Every December, with visions of sugarplums dancing in their heads, investors begin to scrutinize their performance, formulate couldas and shouldas, and determine what to try next year. It's an annual, masochistic, right of passage. My year-end vision is different. I see a bunch of Wall Street fat cats, ROTF and LOL, while investors and their alphabetically correct advisors determine what to change, sell, buy, re-allocate..
Line Three reflects historical trading results and is labeled: Cumulative Net Realized Capital Gains. This total is most important during the early years of portfolio building and it will directly reflect both the security selection criteria you use, and the profit taking rules you employ. If you build a portfolio of Investment Grade Value Stocks (IGVS), and apply a 5% of Cost Basis diversification rule, you will rarely have a downturn in this monitor of both your selection criteria and your profit taking discipline. Any profit is always better than any loss and, unless your selection criteria is really too conservative, there will always be something out there worth buying with the proceeds. Three 8% singles will produce a larger number than one 25% home run, and which is easier to obtain? Obviously, the growth in Line Three should accelerate in rising markets (measured by the IGVSI). The Base Income just keeps growing because Asset Allocation is also based on the cost basis of each security class… get it? Note that an unrealized gain or loss is as meaningless as the quarter-to-quarter movement of a market index. This is a decision model, and good decisions should produce net realized income.
One other important detail: No matter how conservative your selection criteria, a security or two is bound to become a loser. Don't judge this by Wall Street popularity indicators, tealeaves, or analyst opinions. Let the fundamentals (profits, S & P rating, dividend action, etc) send up the red flags. Market Value just can't be trusted for a bite-the-bullet decision… but it can help.
This brings us to Line Four, a reflection of the change in Total Portfolio Market Value over the course of time. This line will follow an erratic path, constantly staying below Working Capital (Line One). If you observe the chart after a market cycle or two, you will see that lines One through Three move steadily upward regardless of what line Four is doing. BUT, you will also notice that the lows of Line Four begin to occur above earlier highs. It's a nice feeling since Market Value movements are not, themselves, controllable.
Line Four will rarely be above Line One, but when it begins to close the cap, a greater movement upward in Line Three (Net Realized Capital Gains) should be expected. In 100% income portfolios, it is possible for Market Value to exceed Working Capital by a slight margin, but it is more likely that you have allowed some greed into the portfolio and that profit taking opportunities are being ignored. Don't ever let this happen. Studies show rather clearly that the vast majority of unrealized gains are brought to the Schedule D as realized losses... and this includes potential profits on income securities. When your portfolio hits a new high Market Value watermark, look around for a security that is no longer an IGVS and bite that bullet.
What's different about this approach, and why isn't it more high tech? There is no mention of the popular market indices, or comparison with anything other than investors' personal, reasonable, goals. This method of looking at things will get you where you want to be without the hype that Wall Street uses to create unproductive transactions, foolish speculations, and incurable dissatisfaction. It provides a valid use for portfolio Market Value, but far from the judgmental nature Wall Street would like. It's use in this model, as both an expectation clarifier and an action indicator for the portfolio manager on a personal level, should illuminate your light bulb. Most investors will focus on Line Four out of habit, or because they have been brainwashed by Wall Street into thinking that a lower Market Value is always bad and a higher one always good. You need to get outside of the Market Value vs. Anything box if you hope to achieve your goals. Cycles rarely fit the January to December mold, and are only visible in rear view mirrors anyway… but their impact on your new performance Line Dance is totally your tune to name.
The Market Value Line is a valuable tool. If it rises above working capital, you are missing profit opportunities. If it falls, start looking for buying opportunities. If Base Income falls, so has: (1) the quality of your holdings, or (2) you have changed your asset allocation for some reason, etc. So, Virginia, it really is OK if your Market Value falls in a weak IGVS Market or in the face of higher interest rates. The important thing is to understand why it happened. If it's a surprise, then you don't really understand what is in your portfolio. You will also have to find a better way to gauge what is going on in your markets. Neither the CNBC talking heads nor the popular averages are the answer. The best method of all is to track IGVS statistics… if you need drugs; these are better than the ones you've grown up with. Have a nice change!
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Investment Performance: Part 1 <--
