Financial Opinion and Insights

Principal plus Interest or Total Return

Jim Lorenzen, CFP®, AIF®

Jim Lorenzen, CFP®, AIF®

All our lives we’ve been told things like, `save the principal and live off the interest’, and `protect your principal and invest the interest’.  It may have even come from your parents; I know I remember mine saying it; but, then, they never learned much about risk management, asset allocation, or the financial planning process.  In those days, financial planning as a profession wasn’t even in its infancy!

But, old chestnuts like that are hard to shake.  

The principal and interest concept does, of course, have some relevance to the debt side of the ledger, when you’re loaning your money, i.e.,  to banks (CDs), government entities (muni-bonds, treasuries, etc.) or corporations (corporate bonds with various safety ratings).  You loan them money and they pay you interest until they return your loan.   But, here’s what you need to know:

No liquid investment alternatives with stable guaranteed principal values exist that can provide real returns by consistently beating the combined impact of inflation and income taxes.

–       Roger C. Gibson
Asset Allocation, 4th Edition 2008, McGraw-Hill

When you ‘loan’, you’re not buying equity.  When you buy equity, you’re engaging in a long-term strategy designed to preserve and/or increase your purchasing power, after taxes, over time.  The key words:  Over time.  You didn’t buy real estate for a six-month hold, did you?

So, do we look at a portfolio composed of debt and equity as two isolated components?  Not necessarily.  Unfortunately, too many investors view their investments at the investment level, i.e., “I bought XYZ at $50 and I want to make sure I protect my $50 position in that investment!”   That’s a process that quickly degenerates into ‘market timing’ which doesn’t work consistently even for the best professional investors.  I’m not sure even Cramer’s picks have done that well consistently.

A better approach is to view investments at the portfolio level, recognizing that risk-adjusted ‘total return’ – a combination of price movements and dividends – is the long term objective of the entire portfolio, not its components.    Have you ever noticed that when someone buys an investment at $50 and sells at $75 to invest in another alternative, the proceeds from the $75 sale become the new `principal’, not the money originally invested at $50?

Most individual investors might be shocked to learn that a simple, low-cost, allocation among well-chosen indexes weighted for the investors’ objectives, timelines, and risk profile – and this would be true even for larger portfolios – would probably perform just as well, if not better, than all the supposedly sophisticated choices they made at higher costs. 

Next time you review your portfolio, take a portfolio-level view of return and volatility over different time periods and determine if both are consistent with your long term objectives and comfort level.  If you need to make changes, chances are you’ll be making a portfolio-level allocation decision; rather than an investment-level buy-sell decision which would likely have less than a 2% impact on your future success or failure.



Jim Lorenzen is a Certified Financial Planner® and an Accredited Investment Fiduciary® in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California.   IFG provides investment and fiduciary consulting to retirement plan sponsors and selected individual investors. Plan sponsors can sign-up for Retirement Plan Insights here.  IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description.  Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader.  The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.

Written by Jim Lorenzen, CFP®, AIF®

March 27, 2012 at 8:00 am