As we write this, the stock market is going through much turmoil, with a lot of uncertainty about where we are heading. Obviously, as always, there are many factors that are contributing to the current economic malaise. The most important ones are 40-year high inflation, increasing interest rates, high energy prices, a much-delayed monetary tightening, and a possible recession on the horizon.
Even though most investors have become accustomed to a constant cycle of boom-and-bust events, wouldn’t it be nice if there was less stress on a day-to-day basis? With the backdrop of the current state of the stock market, a great many folks would want an investment strategy that could avoid the roller-coaster ride of the stock market, works largely on auto-pilot, and is relatively stress-free. In addition, we would want our strategy to deliver high income and a decent long-term growth of over 10%, beating inflation and building wealth over time.
Being financially independent is sort of a prerequisite for retirees, but it could be a great stress reducer for folks who are much younger and maybe several years away from retirement. Being financially independent does not always have to translate to F.I.R.E. (Financially Independent, Retire Early); however, it could if that was your goal. Once you are close to being financially independent, it does not mean that you necessarily want to retire early or quit working altogether. It just means that it affords you the choice of living life on your terms. You may still like to work for many more years and consolidate your gains and secure a wealthy retirement.
In simple terms, being financially independent means that your passive investments generate (or can generate) enough income on a regular basis so as to meet your “basic” living expenses. Please note the emphasis is on basic living expenses and not all your desires and wants. Obviously, the surest way to achieve financial freedom is by saving more and investing wisely for the long term. It is also important to be able to distinguish between the “needs” and “wants” in your life and reduce unnecessary spending, thus reducing your basic living expenses. However, this is something that is very personal and can vary greatly from one person to another.
Whether you are a retiree or you just want to be financially independent, you need a strategy that should meet the following goals:
- Produce sufficiently high income to meet basic needs;
- Preserve capital in bad times (relatively speaking);
- Provide reasonably high growth for long-term wealth preservation.
Note: From time to time, we publish articles on similar investment themes as this article. Obviously, we think there is no better time than now to re-visit the multi-basket strategies that are presented in this article. In our view, these strategies are even more relevant in the current market environment. Moreover, new readers would possibly benefit greatly from these ideas. Regular readers who like these strategies should also benefit from the updated information and new ideas. Thanks for reading.
Income
When we say “sufficiently high income,” this is more of a subjective term, and it depends upon the size of your assets, your lifestyle, and basic living expenses. Obviously, different people have different needs. If you could reduce your expenses, your need for income also gets lower accordingly.
Percentage Yield required = 100 * (Yearly Expenses / Size of Assets)
In the above formula, retirees getting social security or any other fixed-income should reduce the yearly expenses by the amount of fixed income.
For example, a retiree couple needs $90,000 a year to meet their expenses, gets $55,000 in social security/pension income, and has $750,000 in retirement savings. So, the yield requirement would be:
Percentage Yield required = 100 * ((90,000 – 55,000) / 750,000)
= 4.67%
It’s a widely accepted notion that any portfolio that claims to produce more than 8% income would run the risk of depleting the capital. In fact, we would rather put the red line at 6%. Sure, your portfolio could be generating more than 8%, but any excess income over 6% should be reinvested back into the portfolio for it to prosper in the long term. Withdrawing more than 6% of income from any portfolio would put the original capital at a higher risk of depletion. Sure, if your asset size is large enough and income needs are smaller than 6%, you should reinvest the balance back into the portfolio.
Capital Preservation
There’s almost no financial investment that can preserve the capital 100% in all kinds of situations. Even the value of cash is subject to inflation and currency fluctuations over time, especially now when the inflation is running at a 40-year high. It’s a given fact that your investments (other than cash) will have some level of volatility – obviously, the lower, the better. So, one has to know one’s tolerance for volatility. The real test of capital preservation becomes apparent during times of high stress, something akin to what we saw in the year 2020 or during the 2008 financial crisis. Even the current market environment with the S&P500 skirting on the edge of a bear market would test many portfolios. An event or correction like this can act as a real eye-opener to review and judge if your portfolio is meeting its defined goals, especially risk tolerance. If not, you should modify your strategy.
Preservation of capital (at least on a relative basis) is important at any age, but it is of critical importance for retirees and older investors. So, our portfolio should be able to achieve much lower volatility and smaller drawdowns than the broader indexes while not compromising on growth during good times.
Reasonable Growth
It’s debatable as to how much growth is reasonable. It can vary based on your personal expectations and factors like the rate of inflation and interest rates. But assuming an average of 3% rate of long-term inflation, in our view, a 9%-10% overall annual growth of the capital (including the income withdrawals) would be very reasonable. However, more recently, inflation has been running at a much higher clip, which makes things a bit more complicated for savers.
Financial Independence
We discussed the concept of financial independence in our introductory section. As we stated earlier, you could be in your 40s and still be financially independent. You could be pursuing a great career, whatever that may be, and still, be financially independent. Just like many things in life, the meaning of this term could vary from person to person. However, the way we see it is all about sustainable income on a regular and consistent basis, even if you have no need for that income today. So, your investment portfolio should be able to safely generate enough income to sustain your basic needs (not including luxuries or vacations, etc.), if any need arises.
For example, your annual earnings are $100K, but if your basic needs (excluding wants, discretionary spending, savings, etc.) are only $40K, then your investment portfolio should generate at least $40,000 annually. Obviously, for retirees, they would like to add some discretionary spending, but then they would also have additional fixed income like social security or pension.
Investment Strategy
In this article, we present a multi-basket strategy that attempts to meet most of the above goals. As such, besides growth, we focus on income-producing strategies that also preserve capital during times of crisis.
We will review our multi-basket strategy that’s not overly complicated and easy to get started. We will provide as many as five sub-strategies (or buckets), but as an individual, you could just do fine by picking and mixing up to three sub-strategies. We also will provide some backtesting examples for each sub-strategy and how they would have behaved during the 2020 crisis or during the 2008-09 financial crisis.
Please note that we manage most of these strategies/portfolios in our Marketplace service that has live performance records at least since 2018 and for some limited portfolios since 2014.
Brief Description of Multi-Basket Strategy
Here we will discuss a multi-basket strategy, with each sub-strategy being unique in terms of income, growth goals, and risk levels. One of the buckets is specifically designed to provide the hedging mechanism to bring lower volatility and lower drawdowns to the overall portfolio. At the basic level, the strategy requires three baskets with an overall yield greater than 5%. For investors who may not need a high income (yield requirement less than 3.5%), they could just invest in two buckets.
Below we will provide several investment buckets for consideration, along with their performance overviews. Depending upon your personal situation, you can pick and choose various baskets and assign them the allocation percentages.
DGI Basket 1: (With Individual Stocks)
Allocation: 35-50%
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 in this bucket. The best part of owning individual stocks is that once you have acquired the position, there are no ongoing fees or expenses.
For our sample portfolio presented below, we will look for companies that are large-cap, blue-chip, relatively safe, and have solid dividend records. For our list below, we will try to select stocks that are likely to provide a high level of resistance to downward pressure in an outright panic situation.
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. We will present 15 such stocks based on our past research, current dividend payouts, and a high level of dividend safety.
For this part of the portfolio, our focus is to select stocks that…
Read More: Income Method: Become Financially Independent, Stress-Free