by Snider Advisors
Traditionally, investors have relied on investments based on the objective of capital appreciation. When you’re investing for capital appreciation, you buy an asset in hopes it will go up in price so you can sell it for more than what you paid for it sometime in the future. The profit you make is called capital appreciation.
But how do you earn capital appreciation when an asset’s value doesn’t increase? How can you profitably sell an asset that has declined by 50% to 80%? Quite simply, you can’t. If history serves as a guide, you can expect to experience about two bear markets a decade. If you’re living off of your portfolio, you may be forced to sell your assets at a loss just to survive. Doing so creates a high probability you will outlast your money. This simple fact illustrates the dilemma of investing for capital appreciation.
When you’re investing with the objective of producing cash flow, you buy an asset not for its future value, but for its potential to generate income. In other words, you make money by owning and asset, not by selling it. Investing for cash flow is the most obvious answer to many of the problems created by investing in markets that can and do decline precipitously on a regular basis.
Let’s look at the most common sources of cash flow:
1. Bonds and CDs. These investments are typically viewed as being safer than stocks because they usually have lower volatility and less chance of a loss of principal. However, the yield generated by bonds can also be low. Over the last 10 years, the total return of the U.S. bond market has been approximately 5.18 percent.
2. Dividend-paying stocks. As of 2012, the dividend yield on the S&P 500 was just slightly over 2 percent. Sure, there are individual companies that pay much higher dividends, but to create a diversified portfolio, you will have to settle for something close to the average.
3. Real estate. Many investors have been able to create passive income through collecting rent on real estate properties they own. Sometimes these yields can be in the double-digits. Real estate investing, however, brings with it a number of challenges, such as maintenance and finding tenants, which may be a turn-off for the average investor. Additionally, the 2008 crash of the mortgage market — and home prices nationwide — proved that this asset class isn’t immune to downturns.
4. Annuities. These often-complicated products are backed by insurance companies and can be quite confusing. Studies show that few annuity customers truly understand the products they’re buying. Annuities are either variable or fixed, immediate or deferred. They also come in thousands of varieties, making an apples-to-apples comparison virtually impossible.
Perhaps the simplest annuity to explain is the immediate fixed annuity. The fixed annuity promises the policyholder a predetermined income for as long as they live, no matter how long that may be. (For example, you pay the insurance company a lump sum of $100,000, and they promise you $3,000 to $6,000 per year.)
The advantage is that it provides the policyholder with a guaranteed cash flow indefinitely, provided the insurance company remains solvent. The disadvantages are that the cash flow remains constant so purchasing power is reduced by inflation, and when the policyholder dies, the remainder of the principal belongs to the insurance company. Also, the return on investment is often limited. It’s highly likely that even a conservative investor can get better returns elsewhere.
5. Options. Option premium is passive income received from the sale of options against an asset. There are two ways to use options. One is speculation and the other is, ironically, risk management. When you buy an option to bet on the future direction of price of the underlying asset, you are doing nothing more than gambling. Not only do you have to guess the future direction of price correctly, you have to do it before the option expires. But remember for every buyer of an option, there’s a “guy” on the other side of the transaction making money. In the Snider Investment Method®, our goal is to be “that guy.” The Snider Method uses options as a tool to generate portfolio income. To learn more about options, read Myths and Misconceptions about Options.
We understand that the thought of trading options can be intimidating. To learn more about how options are used in the Snider Method, attend our free information session April 18th in Las Colinas. If you can’t make it to the DFW area, join us for a webinar on May 7th.