While focusing upon safety and income is appropriate for many individuals, it is important to realize that there are some drawbacks to this approach. These shortcomings also mean that this investment approach is not appropriate for all investors. In this chapter, we will examine some of the important caveats regarding an investment approach focused on safety and income and also briefly discuss the types of investors that may be better off managing their portfolio for capital appreciation.
Inflation is the enemy of all savers and investors. Quietly, year after year, inflation eats away at the real value of dollars saved and invested. In fact, one of the primary reasons for investing is so that money saved today can retain its value into the future. By achieving capital appreciation, a portfolio can keep pace with or perhaps even exceed the rate of inflation, thereby increasing an investor's real purchasing power. However, an investment approach focused solely on principal safety may not be able to keep pace with inflation.
This is important to consider, because some investors may feel that their money is safe simply because their principal is not at risk of loss. However, if the total return on the investment portfolio is below the long-term rate of inflation, the investor is "losing" money even if they do not realize it. That is because their purchasing power is gradually declining even as their principal balance remains stable.
Investors interested in income must also be aware of the effects of inflation. In order to preserve purchasing power, the amount of income generated by the portfolio must increase over time. If it does not, future income will have less value in "real terms," resulting in a decline in purchasing power and standard of living.
Inflation is one of the main reasons why even investors focused upon safety and income should not ignore portfolio growth. By achieving some capital appreciation in the portfolio, an investor can help to protect themselves against the long-term effects of inflation.
Taxes are an important consideration for most investors. However, tax considerations become even more important when an investor focuses upon generating income. That is because many individuals will find that income is taxed at a higher rate than capital gains.
Tax avoidance strategies are heavily dependent on an individual's unique circumstances, and should be devised in consultation with an accountant or financial advisor. However, one simple step that some investors can take is to hold income-generating assets in tax-sheltered accounts (such as retirement accounts) while holding non-income-generating assets in fully taxable accounts. Such an approach would help to minimize current taxes on income generated from the overall investment portfolio. However, this approach would not work if the investor needs portfolio income to meet current cash flow needs. In these circumstances, an investor will have no choice but to receive the income and pay taxes on it.
While focusing upon safety and income is an attractive approach for many individuals, it is not appropriate for everyone. In particular, investors with long-term goals may want to consider focusing more closely upon capital appreciation in their portfolios. There are two reasons why a long-term time horizon makes capital appreciation more important. The first is that over longer periods of time, inflation begins to have a greater impact on a portfolio's real value. This means that principal appreciation becomes increasingly necessary simply to keep pace with the rate of inflation.
Secondly, safety can have different meanings when analyzed over different time periods. For example, when investing to meet short-term objectives, safety might be viewed as the amount of principal fluctuation on a quarterly or yearly basis. In these instances, the overriding concern is to avoid a decline in portfolio value that would prevent the financial goal from being met. However, as an investor's time horizon stretches into decades, these quarterly or annual principal fluctuations become less important. Instead, the investor's main risk becomes the portfolio's ability (or inability) to grow to a sufficient size to meet their future financial objectives. Over these longer time periods, a willingness to experience short-term declines in portfolio value in order to meet longer-term objectives may be appropriate.
This chapter has examined the impact of inflation and taxes on a portfolio's performance. Investors must carefully consider the impact that these two forces will have on their ability to meet their financial goals when structuring a portfolio. When seeking to combat inflation, the opportunity for capital appreciation becomes an important consideration. In order to mitigate the effects of taxes, investors should carefully consider the differing treatment of income and capital gains in some tax codes. For all tax issues, consultation with an expert is advised.
Investors with very long-term time horizons may find that a focus upon safety and income is not appropriate. For instance, younger individuals saving for retirement may be better served by focusing on capital appreciation. Individuals with a long-term time horizon will find that they are better able to withstand short-term portfolio declines as they structure a portfolio designed to meet their long-term financial goals.