Investing in broad market indexes at regular intervals can be a reasonable long-term strategy for younger investors who have many years before they would need income. The main benefits are instant diversification, the opportunity to buy on auto-pilot, and taking advantage of dollar-cost-averaging (buying low as well as high). Above all, it requires almost no ongoing involvement or market knowledge once the initial investment allocations have been determined. However, even then, there is no escape from a roller-coaster ride with the extreme ups and downs of the market. Moreover, this strategy may not suit or work very well for investors in their 50s or older.
Another major problem with index investing is that a vast majority of folks do not have tolerance for the deep drawdowns and, many times, resort to panic selling exactly at the wrong time. On the other hand, income investors, including retirees who live off that income, have an additional 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, as it did during the period 2000-2003.
The other model that is often referred conservative and safe for retirees is the 60:40 stock and bond allocation model. However, we find two problems with that model. First, it compromises on growth on 40% of your assets. Secondly, the year 2022 has shown that, at times, bonds can go down along with stocks, and then there is no escape from the deep drawdowns that can take years to come back even.
The NPP strategy described in this article should be of interest to any long-term investor, but especially to the following audience:
• Income and conservative investors who don't like the roller-coaster ride of the stock market and rather sleep relatively well even during the depth of a correction
• Retirees or near-retirees who may want to avoid the sequential risk of the stock market
• Folks who are already 50-plus or approaching 50 and believe that lower volatility would lead to higher returns in the long term (and vice versa)
• Investors who are self-directed and prepared to spend at least a few hours a month managing their portfolios.
That said, everyone's situation is different, and one size does not fit all, so it is always a good idea to analyze any new strategy and see if it would suit your specific goals, needs, and temperament.
Since early 2020, we have been writing 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. In fact, it is even hard to find anything that is near-perfect, so we agree the name may still be a bit over the top. However, we think the underlying 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 Portfolios," but from time to time, we like to provide updates and the progress of the NPP portfolio here on the SA public platform for the benefit of our regular readers. As usual, we will provide an overview of the performance and a broad comparison of our NPP strategy vis-à-vis the S&P 500 (based on back-tested data as well as our live performance since January 2020). In the end, we will provide a sample NPP 3-bucket portfolio.
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, there is no point in chasing the market. Rather, we should look for strategies that produce low volatility, preserve capital, and provide a decent income and reasonable total returns over the long term. In our view, these are the goals that most retirees and other conservative investors would want as well. Retirees, in particular, 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 1.5% yield today, so index investing would not be an ideal option for most income investors. In addition, the extraordinary streak of high performance of the S&P 500 during the past 13 years (prior to 2022) is unlikely to continue in the next decade.
If we want to look at the recent history, the past 30 months have seen an incredible roller-coaster ride for the broader market. We started the year 2020 with a stock market that was breaking new records, backed by a strong economy. Then came the pandemic that not only impacted the world economy in so many significant ways but also turned daily life upside down. At the peak of the panic, the S&P 500 lost nearly 30%, while Dow Jones Industrials had fared even worse. Fortunately, the stock-market panic was short-lived even though the pandemic lasted almost two years. Even though the pandemic is mostly in the rear-view mirror now, we are still seeing economic fallouts like supply chain issues and runaway inflation due to excess money supply created by central banks and close to zero interest rates for too long.
However, now, the interest rates are rising (and rising fast), and the liquidity is being squeezed out of the system, with only a marginal impact on inflation so far. That means interest rates will have to rise much more and will likely cause a recession. The only question is if it will be a minor one or a deeper and prolonged one. The S&P500 is currently down nearly 18% from the peak (as we write this) and trying to test its lows from the month of June. Also, the high-flying stocks of the pandemic era and so many established technology stocks are down 50% or more.
So, the question that we want to ask ourselves boils down to this. Do we really want to constantly worry about the value of our portfolio, or is there a better alternative? We think a conservative investor or a retiree would rather want low volatility, minimal drawdowns, consistent income, and decent growth on the overall value of the portfolio to meet inflation and support 30-40 years of retirement. This is exactly the objective of the NPP strategy that you would see in a comparative analysis of the NPP strategy and the broader market index like the S&P500 in the next section.
What's the best way to manage a stock portfolio and still sleep well at night? How can we preserve capital, earn roughly 5% income (if income is needed), and at the same time grow our investments to get a long-term total return of roughly 10% or better? 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 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. But for the vast majority of folks, that's not the recipe for success. 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 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 would have performed since the year 2008. Moreover, this will demonstrate how rotational portfolios can act as a counterbalance to buy-and-hold portfolios during tougher times. We run and manage many such rotational portfolios and three buy-and-hold portfolios inside our Marketplace service.
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, etc.
Know Your Tolerance of Drawdowns:
It is important to know your tolerance for drawdowns. During the good times (bull runs), it is natural that most folks do not think much about drawdowns. However, for retirees and conservative investors, it is of paramount importance to know their risk tolerance and have an idea about how much of a drawdown would be tolerable to them. In addition to the level of tolerance to drawdowns, there is always the inherent risk of negative sequential returns during the early years of retirement. So, if you think that in a worst-case scenario, you could only tolerate a 20-25% drawdown, then you should not be invested in broad market indexes. Broad market indexes like S&P 500 had a drawdown (loss from top to bottom) of over 45%, 50%, and 30%, respectively, during the dotcom crash (2000-2002), financial crisis (2008-2009), and Covid-19 crash (Jan–March 2020). So, it may not be very frequent, but it does happen at least a couple of times in a decade. Sometimes a downturn can end quickly, as we experienced during the Covid-19 crash, but at other times it can be long, slow, and painful, for example, like what we witnessed from 2000-2002.
So, let's compare the drawdown performance of our NPP portfolio and the S&P 500 during some of the worst times during the last 15 years (based on back-testing). We are not in a position to go beyond 2008 due to a lack of reliable data, but at least it would cover the financial crisis and a few other deep correction periods.
List of drawdown timeframes:
• Jan-2008 to Mar-2009 (Financial and Housing crash)
• Oct-2018 to Dec-2018 (Crash of 2018)
• Jan-2020 to Mar-2020 (Pandemic crash)
• Jan-2022 to Sep. 16, 2022 (the current period)
As you can see above, the drawdown of the NPP portfolio was less than half of the S&P 500 most times. The current downturn is still in progress, so it is difficult to draw any conclusions.
Below is the combined NPP portfolio performance (based on back-testing results since 2008). We will then provide more details on the three components of the NPP portfolio.
As of 16-Sep-2022
CAGR of DGI bucket since 2008:
CAGR of CEF-High-Income bucket since 2008:
CAGR of ROTATION bucket since 2008:
CAGR of Combined NPP portfolio since 2008:
CAGR of S&P 500 since 2008:
** CAGR – Compound Annual Growth Rate
Chart-1: The Combined NPP portfolio vs. S&P 500 Since 2008
Below is the chart from the "live performance" of the NPP Portfolio since Jan. 2020. (Since this comes from our Marketplace service, it takes into account 6 Rotational portfolios and 3 Buy-and-hold portfolios). In practice, an investor would just need two buy-and-hold buckets and one (or maybe two) rotational buckets. In the chart below, you will notice that at the market bottom in March 2020, S&P 500 and Dow Jones were down nearly 30% and 35%, respectively; however, NPP was down only about 15%.
In this section, we will provide an overview of each of the three buckets and their individual performances vis-à-vis the S&P 500.
Bucket 1: DGI Bucket (40% of the assets)
Bucket 2: Rotational Bucket (40 - 45% of the asset)
Bucket 3: CEF High-Income Bucket (15 - 20% of the assets).
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 a high level of dividend safety.
The goals of the DGI Bucket are:
• Long-term investments 3%-4% dividend income
• Long-term total return in line with the broader market
• Drawdowns to be about 70% (or less) of the broader market
This is our long-term buy-and-hold bucket. 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.
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. Please note that this is just a list for demonstration purposes, and there can be many other stocks that could be equally qualified.
AbbVie Inc. (ABBV), Amgen (AMGN), Clorox (CLX), Digital Realty (DLR), Enbridge (ENB), 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 3.90% compared to 1.54% from S&P 500. If you still have some years before retirement, reinvesting the dividends for a few years would take the yield on cost up to 5% easily.
Note: For performance analysis, ABBV was replaced with its parent co. ABT, prior to the year 2013 (prior to spinoff).
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 as well.
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 this strategy requires some regular work on a monthly basis. One can start with one rotation strategy, but as one gains more experience and confidence, one could diversify into multiple strategies. We provide eight such strategies in our Marketplace service, but for most folks, two or three such strategies should be more than enough.
Note: A word of caution for new investors - just because we're allocating 45% 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 in smaller steps, and one should preferably use more than one such strategy.
A Rotation Strategy for the Bull as well as Bear markets:
In the Rotational bucket, we normally rotate between a fixed set of securities on a periodic basis (usually a month), based on the relative performance of each security during the previous period of defined length.
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 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 seven 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 seven securities are:
• Vanguard High Dividend Yield ETF (VYM)
• Vanguard Dividend Appreciation ETF (VIG)
• iShares MSCI EAFE Value ETF (EFV)
• iShares MSCI EAFE Growth ETF (EFG)
• Cohen & Steers Quality Income Realty Fund (RQI)
• iShares 20+ Year Treasury Bond ETF (TLT)
• iShares 1-3 Year Treasury Bond ETF (SHY)
• ProShares Short 20+ Year Treasury Bond ETF (TBF)
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. Anything high yield tends to be high risk.
Interest rates have been low since 2008, and even though the Fed is slated to increase over the next two years, rates are still likely to remain low in comparison to the historical norms. In fact, the fear is that Fed is behind the curve, and they might overshoot and cause a recession.
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).
Investors should recognize that this is a relatively high-risk bucket. Some of these securities use leverage to generate high income. Leverage works both ways, and in times of panic or recessions, these securities tend to lose more than the broader market. So, we will caution not to over-invest in them. We recommend up to 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 they are much better in many aspects compared to annuities.
We present here a set of 11 high-income investment funds; most of them are CEFs. However, one of them is an individual stock (Enterprise Products Partners (EPD)), 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 8.5%.
Note: For performance analysis, a couple of funds did not have a history prior to 2013, so they were suitably replaced for the prior period.
Obviously, the market is going through a highly uncertain period. Post-pandemic impacts like supply chain disruptions, 40-year high inflation, high energy prices, a war in Europe causing geo-political tensions at a level not seen in many decades, fast-rising interest rates, and a hawkish Fed are some of the reasons for the current market swoon.
However, as long-term investors, we believe we do not need to fret too much about the market's frequent swings. What we need is a well-rounded, diversified, and multi-asset investment strategy. We have presented one such diverse investing approach with three baskets, which should provide lower volatility, an extra layer of safety, and long-term growth. Above all, the combined portfolio should generate a very decent income of 5% and provide protection from bigger 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, and 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 are of the opinion that the extra work is worth the time and effort if that were to allow us to sleep well at night with an assurance that our portfolio is well equipped to handle anything that market may throw at it.
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
I am an individual investor, an SA Author/Contributor, and manage the “High Income DIY (HIDIY)” SA-Marketplace service. However, I am not a Financial Advisor. I have been investing for the last 25 years and consider myself an experienced investor. I share my experiences on SA by way of writing three or four articles a month as well as my portfolio strategies. You could also visit my website “FinanciallyFreeInvestor.com” for additional information.
I focus on investing in dividend-growing stocks with a long-term horizon. In addition to a DGI portfolio, I manage and invest in a few high-income portfolios as well as some Risk-adjusted Rotation Strategies. I believe "Passive Income" is what makes you 'Financially Free.' My personal goal is to generate at least 60-65% of my retirement income from dividends and the rest from other sources like real estate etc.
My current "long-term" long positions (DGI-dividend-paying) include ABT, ABBV, CI, JNJ, PFE, NVS, NVO, AZN, UNH, CL, CLX, UL, NSRGY, PG, KHC, TSN, ADM, MO, PM, BUD, KO, PEP, EXC, 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, RIO, O, NNN, WPC, TLT.
My High-Income CEF/BDC/REIT positions include:
ARCC, ARDC, GBDC, NRZ, AWF, CHI, DNP, EVT, FFC, GOF, HQH, HTA, IIF, IFN, HYB, JPC, JPS, JRI, LGI, KYN, MAIN, NBB, NLY, OHI, PDI, PCM, PTY, RFI, RNP, RQI, STAG, STK, USA, UTF, UTG, BST, CET, VTR.
In addition to my long-term positions, I use several "Rotational" risk-adjusted portfolios, where positions are traded/rotated on a monthly basis. Besides, at times, I use "Options" to generate income. I am also invested in a small growth-oriented Fin/Tech portfolio (NFLX, PYPL, GOOGL, AAPL, JPM, AMGN, BMY, MSFT, TSLA, MA, V, FB, AMZN, BABA, SQ, ARKK). From time to time, I may also own other stocks for trading purposes, which I do not consider long-term (currently own AVB, MAA, BX, BXMT, CPT, MPW, DAL, DWX, FAGIX, SBUX, RWX, ALC). I may use some experimental portfolios or mimic some portfolios (10-Bagger and Deep Value) from my HIDIY Marketplace service, which are not part of my long-term holdings. Thank you for reading.
Disclosure: I/we have a beneficial long position in the shares of ABT, ABBV, JNJ, PFE, NVS, NVO, UNH, CI, 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, RIO, ARCC, AWF, BST, CET, CHI, DNP, EVT, FFC, GOF, HCP, HQH, HTA, IIF, JPC, JPS, JRI, KYN, MAIN, 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.
Additional disclosure: Disclaimer: The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock. The Author is not a financial advisor. Please always do further research and do your own due diligence before making any investments. Every effort has been made to present the data/information accurately; however, the Author does not claim 100% accuracy. The stock portfolios presented here are model portfolios for demonstration purposes. For the complete list of our LONG positions, please see our profile on Seeking Alpha.