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Investor’s column: Here’s why safe investing is more complicated than you might think

People on the cusp of retirement often are looking to reposition their portfolios to focus on three primary characteristics: safety, income and growth.

Understandably, they want a safe strategy to make sure they don’t lose their money. They need income to replace their current paycheck, and they desire growth in their portfolio to protect against inflation to maintain their standard of living.

In a perfect world, they find an investment strategy that locks down each of these issues. The problem is that there is no single, magic bullet that meets all these needs. A focus on one of these areas by default moves away from pursuing the other two regions.

The best solution is a portfolio that combines several strategies to create a better balance between the three often opposing objectives. Here are some of the ramifications I have seen over the years with an unbalanced focus on safety.

“Don’t eat your seed corn” is a truism that stands the test of time. This wisdom comes from agriculture whereby a farmer must set aside some of his best harvest seeds to be used to plant for future crops.

This prudent practice is meant to ensure the ongoing viability of the farm. This truism usually finds its way into investing through some variation of the statement “Don’t dip into your principal.”

I fully support the concept and ideally, we can come up with a portfolio that limits principal fluctuations — but this idea taken literally can lead to a lot of problems.

A passionate focus on principal protection leads investors to overconcentrate their portfolios and can create much more risk than a “safe” investor is prepared to assume.

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Gardner Sherrill is an independent wealth advisor with Sherrill Wealth Management in Bradenton.

As an example, I often see investors who focus on creating yield by building portfolios targeting an income stream to meet a specific lifestyle need. The idea is that they can live on the yield while leaving the principal intact.

Over the past 25 years of my career, interest rates steadily have moved downward, forcing these investors to take on more credit risk to generate the same level of income. What was initially a portfolio of treasuries and municipals slowly turned into corporates, then high yields and even preferred stocks.

What was once a safe portfolio has now become much more aggressive and in many ways more sensitive to an economic downturn than a traditional portfolio of high-quality stocks and bonds.

Another error I see comes from concentrating wealth into complex products that often guarantee principal or provide alternatives to traditional stocks and bonds. There are times that an allocation to one of these vehicles can make sense.

My issue is that I often see too high a percentage of one’s wealth placed in these products. Product solutions often come with high fees, long surrender periods and contractual nuances that greatly detract from their overall ability to meet your long term objectives.

The safety of your principal often comes at the expense of generating meaningful income or growth.

The varied issues with these products are beyond the scope of this article but generally revolve around a couple of key weaknesses. If you are interested, search for the following:

Calculations of simple interest vs. compounded interest;

Index returns with dividends vs. options that don’t include the dividend;

Annuitization schedules whereby you are first paid your principal and then (if you live long enough), your guaranteed growth rate.

The last area of concern I have seen is around dividend investing. As interest rates have remained low, many safe investors have ventured into dividends to supplement their income needs.

Professor of finance Meir Statman explains investor preference for dividends: “If they have poor self-control, and are unable to control spending, then a cash flow approach creates a spending limit — they will only spend income and not touch the capital.”

If your portfolio consists entirely of dividend-paying stocks and bonds, it is possible to live on the income it generates and never touch the principal balance. The concern I have is that by limiting your selection to only dividend-paying stocks, you are reducing your diversification options — as half of the world’s equities don’t pay dividends.

Additionally, from a tax efficiency standpoint, you are allowing outside management to dictate your tax options. Ultimately, a dividend-focused portfolio is tax-inefficient, has poor diversification and potentially creates missed opportunities.

A better approach is perhaps to take a total return approach to generate income. Total return is the same approach advocated in trust law under the Uniform Prudent Investor Act.

This approach doesn’t care if your income comes from interest, dividends or even capital gains from the sale of securities. A total return approach allows you to be fully diversified, provides tax efficiency and allows you to capture market returns.

Furthermore, a properly allocated portfolio can target your needs for safety, income and growth.

Ultimately, all investments have risks, even safe ones. The goal should be to build a safe portfolio that provides the growth and income necessary to achieve your objectives.

In isolation, these goals can often work at cross purposes to each other. A total return approach will keep you centered and balanced but may require that you dip into the principal during difficult times.

The idea I want to communicate is that safe investing is more complicated than principal protection and that a primary focus on principal security may not be safe.

Gardner Sherrill is an independent wealth advisor with Sherrill Wealth Management in Bradenton. To learn more, visit sherrillwealth.com.

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