This is the second in my series on series of articles on the keys to a successful investing strategy. Part 1 can be found here: http://aricherlifefp.wordpress.com/2012/01/10/investing-101-part-1-begin-with-the-end-in-mind/
A good investment strategy is comprised of several key practices. The second key is to make sure that your investment portfolio is risk-appropriate. The primary factor in determining the risk of your portfolio is the mix between equity investments (stock, usually in mutual funds) and fixed-income investments.
Equity investments have a higher historical & expected return over the long run, but are more volatile (more risky). Fixed income investments are less volatile, but also have a lower historical and expected return. The higher the proportion of equity investments in your portfolio, the higher the expected.
Each of us has a certain set of circumstances, situations, beliefs and tolerances that define a unique risk capacity for us. For example, a young person with no dependents, who has already built their emergency fund, and who is comfortable with volatility may want to take on more risk than someone who has dependents, is closer to retirement, has a very risky job or is closer to retirement.
Two of the biggest mistakes investors make are:
1. Taking too much risk and
2. Taking too little risk.
There is no right or wrong when it comes to making the risk decision. Each of us choose the equity/fixed income mix that fits us best. Understanding the consequences of a given risk decision is an important factor. I spend time with each client looking at the historical impact of various risk decisions on what size losses or gains you might expect over one, three and five year periods. There are calculators on the internet and various rules of thumb (some driven by your age – which I really don’t like) that you can use.
I believe that there is no better way to make the most appropriate decision for you than understanding the costs and benefits of taking risk in your portfolio.