I recently had a conversation with someone who was new to investing. I explained some basic things to her, mainly as they pertained to mutual fund investing. One thing I tried to make clear was that investing is about making choices.
Currently there are many investment choices and vehicles. These include cash, CDs, bonds, stocks, mutual funds, exchange traded funds (ETFs) and commodities.
All of these choices have at least one thing in common – risk.
To be clear, the amount of risk varies among these choices, but there is some element of risk with each one. So, investing is about making choices among investments and among levels of risk in search of return. Investing has the objective of achieving some level of return on your investment.
There are a variety of risks to you when you invest including: losing your whole investment, losing money on your investment, getting ripped off or missing out on a better investment. There are also risks to the investment itself including inflation, interest rates, exchange rates and global politics.
What should you do? You should invest wisely and within your tolerance for risk.
Investing wisely means that you take your time deciding how and where to invest. You can do research on your own, or you can have someone do the research for you and make recommendations. You have to know the level of risk associated with your investment to know if it fits within your risk tolerance. Your investment needs to be appropriate to the timeframe in which you will be investing. If you will need the money in six to twelve months you will invest differently than if your objective is ten or fifteen years down the road. One calls for a conservative approach while the other gives greater opportunity for growth or appreciation.
Most likely you have heard it said “the greater the risk, the greater the potential reward.” In investing this is true. But…, the potential loss is also greater.
Investing within your tolerance for risk means knowing how “safe” you need your investment vehicles to be. There is no exact science to determining risk tolerance, and many evaluation tools are available. Many of these simply involve going through a questionnaire.
Your evaluation of your risk tolerance should take into account your financial goals and the timeframe in which you will invest. If the risk level of your investments is inappropriate for your goals you may not achieve those goals.
You do not want to find yourself in a situation where you are constantly worried about your investments because the risk is so high. If that is the case, you have invested outside your risk tolerance. You want your investments to be such that you recognize there is risk but you have peace of mind.
Generally speaking, cash and CDs are very low risk. Mutual funds, individual stocks and individual bonds have varying degrees of higher risk.
Diversification is a method for managing your risk. That is, using a variety of investments and investment vehicles. Putting all your money into one investment is the greatest way to risk losing it all. You might have cash, CDs, stocks, bonds and mutual funds. Within those stocks, bonds and mutual funds there might be a variety of holdings with varying risk characteristics. Allocate different percentages of your investable assets to investments with differing levels of risk.
Investing is an important part of managing your financial situation. Taking the right approach will lead to success in achieving a good return.
So what’s it going to be? Door # 1, door # 2 or …