 15 stocks is reasonable at 3.18% compared to 1.3% from S&P500. If you still have some years before retirement, reinvesting the dividends for few years would take the yield on cost up to 4% easily.
Bucket 2: Rotational Portfolio
We usually recommend deploying at least two Rotational strategies to allow some diversification within this bucket; however, for simplicity's sake, we are presenting only one such strategy here, which in our opinion, is one of the best for the current environment with moderate risk.
So, what's a Rotation strategy, and why invest in it? First, this is our insurance bucket (or hedging bucket), which should preserve our capital in times of crisis or panic. In addition, it would reduce volatility, provide a decent return, and some of them could provide a good income.
Along with the DGI portfolio, these strategies are an essential part of our overall portfolio. Investment in stocks is inherently risky, and the Rotational strategies provide the necessary hedge against the risk. They bring the overall volatility of the portfolio down and limit the drawdowns in a panic or a major correction scenario. The biggest advantage is that they let the investor sleep well at night. They bring a level of assurance that helps the investor to maintain calm and stay invested in good times and bad.
However, we must caution that these strategies require some regular work on a monthly basis. One can start with one rotation strategy, but eventually, one should invest in multiple rotational strategies. As one gains more experience and confidence, one could diversify in multiple strategies. We provide eight such strategies in our Marketplace service.
The strategy outlined below invests in two securities every month from a pool of six securities. It uses the "relative momentum" of each security to determine the top two performing securities over the last three months.
Note: A word of caution for new investors - just because we're allocating 40% of the portfolio to this strategy, we are not recommending that you change to this strategy overnight with large sums of money. Rather, it should be done gradually over time, and one should preferably use more than one such strategy.
A Rotation Strategy for the Bull as well as Bear markets (Bull-N-Bear Rotation Model)
This portfolio is designed in such a way that it aims to preserve capital with minimal drawdowns during corrections and panic situations while providing excellent returns during the bull periods. Due to much lower volatility, this portfolio is likely to outperform the S&P 500 over long periods of time. However, it may underperform to some extent during the bull runs.
The strategy is based on six diverse securities but will hold any two of them at any given time, based on relative positive momentum over the previous three months. Basically, we will select the two top-performing funds. The rotation will be on a monthly basis. The six securities are:
- Vanguard High Dividend Yield ETF (VYM)
- Vanguard Dividend Appreciation ETF (VIG)
- iShares MSCI EAFE Value ETF (EFV)
- Cohen & Steers Quality Income Realty Fund (RQI)
- iShares 20+ Year Treasury Bond ETF (TLT)
- iShares 1-3 Year Treasury Bond ETF (SHY)
Please note that the last two are long-term and short-term Treasury funds, which are used as hedging securities.
The backtesting results going back to the year 2008 are presented below:
Chart 4: Growth Chart with No Income Withdrawals:
Growth Chart with 6% Income (Inflation-Adjusted) Withdrawals:
The below chart demonstrates the dangers of sequential risk with index investing and how devastating a deep correction can be at the onset of retirement (if you were to draw a significant amount of income). So, yes, drawdowns matter a lot, especially if you're a retiree who needs to withdraw income and a correction happens early in your retirement years. Due to a deep drawdown and 6% income withdrawals, the S&P 500 really got crushed and never got a chance to make a comeback in spite of the extraordinary growth of the S&P 500 in the last 12 years.
Chart-5: Growth Chart with 6% Income Withdrawal
Bucket 3: High Income Bucket
Earning a high enough income while preserving the capital and getting a decent total return has been a challenge for much of the last decade. Interest rates have been low since 2008 and are likely to remain low for the foreseeable future. Anything high yield tends to be high risk.
For high income, one has to essentially look at investment vehicles like REITs (Real Estate Investment Trusts), mREITs, BDCs (Business Development Companies), MLPs (Master Limited Partnerships), and CEFs (Closed-End Funds).
The investor should recognize that this is a relatively high-risk bucket. If you're a highly conservative and risk-averse investor and your income needs are relatively low compared to the size of your capital, you could definitely avoid it. However, for folks with limited capital and high-income needs, this bucket assumes a lot of importance. But even then, we recommend an upper limit of 20%-25% exposure to this bucket.
For this income bucket, we need to be highly selective and choose the best of the best funds in each of the respective asset classes. Also, one should consider this part of the portfolio as a sort of "annuity" subset of the overall portfolio. However, we believe that this is a lot better choice than annuities in many respects. This portfolio gives a kind of assured high level of income but will likely grow better than the rate of inflation over a long period of time. More importantly, annuities usually leave nothing for the investor's heir, whereas this portfolio would be fully passed on to heirs.
We present here a set of 11 high-income investment funds (CEFs, BDCs, REITs). However, two of them are individual stocks, including one of them (Enterprise Products Partners) being a partnership. Please be aware that a partnership usually issues a K-1 form (partnership income) at tax time instead of dividend income.
Below are some of the best funds within each asset class. The average yield of the portfolio presented below is roughly 7.4%. Currently, many (if not most) of them are trading a bit expensive. Our recommendation is to build the positions gradually over a period of time, rather than a lump sum investment.
You also could see our monthly article series "5 Best CEFs of the month." This series tries to identify funds that are trading relatively cheaper but still have a good record on the basis of several metrics. But they may not always be the best of the best since it considers current valuation as well.
Despite the recent volatility and losing streak in September, the stock market has performed exceptionally well during the last 18 months. Technically, last year's 30% correction could be classified as a bear market, albeit a very short one. The economic recovery is still continuing, though many challenges remain on the horizon. There's a general sense of unease about the economic uncertainties, easy-money policies, rising inflation, and overstretched asset prices.
The current market situation can easily be compared with either the year 1998 or the year 2000, depending on your perspective. In other words, it is very hard to say with any degree of certainty if we're in a long-term bull market or if we're on the cusp of a downturn. It is easy to spot a constant stream of bearish articles or viewpoints from market experts on how a deep correction would come shortly. But then we have been hearing such stories for the last many years but never materialized. So, it is pointless to try to predict when the bull market will end, or a painful bear market will start.
However, as long-term investors, we have a different approach to face uncertainties in the market. We have presented above a diverse investing approach with three baskets, which would provide an extra layer of safety and diversification. Above all, the combined portfolio should generate a very decent income of 5% and provide protection from huge drawdowns.
We may like to caution that the approach outlined above may not be appropriate for everyone. These strategies require a long-term investment horizon, discipline, some time, and effort on a monthly basis, especially in managing the Rotational part of the portfolio. Also, the Rotational strategies work best within a tax-deferred account. The main idea of this series of articles is to get the readers to think and explore a multi-basket investment approach. However, we strongly believe that the extra work is worth the time and effort if we could sleep well at night with an assurance that our portfolio would at least match or exceed the broader market over the long term, with low volatility and minimal drawdowns that are tolerable.
High Income DIY Portfolios: The primary goal of our "High Income DIY Portfolios" Marketplace service is high income with low risk and preservation of capital. It provides DIY investors with vital information and portfolio/asset allocation strategies to help create stable, long-term passive income with sustainable yields. We believe it's appropriate for income-seeking investors including retirees or near-retirees. We provide ten portfolios: 3 buy-and-hold and 7 Rotational portfolios. This includes two High-Income portfolios, a DGI portfolio, a conservative strategy for 401K accounts, and a few High-Growth portfolios. For more details or a two-week free trial, please click here.
This article was written by
Financially Free Investor is a financial writer with 25 years investment experience. He focuses on investing in dividend-growing stocks with a long-term horizon. He applies a unique 3-basket investment approach that aims for 30% lower drawdowns, 6% current income, and market-beating growth on a long-term basis and he focuses on dividend-growing stocks with a long-term horizon.He runs the investing group High Income DIY Portfolios which provides vital strategies for portfolio management and asset allocation to help create stable, long-term passive income with sustainable yields. The service includes a total of 10 model portfolios with a range of income targets for varying levels of risk, buy and sell alerts, and live chat. Learn more.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of ABT, ABBV, JNJ, PFE, NVS, NVO, UNH, CL, CLX, GIS, UL, NSRGY, PG, KHC, ADM, MO, PM, BUD, KO, PEP, D, DEA, DEO, ENB, MCD, BAC, PRU, UPS, WMT, WBA, CVS, LOW, AAPL, IBM, CSCO, MSFT, INTC, T, VZ, VOD, CVX, XOM, VLO, ABB, ITW, MMM, LMT, LYB, ARCC, AWF, CHI, DNP, EVT, FFC, GOF, HCP, HQH, HTA, IIF, JPC, JPS, JRI, KYN, MAIN, NBB, NLY, NNN, O, OHI, PCI, PDI, PFF, RFI, RNP, RQI, STAG, STK, USA, UTF, TLT either through stock ownership, options, or other derivatives. 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.
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