Investment vehicles vary in terms of risk, from the safer money market securities to the highly volatile futures and commodity offerings. In general, the amount of risk investors take will correspond with the return they can potentially earn. In other words, high risk generally correlates with high return and lower risk with lower return. Where an investor's portfolio falls on the risk spectrum should reflect the particular investor's:
Investing should not be considered a gamble - with careful planning it is possible to both manage your risk and make money.
When you're investing for a specific goal, like college or retirement, the amount of time that stands between now and the date you'll need the money will help determine your investment strategy. The reason time horizon plays such a big part in investing is that investments that fluctuate in value have the potential to produce larger returns over time.
If you can tolerate a high degree of fluctuation-that means leaving the money invested through all the ups and downs-you can seek greater potential returns. Then as you move closer to your goal, you can begin to move the money into more stable investments so the money will be there when you need it.
Generally, stocks produce higher returns with greater fluctuation, bonds offer moderate returns with little or no fluctuation, and cash generates low returns with zero fluctuation. Although investment returns can never be predicted in advance, it's helpful to make some assumptions so you'll know how much you need to save and invest to reach your goal. Some common assumptions in use today are 12% returns for stocks, 8% for bonds, and 4% for cash.
So let's say you're investing for your two-year-old child's college expenses. At this point you can invest their entire college fund in stocks because there's enough time to ride out any ups and downs before you'll need the money. Around the time they graduate from junior high school you'll want to start moving some of the money out of stocks and into bonds whose maturity dates coincide with the four years of college. Then a year or so before you have to start writing tuition checks, you'll liquidate enough bonds and put the cash into a money market fund to cover upcoming expenses.
If there's one thing just about everybody in the investment world agrees upon, it's the benefits of diversification. Simply stated, diversification involves spreading your money around instead of plunking it all into a single investment. Why do this? Because the investment you think will do the best may not. Investments produce varying returns, and by having your money spread out, you reduce the risk of concentrating too much of your portfolio in the wrong one.
The mathematics of how diversification actually reduces risk is beyond the scope of this book. Nonetheless, it is important to understand that building your investment portfolio and diversification is slightly more complicated that the old saying “don’t put all of your eggs in one basket.”
To get an idea of how diversification works, let’s take a look at an hypothetical example:
Additional Resources: Modern Portfolio Theory
· Modern Portfolio Theory and Investment Analysis
Given the above hypothetical and naive example, what do you think the perfectly optimal, or “efficient” portfolio allocation should be. If you held 50 percent of your portfolio in the US market and 50 percent in the European market, your long-term return would have been 14% and your portfolio’s volatility, as measured by standard deviation, would be zero.
Now it is obvious that the above example is an over-simplified hypothetical example, but nonetheless, you can see how it is important to not only analyze what investments will do well over the next 12 to 18 months when selecting investments for your portfolio. In order to get the most out of diversification, you should also consider how your investments will likely perform relative to each other.