Thursday, April 20, 2006

An income investor with mean varience :: Part 1 of 2

Recently Geoff Considine has been analyzing various income portfolio's with his companies portfolio optimization software. Geoff's software (which costs $35/year) gives ordinary folks the ability to compose mean-variance optimized portfolios. In simple words, by allocating your portfolio assets along an "efficient frontier," it is possible to construct a portfolio with the greatest return for the least risk.

Before the development of Modern Portfolio theory by Harry Markowitz in 1958, investors who wanted more return and less risk got it by investing in income producing securities. The cash return of an income portfolio is immune to market forces; it is a bird in the hand. To some extent income investors exchanged the growth effect of compounding interest (by reinvesting dividends) for the more uncertain chances of growth in market price.

Traditionally income investment meant bonds, preferred stocks, and blue chip dividend paying companies. Since the days of Graham and Dodd, investors have a choice of many types of income security such as real estate investment trusts [REITs], business development companies [BDCs], income trusts, income deposit securities, publicly traded partnerships [PTPs, MLPs], and income oriented dividend and bond ETFs.

What Geoff Considine has shown in his recent articles about income investing and portfolio risk, is that blindly investing in high yield assets doesn't reduce risk as much as you might think. That is because many stocks/securities with high yields got that way because their prices are low relative their dividend payouts as a result of distress (real or perceived) or the inherent risk that flow through entities take on as result of paying out all their income as dividends. You have to be an intelligent investor to make safe money from income investing.

Geoff has shown the expected result that dividend ETFs like (DVY),(PID) or (SDY), tend to give more income than broad market indexes and have somewhat less volatility. This happens because of the stable companies/industries that are overweight in the dividend paying segment of the broad market. Dividend paying companies tend to be larger, more mature, and operate in regulated industries with fairly slow growth and risk (utilities, banking, and pharmaceuticals).

Most importantly dividend paying companies have stable cash flow that can be returned to shareholders as dividends. However dividend paying companies rarely have yields greater than 3% because of the need pay taxes and retain income to finance growth. To get more than a 3% income return on your investments you must have high yield equities in your portfolio. But all high yield income securities are not created equal, only by choosing carefully can you earn the greatest rewards for the least risk.

Part two of this series will cover what makes income securities tick, and how they offer real portfolio diversification which gives investors lower risk, higher risk adjusted returns, and cash return on capital.

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