No one investment type does it all
The financial consultant’s role is to explain that a pool of money should be conceptually divided into several smaller pools that do different things and have different but complementary objectives.
A generalized approach, which must be tailored to each individual’s needs, seeks to find the highest yield and the greatest liquidity for the least amount of risk. An overview of this type of portfolio can most easily be visualized by a segmented pyramid, divided into short term, intermediate term and long term investment options, with a final level, protection.
Level 1: Short term
The top of the pyramid is represented by funds that are relatively risk-free and immediately available. Normally, an individual would look to have a four to six month reserve fund in this segment to cover fixed short-term or extraordinary expenses. This is considered to be an individual’s first line of defense in case an emergency need of cash should arise.
The most common investments for this type of liquidity are money funds, checking accounts and savings accounts.
Level 2: Intermediate term
This level is generally expected to give a higher rate of return over time than Level 1. It is usually a little less liquid than Level 1 and generally entails a higher degree of risk.
These monies are most commonly invested in certificates of deposit, treasury bills, government securities, real estate investment trusts, commodities, common and preferred stock and mutual funds.
Level 2 is divided into two primary classifications, debt and equity. Most homeowners usually have both debt, or the balance on the mortgage, and equity, which is the difference between the mortgage and the home’s current value.
If you are buying a common stock or mutual fund, you are buying an equity interest in a company. If you buy a tax-free bond, Treasury bill, certificate of deposit or leave your money in a savings account, you are participating in the debt side of the equation.
The primary difference between the debt side and the equity side is that with the debt side, you are generally more concerned with the conservation of principal and earning a specific return on your investment. On the equity side, you are more interested in growth of principal and less in earning a fixed return.
Level 3: Long term
This segment of the pyramid is characterized as being the least liquid part of a portfolio, but over time, should give the highest rate of return.
The most common form of investment in this segment is real estate. This might be in the form of remodeling and reselling a duplex, subdividing a large tract of land or purchasing a limited partnership through an investment-banking firm.
Level 3 is broken down into three segments: pension profit sharing, retirement and salary reduction plans; all cash income oriented equity investments; and leveraged growth equity investments.
Profit sharing, income reduction and retirement plans are one of the best and most under utilized ways of accumulating an estate. Properly managed, this is usually the largest part of an individual’s financial plan upon retirement.
Income oriented equity investments have become very popular in recent years, and are most often associated with very little or no leverage. These programs usually pay a high return with little, if any, excess tax deductions. The most popular income programs at the present time are in real estate, oil and gas, and equipment leasing.
Leveraged equity investments were more popularly known for their tax advantages under the old tax bill but are now structured toward aggressive growth. This is most commonly seen in buying real estate or businesses with borrowed money.
Level 4: Protection
Insurance is needed to properly protect and maintain a well-rounded financial plan. Insurance has changed considerably over the years, and is now looked at for its investment attributes as well as for its traditional protection coverage.
Insurance products like variable annuities and single premium whole life policies are most appropriate in the intermediate term portion of our segmented pyramid. Tax shelter annuities would be best viewed in the long-term area. The traditional concept that insurance protects an individual’s overall financial plan is represented by Level 4.
Allan Johnston is regional manager for Wedbush Morgan Securities in Anchorage. He can be reached via e-mail at ([email protected]).