isk
doesn't have to be a scary word. In the context of your life savings,
it's a measure of your comfort level with stocks, bonds and other financial
instruments. Indeed, successful investing begins with a good understanding
of risk and your reaction to it.
Generally,
the more money you want to make in the financial markets, the greater
the risk you will have to take. Investing in individual stocks or stock
mutual funds can be higher in risk as these investment options tend to
be more volatile. That means it will be harder for you to judge whether
you will win or lose from your investment. Bonds can involve moderate
risk, as long as you're staying with AAA-rated corporate bonds and U.S.
Treasuries. Savings accounts and certificates are certainly more completely
predictable, but they do have one downside: In time, the interest earned
might not keep up with the inflation rate.
Whatever
your choices, you have to consider balance. It's important to offset higher-risk
investments with ones that are safer bets. As the old saying goes, don't
put all your eggs in one basket. That holds true for building a portfolio
that brings you consistent returns.
Financial
planners agree most people tend to take on more risk than they really
can bear. Before you make decisions, you need to assess your own risk
tolerance by asking yourself the following questions:
How
old are you?
If you're young and don't face retirement in the near future,
you might consider putting a bigger chunk of your savings into the stock
market. Why? You have time to take more risk, riding out the market's
peaks and valleys. While the market does bounce around, the past has proven
that stocks have provided the highest rates of return of any major asset
class. Over the past 100 years, the Dow Jones Industrial Average's average
annual gain was 15.3%.
Rather than investing
in individual stocks, which requires astute attention to company balance
sheets and other factors, many people prefer mutual funds. These are professionally
managed accounts where your money is pooled with other individuals and
invested in stocks and bonds. One advantage to mutual funds is that they
can invest in a diverse mix of stocks and bonds. That means you'll never
become too exposed to one area of the market, so you won't have to fret
over losing all your savings if a certain industry stumbles. But take
care when selecting a fund. Check not only for recent performance but
also for staff changes and management costs, which you end up paying for.
Instead, you might consider owning an index fund, which mirrors the performance
of a market index such as the Standard and Poor's 500. Index funds often
outperform mutual funds in which managers select stocks.
If you are closer
to retirement age, you'll probably want less risk in your portfolio. Since
your goals aren't quite as long-term, you may want to begin shifting some
of your higher-risk investments into areas that will ensure that your
earnings will be protected, such as savings accounts, certificates and
corporate bonds.
But even after you
retire, you don't have to keep all your assets at your fingertips. Many
people live 20 years or more beyond their retirement age. That's plenty
of time to actively invest.
What
are your needs?
You're young but you just got married. And you're having a baby. And you
want a new house. In this case, you're going to need money sooner rather
than later. With this in mind, you cannot afford to take the same kinds
of risks with your money as you could if you didn't have these expenses
and responsibilities.
Consider earmarking
any money you'll need within the next three years in safer areas. These
include certificates and Money Market Savings Accounts or a corporate
bond of a company with a good debt-payment history. Why these and not
the stock market? Well, say you need cash for a down payment on a new
house in about three years. It's a pretty good bet the stock market will
go up in 20 years, but in three? No one knows. In a case like this, keep
your money somewhere that's more predictable-so you'll have the amount
you need in the time you need it.
What
is your personality?
Some people like to bungee jump. Others don't. The same can be said for
investing: Some people are willing to take bets while others have headaches
just thinking about it. If you tend to lose sleep over your investments,
then maybe the stock market isn't for you.
Say you put some
of your money in a stock. What would you do if the following year the
price of that stock fell 20%? Would you take your money out? Or would
you add to your holding because the stock is so cheap? What if you're
ready to put a little of that extra money into a corporate bond? A year
later, you may find out that the bond lost money because the company missed
a debt payment. Are you getting nervous? If these scenarios make you uneasy,
they could contain too much risk for your personality. However, if you
don't quiver at the thought of leaving the money invested, your temperament
for risk is probably a bit higher.
Do
you have time for homework?
By taking the time to do your research and checking the financial section
in your newspaper, you'll be able to manage your reaction to risk. And
that, in turn, will make you a smarter investor. You'll learn to pace
yourself and avoid panic, even when the market falls 20%. Boning up on
money matters can boost your confidence while lessening the chance that
you'll act hastily. After all, investing is not a game; it's serious business.
Making spontaneous gambles can get you in trouble.
Just as there is
no one best way to invest, there's no one correct level of risk tolerance.
It's purely personal. If you have neither the time nor the discipline
to do the necessary homework, consider consulting a professional. A financial
adviser can give you guidance on how to manage your investments and understand
risk. He or she may also provide the peace of mind you might not get when
investing on your own.
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