Managing an active stock portfolio in drawdown.

[Lemur]

Forward-thinking here that my investment strategy in withdrawal phase (defensive | capital preservation + some growth) is going to be different than my current accumulation strategy (offensive | significant growth). For a while, I was even thinking that maybe the best defense is the best offense but I realized that didn't make sense because if a downturn happens...I get leveraged losses with the sort of style I've now and I would struggle to recover in a downturn environment.

Investing in equity is simply purchasing a business for its expected future cash flows. The benefit of investing in individual stocks is I know exactly what I am getting...I can screen every business for market cap, earnings yield, dividend yield, growing revenues, operating profitability, current ratio, interest coverage ratio, return on equity, and positive free cash flows and be left with a list of companies that are at least financially sound. That is the science; the art would just be going through that list and picking the ones that have good growth prospects (could go on Dept. of Labor and see if that industry is expected to grow) and/or pick ones that people "can't do without." Like food or medicines, etc.

We've heard the touted 4% safe withdrawal rate and more common on these forums the 3% safe withdrawal rate. The question that I think about lately is how I would set up an active portfolio to make this withdrawal a success to begin with. Success meaning - not running out of money or better yet initiating a runaway effect.

When one depends on their portfolio for spending, how do you know which stock to pull from and how do you know when its time to drop a stock from this setup or re-allocate accordingly?

I try to answer that question by taking a snapshot of my active portfolio in real-time (not counting indexes for this exercise) and extrapolate some ideas and questions:

https://i.postimg.cc/SR9h44Rg/Capture-2.png

1.) Column A - I am going to want to diversify across sectors to eliminate sector risk.
2.) Column G - Earnings Per Share should be positive.
3.) Column H - One should invest in a company paying dividends.
4.) Column J - Question...would this exercise be as simple as investing in good stocks (post-screened for some metrics mentioned above) where the earnings yield + dividend yield is greater than 5%? (The highlighted green stocks show that Walmart + JNJ is a good deal for this). I choose 5% for margin of safety (greater than 3/4% SWR).
5.) Yellow highlighted is interesting because it shows that this would not be a good portfolio in its current state to try to draw down on. Mainly due to the speculative picks.

How to actively manage - I guess there might be several different ways to do this. One could draw down from any stocks that have recent run ups or when one of the stocks begins to drop below 5% Earnings Yield + Dividend Yield. (Edit: A reminder and how could I forget from one of my favorite investing books. Actually better to sell the stocks that are lagging in your portfolio to tax-loss harvest and to let the winners run. “Selling your winners and holding your losers is like cutting the flowers and watering the weeds.” – Peter Lynch) Or my favorite, just write a covered call to collect premium and watch the stock. Alternatively, just setting up Buy/Hold/Sell price targets and picking the ones overvalued and selling from that point.

Lastly - systemic risk like a market drop. I think this may not matter with variable spending; especially if your total net-worth is running away a bit...perhaps some of that capital can be diverted to DEEP ITM SPY Puts (Insurance). This of course would suck if you just quit your job. Sequence of returns risk - have an allocation of safe money from the beginning (like bonds?) that equal a few years of spending.

Discussion is welcomed - we're talking about this ancient idea called fundamentals.

[Qazwer]

Absolute number of stocks might also matter. With low cost or ‘zero cost’ trades, you can increase your diversification. So if you are wrong, you lose less. If you are correct, you will also gain less but defense is different than offense.

[Lemur]

@Qazwer - True and good point. Luckily with Vanguard all stock trades are free. Commissions are $1 per contract for options trades.

[white belt]

I like using Chris Cole’s Dragon Portfolio framework to identify the different business cycles and how your different asset classes perform in each cycle (even if you end up tweaking the specific assets to your own preferences). Then you can ensure that you have sufficient uncorrelated assets to thrive in any market situation. I haven’t quite figured out how that would look when factoring in SWR because his aim with creating the portfolio was capital preservation for 90 years, but it’s probably a useful starting point.

I don’t do enough active stock trading to know how to address your first question, but I imagine you could apply the same type of analysis you do to ETFs that follow other assets like commodities or currencies. From a resilience perspective, I would be wary of relying entirely on paper (digital) assets if you want your portfolio to last through any type of turmoil (that’s why Dragon Portfolio is ~20% physical gold). Who knows that kind of controls a government might put on markets in a crisis? (e.g. the German stock market under Nazi rule had a law that the market could only go up, so you could only transact at a price higher than the current one). This is also where other forms of capital and ERE skills come in.

[ertyu]

there's a book that i never read called the second leg down. the idea is, alright, the big crash has happened, you didn't catch it, and now vix is high and puts are expensive. wat do? your post made me think about it. i should look it up.

[Lucky C]

3.) Column H - One should invest in a company paying dividends.

Why?

4.) Column J - Question...would this exercise be as simple as investing in good stocks (post-screened for some metrics mentioned above) where the earnings yield + dividend yield is greater than 5%? (The highlighted green stocks show that Walmart + JNJ is a good deal for this). I choose 5% for margin of safety (greater than 3/4% SWR).

Can't possibly be that simple. You'd be buying stocks after their earnings shot up to be above your threshold and hence their prices have already gone up, and selling after their earnings have dropped / dividends have been cut and so their prices would have already dropped a lot. I wouldn't be surprised if the opposite (buying when earnings+dividend yield were below 5% and selling when they are above 5%) would outperform, though it doesn't seem to be a good basis for stock picking either way.

Check out Meb Faber's work on shareholder yield (dividends+buybacks) and tail risk hedging (allocating some money to OTM SPY puts like you mention). I believe he has an eBook on Shareholder Yield and ETF SYLD based on that, and a white paper on tail risk with ETF TAIL. I believe some of his strategies and funds would suit you well, though you may want to try to DIY to avoid the fees and possible illiquidity of his funds.

[Lemur]

Thanks @Lucky C . I’ll look into that. Really sounds like what I am looking for.

My thoughts with “must pay dividends” was that any company that is doing so is likely financially sound (minus REITs which are required to pay out). I was using it as a criterion for a defensive stock.

More thinking this morning Is if I just wanted to force 5% annual returns, it is not difficult to extract 0.40% gains per month just writing OTM covered calls. The more net worth one has (lower SWR), the further delta you can pick too. The premium is used for spending. If any stock does get called away, that is a chance to reallocate.

Or even better, if average portfolio dividend yield is 2%, I would need just 3% from CC writing to total 5% ish...and I could go far out of the money.

This does cap gains and turn your stock into more like a high yield bond but that is sort of the point. If timing is good, then growth can still be had as well. Though I vaguely recall in an earlier thread on a similar strategy that in the long-run , CC writing does not perform as well. This is due to inevitable corrections in the market...and then you’ll have the threat of writing your next CC at a lower strike price but if the stock recovers you missed out on the recovery cycle.

Edit: now really liking this idea of just not gain capping and just using the tail risk hedging instead.

Linking for future reading : https://www.grahamcapital.com/Tail%20Risk%20Hedging.pdf

[Lucky C]

I agree with the dividends = defensive reasoning, just asking "why?" since everything should be questioned. To maximize total returns I would not seek out dividend stocks specifically, but at super high valuations and retail sentiment (like today) I would prefer a very defensive approach.

I was thinking that a good defensive portfolio might be to mimic the DJIA but with some tweaks to compensate for its shortcomings. Firstly when DJIA decides to make changes, I believe a stock tends to do better leading up to its addition compared to after its addition to the index, and does better after removal from the index compared to the time leading up to its removal. I'm not sure how strong this is historically, but it can be researched. The fix I was thinking of was to lag DJIA changes by a year, so you can potentially get a bounce after a stock is cut, before you remove it from your portfolio.

The other "problem" with DJIA is that it's dollar weighted, which doesn't make sense for an individual investor's portfolio. Instead you could equal weight and rebalance each year. You could also tilt more weight toward higher dividend payers a la Dogs of the Dow, but of course you don't have to be that strict if you want more diversification. You could combine dividends and momentum and buy the top 5 yields + top 5 performers, rebalanced each year or perhaps more often, to try and get both income and growth while staying within the safety of the Dow Jones. Would that give you better reward/risk than equal weighting the index? I don't know, but it might be worth investigating!