There are three main reasons why an individual might wish to invest: the first reason is to protect their hard-earned money and ensure its safety. The second reason is to generate current income with which to meet expenses; and the third is to grow their principal and achieve capital gains. In this write-up, we will examine investment strategies to meet those first two goals: safety and income.
When constructing a portfolio, an investor must choose which investment objectives to focus on. Possible objectives include: principal appreciation, income generation, and principal preservation. Of course, in a perfect world every investor would prefer to see his or her principal amount grow while still generating substantial current income. Furthermore, investors would like for this to occur with little risk of principal loss.
Unfortunately, in the financial markets accomplishing this is often difficult if not impossible. Therefore, investors must choose which priorities they will focus on when building their portfolios. This is a personal choice based on individual circumstances, objectives, risk tolerance and constraints. However, some general guidance can be given.
Defining Your Objective
An investor who would find it difficult or impossible to rebuild the principal they have saved should focus on preservation of capital. Similarly, if the investor knows that they will need the money at a defined point in the future, they should carefully monitor the amount of risk they take. In these instances, a focus on safety is probably appropriate.
On the other hand, if any investor depends on cash flow from their portfolio to meet part or all of their current expense, the investment programme’s focus should probably be on income generation. Finally, if an investor is focused on longer-term goals which will require a significant sum of money, capital appreciation should probably be their focus.
Although it may be impossible to build a portfolio with no risk of capital loss, high levels of current income and exceptional growth potential, the three investment goals need not be mutually exclusive – and it is possible to construct a portfolio that is relatively safe while still offering the potential for some capital appreciation.
Such a portfolio can also be structured to generate the current income necessary to meet expenses. There are limits to this approach, though. For instance, aggressive growth-mandates are generally not congruent with safety of principal or income generation. These limits force an investor to choose what their primary investment goals will be.
Determining Your Risk Appetite
Once an investor has experienced a substantial loss, it becomes increasingly difficult to meet their financial goals. A simple example will provide evidence as to why it is important for investors to protect their principal. If a portfolio loses 50% of its principal, an investor must generate gains of 100% just to reach the break-even point. Given long-term averages for various investment classes, 100% gain can take years or even decades to achieve.
This does not mean that investors should avoid taking any losses at all. All investments contain some risk: the key to success is to identify an appropriate risk tolerance and then manage the portfolio to that tolerance. In some instances, this may mean that the avoidance of any losses is appropriate; but in others moderate capital losses may be tolerable if the portfolio is designed to meet its long-term return objectives.
Upside of Income Investments
Many investors depend on income from their portfolio in order to meet current expenses. This is true not only for individuals but also for institutional investors, such as endowments or pension funds. Furthermore, income provides an important component of the total return of a portfolio. Therefore, even investors focused on capital appreciation should be aware of the importance of income in their portfolios.
In a diversified portfolio, the performance of the fixed income portion will be dominated by the income component. While equities are likely to benefit from some capital appreciation over time, even in the stock market income has been responsible for a substantial portion of total returns over time. Therefore, investors who ignore the effect of income on their portfolio performance generally do so to their own detriment.
While focusing on safety and income is appropriate for many individuals, it is important to realise that there are some drawbacks to this approach. These shortcomings also mean that this investment approach is not appropriate for all investors. For instance, inflation is the enemy of all savers and investors.
Quietly, year after year, inflation eats away at the real value of money saved and invested. In fact, one of the primary reasons for investing is so that money saved today can retain its value into the future. By achieving capital appreciation, a portfolio can keep pace with or perhaps even exceed the rate of inflation, thereby increasing an investor’s real purchasing power. However, an investment approach focused solely on principal safety may not be able to keep pace with inflation.
This is important to consider, because some investors may feel that their money is safe simply because their principal is not at risk of loss. However, if the total return on the investment portfolio is below the long-term rate of inflation, the investor is ‘losing’ money even if they do not realise it. That is because their purchasing power is gradually declining even as their principal remains stable.
Investors interested in income must also be aware of the effects of inflation. In order to preserve purchasing power, the amount of income generated by the portfolio must increase over time. If it does not, future income will have less value in ‘real terms’ – creating a decline in purchasing power and standard of living. Inflation is one of the main reasons why even investors focused on safety and income should not ignore portfolio growth. By achieving some capital appreciation in the portfolio, an investor can help to protect him/herself against the long-term effects of inflation.
Keeping an Eye on Growth Opportunities
While focusing on safety and income is an attractive approach for many individuals, it is not appropriate for everyone. In particular, investors with long-terms goals may want to consider focusing more closely on capital appreciation in their portfolios. There are two reasons why a long-term time-horizon makes capital appreciation more important. The first is that over longer periods of time, inflation begins to have a greater impact on a portfolio’s value. This means that principal appreciation becomes increasingly necessary simply to keep pace with the rate of inflation.
Secondly, safety can have different meanings when analysed over different periods. For example, when investing to meet short-term objectives safety might be viewed as the amount of principal fluctuation on a quarterly or yearly basis. In these instances, the overriding concern is to avoid a decline in portfolio value that would prevent the financial goal from being met.
However, as an investor’s time-horizon stretches into decades, these quarterly or annual principal fluctuations become less important. Instead, the investor’s main risk becomes the portfolio’s ability (or inability) to grow to a sufficient size to meet their future financial objectives. Over these longer time periods, a willingness to experience short-term declines in portfolio value in order to meet longer-term objectives may be appropriate.
Almost no one likes the idea of seeing their hard-earned money disappear as a result of losses in their investment portfolio. Safety of principal is even more important for investors who are unable to easily replenish their funds. While younger workers have time to make up investment losses, older workers or retirees may find they are unable to do so. That is the main reason many investment advisors recommend investors gradually shift to a more conservative approach as they grow older. However, regardless of an investor’s age, large investment losses are difficult to overcome – which makes risk management and diversification important for all investors.
Income has provided a substantial portion of the total portfolio return over time, making it vital that investors consider this important aspect of investment returns as they structure their portfolio. The more reliant an investor is on cash flow, the more important this consideration is.
All investors should pay close attention to the safety and income components of their portfolio. For older workers, retirees and individuals dependent on their portfolios’ cash flows, a focus on safety and income is imperative.
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Omega Capital Limited is an Investment management, private equity and investment advisory firm. The Company is authorised and regulated by the Securities and Exchange Commission of Ghana.
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