When constructing a portfolio, an investor must choose which investment objectives to focus upon. Possible objectives include: principal appreciation, income generation and principal preservation.
Of course, in a perfect world, every investor would prefer to see his or her principal amount grow while still generating substantial current income. Furthermore, investors would like for this to occur with little risk of principal loss. Unfortunately, in the financial markets, accomplishing this magical trifecta is often difficult if not impossible. Therefore, investors must choose which priorities they will focus on when building their portfolios. This is a personal choice based on individual circumstances, objectives, risk tolerance and constraints. However, some general guidance can be given.
An investor would find it difficult or impossible to rebuild the principal that they have saved should focus on preservation of capital. Similarly, if the investor knows that they will need the money at a defined point in the future, they should carefully monitor the amount of risk they take. In these instances, a focus upon safety is probably appropriate.
On the other hand, if an investor depends upon cash flow from their portfolio to meet part or all of their current expenses, the focus of the investment program should probably be upon income generation. Finally, if an investor is focused upon longer-term goals which will require a significant sum of money, capital appreciation should probably be their focus.
Although it may be impossible to build a portfolio with no risk of capital loss, high levels of current income, and exceptional growth potential, the three investment goals need not be mutually exclusive, and it is possible to construct a portfolio that is relatively safe while still offering the potential for some capital appreciation. Such a portfolio can also be structured to generate the current income necessary to meet expenses. There are limits to this approach though. For instance, aggressive growth mandates are generally not congruent with safety of principal or income generation. These limits force an investor to choose what their primary investment goals will be.
Once an investor has experienced a substantial loss, it becomes increasingly difficult to meet their financial goals. A simple example will provide evidence as to why it is important for investors to protect their principal. If a portfolio loses 50% of its principal, an investor must then generate gains of 100% just to reach the breakeven point. Given long-term averages for various investment classes, 100% gains can take years or even decades to achieve. This does not mean that investors should avoid taking any losses at all. All investments contain some risk; the key to success is to identify an appropriate risk tolerance and then manage the portfolio to that tolerance. In some instances, this may mean that the avoidance of any losses is appropriate, but in others moderate capital losses may be tolerable if the portfolio is properly designed to meet its long-term return objectives.
Many investors depend on income from their portfolio in order to meet current expenses. This is true not only for individuals, but also for institutional investorssuch as endowments or pension funds. Furthermore, income provides an important component of the total return of a portfolio. Therefore, even investors focused on capital appreciation should be aware of the importance of income in their portfolios.
In a diversified portfolio, the performance of the fixed income portion will be dominated by the income component. While equities are likely to benefit from some capital appreciation over time, even in the stock market income has been responsible for a substantial portion of total returns over time. Therefore, investors that ignore the effect of income on their portfolio performance generally do so to their own detriment.
Almost no one likes the idea of seeing their hard earned dollars disappear as a result of losses in their investment portfolio. Safety of principal is even more important for investors who are unable to easily replenish their funds. While younger workers have time to make up investment losses, older workers or retirees may find they are unable to do so. That is the main reason why many financial planners recommend that investors gradually shift to a more conservative approach as they grow older. However, regardless of an investor's age, large investment losses are difficult to overcome, which makes risk management and diversification important for all investors.
Income has provided a substantial portion of total portfolio returns over time, making it vital that investors consider this important aspect of investment returns as they structure their portfolios. The more reliant an investor is on cash flow, the more important this consideration is.
All investors should pay close attention to the safety and income components of their portfolio. For older workers, retirees, and individuals dependent upon their portfolios' cash flows, a focus on safety and income is imperative.