Three steps to building a sound investment strategy - Personal Finance

Healthcare Financial Management, Oct, 1991 by William G. Kistner

With the recession apparently over and 1991 nearing its close, the planners among us will begin to concentrate on personal financial goals for 1992. For most people, personal life changes commonly drive financial planning. Retirement from a career or the birth, graduation, or marriage of a child often govern the technical components of a person's investment strategy.

Create a profile. After reviewing one's personal financial situation and identifying goals for 1992, assets can be allocated. The first step in asset allocation is to determine a personal investment profile.

Age often represents the most important element in determining appropriate asset allocation. In effect, the younger the person, the longer his or her investment horizon and the more risks he or she can assume.

A person's need for liquidity, an investment constraint, should be examined. A liquid asset can be converted to cash in a short period without significant penalty. Investment liquidity may be required if a person anticipates making large personal expenditures, such as educational costs.

Portfolio size also deserves attention. A small portfolio typically should be concentrated in cash, fixed income, equity investments, and other traditional financial assets. In most cases, mutual funds are preferred investment vehicles to achieve diversification, but liquidity is equally important.

Large portfolios can introduce non-financial assets (such as real estate, tangibles, and illiquid investments) and investment vehicles (such as investment partnerships). Total portfolio liquidity is not a dominant consideration. A large portfolio often consists of individual issues of securities rather than mutual funds.

Cash flow is another consideration to be weighed. Significant excess cash flow diminishes a person's need for asset liquidity, while marginal excess cash flow increases the need for portfolio liquidity. Along with assessing the need for cash flow, a person's income tax bracket, risk tolerance, and target rate of return must be considered in structuring an investment portfolio.

Set goals. At any point in time, one or more of several investment objectives should be determined. These include:

* Liquidity: Securities listed on the national exchanges are liquid because they can be sold in short order. Liquidity means flexibility to make immediate portfolio changes in response to shifts in market conditions, personal circumstances, or investment objectives;

* Income or cash flow: Personal circumstances may dictate the need for current yield or cash flow from a person's investments. For example, a retired individual whose pension and Social Security benefits cannot satisfy current lifestyle expenses may require cash flow from investments;

* Capital growth: When current income is not needed, an investor can pursue an objective of growth or appreciation of capital. Although inherently risky, variable returns through growth historically offer an opportunity for greater long-term returns;

* Safety of principal: Many people cannot afford to specualte with their investment. For the most part, however, a conservative portfolio also means a lower return; and

* Beating inflation: The insidious nature of inflation also should figure into investment plans.

Weigh risks. A final step in allocating assets and settling on investment options involves considering some of the risks associated with each asset category, including:

* Market risk: The uncertainty or unpredictability of the market valuation of an asset at a particular time;

* Business risk: The chance that a company or industry fails to perform well;

* Interest rate risk: Especially true of fixed-income securities and some equities, such as utilities. Rising interest rates can cause market values to decline. This possibility deserves significant consideration if aperson must sell a fixed-income security before it matures;

* Credit risk: The possibility that a company or organization issuing a fixed-income security will default. Bonds of organizations with the highest quality ratings have lower yields than bonds issued by firms with lower credit ratings;

* Inflation risk: The chance that inflation will erode the value of an investment if returns fail to beat or match the rate of inflation; and

* Liquidity risk: The possibility that an asset cannot be converted to cash when it is needed. For example, real estate investments generally are illiquid.

A person's investment strategy in the coming year should be driven by all of these elements, each of which deserve careful thought. Personal goals, investment objectives, and the ability to assume risks are essential deliberations in constructing a sound investment strategy.

William G. Kistner, CPA, is a tax partner with Ernst & Young in Chicago, Ill. Reader's comments and questions are encouraged and can be addressed to: William G. Kistner, CPA, Ernst & Younh, 150 S. Wacker Dr., Chicago, IL 60606.