One of the most important steps in the investment process is determining an Investment Objective. Each investment objective has its own risk/return profile. As return requirements rise the amount of risk you must take on to have a reasonable expectation of meeting that goal also rises. Risk, for a diversified portfolio, is simply a measure of how bumpy of a ride it’s going to be. Put another way it’s the level of discomfort or anxiety it has the potential to give you, the investor.
The financial industry typically thinks of risk and reward as a one-dimensional linear relationship. There is “income” at one end of the spectrum and “growth” at the other, and risk and expected return increases as you move along the line. Objectives geared more towards capital preservation or generating current income will have a higher allocation to bonds, while a more growth-oriented objective will have a higher allocation to stocks.
In reality, however, objectives aren’t always that simple and there are many different kinds of risk to consider. This pyramid here has ten sections, one for each of our investment objectives. Each point represents a different goal: Growth, Stability, and Income. As you move up the pyramid towards Growth, your portfolio becomes more volatile and your risk of capital loss increases. As you move down the pyramid towards Stability those risks are reduced, but you’ll also notice the risk of losing purchasing power over time, otherwise known as inflation risk, increases. And as your goals shift from investing in bonds for stability to investing in them to generate higher yields, your credit risk, liquidity risk, and sensitivity to changes in interest rates all increase.
Those different sections of the pyramid guide the overall asset allocation – the mix of stocks, bonds and alternative investments — as well as security selection. The ten different objectives are described below:
Stability places exclusive emphasis on preserving capital and minimizing volatility.
Stability & Income seeks a balance between generating income for current needs and minimizing portfolio volatility
Income places exclusive emphasis on generating current income
Balanced – Stability Biased places an emphasis on preserving capital and lowering portfolio volatility, with long-term potential capital appreciation and current income as secondary goals
Balanced – Income Biased places an emphasis on generating current income, with long-term potential capital appreciation and portfolio stability as secondary goals
Balanced seeks a middle ground between the three competing goals of stability, long-term growth, and current income
Stable Growth seeks a balance between reducing portfolio volatility and participating in market growth
Growth & Income seeks a balance between generating income for current needs and growing the portfolio for the future
Balanced – Growth Biased places an emphasis on potential long-term capital appreciation, with portfolio stability and current income as secondary goals
Growth places exclusive emphasis on potential long-term capital appreciation