Goals & objectives
When you encounter recommendation-based questions on the exam, it’s fairly normal to see an investment objective mentioned. This tells the investor’s overall goal with their invested capital (money). Financial professionals use investment objectives to determine if an investor’s current asset allocation is suitable and determine what investments should be recommended. It’s important you’re aware of each objective, what they translate to, and how they relate to making suitable recommendations. We’ll cover these investment objectives in this section:
- Preservation of capital
- Safety of principal
- Tax-advantaged income
- Moderate income
- Moderate growth
- High-yield income
- Aggressive growth
- Speculation
Preservation of capital
When a person wants to make an investment but also avoid as much risk as possible, preservation of capital is their investment objective. This is the least risky objective available to investors, which could result in an insured investment (like a certificate of deposit (CD)). Securities suitable for this investment objective are generally short-term debt securities with little risk exposure. Elderly investors and those needing to keep funds safe & liquid (e.g. making a home purchase within a year) are most likely to identify the preservation of capital as their overall investment objective.
Specific investments suitable for a preservation of capital objective include:
Safety of principal
Safety of principal is a small step up on the risk spectrum from the preservation of capital, resulting in large allocations into safe debt securities that have longer time horizons. As you already know, more price volatility exists for long-term debt securities. In most cases, investors with this objective are seeking investments that provide stable income over long periods of time. Older investors in retirement are most likely to identify safety of principal as their overall investment objective.
Specific investments suitable for a safety of principal objective include:
Tax-advantaged income
As you probably can guess, an objective of tax-advantaged income is suitable for investors seeking income taxed at lower rates or free from tax. In most cases, these are investors in high tax brackets or organizations subject to large tax liabilities. This objective is not specific to short or long-term investments, although recommendations tend to favor longer-term fixed-income securities to obtain higher rates of return.
In general, there are two primary investment products that provide tax-advantaged income:
*While dividends from stock are taxed at lower rates (15% or 20%) than interest from bonds (up to 37%), preferred stocks are especially suitable for corporate investors. Corporations are able to deduct at least 50% of the dividends they receive from taxation.
Moderate income
If an income-seeking investor is willing to take on some risk in return for moderate levels of income, they have a moderate income investment objective. The typical investor with this objective is older, but typically not in a situation where they must be completely risk averse. For example, a 60-year-old recent retiree with a funded retirement plan may seek to replace their employment income with fixed-income securities that aren’t too safe or too risky.
Specific investments suitable for a moderate income objective include:
Moderate growth and capital appreciation
Investing in common stock typically comes with at least a moderate amount of risk. Investors seeking capital appreciation (buy low, sell high) from common stocks without exposure to significant risk tend to have a moderate growth (sometimes referred to simply as ‘growth’) investment objective.
Younger-to-middle-age investors with long time horizons and no need for current income are most likely to have a moderate growth objective.
Specific investments suitable for a moderate growth objective include:
- Large and mid-cap common stocks of growth companies
- Defensive stocks
High-yield income
When an investor is willing to take on significant risk to obtain high yields on fixed-income securities, their objective is high-yield income. Investors primarily invest in junk bonds, which are rated BB or below by the rating agencies. Many times, issuers of these bonds are legitimately at risk of bankruptcy. Junk bonds typically have two characteristics, both of which lead to high yields. First, they typically have high coupons (interest rates). Second, they commonly trade at large discounts as demand for these bonds falls when default risk rises.
Preferred stock, especially from distressed issuers, may also be a suitable investment for this objective. Similar to junk bonds, this type of preferred stock tends to have higher dividend rates while trading at discounts.
Investors seeking high-yield income are typically aggressive investors in search of higher returns from fixed-income securities. Elderly and conservative investors usually avoid this objective given the risks involved.
Specific investments suitable for a high-yield income objective include:
Aggressive growth
Growth (capital appreciation) always involves buying securities at a low price and selling it later at a higher value. We’ve learned extensively about growth-focused companies, which are businesses focused on increasing their revenues through expanded operations. An aggressive growth objective primarily invests in smaller companies, which have high growth potential. What if you invested in Amazon during its IPO in 1997 when it was an online bookstore? Its IPO price was $18 per share, and Amazon is now trading above $3,000 a share (as of September 2020). That’s a return of over 16,000%! Amazon’s business model was largely unproven in the late 1990s, but it’s now one of the largest companies in the world.
For every Amazon, there are hundreds of failed companies that didn’t become successful. In fact, only a third of small businesses survive their first 10 years of business. And that’s just survival. It typically takes several years before small businesses and start-ups become profitable.
In addition to small businesses, companies from emerging markets also offer high growth potential. As a reminder, emerging markets are regions of the world that have not been big players in the world economy, but are currently becoming more prominent. Countries like Mexico, Thailand, and South Africa are examples of emerging markets. As their economies grow significantly, so do the companies from those regions. Investors in emerging market securities must also be aware of the risks involved, which go beyond typical risks (business risk, financial risk, etc.). Many of these regions and countries have governmental issues (corruption, “red tape”, etc.), economic problems, and weak infrastructure for business.
Certain sector funds are also suitable for aggressive growth. As a reminder, sector funds invest primarily in stocks of companies from a specific industry. Technology and energy tend to be the most aggressive sectors that provide high risk and return potential.
An investor with an aggressive growth investment objective believes in taking chances. Many of the companies or securities they invest in may end in bankruptcy, but the winners (like Amazon) hopefully will outperform the losers. These investments tend to have high betas, meaning their market prices historically have moved faster than the general market.
This objective is only suitable for investors that are very comfortable with risk. Time horizons can be long or short, although it’s always more prudent to approach risky strategies with a long time horizon in case an investment loses significant value. The longer the time horizon, the longer the investor has to recoup their losses. These investors tend to be young and are not concerned with obtaining income. Remember, growth companies do not generally pay dividends.
Specific investments suitable for an aggressive growth objective include:
- Common stock of small businesses and start-ups
- Sector funds, especially technology and energy
- Emerging market securities
Speculation
While speculation involves investing, many times it’s not terribly different than going to a casino. Speculative investors typically bet on the short-term direction of the market, which is very unpredictable. Investors seeking this objective should be as aggressive and risk-tolerant as it gets. If their “bet” is right, they can make significant sums of money quickly. If their “bet” is wrong, it’s possible to lose more than their account is worth.
Speculation is the riskiest investment objective and is only suitable for the most aggressive investors. Younger investors with significant assets are the typical investor to apply this objective to their overall portfolio.
Specific investments suitable for a speculation objective include:
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