Basic Investment Objectives: An Overview
The options for investing your savings are continually increasing, but every one of them can still be categorized according to three fundamental characteristics: safety, income, and growth.
Those options also encompass the objectives of any investor. While the investor may have more than one of these objectives, and may well have all three, the success of one comes at the expense of the others.
The first task of any successful individual investor is to find the correct balance among these three worthy goals.
It is said that there is no such thing as a completely safe and secure investment. But you can get pretty close.
Investing in government-issued securities in stable economic systems is one. U.S.-issued bonds remain the gold standard. You have to envision the collapse of the U.S. government to worry about losing your investment in them.
Next in safety are AAA-rated corporate bonds issued by large, stable companies. Such securities are arguably the best means of preserving your principal while receiving a pre-set rate of interest.
The risks are similar to those of government bonds. You'd have to imagine IBM or Costco going bankrupt in order to worry about losing money investing in their bonds.
- Any investment can be characterized by three factors: safety, income, and capital growth.
- Every investor has to pick an appropriate mix of these three factors. One will be preeminent.
- The appropriate mix for you will change over time as your life circumstances and needs change.
Extremely safe investments also are found in the money market. In order of increasing risk, these securities include Treasury bills (T-bills), certificates of deposit (CDs), commercial paper, or bankers' acceptance slips.
Safety comes at a price. The returns are very modest compared to the potential returns of riskier investments. This is called "opportunity risk." Those who choose the safest investments may be giving up big gains.
There also is, to some extent, interest rate risk. That is, you could tie your money up in a bond that pays a 1% return, and then watch as inflation rises to 2%. You have just lost money in terms of real spending power.
That is why the very safest investments are short-term instruments such as 3-month and 6-month CDs. And those safest investments pay the least of all in interest.
What Are Basic Investment Objectives?
Investors who focus on income may buy some of the same fixed-income assets that are described above. But their priorities shift towards income. They're looking for assets that guarantee a steady income supplement. And to get there they may accept a bit more risk.
This is often the priority of retirees who want to generate a stable source of monthly income while keeping up with inflation.
Government and corporate bonds may be in the mix, and an income investor may go beyond the safest AAA-rated choices and will go longer than short-term CDs.
The ratings are assigned by a rating agency that evaluates the financial stability of the company or government issuing the bond. Bonds rated at A or AA are only slightly riskier than AAA bonds but offer a higher rate of return. BBB-rated bonds carry a medium risk but more income.
Below that, you're in junk bond territory and the word safety does not apply.
Income investors may also buy preferred stock shares or common stocks that historically pay good dividends.
By definition, capital growth is achieved only by selling an asset. Stocks are capital assets. Barring dividend payments, their owners have to cash them in to realize gains.
There are many other types of capital growth assets, from diamonds to real estate. What they all share is some degree of risk to the investor. Selling at lower than the price paid is referred to as a capital loss.
The stock markets offer some of the most speculative investments available since their returns are unpredictable. But there is risky and riskier.
Blue-chip stocks are generally considered the best of the bunch as many of them offer reasonable safety, modest income from dividends, and potential for capital growth over the long term.
Growth stocks are for those who can tolerate some ups and downs. These are the fast-growing young companies that may grow up to be Amazons. Or they might crash spectacularly.
The dividend stars are established companies that may not grow in leaps and bounds but pay steady dividends year after year.
Profits on stocks offer the advantage of a lower tax rate if they are held for a year or more.
Many individual investors avoid stock-picking and go with one or more exchange-traded funds or mutual funds, which can get them stakes in a broad selection of stocks.
One built-in bonus of stocks is a favorable tax rate. Profits from stock sales, if the stocks are owned for at least a year, are taxed at the capital gains rate, which is lower than the income tax rates paid by most.
Safety, income, and capital gains are the big three objectives of investing. But there are others that should be kept in mind when they choose investments.
Tax Minimization: Some investors pursue tax minimization as a factor in their choices. A highly-paid executive, for example, may seek investments with favorable tax treatment to lessen the overall income tax burden.
Contributing to an individual retirement account or any other tax-advantaged retirement plan is a highly effective tax minimization strategy for all of us.
Liquidity: Investments such as bonds or bond funds are relatively liquid, meaning they can in many cases be converted into cash quickly and with little risk of loss. Stocks are less liquid since they can be sold easily but selling at the wrong time can cause a serious loss.
Many other investments are illiquid. Real estate or art can be excellent investments unless you are forced to sell them at the wrong time.
The safest investments are found in the money market. They include T-bills, CDs, commercial paper, or bankers' acceptance slips. Other safe investments include highly-rated government and corporate bonds.
Balancing Safety, Growth, and Capital Gains
For most investors, the answer does not lie in a single choice among safety, growth, or capital gains. The best choice is a mix of all three that meets your needs.
And remember, that changes over time. Your appetite for capital gains may be highest when you're at the start of your career and can withstand a lot of risk. As you approach retirement, you might prioritize holding onto that nest egg and dial down the risk.
At any stage, though, your portfolio will probably reflect one pre-eminent objective with all other potential objectives carrying less weight in the overall scheme.