Two Ways to Make Your Investment Income More Reliable

There is no single solution for developing a winning portfolio or investment strategy. Neophytes and seasoned investors alike can pick and choose from thousands of stocks, bonds and mutual funds to find the right combination that fits their risk tolerance. But there are inherent risks involved with traditional investment strategies that can either leave investors overexposed in equity markets or too reliant on conservative investments that barely keep up with the rate of inflation.

Found somewhere in between those two extremes is a strategy that focuses on reliability of income—or what I like to call the "New ROI." This investment strategy invests in equities for their high growth potential while developing portfolio diversification and stop-loss models to hedge against wild market swings. (For more from this author, see: Protect Your Investments With a Stop-Loss Plan.)

The "New ROI" Philosophy

When it comes to retirement investing, too much emphasis is on investment returns, which often comes at the expense of income dependability and peace of mind. With a focus on return on investments, investors might get the feeling they’re on an endless rollercoaster ride.

Taking a different approach, the "New ROI" looks at reliability of income first and foremost. This often means returns won’t outpace the market, but that’s okay, because it also means the "New ROI" won’t be hit as hard by extreme market downturns—those that surpass correction territory and have the ability to decimate portfolios.

The following two points are key factors that allow for upside gain while protecting against catastrophic losses.

Real Diversification

Most equities-based strategies promise security based on antiquated asset allocations or diversifications, leaving investors overexposed to market fluctuations. However, the New ROI looks to minimize risks and maximize gains by focusing on real and true market diversification by targeting asset allocation equally over the 11 sectors of the economy: 

  • Health care
  • Consumer discretionary
  • Consumer staples
  • Technology
  • Financials
  • Energy 
  • Industrials
  • Telecommunications
  • Materials
  • Utilities
  • Real estate

With the "New ROI", you are essentially spreading your risk across 11 sectors. To make this investment strategy work, you must weight your assets equally by investing 9.09% of your equities in each sector. Why build a portfolio based on equal sector allocation? Most importantly, it provides your portfolio with additional protection against overexposure or underexposure to any one sector of the economy.

With all the market growth during this latest bull run, the "New ROI" has lagged behind as the index has grown heavy in various sectors, but this is intentional by design. The power of this equal sector approach is it is poised to limit losses in the case of a single-sector collapse as we experienced with the dotcom bubble. In that catastrophic crash, the Nasdaq Composite lost 78% of its value as it fell from 5046.86 to 1114.11.

Stop-Loss Model

Market timing is one approach to investing. Some investors swear by it and have developed strategies based on market cycles. But the "New ROI" avoids market timing strategies and instead relies on mechanical models with a built-in stop-loss model in place. (See also: 6 Common Portfolio Protection Strategies.)

In the "New ROI", the portfolio typically places a stop-loss target at 10% of equity value. In this case, markets can recover, but that’s a decision we’re willing to make as corrections often don’t stop at 10%, they keep dropping. As an example, take a look at the  2007-2009 financial crisis, where the S&P 500 eventually lost 37% of its value.

Without the safety net of a stop-loss order in place, emotions can overtake sound judgment. On February 6, 2018, the Dow Jones Industrial Average went into free-fall, dropping an astounding 1,175 points, the biggest one-day fall in history. The S&P 500, also reeling, was entering correction territory—a decline of at least 10% from its previous high.

Later that month, “Mad Money” host, Jim Cramer, and Carley Garner of DeCarley Trading, discussed the emotional aspects of investing and the “investor euphoria” that helped cause the massive sell-offs earlier because there weren’t dramatic changes to the fundamentals to cause such volatility.

But that’s the beauty of a stop-loss model. It helps keep emotions in check and staves off irrational investment behavior. Also, by maintaining discipline and sticking to true asset diversification, investors are able to realize market upsides, while mitigating risks for any potential correction.

(For more from this author, see: Taking the Emotion out of Investing.)