Managing Your Investment Portfolio: Part Three
Identifying Constraints

by Gerald Townsend, Financial Editor
March 2010

The first two columns of this series examined setting realistic goals, understanding financial risk capacity as well as emotional risk tolerance, and considered how assets, debts and cash flow work together. Now it is time to discuss the constraints placed upon your investment portfolio.

A constraint is simply something that restricts what you invest in and how you invest, much like a fence around a pasture. It is dangerous outside the fence, but safely inside, the cows chew contentedly on the grass.

First Things First
There are several prerequisites to check off before launching a portfolio. Do you have adequate savings? The often repeated advice of having three to six months in savings remains sound. Until you have this emergency cushion, don’t commit money to longer-term investments. Have you acquired insurance against the risks of premature death, disability, health, property losses, etc? Have you taken care of your transportation needs and purchased a home?

Time Horizon
How long are you investing for? If you are saving to buy a new car, your time horizon may be five years vs. fifteen years with a college savings account. Retirement may be twenty years away, but in reality, a retirement investment has a lifetime length. Depending on your time horizon, some investments are more suitable than others. Don’t fund a short-term goal with long-term investments or a long-term goal with short-term investments.

Liquidity and Marketability
Liquidity refers to being able to sell or liquidate an investment with minimal price fluctuation or loss of principal. Marketability simply means that a ready market exists for an investment. A bank savings account is liquid. Stocks and bonds are marketable, but not liquid. Real estate is neither liquid nor marketable. Emergency funds and imminent goals require liquid funds, while a mix of marketable and non-marketable assets are suitable for longer-term goals.

Taxes
Uncle Sam is a partner in our finances, but let’s keep him a minority partner. Tax considerations are important, but they should direct, not drive, investment decisions. Stocks are best held in taxable accounts that can benefit from the lower rate on qualified dividends and capital gains. Bonds are best held in tax-deferred accounts due to the higher tax rate on regular interest.

Diversification
The concept of diversification is not new — it is ancient wisdom. In Ecclesiastes 11:2, we are cautioned to "divide your investments among many places, for you do not know what risks might lie ahead." Fixed-income investors diversify by owning bonds of different maturities and varying qualities. Equity investors own stocks from different industries and countries. Mutual fund investors can diversify across managers.

Personal Considerations
Investment decisions are also impacted by a person’s age, health or other personal considerations. Certainly, the older someone is, a portfolio tends to focus more on maintaining principal and achieving a modest income return, while the goals of a younger investor may require more emphasis on growth-oriented investments.

However, there are many cross-currents in this decision-making process. If a person retires at age 60, their portfolio may need to provide returns for a 40-year retirement period. Getting too conservative, too early, subjects the portfolio to the ravages of inflation. Even in our retirement years, a soundly diversified and well-balanced portfolio is the wisest choice.

Gerald A. Townsend, CPA/PFS, CFP^®, CFA^® is president of Townsend Asset Managment Corp., a registered investment advisory firm. Email: Gerald@AssetMgr.com

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