The stock market is once again reaching for new all-time highs, especially in the last several days after the U.S. presidential elections. First, the election uncertainty appears to be largely over with the media projecting the president-elect, even though the results are still being contested and legally challenged in some states. Second, the market believes that the U.S. Congress will remain divided, with Senate control staying with the Republicans while control of the House will remain with the Democrats. A divided Congress will ensure that none of the far-reaching ideas or policies of the left get passed into law. At least, that’s the theory that we are being told. Of course, there has been some positive news this past Monday on the COVID-19 vaccine trials, and that led to a big rally. This was good news not only for healthcare stocks but generally for most traditional stocks. It also meant that the money was moving from work-from-home and tech stocks to more traditional stocks like banks, transport, energy, and cyclicals.
On the surface, the market looks a bit toppy and expensive when the real economy is still struggling with unemployment as high as 7%. That said, the economic recovery is still intact. With a viable vaccine on the horizon, the pandemic may finally be over by summer 2021. Irrespective of the final election results, there’s a strong possibility of more stimulus being passed now than before.
With the above picture, if you have some cash sitting on the sidelines, is it a good time to invest? Will the market’s upward momentum and gains continue, or will they wither away? The decision to invest or stay in cash becomes even more difficult if you are a retiree or rear retiree and need to generate safe income from your investments.
Obviously, interest rates are near zero thanks to the pandemic, and they will remain near-zero for the foreseeable future. With that, bank saving accounts pay next to nothing. If you have significant sums of money in a savings account, you literally see your money losing its value every month due to near-zero interest rates, a falling U.S. dollar, and the rising stock market.
Let’s assume that you have a cash problem. In other words, you have some idle cash sitting in a savings account that needs to be invested because it’s rusting slowly. There can be many reasons based on individual situations. Maybe you sold a lot of stocks in 2019 or prior to the pandemic when the market was reaching new highs. You raised a lot of cash then and need to get back in the market now. Maybe you just retired and want to roll over a sizable chunk of money into an IRA. Or maybe you just got some inheritance that needs to be invested. Or maybe you sold an investment property and did not want another one because you do not want the day-to-day headache of managing the property. However, the problem at hand is to invest cash somewhere that can generate a decent income, preserve capital, and provide some reasonable growth on a long-term basis.
So, the big question is where to invest safely and still generate some income and returns.
Needless to say, you have many options. Sure, your first priority probably would be to preserve the capital. Depending upon your individual situation, risk tolerance, income needs, and time horizon, here are some common options, along with their benefits and downsides. However, what options will suit you depend largely on your own situation.
Also, please note that the list below is simply a list of investment options and not all of them generate income. In the later part of this article, we will provide a 3-basket strategy that aims to generate a 5% safe income, preserve capital, and provide good long term growth of capital.
1. Short-Term Cash – Certificate of Deposits or Money Market Funds
We know many folks would just hate the idea of CDs, especially in the current environment. We don’t disagree. With interest rates near zero, this is hardly an option to park your cash. But there may be situations when this is your best option. If this cash is your emergency fund, or if you are going to need it for any purpose in the next six months to a year down the line, it may be prudent to keep it in CDs or money market funds. Agreed, the interest rates you get from these products are dismal. They don’t even meet the impact of inflation. You barely get less than 0.90% interest rate on a one-year FDIC insured CD, but it’s still better than 0.01% interest in a saving account. A three-year CD will fetch you a max 1.0% to 1.25% interest rate. You can also go for “laddered” CDs, where your broker buys you multiple CDs at once with varying maturities. The advantage is that you would have access to partial amounts at regular intervals (like every three or six months). Please note that FDIC insurance is generally up to $250,000 per account owner, per issuer. Money market funds are another way to get a somewhat higher rate of interest than a typical savings account.
For most other situations, CDs or money market returns are simply not good enough. Sure, there’s no risk of losing capital with these instruments, but over time the inflation will eat into the capital significantly.
2. Invest in a Target-Date Fund
If your money is in a 401K type account or an IRA account, one simple method could be to choose a target-date fund. Generally, you match the fund date, which would approximately mature just in time for your retirement. Generally, this may be a reasonable option for those who are relatively younger and do not have much interest or time to consider individual stocks or other funds. These kinds of funds invest more aggressively when you are young and have many years away from retirement, but their investment mix gradually becomes increasingly conservative (more bonds and fewer stocks) as the retirement year approaches.
Most of the brokerage firms like Fidelity, Vanguard, and Charles Schwab offer these funds at very reasonable expense ratios.
3. Invest in a Balanced 70:30 (or 60:40) Stock-Bond Fund
If you are investing for the long term and do not like to own individual stocks, you could choose to make your own balanced fund. For example, invest 70% cash in stock funds and 30% in bonds. Rebalance on an annual basis, and you are done. The stock investment portion will provide growth and protect from inflation, whereas the bonds portion should reduce volatility and provide some income. This option also works well for retirement accounts where your choice of funds is limited.
Some folks may argue that 60:40 Stock/Bond investing is dead, and it no longer works. However, we tend to disagree. It certainly is not the best investment plan, and you could do much better with some other plans. But if your investment style is a hands-off approach, and your goal is to have lower volatility with roughly 8% annual returns, this approach should still work on a long term basis.
4. Invest in a 40:30:30 Domestic Stock/International Stock/Bond Portfolio
This option is just a different variation of the strategy described in the point above. You divide the stock investment into two parts by investing 40% in the domestic market, 30% in foreign stocks, and the balance in bonds. Even though the U.S. stock market is the largest in the world and by different estimates it makes about 35% of the global stock market, you would still be missing about 60% or more of opportunities if you do not invest in global markets. However, with a large number of companies in the S&P 500 index drawing 50% or more of their revenue from outside the U.S., you may already be exposed to the global markets to a certain degree.
5. Write Stock Covered Call Options
This is probably the best way to earn a decent amount of income on cash while it’s waiting to be invested. However, the downside is that it’s not very simple to play options on a regular basis. It does require some level of knowledge, expertise, and some experience. If you are just starting new, it’s best to practice in a trial account without the involvement of real money. Most people can get the hang of it in a couple of months. Many brokers offer practice or trial accounts along with real-money accounts.
Stock Option example:
The first step is to buy a certain very safe dividend-paying stock in a multiple of 100 shares lot.
Subsequently (or simultaneously with buying the stock), write (or sell) covered-call option(s) with a short-term maturity of 1-3 months. You collect the premium upfront for selling a covered call, which gives the buyer of the call (the counterparty) the right to buy your shares at a certain minimum price until the strike date (maturity date). For each lot of 100 shares, you could sell one option.
For example, you buy 100 shares of Verizon (VZ) at $61.00 a share and immediately sell one covered call (one option equals 100 shares) at a strike price of $62.50 at a premium of $0.95, and call expiring on Jan. 15, 2022. It means you would collect $95 ($0.95x100shares) immediately as income, and giving the buyer the right to buy your 100 shares at $62.50 a share at any time between now and Jan 15, 2020. Obviously, for the buyer to exercise this option, the market price of VZ would need to move above $62.50 (or preferably $63.45) a share to be profitable to the buyer. There are a few possible outcomes:
- VZ trades at above $62.50 on Jan. 15, 2021. Your shares will likely get called, and your profit would be $150 from the shares (100*($62.50 – $61)), $95 from the premium collected, and possibly $62 from the dividend in early January (ex-date Jan 08, 2021). However, since the dividend ex-date will be prior to the expiration date, the call buyer may exercise the option prior to the dividend ex-date if the stock price is above $61.88 ($62.50 – $0.62). If the shares get called, you will have a net gain of $307(150+95+62), or 27.41% annualized return over 67 days.
- VZ trades below $62.50 (or below $61.88 before the dividend ex-date), your shares should not get called, and the option will expire. You get to keep the premium of $95, giving you an annualized return of 8.48%. You also should receive $62 of dividends, raising your income to 14.02% annualized.
- The third option is that VZ shares fall below your buy price (< $61 or $60.05 after including premium). The option will expire worthless. You may have a paper loss in this scenario, but you still hold the stock. In this situation, you could write another call option and collect the premium all over again.
The above process is not overly complicated, but it does require some experience and time commitment. Please note that you should be aware of the risks involved with this strategy, so you should only use this strategy with stocks that you are prepared to hold long term.
6. Construct an All-ETF Portfolio
For passive investors who do not like to pick and invest in individual stocks or investors whose investment capital is not large enough for individual stocks, another good choice would be to invest in a few selected ETFs (exchange-traded funds). ETFs trade like stocks and can provide you the liquidity as well as broad diversification based on what kind of ETF you choose. There are hundreds of ETFs available, ranging from the broad-based market and index ETFs, sector ETFs, dividend ETFs, and international ETFs to very specialized ones. Some of the low-cost, dividend-paying ETFs are listed below:
- Vanguard High Dividend Yield ETF (VYM)
- Vanguard Dividend Appreciation ETF (VIG)
- iShares Core High Dividend ETF (HDV)
- iShares Select Dividend ETF (DVY)
- ProShares S&P 500 Dividend Aristocrats (NOBL)
- Vanguard Real Estate ETF (VNQ)
- iShares U.S. Preferred Stock ETF (PFF)
- Vanguard Long-Term Corporate Bond ETF (VCLT)
- iShares Core U.S. Aggregate Bond ETF (AGG) or Schwab U.S. Aggregate Bond ETF (SCHZ)
7. Construct and Invest in a DGI Portfolio
A DGI (dividend growth investing) portfolio is one of our favorites. If you are the DIY (do-it-yourself) type investor, you would rather do well by constructing a DGI portfolio of 15-20 stocks, provided your income needs are fairly reasonable in the range of 3%-4%. There are some initial work and due diligence involved while selecting the companies, but once the portfolio is set up, there’s very little work to do. If you are in the accumulation phase, just reinvest the dividends and let the dividend income stream grow with time.
8. High-Income Method-1
Construct a REIT/MLP/BDC Portfolio:
High-Income portfolios do not suit everyone, especially in terms of emotional temperament. They need to be looked at as income instruments rather than their daily market-value. As long as their income is not in jeopardy, their market value should not matter. You need to consider this kind of portfolio as some sort of annuity, where you get your fixed high income, but there’s not much expectation of growth of capital or even preservation at times. That said, we think they are much better than an annuity, which also can provide you fixed income for life, but they usually provide nothing to your heir. However, a portfolio of high income will not only provide high income for your needs, but there will be plenty left for heirs.
They are relatively volatile and high risk, and in a recessionary environment, they get hit especially hard. For example, in 2020, during the COVID-19 pandemic, these investments lost much more value than, say, the S&P 500. They also have been slow to recover and still lag the broader market year-to-date.
But if your needs are high income and that happens to be your first priority, then you should consider it. You should do your due diligence and learn about them before you jump into them. This type of portfolio can easily provide an income yield in excess of 5% or more. In fact, you could easily aim for 8%, but reinvest 2% and withdraw up to 6% for your income needs. You could select 5-10 companies from the REITs, MLPs, and the BDC sector. You also could select CEFs (closed-end funds) covered in the next bullet point. Most of these companies provide ample distributions.
Some companies worth exploring in this space would be –
- Annaly Capital Management (NYSE: NLY)
- Enterprise Products Partners, L.P. (NYSE: EPD)
9. High-Income Method-2
Invest in an All-CEF Based Portfolio for High Income:
This is another form of the high income option. The kind of risks and benefits we discussed under point 8 above apply here as well.
You basically invest in a few CEFs selected from different asset classes. A CEF, like a mutual fund, invests in a portfolio of securities and is generally managed by an investment management firm. But unlike mutual funds, CEFs are closed in the sense that capital does not flow into or out of them when investors buy or sell shares on the stock exchange. That’s why there’s generally a difference (premium/discount) between its NAV (Net Asset Value) and the market price.
Most of these funds use some level of leverage (normally 20%-40%), and for that reason, they are considered relatively riskier. Sure, there are many funds that use no leverage or very little, and they are obviously less volatile. Due to the high amount of leverage, it’s very important that you choose funds that have proven management and excellent past records. Besides the high yield, generally in the 6%-8% range, another advantage that these funds can offer is that at times they trade at deep discounts to their NAVs. So, assuming other factors being equal, you buy when they are offered at a good discount and should not buy them when they are commanding a premium to NAV.
We provide a sample portfolio of CEFs in a later section of this article.
10. A Combination of Two or More of the Above Strategies
Most often, it’s best to combine a couple of strategies to hedge your bets because if one strategy zigs, the other one may zag. What kind of strategies you combine would be a personal decision and should be based on your goals, needs, and risk tolerance. We have provided a long list above, but there would be many more strategies.
A Sample Multi-Basket Portfolio
(to generate safe income and good growth)
If it was very short-term money, like 3-6 months, we would just leave it in a savings account or money-market account. If we do not need this money for up to a year or two, we could probably sell covered calls and cash-secured put options.
If we are pretty sure that the money was not needed for more than two years, we will invest in a multi-basket approach, as outlined below.
However, even two to three years is not a very long period of time and we would like to hedge our bets. That means we do not put all our eggs in one basket and spread our risk. In other words, we would invest in different types of strategies and asset classes. Our favorite method is to divide our money into three or four baskets. Each basket will be invested with a specific strategy that would have unique goals and risk profile. However, when combined together, the resultant portfolio is not only highly diversified and balanced but also can provide income in excess of 5% and very decent growth. Let’s assume we have $200,000 available for immediate investment.
[Source: Author/ Financially Free Investor]
Basket A: DGI strategy (35% of the capital)
Strategy Type – Passive
- Earn roughly 3%-4% income
- Grow the capital in the long term
- Provide less volatility and drawdowns than the S&P 500
To meet the above goals, we will select roughly 10-15 stocks. However, that would depend on the amount of capital. Since the investable amount is only $70,000 (in our example), we will stick to 10-15 stocks. We should select stocks from different sectors of the economy. We will try to select the best and the safest stock in each sector while meeting the income goals of the portfolio.
We have $70,000 allocated to this basket (35% of $200,000). Below is the list of 14 companies that we selected for this portfolio.
(Source: Author/ Financially Free Investor)
This DGI portfolio is reasonably diversified and will generate a decent 3.25% income. We believe it should exceed or at least match the market returns in the long run.
Basket B: 8% Income Strategy (25% of the capital)
Strategy Type – Semi-Active
- Earn roughly 8% income
- Grow the capital by another 2% (in addition to income) in the long term
The main purpose of this bucket is to generate high income, preferably 8% or higher. This is the riskiest basket out of the four, but this will help compensate for a lower level of income from other baskets and thus reduce the need to take risks in other baskets. However, if such a portfolio is well diversified and invested in good funds with a solid track record of NAV performance, we believe it probably has no more risk than the broader market.
We have selected nine CEFs to make it a diverse portfolio:
Basket C: Risk-Adjusted Rotation Strategy (25% of the capital)
Strategy Type – Active
- Grow the capital at a rate equal to or greater than that of the S&P 500
- Provide roughly 6% income.
- Preserve and protect the capital in times of crisis or corrections.
- Provide two thirds of the volatility and one fourth of drawdowns than the S&P 500.
These are rather ambitious set of goals. Our Income-Oriented Risk-Hedged Portfolio attempts to meet all four goals.
This model will use only two securities in this portfolio in a 75%/25% mix:
QQQX is a closed-end-fund and has a reasonably long history going back to January 2008, which incidentally covers the last recession of 2008-2009. It invests mainly in the top 100 Nasdaq stocks. The fund also uses covered calls to generate income. QQQX currently provides a quarterly distribution of roughly 6.50%.
TLT is the 20-plus year Treasury Bond ETF that invests 95% of its assets in U.S. Treasuries with a maturity of 20-plus years. It currently provides a yield of roughly 1.62% on a monthly basis.
Every month we will compare the relative performance of the two securities over the previous three months. We will invest 75% of the capital in the winning security and 25% in the other one. For example, if QQQX outperformed TLT, we will invest 75% in QQQX and 25% in TLT. On the other hand, if TLT outperformed QQQX, we will invest 75% in TLT and 25% in QQQX. We will repeat this process on a monthly basis.
We will provide the backtesting results using the QQQX/TLT. Our backtesting model shows that from 2008 to the present, we were invested for 92 months in QQQX out of a total of 153 months, roughly 60% of the time.
Starting in January 2008 and until the end of Oct. 2020, this strategy has provided an annualized return of 12.15%, compared with 8.57% of the S&P 500. However, the big difference is in the drawdowns. The strategy had a max drawdown of about -12% compared to a whopping drawdown of -48.5% in the case of the S&P 500. The worst year performance since 2008 for the strategy was less than -4% compared to -37% for the S&P 500.
[Source: Author/ Financially Free Investor]
Note: We provide a similar version of this portfolio in our Marketplace service.
Basket D: Bond/Preferred Basket (15% of the capital)
Strategy Type – Passive
Fixed Income Basket: We will invest a small amount in this fixed income portfolio. The average income yield will be about 3%.
Note: Alternatively, investors who are comfortable with Options (selling covered calls and cash-covered puts) could use this bucket for selling options to generate income. By using options, you could comfortably generate an income of 8%-10%, on average. However, this will not be a passive strategy.
- Earn roughly 3%-4% income
- Preserve capital and provide 6% total return in the long term
- Balance the volatility in other portfolios
We will invest in three fixed income securities ((ETFs)) in equal proportions (33% each).
- Bond Fund: For bond allocation, we will select the Schwab U.S. Aggregate Bond ETF (NYSEARCA: SCHZ). It provides a roughly 2.52% dividend yield, and its portfolio consists of mostly high-quality bonds. The fund is invested in U.S. Treasuries (40%), mortgage-backed securities (27%), and corporate bonds (27%), with only 15% of the assets having maturities longer than ten years. The fund has a very low expense ratio of 0.04%.
- Inflation-Protected Treasuries: We will allocate one-third of the capital of this portfolio to the iShares TIPS Bond ETF (NYSEARCA:TIP), which seeks to match the Bloomberg Barclays U.S. Treasury Inflation-Protected Securities (OTCPK:TIPS) Index (composed of inflation-protected U.S. Treasury bonds). The fund has a weighted average maturity of about 7-8 years and currently provides a low yield of 1.00%.
- Preferred Stocks: We will allocate 33% to iShares Preferred and Income Securities ETF (PFF). This ETF fund is the largest amongst Preferred securities funds and has a good record. It provides a yield of 5.42% currently.
[Source: Author/ Financially Free Investor]
The Combined Portfolio (Income and Returns)
Based on the above, here’s the summary of the portfolio of four buckets. We also show the estimated potential income and returns.
(Source: Author/ Financially Free Investor)
As you could see, for very short-term cash, there really are no good investment options, except getting paltry returns in a CD or a money-market account. The only decent alternative to generate good income may be using stock call-options, which requires significant knowledge and time commitment but also comes with significant risks.
If the investment horizon is two years or more, in our opinion, the multi-prong strategy discussed at the end of this article could be an excellent choice. It’s suited both for the long-term as well as a medium-term investment horizon. The main advantage of the strategy is its strategic asset diversification.
Investing has never been easy or risk free and never will be. That’s why it’s important to have a well thought out plan formulated based on your personal goals, skill-level, income-needs, and risk tolerance.
High Income DIY Portfolios: The primary goal of our “High Income DIY Portfolios” Marketplace service is high income with low risk and preservation of capital. It provides DIY investors with vital information and portfolio/asset allocation strategies to help create stable, long-term passive income with sustainable yields. We believe it’s appropriate for income-seeking investors including retirees or near-retirees. We provide ten portfolios: 3 buy-and-hold and 7 Rotational portfolios. This includes two High-Income portfolios, a DGI portfolio, a conservative strategy for 401K accounts, and a few High-Growth portfolios. For more details or a two-week free trial, please click here.
Disclosure: I am/we are long ABT, ABBV, JNJ, PFE, NVS, NVO, UNH, CL, CLX, GIS, UL, NSRGY, PG, KHC, ADM, MO, PM, BUD, KO, PEP, D, DEA, DEO, ENB, MCD, BAC, PRU, UPS, WMT, WBA, CVS, LOW, AAPL, IBM, CSCO, MSFT, INTC, T, VZ, VOD, CVX, XOM, VLO, ABB, ITW, MMM, LMT, LYB, ARCC, AWF, CHI, DNP, EVT, FFC, GOF, HCP, HQH, HTA, IIF, JPC, JPS, JRI, KYN, MAIN, NBB, NLY, NNN, O, OHI, PCI, PDI, PFF, RFI, RNP, RQI, STAG, STK, USA, UTF, UTG, TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock. Please always do further research and do your own due diligence before making any investments. Every effort has been made to present the data/information accurately; however, the author does not claim 100% accuracy. Any stock portfolio or strategy presented here is only for demonstration purposes.