Question

You wish to invest in Agency MBS but wish to minimize your exposure to prepayment risk as much as possible. In particular, you wish to avoid contraction risk to the extent possible.

Discuss the various products you will consider to satisfy your investment objectives and justify your selection of your choice

Answer 1

Generally speaking, four main investment objectives cover how you accomplish most financial goals. While certain products and strategies work for one objective, they may produce poor results for another. Most people have long- and short-term financial planning needs, and will likely use more than one of these strategies at the same time with no conflict. The goal is to find the combination of the four objectives that makes sense for your financial situation.

1.Capital Appreciation

Capital appreciation is concerned with long-term growth and is most common in retirement plans where investments work for many years inside a qualified plan, such as a 401(k) or IRA.1 However, investing for capital appreciation is not limited to qualified retirement accounts. This objective involves holding stocks for many years and letting them grow within your portfolio while reinvesting dividends to purchase more shares.

Compound interest is the greatest force for those concerned with capital appreciation. Let's imagine that you make an initial $1,000 investment and add $100 monthly for the next 20 years. The total amount contributed during that period would be $25,000. However, if your investments generate an 8% return annually, compound interest will place your total savings at $59,575.31.2

Investors using the capital appreciation strategy are not concerned with day-to-day fluctuations. However, they keep a close eye on the fundamentals of the company for changes that could affect long-term growth. A typical strategy involves regular purchases.

2.Current Income

The current income involves investing in stocks that pay a consistent and high dividend, as well as some top-quality real estate investment trusts (REITs) and highly-rated bonds because these products produce regular current income. People concerned with current income should consider investing in blue-chip stocks, which are shares in large, prominent corporations that have shown a long history of growth and consistent dividend payouts.3 These companies have proven they can withstand economic downturns and still prosper, so they're generally a safe choice.

Many people who focus on current income are retired and use the income for living expenses. In contrast, others take advantage of a lump sum of capital to create an income stream that never touches the principal, yet provides cash for certain current needs—such as college tuition.

3.Capital Preservation

Capital preservation is often associated with retired or nearly retired people who want to make sure they don't outlive their money. For this investor, safety is critical—even if it involves giving up return potential for security. The logic for this safety is clear: A retiree who loses money through unwise investments is unlikely to get a chance to replace it.

Younger investors can have a stock-dominated portfolio because they have many years to recover from any losses that may occur due to market changes or economic downturns. This isn't the case for older individuals. Investors who want capital preservation tend to invest in bank CDs, U.S. Treasury issues, and savings accounts because they offer modest returns but possess much less risk than stocks.

4.Speculation

The speculator is not a true investor, but a trader who enjoys jumping in and out of stocks for capital gain. Speculators or traders are interested in quick profits and use advanced trading techniques like shorting stocks, trading on the margin, options, and other special methods. Speculators have no real attachment to the companies they trade, and they may not know much about the underlying business except that the stock is volatile and ripe for a quick profit.

Many people try speculating in the stock market with the misguided goal of getting rich, and the overwhelming majority fail at doing so. If you want to try your hand, make sure you are using money you can afford to lose without jeopardizing your livelihood or retirement ambitions. It's easy to get a false sense of competence after initial success, so thoroughly understand the real possibilities of losing your investment.

The Bottom Line

Your investment style should match your financial objectives. If it doesn't, get professional help in dealing with investment choices that match your current life and the one you desire. There is no one-method-fits-all approach when dealing with financial decisions, so it's essential to have a clear understanding of your situation to make the best choice for yourself. Likewise, it's important to adjust your strategy as you age and near retirement.