The options for investing savings are continually increasing, yet every investment vehicle can generally be categorized according to three fundamental characteristics: safety, income and growth.
Those options also correspond to types of investor objectives. While an investor may have more than one of these objectives, the success of one comes at the expense of others. Let’s examine these three types of objectives, the investments that are used to achieve them and the ways in which investors can incorporate them into a strategy.
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 corporate bonds issued by large, stable 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. In order of increasing risk, these securities include: Treasury bills (T-bills), certificates of deposit (CD), commercial paper or bankers’ acceptance slips, or in the fixed-income (bond) market, in the form of municipal and other government bonds and corporate bonds. As they increase in risk, these securities also increase in potential yield.
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 and may have more risk than some of the more speculative stocks. In other words, corporate bonds are not always safe, although most instruments from the money market can be considered very safe.
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. 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 generally also offer a higher income return than AAA bonds. Similarly, BBB-rated bonds can be thought to carry medium risk, but they 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.
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 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. Common stock is rarely able to provide the 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.
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 401(k), 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 making 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.
The Bottom Line
Again, the advantages of one investment 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 carrying less 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 or family situation. Each investor can determine an appropriate mix of investment opportunities. But you need to spend the appropriate amount of time and effort in finding, studying and deciding on the opportunities that match your objectives.
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