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.
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.
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.
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.
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