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The science of smart investing: How do you earn a “known return” in your portfolio?

The science of smart investing: How do you earn a “known return” in your portfolio?

Most advisors rely on Modern Portfolio Theory, focusing on the capital appreciation of portfolios; but there is no guarantee that clients’ assets will appreciate to the needed levels year in and year out. In fact, from 2000 to 2011, the stock market had almost no return, so any investors withdrawing 5 percent per year would have dug a hole in their principal, thereby impacting their ability to use their investments for income.

On the other hand, an old idea has once again emerged as a solution. It produces what we call the “known return” (in dividends and interest payments), allowing an investor to know that when his or her investment portfolio is used for cash flow, income will be available. This philosophy offers the ability to set a budget and a “known return” when managing income or distribution needs, without the need to dig into the portfolio’s principal.

For example, compare two theoretical portfolios, starting with $5 million in assets: One portfolio is invested in the S&P 500, as an equity portfolio; the other is a portfolio of 14 different asset classes, all producing at least a 5 percent income and chosen for their lack of correlation with one another. We call this the “income portfolio.”

Now, assume each portfolio takes a distribution of 5 percent in relation to its year-end portfolio value, for cash-flow purposes. The S&P 500 portfolio, given a positive market environment, from 2009 to 2013 does better than the income portfolio, with an ending value of $9.18 million (or nearly an 83 percent gain in addition to the distribution taken), compared to the income portfolio, ending at $8.02 million (or about a 60 percent gain).

“Let us weigh the gain and the loss in wagering that God is. Let us estimate these two chances. If you gain, you gain all; if you lose, you lose nothing. Wager then without hesitation that He is.” – Pascal’s Wager

But what happens when markets are producing neutral-to-negative returns? We looked back at 2000 to 2008 with the same parameters and found that the equity-based model, while you’re hoping for capital appreciation, requires you to draw on principal since the stock market doesn’t average 5 percent, and the results are dramatic. The equity-based model portfolio value at the end of 2008 is $2.2 million dollars (a loss of over 50 percent). In comparison, the income portfolio ends up offering a final value more than double the equity portfolio’s, at $5.62 million.

This study shows that drawing on principal in a portfolio can have huge consequences for investors trying to recover when the markets produce negative or neutral returns. Specifically, the equity portfolio investor cannot replace the income lost because of the drop in portfolio value and must therefore change his/her time frames or objectives.

For those hoping to use their investment portfolio as a source of income, the income portfolio offers a greater chance at succeeding when it counts. In short, you can either spend what you earn through investing in income or spend what you hope to earn through capital appreciation. We suggest that no investor invest on a “hope” when they can accomplish their goals with a “known return.” For more information, please contact IFAM Capital Advisors for a detailed copy of our distribution study.

IFAM is a Federally Registered Investment Advisor with its compliance office at IFM Capital, 4102 S. Timberline Rd., Fort Collins, CO 80525. Phone 970.530.5033. If you would like a copy of our ADV and client disclosure brochure, please contact this office. The data used for the performance calculations was obtained from sources deemed reliable, and then organized by the staff at IFAM Capital. We believe the data provided to be accurate but cannot guarantee it. The results shown should not be considered to be indicators of future performance. IFAM Capital does not assure that IFAM Capital’s performance will be favorable or that our strategies will work under changing market and economic conditions. Significant losses may occur in your account. Fidelity Investments is an independent company, unaffiliated with Institutional and Family Asset Management, LLC. Fidelity Investments is a service provider to Institutional and Family Asset Management, LLC. There is no form of legal partnership, agency affiliation or similar relationship between your financial advisor and Fidelity Investments, nor is such a relationship created or implied by the information herein. Fidelity Investments has not been involved with the preparation of the content supplied by Institutional and Family Asset Management, LLC, and does not guarantee, or assume any responsibility for its content. Fidelity Investments is a registered service mark of FMR LLC. Clearing, custody or other brokerage services may be provided by National Financial Services LLC or Fidelity Brokerage Services LLC.

This article was originally published in the August/September 2016 issue of Worth.

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