|
|
Basic Investment Objectives
The options for investing our savings are continually increasing, yet
every single investment vehicle can be easily categorized according to
three fundamental characteristics - safety, income and growth - which
also correspond to types of investor objectives. While it is possible
for an investor to have more than one of these objectives, the success
of one must come at the expense of others. Here we examine these three
types of objectives, the investments that are used to achieve them and
the ways in which investors can incorporate them in devising a strategy.
Safety
Perhaps there is truth to the axiom that there is no such thing as a
completely safe and secure investment. Yet we can get close to ultimate
safety for our investment funds through the purchase of
government-issued securities in stable economic systems, or through the
purchase of the highest quality corporate bonds issued by the economy's
top companies. Such securities are arguably the best means of preserving
principal while receiving a specified rate of return.
The safest investments are usually found in the money market and include
such securities as Treasury bills (T-bills), certificates of deposit,
commercial paper or bankers' acceptance slips; or in the fixed income
(bond) market in the form of municipal and other government bonds, and
in corporate bonds. The securities listed above are ordered according to
the typical spectrum of increasing risk and, in turn, increasing
potential yield. To compensate for their higher risk, corporate bonds
return a greater yield than T-bills.
It is important to realize that there's an enormous range of relative
risk within the bond market: at one end are government and high-grade
corporate bonds, which are considered some of the safest investments
around. At the other end are junk bonds, which have a lower investment
grade, perhaps possessing more risk than some of the more speculative
stocks. In other words, it's incorrect to think that corporate bonds are
always safe, but most instruments from the money market can be
considered very safe.
Income
However, the safest investments are also the ones that are likely to
have the lowest rate of income return, or yield. Investors must
inevitably sacrifice a degree of safety if they want to increase their
yields. This is the inverse relationship between safety and yield: as
yield increases, safety generally goes down, and vice versa.
In order to increase their rate of investment return and take on risk
above that of money market instruments or government bonds, investors
may choose to purchase corporate bonds or preferred shares with lower
investment ratings. Investment grade bonds rated at A or AA are slightly
riskier than AAA bonds, but presumably also offer a higher income return
than AAA bonds. Similarly, BBB rated bonds can be thought to carry
medium risk but offer less potential income than junk bonds, which offer
the highest potential bond yields available, but at the highest possible
risk. Junk bonds are the most likely to default.
Most investors, even the most conservative-minded ones, want some level
of income generation in their portfolios, even if it's just to keep up
with the economy's rate of inflation. But maximizing income return can
be an overarching principle for a portfolio, especially for individuals
who require a fixed sum from their portfolio every month. A retired
person who requires a certain amount of money every month is well served
by holding reasonably safe assets that provide funds over and above
other income-generating assets, such as pension plans, for example.
Growth of Capital
This discussion has thus far been concerned only with safety and
yield as investing objectives, and has not considered the potential of
other assets to provide a rate of return from an increase in value,
often referred to as a capital gain. Capital gains are entirely
different from yield in that they are only realized when the security is
sold for a price that is higher than the price at which it was
originally purchased. (Selling at a lower price is referred to as a
capital loss.) Therefore, investors seeking capital gains are likely not
those who need a fixed, ongoing source of investment returns from their
portfolio, but rather those who seek the possibility of longer-term
growth.
Growth of capital is most closely associated with the purchase of common
stock, particularly growth securities, which offer low yields but
considerable opportunity for increase in value. For this reason, common
stock generally ranks among the most speculative of investments as their
return depends on what will happen in an unpredictable future. Blue-chip
stocks, by contrast, can potentially offer the best of all worlds by
possessing reasonable safety, modest income and potential for growth in
capital generated by long-term increases in corporate revenues and
earnings as the company matures. Yet rarely is any common stock able to
provide the near-absolute safety and income-generation of government
bonds.
It is also important to note that capital gains offer potential tax
advantages by virtue of their lower tax rate in most jurisdictions.
Funds that are garnered through common stock offerings, for example, are
often geared toward the growth plans of small companies, a process that
is extremely important for the growth of the overall economy. In order
to encourage investments in these areas, governments choose to tax
capital gains at a lower rate than income. Such systems serve to
encourage entrepreneurship and the founding of new businesses that help
the economy grow.
Secondary Objectives
Tax Minimization
An investor may pursue certain investments in order to adopt tax
minimization as part of his or her investment strategy. A highly-paid
executive, for example, may want to seek investments with favorable tax
treatment in order to lessen his or her overall income tax burden.
Making contributions to an IRA or other tax-sheltered retirement plan,
such as a 401k, can be an effective tax minimization strategy.
Marketability / Liquidity
Many of the investments we have discussed are reasonably illiquid,
which means they cannot be immediately sold and easily converted into
cash. Achieving a degree of liquidity, however, requires the sacrifice
of a certain level of income or potential for capital gains.
Common stock is often considered the most liquid of investments, since
it can usually be sold within a day or two of the decision to sell.
Bonds can also be fairly marketable, but some bonds are highly illiquid,
or non-tradable, possessing a fixed term. Similarly, money market
instruments may only be redeemable at the precise date at which the
fixed term ends. If an investor seeks liquidity, money market assets and
non-tradable bonds aren't likely to be held in his or her portfolio.
Conclusion
As we have seen from each of the five objectives discussed above, the
advantages of one often comes at the expense of the benefits of another.
If an investor desires growth, for instance, he or she must often
sacrifice some income and safety. Therefore, most portfolios will be
guided by one pre-eminent objective, with all other potential objectives
occupying less significant weight in the overall scheme.
Choosing a single strategic objective and assigning weightings to all
other possible objectives is a process that depends on such factors as
the investor's temperament, his or her stage of life, marital status,
family situation, and so forth. Out of the multitude of possibilities
out there, each investor is sure to find an appropriate mix of
investment opportunities. You need only be concerned with spending the
appropriate amount of time and effort in finding, studying and deciding
on the opportunities that match your objectives. |
|