Cost Basis is the total amount paid for a security, any security, in the portfolio. The cost basis of a dollar of cash is $1. Cost Basis includes commissions and exchange fees, and will be reduced on occasion when "returns of capital" are distributed. Cost Basis is the very foundation of The "Working Capital Model".
* To illustrate, let's start with a portfolio of $100,000 in cash. (The size doesn't matter.) We expect to invest $60,000 of this in Equities and the remainder in Fixed Income.
* Once the portfolio has been constructed, the "Working Capital" total will remain at $100,000 until there are cash additions or withdrawals, and realized gains or losses.
* Day to day changes in Market Value are ignored.
As cash increases from income and from deposits it becomes a part of the "Working Capital" total and is reinvested in a way that maintains the 60% to 40% Asset Allocation, based solely on cost basis.
Thus, both investment "Buckets" are constantly growing, as is the income generated from the portfolio, while the Asset Allocation is being maintained with no unwarranted influence from current market conditions.
Note that with The "Working Capital Model", Cost Basis is used for all diversification calculations as well.
Cash Flow then becomes the engine that propels The "Working Capital Model" forward toward goal achievement.
* It is only fitting and proper the successful Investment Portfolio has this common ground with the successful business entity of any size.
Performance analysis becomes much more productive and forward going because both future predicting and comparing with arbitrary indices/averages is eliminated. Year-end adjustments are unnecessary. Cash Flow analysis shows how effective the allocation formula is and helps isolate how effectively the investor is managing each investment bucket.
Investment Performance Evaluation should be a measure of the extent to which a goal or objective has been achieved. The "Working Capital Model" facilitates the clear analysis of goal achievement based solely on each investors unique portfolio structure. Market Value analysis, on the other hand, tells you nothing about progress toward your long term income goals or the appropriateness of your Asset Allocation.
Three specific numbers are important to long term portfolio Working Capital growth.
* Gross Realized Earnings as a percentage of beginning Working Capital. This number should be better than the One Year CD Rate at the beginning of the year.
* Gross Realized Capital Gains as a percentage of the Cost Basis of Securities Sold. This percentage should be right around the profit taking target you've set for yourself. You may also want to determine the Average Holding Period of each sold security. Shorter holding periods enhance portfolio working capital growth. It is important to set a reasonable target, one that can be achieved frequently throughout the year. Three 8% gains may not be exciting, but they can produce more revenue than one 20%er!
* Growth in Working Capital as an annual percentage. A negative number in this area is totally unacceptable and should (almost) never occur. If it does, the portfolio manager (investor) has: (1) allowed too much risk into the security selection process, or (2) realized losses on older holdings that could not be given up on too quickly.. The actual growth rate will be somewhere between the target profit taking rate for equities and the average yield for fixed income... thus, it depends upon the asset allocation (the size of each bucket), which depends on the age, circumstances, and risk tolerance of the investor. Hey, is this easy or what.
As portfolio Working Capital grows, so does the income that it generates. As a result, there will always be some uninvested cash looking for a home. This is a good thing and should not be tinkered with by applying artificial or automatic reinvestment mechanisms. Every dollar deserves to be allocated separately to the appropriate bucket, and there are times when investment opportunities in the Equity market are few and far between. Income Securities can and should be purchased whenever the allocation formula warrants because? Because it is an income compounding decision, not a price decision.
Similarly, because of the disciplined investor's dedication to the profit taking purpose of the Equity Allocation of the portfolio, large amounts of "Smart Cash" will accumulate with broad advances in the Stock Market. (Smart Cash is defined as cash that results from the realization of profits plus income from securities in the portfolio).
* This is not a hedge on anything, and not some form of market timing. It's simply profits earning some compound interest until new opportunities arise. [Yes, Virginia, compounding is still an important growth provider.]
Rising Markets require GREED CONTROL just as surely as Falling Markets demand protection against FEAR... the two heads of the ole Uncertainty Monster!
While the Media and your buddies drool or cringe, respectively, your Working Capital focus keeps you on target, looking for higher yielding, quality, income securities and/or quality equities that have fallen from grace with the Market.
"Smart Cash" is only "smart" if it doesn't burn a hole in your Asset Allocation.
* Knowing that excessive amounts are the result of profit taking should encourage investors to avoid the purchase of high priced old favorites, hot new issues, and the best performing funds.
* When the fear head is talking to you, The Working Capital Model will be whispering in your other ear to get that Equity Allocation back where it belongs with lower priced quality issues... possibly the same ones you recently sold for profits.
* Typically, more speculative investor types will not be able to control their greed and will fall from Asset Allocation grace by changing and by outthinking themselves.
This is the moment of truth. Be disciplined, don't invade the fixed income portion of the portfolio under any circumstances. Tolerate excessive cash destined for Equity Investing. Don't look at the calendar or the Market Averages for help.
A focus on Working Capital Model Asset Allocation really works if you allow it to throughout changing conditions in all markets.
* It also aids in the understanding of what happens to those "Trading Profits" that just don't seem to move , dollar-for-dollar, to the bottom line. Trading takes place within the ebb and flow of both the stock and the bond markets, which may or may not be moving in the same direction.
* Although your realized gains, and other income, are very real, they are not directly related to the portfolio's Market Value. This is corrected in Working Capital analysis, where the one for one relationship exists.
Click for Details --> WCM Part 3