Although bond yields have been climbing, many investors and retirees aren't getting adequate cash flow from their investments.
A New York Times article titled, "Why Many Retirees Could Outlive a $1 Million Nest Eggs" said:
"For people close to retirement, the problem is acute. The conventional financial advice is that the older you get, the more you should put into bonds, which are widely considered safer than stocks. But consider this bleak picture: A typical 65-year-old couple with $1 million in tax-free municipal bonds want to retire. They plan to withdraw 4% of their savings a year - a common, rule-of-thumb drawdown. But under current conditions, if they spend that $40,000 a year, adjusted for inflation, there is a 72 percent probability that they will run through their bond portfolio before they die."
The 100% Bond PortfolioThe traditional view of investing in Treasury bonds (TLT - News) is they are "risk free." But with the possibility of a debt default by the U.S. government and the threat of higher interest rates damaging the value of bonds further, many people are learning the Treasury market has plenty of potholes.
The 10-year U.S. Treasury yield (IEF - News) surged more than 50% over the past year, but the yield is still just at 2.62%. That means someone with a 4% withdrawal rate on their investments is eroding their principal.
The 100% Stock PortfolioSome investors are betting everything they own on the stock market (SCHB - News). This is the opposite extreme of the 100% bond portfolio example cited above. The theory behind this strategy is that since stocks have easily outperformed bonds over long-periods of time (25 years or longer), an all-stock portfolio will solve everything. (The Wall Street Journal recently ran a piece titled, "The 100% Stock Solution.")
On paper, the 100% stock portfolio may look good. But in the real world, market declines of 40%-60% as we've experienced in our life-time (see 2000-02 and 2008-09) can permanently disrupt even the best of investment plans. And that's why a 100% stock portfolio is probably best geared for those who 1) can afford very large drawdowns, and 2) who don't mind large swings in market volatility.
A Better StrategyA less extreme approach is what our ETF Income Mix Portfolio does. Each month we sell covered calls on ETFs that track a few different asset classes; stocks (DIA - News), gold (GLD - News), and U.S. real estate investment trusts (VNQ - News).
By using this technique, not only are we able to collect dividends from the underlying ETFs, but we also generate income from the options. And in the case of gold, we are able to convert a dead asset that generates no dividends, into an incoming producing asset! Over the one-year period ending September 2013, our Income Mix Portfolio has generated $10,900 or $908 per month, based upon a $100,000 all-ETF portfolio. Each month we tell readers the best combination of ETF covered call options to sell.
One final strategy for solving the income shortage puzzle, is to sell out of the money call and put options. This is definately a less conservative strategy compared to selling covered calls because you don't own the underlying ETFs. However, properly placed trades often result in call and put options that expire completely worthless, which is what we want.
Below is a recent example of a GLD income trade we did. Our May 1 ETF Weekly Pick on GLD options said the following:
"After meandering in the mid-teens over the past five months, gold volatility (^GVZ) has jumped to over 20. That's translated into higher call option premiums for the SPDR Gold Shares (GLD). We like selling the GLD May 2013 143 call options (GLD130524C00143000) for around $200 of monthly income. These options expire on May 23, 2013 and our goal will be to watch them expire worthless. Although GLD has rallied hard since its swoon toward $130, the YTD price trend is still down."
How did our GLD income trade work out?
Just as we expected, our GLD May 2013 143 call options expired worthless and we bagged the monthly income.
ConclusionAlthough selling covered calls putsa collar or limit on any potential capital gains, the monthly cash flow we get helps us to achieve our primary investment objective: More income with less risk.
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