Once you’ve determined your short- and long-term financial goals, it’s time to develop an investment strategy. Understanding key investment principles such as risk tolerance, diversification and asset allocation can help.
Risk tolerance is how much potential for loss you’re willing to accept when it comes to your portfolio. Risk tolerance varies with a person’s age, income and financial goals. For example, a 70-year-old retired widow would generally have a lower risk tolerance than a 30-year-old executive.
There is a trade-off between how much risk you are willing to assume and how much you should expect in returns. If you are unwilling to assume much risk, you must be willing to accept a low-risk rate of return.
When creating a portfolio, some investors try to choose the investments they believe will give them the best opportunity to outperform the market. However, most financial experts believe that the most effective investment strategy for building a long-term portfolio involves diversifying across a broad range of asset classes, such as stocks, bonds, money market and real estate. The theory is that the investor can lessen risk because each asset class has a different correlation to the others.
For example, when stocks rise, bonds often fall. At a time when the stock market begins to fall, real estate may begin generating above-average returns. Investing in mutual funds from different asset classes is often the easiest way for most investors to diversify their portfolios.
Because of the uncertainty of the markets, asset allocation (dividing holdings among different asset classes) is a good way to manage risk and build a long-term portfolio.
Establishing and maintaining a diversified portfolio is a better approach than trying to “time” the market. Market timing is attempting to guess which way the financial markets will move, then moving funds from one account or asset class to another based on these predictions. Since no one can know for sure how the markets will perform, particularly over the long term, market timing is a strategy that’s bound to fail most of the time.
How do you create a portfolio that is right for your needs? Many financial services companies give you tools to help you diversify your portfolio among a range of asset classes like stocks, bonds and money market investments. They are designed to interpret your risk tolerance, investment preferences and “time horizons” (the number of years you have to invest before you use the money, and how many years you’ll need that money to last). Talk to your investment advisor about creating a diversified portfolio that meets your needs within your comfort zone.
Once you have designed your investment portfolio, your main objective should be to maintain the balance in your asset mix. Periodic rebalancing is a sensible way to ensure that you maintain an appropriate allocation strategy. Generally, you need to rebalance your portfolio only if you’ve experienced a noticeable shift in your original asset mix. Keep in mind that rebalancing will not necessarily increase your returns.
There are a few ways to rebalance your holdings. You can transfer funds from accounts that have grown larger than their target allocations to the accounts that have become smaller. You can contribute a lump sum to the accounts that are now proportionally smaller to bring your investments in those asset classes back to their target levels. You can also change your future allocations so that your contributions are applied to the investments that are below their recommended targets while keeping your current mix of assets.
You should review your portfolio every three to five years to see if you need to make changes. Your life circumstances may change, and these life events may mean you should not simply rebalance, but instead adjust your investment strategy. Life changes that can affect your strategy include:
This article is part of an ongoing series of articles regarding retirement
savings. The information has been provided by various A&M System ORP
and TDA vendors. 