Preserving The Harvest: How you can maximize your investment gains and avoid needless loss in retirement

The first quarter for 2017 is in the books. One fascinating statistic to emerge after these first 62 days of trading was that the Standard & Poor’s 500 Index (SPX) never closed negative. For perspective, this has only happened in four years since 1980 – in 1987, 2006, 2012, and 2013. In fact, this marks the seventh straight quarter of gains for the index. Streaks of this length are rare.

Which brings us to the question of how to garner the most bang for your buck in the current economic climate. I make the analogy to a harvest: with our financial crops, we want to harvest both income and gains. To preserve and maximize our harvest, I suggest a two-prong approach. The first is income investing, meaning a method of generating income from an investment with as little selling as possible. The second piece is low cost investing.

Today, there’s an important methodology that uses both prongs. This means taking the discussion beyond just Exchange Traded Funds (ETFs).

ETFs are great until they’re not.

You guys know that ETFs are one of my favorite investment vehicles, mostly because of their simplicity and stability. Exchange Traded Funds are like baskets of securities – baskets filled with both domestic and international stocks, bonds, and real estate investment trusts (REITs). They have low costs and high tax efficiency. Think about it – if you have very little turnover, your basket won’t trigger a tax event. So, ETFs can spell a win-win in a lot of cases.

In other cases, particularly when you’re looking to cash in during your harvest years (the years when you’re living mostly off your investment income), there’s a method of investing that can be a click above ETFs. The method is holding individual companies. That’s right, individual stocks.

Wait, what? I know. I’m harkening back to an original approach to investing. But this old-school style has merit. Let me walk you through why.

Why you should own individual stocks

For starters, investors have turned their eyes away from the old “Own Your Age in Bonds Rule” (OYAIB), in favor of the moderate risk tolerance approach of the 15/50 Stock Rule. The 15/50 Rule inherently increases what you have in stocks, or your stock allocation may be higher than it would have been under the old OYAIB methodology. But just because we have less in bonds doesn’t mean we need any less income.

So how do we make up for the lost interest associated with owning a lower percentage of bonds? And how do we make up for bonds with lower interest yields due to the Federal Reserve? I’m glad you asked.

One way or another, replacement of this income will have to come from the stock side.

Consider the big picture. Your pre-retirement endgame focuses on your total rate of return, which consists of the gains and income you generate. When you’re under, say, age 60, gains are the key element in the total rate equation. As you move into your harvest years, cash flow becomes all the more important. Once you hit age 60, emphasis shifts away from gains to the income component of your total rate.

The case study

Let’s put this into context with a case study. Meet Doris and Jim. These two have $1 million saved for retirement. Both receive Social Security benefits and a small pension. Based on their financial situation and goals, they need a full 4% a year from their investments. Currently, their portfolio only generates an income of 3%, due to low stock and bond yields. So, Doris and Jim need to generate the extra 1% from selling something in their portfolio.

How much will you need? Retirement Calculator

Imagine that the portfolio is in one ETF – an ETF that holds all DOW 30 stocks. In this case, their only option to sell is an ETF. Here, a sale of a 1% stake in their portfolio results in selling everything inside that ETF, across the board. Some of the DOW 30 stocks have done well, while others haven’t and are at low prices. So you can see how Doris and Jim may not want to sell after all.

Now imagine that the couple owns the exact same mix of securities, except this time, their ownership is in each individual Dow stock. They have the exact same need of that extra 1%, so it’s time to sell. From their $1 million, the 1% translates into $10,000. Since they own 30 stocks, they need only sell a small piece of four of them. Calculate it out at $2500 each, times four, and Doris and Jim have their supplemental income of $10,000. Bingo.

By choosing this route, you have the option to sell individual stocks of your choosing. This translates into never being forced to sell something while it’s down. The flipside is the ETF scenario, where you sell pieces of everything, both up and down. See the benefit?

Sell high, not low

This particular method of supplementing your income almost forces you to sell high versus selling low. “Sell high, not low,” is the cousin of “buy low, sell high.” It’s what we’re supposed to do. The end result is a form of rebalancing – a method proven to reduce risk and increase returns over time.

Some folks are scared of stocks and believe me, I understand. As we all know, nothing in life is guaranteed. And stocks can be emotionally taxing. But when we think about risk, it’s important to remember that inherent with risk is volatility. The trick is to weather the risk and manage the volatility. So even if you generate positive returns over time, the real risk comes with being forced to sell while your holdings are in the midst of a pullback. Being forced to sell low means you’re at the mercy of volatility. This isn’t a good place to be.

Using the individual stock strategy ups your chances of having some stock winners (even in terrible years), and largely eliminates a forced sale of assets while they are down.

And remember that during your harvest years, you’re living off the fruit of your labor. The goal is to take only what you need from your baskets – ideally just the income. But if your situation mirrors Doris and Jim’s, and you have a gap in your cash flow, you’ll have to dip into investments. Through an individual stock investment method, you’ll effectively skirt selling low. Overall, the focus remains on harvesting some of your gains, and not selling stocks that may be temporarily in the gutter. If you end up only using your income (plus chipping off gains), then your harvest will bear fruit for a very, very long time.

Take the quiz: Will you be a happy retiree?

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