Investment Strategy
This is fairly brief and focused - may want to integrate it into a more extensive treatment on investment.
Details on specific kinds of investments are documented elsewhere. The present document focuses on investment strategy - what incentives there are to encourage investment at all, and the strategies investors follow in pursuit of their goals.
CORE CONCEPTS
EROSION OF VALUE
Returning to basic economics, money has no intrinsic value, and its sole basis of worth is in exchange for goods and services. In this regard, the purchasing power of money decreases over time - one dollar buys less today than it did ten years ago, and will buy even less ten years in the future.
There are various measurements that attempt to gauge the degree to which money decreases in value (inflation, consumer price index, et. al.), with arguments in favor of using one over others - but they key is that all are based on the same fundamental premise: that money does lose value over time.
As an example, if inflation (or another index, I'll use "inflation" as shorthand hereafter) is set at 3%, $100 today will buy 97% as much next year as it will this year and 94% the year after (Recall that the effect compounds, so three years is 97% of 95% of 97% of today's purchasing power). After ten years, it will buy only 76% as much, and 56% as much after 20 years. A person putting aside money for retirement forty years in the future will find the dollar they save today is worth about thirty cents worth of goods in trade when they need it.
For the person who is saving cash for a specific future purchase, the erosion of value means they will need to put away more than the current price of the item they wish to buy five years hence, as the price will be higher (or money will be worth less, depending on your perspective) at that time.
It also stands to note that the erosion of value is one of the factors take into account when setting an interest rate to be collected on loans - to be paid back, dollar-for-dollar, over a long period of time means getting back less value in terms of purchasing power than was loaned out. But this is a digression.
Basically, storing cash means losing value (purchasing power), so to preserve the purchasing power of a given sum of money, an individual must invest these funds, with an eye toward earning a return on their investment that will counterbalance the erosion of value.
Ignoring the effect of taxes (for now), an individual must invest their funds such that they earn a rate of interest that is equal to the rate at which inflation is eroding the value of those funds.
- If interest and inflation are perfectly equal, purchasing power will be maintained.
- If interest is less than inflation, purchasing power will diminish (albeit more slowly than it would if it were earning no interest at all)
- If interest is greater than inflation, purchasing power will increase.
At this point, the primary goal of investment are clear: to maintain or increase the value (purchasing power) of money over time.
THE EFFECTS OF TAXATION
Taxation is arbitrary, and subject to change, but it does have an effect on investments, in that the earnings of investments are taxed as income on account of the apparent "gain" in dollar value, and in spite of what might be an actual loss in purchasing power.
Therefore, when inflation rates are at 3%, an individual who is taxed at a rate of 25% must earn at least 4% to cover not only the loss in value of their money, but the taxes on the earnings on their investments. If they earn merely 3%, they will lose purchasing power to taxes over time.
There is (and has long been) a great deal of debate over the righteousness of this practice, given that the investor is being taxed on an amount of dollars that they have "earned", even though they are breaking even in terms of purchasing power. Some argue for a complete repeal of taxes on investments, others suggest taxes should be mitigated to account for inflation, but this is largely a separate matter.
A practical factor to be considered when choosing a targeted rate of return as well as specific investment vehicles is the comparison of tax-free investments (such as municipal bonds) versus investments whose returns are subject to taxation (just about everything else). For example, a tax-free government bond paying 6% is more attractive than a corporate bond paying 7% due to the effective after-tax rate on a person taxed at 20%).
For purposes of the present study, I plan to set aside this factor to keep things simple - but it remains a consideration that can be significant in specific instances.
GROWTH
Beyond merely preserving the value of money over time, there is the potential for an investor to generate value by investing funds to earn a return that exceeds the rate at which inflation and taxation erode the value of money, which results in a net increase in purchasing power.
Investors may take a long-term approach to build their fortune over a period of many years or a short-term approach to make a quick fortune. While the latter is generally regarded as foolish, it remains a strategy of many investors.
INCOME
An investor with a significant amount to invest may seek to achieve earnings only to the extent that the will cover his expenditures. Some sources suggest this is the same as growth (the amount of growth is withdrawn as income), but there are significant differences in the investment choices made.
Primarily, an income investor generally has sufficient capital to engage in low-risk investments (whereas a growth investor has a smaller amount and takes on higher risk in order to increase the value of his portfolio) and that an income investor seeks investments that provide a regular and dependable stream of payments (such as bonds and preferred stock) whereas a growth investor seeks investments that will appreciate in value.
STRATEGIC FACTORS
AMOUNT(s)
One key factor in planning an investment strategy is the amount of money involved. Specifically, there are two amounts to consider:
First, there is an amount that will be needed at a future date. This can be a lump-sum amount needed for a one-time purchase (an automobile or a home), or the amount may be several smaller amounts over time (tuition payments over a four-year degree plan or monthly income needed in retirement).
Second, there are the amounts that can be contributed toward achieving the savings goal. Likewise, a person may start with a lump-sum amount, or they may make periodic contributions over time.
The amounts are largely fixed: a person can only afford to invest so much of their income, and future costs will definitely be higher, but this is a matter of budgeting (a person may make sacrifices to invest more funds, or they may research cheaper alternatives to their perceived future needs).
TIME
Another factor is the amount of the amount of time involved. Given the effects of interest over time, it is a very important factor. The longer the horizon, the lower the rate they must earn, but it is not a straight-line (due to the effects of compounding).
A person who needs to double their money in one three years must earn a 26% rate of return; one who needs to double their money in six years needs earn only 12% (not 13%). This is the effect of compound interest (interest earns interest), and it can be very dramatic over longer time spans.
Time is also largely fixed: a child will attend college at a certain age, a person will retire at a certain age, a vehicle or house will be needed at a certain time, though there is the ability to extend the time by adjusting these dates to some degree (putting off retirement, driving the old car a few years more, etc.)
RATE
When an investment is tied to a specific goal or need, the task of determining their required rate of return is a fairly straightforward calculation (it can be a lot of math, but it's simple math), taking the amounts and time as given.
However, when an individual has no specific goal, but merely wishes to preserve or increase the value of their money, it may be necessary to determine a rate independent of these inputs - basically, to pick a rate from thin air, based only on the known factor (the rate of erosion) and the investor's risk tolerance (next topic).
The rate of earnings is the most flexible, and least predictable factor in investment decisions. An investor may earn a pittance by investing in some alternatives (a savings account) or reap large returns from high-risk investments (junk bonds and penny stocks), choosing them according to their investment needs and risk tolerance.
RISK
All investments involve risk - and generally stated, the level of risk corresponds to the rate that an investor wishes or needs to earn (high returns entail high risk).
By definition, risk is the variation between the targeted rate of return and the rate that is actually earned. While it's simple enough to calculate risk in arrears for various classes of investment, it's difficult to predict in advance with much accuracy.
Most of the models of risk assessment I have seen utilize historical data to compute an average return (as expected return) and either the standard deviation or IQR as a measurement of risk. The point here is not to evaluate these models of risk, but merely to suggest that risk, however, assessed, is a factor in investment, and that it's difficult to measure.
Even more difficult to measure is the individual investors' individual tolerance for risk. Some investors are extremely fearful of risk, others seem indifferent to it, and the degree of risk a person finds tolerable may depend on the goals of a specific investment (the same individual may be very conservative with their retirement funds, moderately aggressive with funds they save to purchase a car, and completely speculative with residual income that has no stated purpose).
BALANCING THE FACTORS
The strategy for investing may involve a combination of the factors mentioned above.
- The amounts (both the amount needed and the amount the investor can contribute) may be flexible. The investor could scale back their desires to need a lower amount or manage their budget to provide more contributions.
- The time involved may be flexible. The investor could delay retirement or a purchase.
- The rate may be flexible - not insomuch as the rate that the investor must earn to accomplish their goals, but the rates available in the market at any given time.
- The risk tolerance may be flexible. Given the desire to accomplish specific goals with specific means in a specific time, the investor may be willing to take on greater risk.
The individual investor has a wide range of latitude in determining the degree to which they are willing or able to be flexible in regard to each of these factors. For example, an investor who has a fixed budget and can only contribute a fixed amount, they will need to be more reasonable about the amount they set as their goal, or the amount of time they wish to achieve it in, or the level of risk they are willing to assume.