Income stock versus Growth Stock

Many investors hope to invest for income. They look for a consistent income say of 1.5% to 2.0% to supplement their bills or even pay for their monthly expenses.

Financial advisers often ask whether you are investing for income or investing for growth. It is advised that if you are more advanced in age, you should take less risk and thus invest for income. If you are younger, you have more time and thus you should be more aggressive and invest for growth. If you are wrong, you have more time to allow the growth stock to perform.

Contrary to popular beliefs, I like to explain why these concepts are flawed.

First, it is not a matter of income or growth. The issue is really how you manage the risk. Stock market fluctuates. It goes in cycles. It has volatility. It is also unpredictable short term.

The premise of income stock is to assign minimum risk to the market. The problem is that the market risk is higher than expectation.

Choosing a wrong stock and blindly wait for it to perform despite clear downtrend can be disastrous.

Looking at some “safe” income stocks during the 2008 market crash, it went down together with the market. Some lost control and went bankrupt. Situation changed. One example is GE. I am sure many people thought it was a good income stock that you can hold for good, collect dividends and double the shares when it goes down. It is a highly respected blue chip. GE consistently delivered growth, earnings and dividends for many years until the housing bubble exposed its huge weakness in its finance division that should have bankrupt the company if not for a government bail out.

There are more important decision processes when investing in the stock market.

The most important point is to ensure that the underlying fundamentals of the stock are intact. However, it is often too late when you realized the fundamentals have broken down.

So the next important key is the ability to control the risk until the situation is clear. The first sign of a breakdown in fundamental is usually revealed technically from a chart. It goes from bullish to bearish or it goes from an up trend to a downtrend. They are many ways to determine that but it is not in the scope here to discuss this. It is important that damage control is done immediately upon first sign of a breakdown.

The way to do damage control is by using options. The important tool I have is the use of puts and a collar trade.

But, the stock may not be performing because it is just going through a temporary setback caused by sentiments and the overall market negative performance. Even the stock may go down 30%, you may just lose 5-6 % if you use the options hedging strategies properly. The breakdown must be controlled. Buy time to allow one to react to the fundamentals.

If you know how to hedge, control risk and trade using options, my argument is that an income stock is not a lot different from a growth stock.

There is room for income stock. Certainly, there are stocks who are clear leaders in the market.. Many value investors have argued a case for IBM, INTC, MSFT. WMT and XOM. I agree that these are good stocks – great business model and good cash flow. But business environment can change. Management can make grave errors on long term strategies. If you were to look at the performance of these companies, they have gone nowhere for the last few years. Certainly, I have done better on investing in other growth stocks given that the risks are similar if you http://www.blogger.com/img/blank.gifcontrol it properly. Alternatively, you can embark on a Double Diagonal or its variation to trade these stock. For this, I will keep to 30% of my portfolio as its upside is limited until it breaks out.

I have different ways to manage these income stocks. Examples are given in my WMT double diagonal or the recent trade on JNJ. You can also buy the stock when it is cheap and hope that it will break out while earning income via its dividends. There are definite risks involved and it must be controlled.

Business environment is dynamic. Some of these companies will make a breakthrough because of re-engineering, new product or a new CEO. The downside is limited but it must be managed in case it goes against some fundamental change in the business environment that adversely affect the performance of the company.

Thus, similar to controlling the break down, you can also control the break up using a collar.

If you set your mind to think that you can make a fixed percentage every month, you will be disappointed. Stock prices fluctuate and sometimes violently. You cannot treat the stock market like getting a fixed salary every month. I just think it is flawed concept. Over the years, I know there will be some losing months. But overall, I keep my losses small and let the winners run. It is therefore possible to shoot for an annual gains of >10% but at the same time, when opportunity presents, I go for the 50% without compromising on my risk.

Many traders go for 80% of their portfolio on "safe" stocks and leave 20% for speculative strategies. I agree that if I were to use more speculative strategies like Iron Condors, Butterfly, Calendars, and many pure options play, I will not allocate more than 20% of my portfolio. I will also keep my position sizing small. I use these strategies only once in a while. In actuality, it is less than 2% of my portfolio.

I invest in highly volatile stocks. For example, I invest in precious metals, commodity and related stocks. I invest in growth stocks like BIDU,AMZN,SNDK, SU and AAPL. These are highly volatile stocks. But I believe I know how to handle the volatility and risk. It has been very profitable for me. These are also very sound companies fundamentally.

I try to identify stocks that are clear market leader – the next google, apple, bidu or amzn. If possible, identify it at an early stage and ride it all the way. It is not easy. These stocks are normally volatile. In many cases, you are scared away by its volatility half way. With options, you can keep you emotions in check. As long as the fundamentals are intact, it is easier to hold on to wild ride until the fundamentals clearly breaks down, then you close the trade. I have also give an example of these my my trade for BYD.

So for me, I go for 70% growth stock and 30% income stock. My strategies for growth stock are primarily covered calls and collars manipulating the various instruments like the pieces in a chess game. If you do it properly, you can go quite far with it. For income stocks, I use month to month covered calls, long term ITM SCs for high dividend stock and double diagonals. But it is from the growth stocks I derive most of my profit.

The primary factors for success are understanding the fundamental; manage the price trends, volatility and risks using options.