Safety and Income: Safety, Income and the Optimal Portfolio
  1. Safety and Income: Introduction
  2. Safety and Income: Why Focus on Safety and Income?
  3. Safety and Income: Caveats Regarding Safety and Income
  4. Safety and Income: Stocks and Dividends
  5. Safety and Income: Bonds
  6. Safety and Income: Banks
  7. Safety and Income: Guaranteed-Income Products
  8. Safety and Income: Real Assets - Gold, Real Estate and Collectibles
  9. Safety and Income: Safety, Income and the Optimal Portfolio
  10. Safety and Income: Conclusion

Safety and Income: Safety, Income and the Optimal Portfolio

By Brian Perry

When constructing a portfolio, the primary consideration is to build the portfolio that is most likely to help an investor achieve his or her financial goals. This optimal portfolio can vary greatly depending on an investor's unique return objectives and risk tolerance. This chapter will discuss how an emphasis on safety and income can be integrated into the portfolio process to help an investor build an optimal portfolio.

Return Objectives
When building an investment portfolio, an investor must determine what it is that they are trying to accomplish. For an individual, this can be any one of many things. An individual may be investing to build a retirement portfolio, to purchase a new home or to build a rainy day fund. These objectives will carry with them different time horizons, which means that the optimal portfolio in each instance is quite different. When the time horizon is very long, such as for some retirement investment programs, a portfolio can be invested in a more aggressive manner. When the time horizon is short or the funds are intended to serve as an emergency backstop, an emphasis on safety becomes more important.

In addition to capital appreciation, a goal of an investment program may be to generate income to meet expenses. This is particularly true for individuals who are retired or who depend on their portfolios for ongoing income. For these individuals, income becomes an important consideration when structuring a portfolio.

Risk Tolerance
Perhaps the most important question an individual needs to ask when constructing an investment portfolio is: "what is my risk tolerance?" The combination of return objectives and risk tolerance will then determine the optimal portfolio and the optimal asset allocation. Again, time horizon plays an important role in determining risk tolerance. The longer the time horizon, the more risk an investor is able to take. The shorter the time horizon, the more cautious an individual should be in his or her investment approach.

The above discussion focuses on the ability to take risk, but there is another important consideration in determining risk tolerance. In addition to ability to take risk, investors should also carefully consider their willingness to take risk. These two factors are not always in alignment. For instance, an investor with a long-term goal may have the ability to take on additional portfolio risk, but if the thought of losing money keeps them awake at night they might not have the willingness to take much risk.

Investors should attempt to align their ability and their willingness to take risk. However, in situations where ability and willingness provide conflicting signals, investors should defer to that which is more conservative. In other words, if an investor has the ability to take risk but not the willingness, they should take less risk. On the other hand, even if an investor is aggressive by nature, if their objectives are short-term in nature, they should probably invest conservatively. (Learn more about this important topic in our article Risk Tolerance Only Tells Half The Story.)

Safety, Income and Growth
Safety, income and growth are the three main objectives within an investment portfolio. The degree of emphasis placed on each of these goals will differ depending on an individual investor's return objectives and risk tolerance. Cautious investors will emphasize safety, while aggressive investors will emphasize growth. Likewise, investors who require cash flows from the portfolio will emphasize income while with no need for income will emphasize growth.

While the degree of emphasis on these three objectives will vary, under most circumstances investors should not exclude one. For instance, even in the most cautious of investment programs, attention should be paid to growing the portfolio enough to keep pace with the rate of inflation. Likewise, even aggressive investors with long-term time horizons should pay strict attention to risk management, as large losses in a portfolio can be difficult to overcome even over long time periods. Finally, regardless of whether an individual intends to withdraw cash from the account, income is responsible for a large portion of total return in investment portfolios over time; therefore, investors that ignore this crucial component do so to their own detriment.

Conclusion
In general, younger investors will have a reduced emphasis on safety and income while older investors will focus more closely on these goals. Likewise, individuals with short-term time horizons will primarily focus on safety while those with longer-term objectives will be interested in growing the portfolio. Importantly though, investors should seek to balance both safety and growth within the portfolio management process; the precise emphasis will vary depending on unique circumstances, but neither should be ignored. Finally, regardless of whether withdrawals are intended from the portfolio, income can help to produce superior total return in a portfolio over time.

Safety and Income: Conclusion

  1. Safety and Income: Introduction
  2. Safety and Income: Why Focus on Safety and Income?
  3. Safety and Income: Caveats Regarding Safety and Income
  4. Safety and Income: Stocks and Dividends
  5. Safety and Income: Bonds
  6. Safety and Income: Banks
  7. Safety and Income: Guaranteed-Income Products
  8. Safety and Income: Real Assets - Gold, Real Estate and Collectibles
  9. Safety and Income: Safety, Income and the Optimal Portfolio
  10. Safety and Income: Conclusion
RELATED TERMS
  1. Aggressive Investment Strategy

    A portfolio management strategy that attempts to maximize returns ...
  2. Portfolio Investment

    A holding of an asset in a portfolio. A portfolio investment ...
  3. Risk Tolerance

    The degree of variability in investment returns that an individual ...
  4. Capital Growth Strategy

    An asset allocation strategy that seeks to maximize capital appreciation, ...
  5. Portfolio Plan

    An investment strategy applied to a personal or corporate portfolio ...
  6. Asset Allocation

    An investment strategy that aims to balance risk and reward by ...
RELATED FAQS
  1. How can I use risk return tradeoff to determine my risk tolerance and investment ...

    Learn how an investor can use the risk-return tradeoff to determine what assets to include in a portfolio, and understand ... Read Answer >>
  2. Why is risk return tradeoff important in designing a portfolio?

    Learn how the risk return tradeoff is used in the construction of portfolios, and how modern portfolio theory seeks to diversify ... Read Answer >>
  3. How do I find out my own risk tolerance?

    Learn why risking capital can be risky business, how much risk can you afford and how to determine the right amount of risk ... Read Answer >>
  4. What is the difference between portfolio management and financial planning?

    Understand the difference between financial planning and portfolio management, and learn which financial professionals can ... Read Answer >>
  5. How is portfolio variance reduced in Modern Portfolio Theory?

    Learn about modern portfolio theory, specifically what it asserts about asset allocation and managing portfolio risk through ... Read Answer >>
  6. How should I allocate my ETF portfolio?

    If I invest strictly in ETFs and my portfolio cont... Read Answer >>
Hot Definitions
  1. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  2. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  3. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  4. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  5. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
  6. Unlevered Beta

    A type of metric that compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta ...
Trading Center