There are four basic factors to consider when investing - your goals, your time horizon, your risk tolerance, and your financial situation.
KNOW THYSELF
Defining your goals is the first step in the investment process. What are you trying to accomplish with your money? Maybe you're looking to achieve long-term growth so that you have enough money to pay for your children's college education and still live comfortably in retirement. Stocks, and stock funds, may be suitable investments for these capital growth investors.
If your goals are short-term, such as paying for a wedding or putting money aside for a down payment, you probably can't afford to take much risk with your principal. CD's and money market funds may be suitable choices for these safety conscious investors. Maybe you're looking for investments that provide regular income, to supplement other sources of income such as social security or pension income. Bonds and bond funds may be suitable investment choices for these current income investors.
Perhaps you're looking for ways to minimize taxes and are considering a tax-advantaged investment or personal retirement account such as an IRA or 401(k) plan at work. Setting goals will help you determine how much money you need to invest, how much your investment needs to return, and when you'll need the money.
INVESTMENT HORIZONS
Identifying your time horizon is the second step in the investment plan process. Knowing how much time you have to invest will influence both how to invest your assets and how much risk you can afford to incur in pursuit of your desired goals. Generally speaking, a shorter time horizon (five years or less) dictates a more conservative set of investments, while a longer investment horizon (ten years or more) allows you to invest more aggressively since you can ride out the downswings in the market.
RISK AVERSE?
Determining your risk tolerance is the third step of the process. Your investment horizon can help you decide how much risk to take on, but if you're afraid of risk, you may wind up investing too conservatively and missing your desired goal. On the other hand, if you're too aggressive in your investment mix, you may be taking excess risk, and jeopardizing the desired goal. Becoming an informed investor means making conscious decisions about risk, since there is a known risk/reward tradeoff.
Diversification can help you control risks by allocating capital across one or more asset classes such as stocks, bonds and money markets. With different risk and return attributes, the lower correlation among these asset classes results in a more desirable risk/return scenario. Mutual funds are popular in part because they provide instant diversification of systematic, or company-specific risk. It is important to note that overall market risk, or unsystematic risk, still exists and cannot be diversified away through mutual funds.
SIZING UP YOUR FINANCIAL SITUATION
The fourth thing to consider is your current financial situation. What other investments do you have? Do you have an emergency fund set aside in case you need it? The better shape you are financially, the greater risk you can afford to assume in pursuit of your goals. The less money you have saved for emergencies and other needs, the more conservative you should be with your investments.
FINDING THE RIGHT MIX
Once you have defined your goals and investment horizon, your tolerance for risk, and your current financial situation, you're ready to develop your asset allocation strategy. It's important to select an asset allocation strategy, or investment mix, that enables you to achieve your goals in the time you have, at a level of risk that's acceptable to you.
Below are some model portfolios based on various investor profiles, and what they have produced historically in terms of average annual returns from 1926 to 1998, relative to frequency of losses and average loss (in years posting a loss):
You will note that the higher the total returns, the greater the losses posted by that asset allocation.
Becoming an informed investor means establishing realistic expectations about performance. Advisers remind investors that it is unrealistic to expect stock market returns of 15 percent to 20 percent per annum, like we had in the 1990's. The historical mean over longer time periods is closer to 8-10 percent. Informed investors also understand that it is almost impossible to time the stock market. For example, data shows that if you missed the 90 best days in the stock market, in the last 30 years, that you'd have a return of just 3.3 percent versus 11.8 percent if you stayed in the market.
KNOW YOUR INVESTMENTS
Other ways to avoid pitfalls include obtaining and reading information on the investment's risk and return attributes, such as provided in an offering memorandum (for stocks and bonds) and a prospectus (for mutual funds). Ask questions and try not to invest in anything you don't fully understand. Also, make sure that you understand the costs involved with your investments, since you want the highest rate of return, net of all costs.
Understand the tax implications of your investments, and whether or not your investments are outpacing the rate of inflation. It's easy to forget inflation today because it has been so low, but if history repeats itself, there will be another time period in the future characterized by higher inflation. Be prepared for such a scenario.
Also, know how liquid your investments are. How easily could you sell your investments, if you needed to? Last but not least, make sure that your investments are legitimate. Don't invest in anything unless you are sure it has been registered with the SEC and all risks concerning the investment have been disclosed.
Finally, if you're not sure about what you're doing, you might want to consider getting the help of a financial adviser. That's what pension funds and other institutional investors often do. In fact, it's their fiduciary obligation to do so under law. The thing to keep in mind is that one bad decision can cost you dearly. Just remember to keep everything in perspective and make educated investment choices.
Finally, make sure you can sleep at night. If you worry every time the market falls, you should probably revisit your investment plan to reduce the exposure to stocks.
