Three Pools of Portfolio Allocation

[Man]

Author for what you see below is: vkrd
Some thoughts on where to invest and how much is needed to r2i Where to invest.
It is a given fact that stock market ( most major averages ) go up as time passes
Then it is fair to assume that markets go up given enough time ( 10-15 years ). Given that scenario, one needs to figure out how to invest and where to invest.
I personally think one should divide the portfolio in to 3 Pools
1) Main objective of this pool is to generate enough regular income.
This is the money you need on a monthly / yearly basis, or in near future.
In other words you will be taking money out of this account. So this pool needs to be
fairly liquid and secure. Although you are getting some return on your investment, your
primary objective is safety with some return.
I would get enough money to last for 7 years
If you need X each month then you need to invest Y
such that Y equals to principal + safe return on investment ( interest generated by
( Laddered Treasuries, Bank CDs etc )
By the end of 7 years you will have no money left over in this Pool. That is OK
since you are going to fill this with the money generated by Pool # 2
2) Main Objective here is to fill pool # 1 by 7th year and start over again.
Make investments in various instruments ( stock / bonds / Tnotes / Mutual Funds etc )
If history is any guide by the end of 7 years your investment will double.
At the end of the 7 th year take 50 % and transfer to pool # 1 Leave other 50 %
and start investing again in pool # 2
In other words
A) you were getting a refgular monthly income from Pool #1 for seven years
B) Your Pool # 2 doubled in 7 years.
C) Your Pool # has no money.
D) Take 50 % of Pool # 2 and transfer that to Pool #1
E) Leave the other 50 % in Pool # 2 and start the cycle again
One thing to keep in mind - There are some 7 year periods in the past that might make you think twice about this. ( is 7 years enough time to recover from lows ? )
3) Main objective here is to invest for long term needs ( House, Kids education, etc )
And Most importantly to beat the infaltion. By beating inflation I mean to add the returns to pool # 1, and pool # 2 to adjust for infaltion. Keep in mind inflation is working against you. Fortunately with proper planning time will be on your side compounding your returns.
Where to invest : This entirely depends on individual needs. What works for
me may or may not work for you or someone lese.
Here are some observations based upon my reaseach. I have picked lot of this data and
my previous posts data from a book by Prof Schiller's of Harvard, Burns ( columnist )
and numerous other sources.
To minimise the risk and to have steady and predictable income devide your total
portfolio in to 3 pools
Pool # 1 : Short term needs ( Regular Monthly income - to last for 7 years )
Pool # 2 : Intermediate term needs (Fill Pool # 1 Reinvest after 7 years 50 % in Pool # 1)
Pool # 3 : Long Term investment ( Add money to Pool # 1, and Pool # 2 to adjust
for inflation, Kids education, and other
long term needs etc )
The approach is simple and passive in nature as apposed to actively managing your self.
Pool # 1 : Laddered T Bills, Tax free Municipal bonds, Insured CDs etc
Pool # 2 : 50/50 Mix of Vanguard 500 index and Vanguard Intermediate Bond Index
Pool # 3 : 75/25 Mix of Vanguard 500 Index and Vanguard Intermediate Bond Index
Once a year rebalance the portfolio by dividing the total value of the two funds
by two and moving enough money to have the portfolio balanced again to 50/50 for
Pool # 2 and 50/75 for Pool # 3
How well has 50/50 and 50/75 worked in the past compared to other investments and what
is the risk compared to other investments -
Think hard. How much risk you are going to take. What percentage in returns is worth
the risk you are taking going 100 % 500 index.
How is that for sleeping good at night and your investments working for you ?
I will post more thoughts on how much money you actually need to generate US $ 1000.00 per month.
safely and beat inflation for XX years.
Comments are welcome.

Thanks to VKRD (if he is still reading) and Desi for this absolute gem of a post. Thanks to Jani and Oko for resurrecting this from the archives. I thought of turning this back into a thread - with Desi's kind permission - and having him, RRK and other finance gurus dissect this in today's global, US, and indian macroeconomic scenario.

(note to self - need to have a plan to start systematically digging through archives)

[Desi]

^^^ Man,
That is fine. Here is the link to the earlier thread for other readers of the thread. [URL="http://www.r2iclubforums.com/forums/showthread.php/1089-VKRD-s-Three-Pools-of-Money?p=9756#post9756"]VKRD's Three Pools of Money
[/URL]
Here below are a couple of other valuable posts from the thread. One might wonder if this is different than building a single AAP. The two posts below by Vinod and RRK explain similarities and differences.

Of course there is a difference and the difference is cognizance and breakdown of funds into various phases of the remainder of the life and comfort level for each. Mathemetically and investment wise the approach achieves the same purpose of managing risk while optimizing growth.

The advantage of this approach is purely psychological - financially it would not make any difference. There are a rather large set of financial advisors who do use this method - but the psychological benefit is based on mental accounting, so it does give comfort, even if it is misplaced.

VKRD should have trademarked this. There is a book called "Buckets of Money" that pretty much does very similar breakup and it is published after VKRD has posted about this.

Vinod

vinod,
thanks for sharing your thoughts. Yes, it is mental accounting, but it does give great "comfort of mind". For my own use, I am devising a "two pool" system. One for long term and another for short term needs.

It is interesting to know that "pool" has become "buckets" in the book. With subprime issue killing the investments, there is no surprise, pool would shrink to bucket.

After the dot com bust, the joke was my 401k has become 4k. Now we can say our pools have become buckets. ;)

vkrd, pls go for copyright before the buckets become glasses..

[Man]

What has worked well for me - reasonably well at least by my expectations - is a strategy of a 2 pool stock investing. In a similar but not as elegant manner I divide my portfolio into a 60% shortterm and 40% longterm portions.

To begin with I only pay attention to about 60 stocks that I know well. Very rarely will I add to that mix and only at the cost of removing from my list a stock I am no longer interested in. Most of these 60 stocks I have a fair sense of movement dynamics in relation to earnings season, overall market sentiment, short interest, etc etc. besides of course very basic financials like P/E, market cap, industry profile and standing, eps, float, etc.
The 60% is a contrarian investment style that takes note of downward movement that is following the market sentiment in a exaggerated way, or post-earnings pop, or cyclical (e.g. tech and oil/energy sectors). If the stock goes up around 15% or so I sell. If it goes down 10% I sell, unless I have a very strong reason not to. Whatever I sell I plug back fairly quickly into another round of buys again following the same principles. The overall pool is large enough to provide opportunities and small enough to ensure familiarity. Typically will execute 1 new buy or sell every few days. The strategy almost by default ensures a diversified exposure as the buy signals between sectors will never be in sync. Even if the wins and losses are split 50/50 in theory, you are going to come out ahead - much more so than with a amalgamized mutual fund that you wield no control over.

If you take a theoretical example of 10 trades a month for 12 months with 5 winners and 5 losers and 100$ invested in each trade with this formula you could arrive at a reasoned estimate of the returns - in reality things dont always work out as well but somewhat well is attractive enough.

The other 40% is a value investment style where I will look for large cap (typically) marketleaders with strong fundamentals that are not going anywhere anytime soon - the Pepsis, and Qualcoms - and try to find them during periods of market downturn. Once I buy I hold -except for diluting portions where I feel the need to rebalance my 60/40 split.

Downsides to this strategy are many - main one is a complete absence of any momentum investing - this is mostly because the learning curve for resistances and bases for shoulders and cups and handles etc is at least for me is a tad too steep, and I rarely find even experts being able to time things with any degree of certainty. Another is discipline - to be able to sell at predetermined trigger points - quite a few times the run up has been quite spectacular and sustained long after my 15% exit point, and it takes a few years to stop wondering about the what ifs. And finally of course time - takes at least 60-90min a day of due diligence including weekends.

Your breakdown indicated to me that a similar strategy can be employed using MF with less than 1% of time and effort involvement and has given me some food for thought.

Critiques/Comments welcome.

[SetToGo]

Man,

That seems like lot of efforts! Just curious, have you compared doing what you do with with just SPY? Does this method beat that?

--

Here's another 2 pool variation (simpler) if you are still earning. Which is what most people follow, I believe.

One current pool where you dump your earnings and use it for day to day expense and short term purchases. Any excess goes into Pool #2, which is your well diversified portfolio (that may be actively managed to reflect your economy projections).

I have seen several investment strategies around selling winners and buying losers that have been proven to work based on historical data. Since past performance does not guarantee future, I am always skeptical about following those.

--

Once your earnings stop (retirement), you can switch to something similar above.

[Man]

Man,

That seems like lot of efforts! Just curious, have you compared doing what you do with with just SPY? Does this method beat that?

LOL......yes STG - by a long shot....the thing with SPY or any other amalgamated option IMO is a sort of drift-with-flow approach - it works only if your timeframes are luxuriantly long and you dont open the box too often to look. Take a look at SPY YTD for example. With what I have outlined over time your odds of picking a potential 15% gainer is far in excess of picking a loser - much more than the 50/50 assumption you might set out with. Things might look even rosier I suspect with options trading using the same paradigm but needs a lot more d/d

[slowLearner]

LOL......yes STG - by a long shot....the thing with SPY or any other amalgamated option IMO is a sort of drift-with-flow approach - it works only if your timeframes are luxuriantly long and you dont open the box too often to look. Take a look at SPY YTD for example. With what I have outlined over time your odds of picking a potential 15% gainer is far in excess of picking a loser - much more than the 50/50 assumption you might set out with. Things might look even rosier I suspect with options trading using the same paradigm but needs a lot more d/d

In the last five years, more than 60% fund managers couldn't beat S&P 500 returns. Those IVY league MBA's can't beat with all those analysts at their disposal! Good luck.

[Man]

In the last five years, more than 60% fund managers couldn't beat S&P 500 returns. Those IVY league MBA's can't beat with all those analysts at their disposal! Good luck.

If you invested 10,000$ in SPY in 2002 what would it be worth today?

[SetToGo]

In the last five years, more than 60% fund managers couldn't beat S&P 500 returns. Those IVY league MBA's can't beat with all those analysts at their disposal! Good luck.

Which also means there are 40% that were able to do it. I believe it is possible to beat the market, but not everyone can do it (certainly I am one of those who cannot do it, yet). But the persistent way to do it is to find the anomalies in the market. I am always skeptical about the trend, momentum and opportunistic based investing which are all susceptible to Black Swan event.

[dbs]

If you invested 10,000$ in SPY in 2002 what would it be worth today?

I was not sure whether you really wanted the answer. But here goes.
It can be upto 15K depending on when you bought it. Obviously it does not include the dividend payout.

[Man]

I was not sure whether you really wanted the answer.

:)

[QUOTE]It can be upto 15K depending on when you bought it. Obviously it does not include the dividend payout.

Thats about a 4% annualized rate of return over 10 years - not exactly a home run by the putative Ivy League MBAs ...in my view the people who are able to benefit from the stock market are those who set meaningful goals, are able to curb greed, exercise control over their sentiments and spend time and effort on due diligence with close attention to basics, and most importantly have a consistent strategy that they stick to. I agree with STG there is no one right way - if there was everyone would be following it - and I believe the benefits of a "managed" protfolio are overstated. Fund managers' pay'n'productivity is linked not to performance but size of their holdings and the more successful ones operate with large pools of money and are hence their decision making is influenced by numerous constraints that an individual investor does not have.