When building portfolios or looking at mutual funds, the terms Income, Balanced, or Growth are often used. Some investors may look at past performance of an Income Fund or portfolio and compare it with the past performance of a Growth fund or portfolio, and that is a Big Mistake.
The Birth of a Portfolio: Suitability
Why on Earth would anyone invest in a Security (Stocks, Bonds, Mutual Funds, etc.) that will probably make an annualized return of 2% when that investor can invest in something that could make 10% a year?
Well, one of the answers, in simple terms, might be that the security that has a potential to make 2% a year might “only” lose 15% in value at any given point in time while the security making 10% a year might lose 45% at any given point in time. These swings in princes, also known as Volatility, might make some investors more worried than others and therefore prevent one group of investors from investing into a more “Risky” investment that pays 10% a year and go instead with the portfolio that pays 2% a year.
Keeping the same example above, say you have two investors, both having the same tolerance for Risk, that is, they are both OK with the idea that at any given point in time, they may be losing 45% of their money on paper (i.e. Unrealized Loss). Let’s re-ask the question, why would anyone then go with a 2% per year potential return on their investment instead of 10% per year?
Once again, there are various reasons. One answer might be that One investor needs to use a big portion of his investments to put a down payment on a house in 2 years while the other investor won’t need the money for another 30 years. The chances of a catastrophic event -one that will make you lose lots of money on paper- is more likely to happen during those 30 years than during those 2 years but, the chances of recovering all your money, and making more money, are higher if you have 30 yrs of time than if you only have 2 years of time. Therefore, the investor with a 2-year time horizon would be better served, in this case, to go with the 2 % per year possible return on investment than with the 10% possible return on investment.
As you can see, it’s not just about making money. It’s about understanding the investor’s circumstances, objectives, and financial goals, and then determine the best investment plan for that person. This process will determine if the portfolio is going to be more Income, balanced, or Growth oriented.
Income Portfolio or Fund
As the name suggests, this is a portfolio designed with the intention to create income. It is common among retirees as they put their nest egg to work after years of accumulation of capital. A typical portfolio would consist of Bonds and Notes, Cash, and Cash equivalents. Depending on several factors, another variation of an income portfolio might be to include preferred stock and utility companies Stock, mainly because these two types of stocks usually pay high dividends although this would be a little bit more towards the risky side.
One problem with a pure income portfolio is that if the income generated is used for daily expenses, as would be the case of Retired investors, then the portfolio could run out of money before the investor is deceased. Besides the obvious facts that could cause a portfolio to run out of money before the investor is deceased (e.g. The investor is spending too much money or the nest egg wasn’t big enough to begin with), another important issue is inflation. If the investments can’t keep up with the rate of inflation, then the investor runs the risk of running out of money, and for this reason, usually a small portion of stocks is added to the portfolio, because stocks tend to exceed the rate of inflation.
Income portfolios are very dependent on the time the investor expects to remain holding the assets. For example, if the investor will need the funds in a couple of years or less, then the income portfolio might actually become a capital-preservation portfolio, with bonds and notes with short maturity.
This is also considered a low volatility portfolio compared to a pure equity (stocks) built portfolio. In an income portfolio, you’re trading high reward (high returns) in exchange for stability in your portfolio.
Balanced Portfolio or Fund
As the name suggests, the portfolio is created with the intention of creating a balance. This balance is usually between income and Growth. For example, the portfolio might contain 60% stocks and 40% bonds.
Balance is also a good term to use because your portfolio is also balanced in terms of Risk and hence, balanced in terms of returns. It’s not the safest investment but it’s not the most volatile and likewise, it won’t produce small returns like an income portfolio but it won’t make you the kind of returns like in a growth portfolio.
Growth Portfolio or Fund
Once again, the name suggests we want the portfolio to grow in size. Historically, Stocks (equity) have provided higher investment returns over time however, they have done so while being subjected to short term volatility (i.e. price swings). Again, High Risk means High reward, so, the investor’s is risking loss of money in exchange for a higher return. The higher the risk tolerance and time the investor is willing to hold the assets in the portfolio, the higher amount of equity can be put into a portfolio.
A younger investor planning for retirement could be well served in a growth portfolio, assuming willingness to assume risk.
Unfortunately, those are the “laws” of investing. You can’t make a lot of money unless you are willing to “lose” a lot of money. Research in academia suggests that most people are growth seekers when the overall market is doing well but many of these same investors become quickly risk averse when the overall market is tanking. In fact, research by the Investment Company Institute (ICI) shows that investors tend to buy more equities when those prices are High and sell those equities when prices are low, thus doing the opposite of the proverbial “Buy Low, Sell High”. More on this topic can be read in our article How to Lose money investing in the Stock Market
Not just the Three Amigos
One thing to clarify is that Income, Balanced, and Growth Portfolios are just the 3 main objectives. There are portfolios that are in-between these objectives.
As you’ve probably noticed by now, usually, Stocks are used for Growth, Bonds for Income, and Cash is used for Stability. Keep in mind that the investor doesn’t stay in a particular portfolio for the rest of his life. If planning for retirement, for example, a young person would start with Growth, even possibly a speculative portfolio, with the forethought that that capital investment will not be used for decades. As the investor ages, he will slowly transition from a Growth to a Balanced portfolio, and eventually into an income portfolio.
