by Stacy Francis, CFP®, CDFA
Achieving a secure financial future has less to do with picking the right stock or mutual fund and more to do with the method in which you divide or diversify your investments. Studies show that asset allocation will account for about 90% of your return. The selection of individual securities and market timing will account for the remaining 10% or so.
As you know an investor’s group of investments, frequently called an investment portfolio, can be divided in numerous ways among stocks, bonds and cash management options. But what should you invest in? To answer this question you will first need to determine your investment profile. What investment profile you chose is based on three main factors – your investment goals, your appetite for risk, and your time horizon.
Your Investment Goals Goals are specific things (e.g., buy a house) that people want to do with their money. Your selection of investments should relate closely to your financial goals; each goal will define the amount and liquidity of the money needed as well as the number of years available for the investment to grow. Liquidity refers to how quickly an asset can be converted into cash. Your house is not a liquid asset because it could take months to sell it. However, your savings account is extremely liquid and can provide cash fast with no penalties.
Your Risk Tolerance Risk tolerance is a person’s emotional and financial capacity to ride out the ups and downs of the investment market without panicking when the value of investments goes down. As you can imagine, risk tolerances vary widely. If thoughts about your mutual funds latest negative returns are keeping you up at night, this is a big clue that you should select saving and investment options with lower risk. On the other hand, it’s important to realize that not taking enough risk has its own set of risks. Conservative investments may not grow as quickly and could stop you from reaching your long-term goals such as retiring early.
Your Time Horizon Time is money. Time is one of the most important resources for investors. A youngish investors with a long time horizon may choose investments that have wide price swings, knowing that time is available for fluctuations to average out. Families investing for a specific mid-life goal (e.g., funding a child’s education or purchasing a home) may choose a more moderate course which has opportunity for growth, but guarantees more safety for the principal. Individuals nearing retirement and those with the need to depend on investment income to cover daily expenses, may wish to select investments that lock in gains and provide a guaranteed income stream.