Finding A Comfortable Level Of Risk

All investments involve a trade-off between risk and return. A certain amount of risk is inevitable if you want your money to grow. The key is determining how much risk you feel comfortable with.

Know Your Risk Tolerance

Are you uncomfortable with change? Can you stick with your long-term strategy even if you face short-term losses? Will you be overly anxious the first time your investments drop in value? These are all questions to answer before developing your strategy.

Understanding your personal risk tolerance will help you create a plan you can stick with through good times and bad.

Many investors forget the risks involved with buying stocks when the market is soaring. It’s easy to be tempted by the lure of sky-high returns and to forget the possibility of a market downturn, or worse, of a bear market. Likewise, during a bear market or a sharp drop in the market, many investors suddenly become extremely risk averse. But if you create a plan built around your personal risk tolerance and stick with that plan, you will avoid having to make sudden changes in your investment strategy as the market changes.

Factors That May Affect Your Risk Tolerance

Although your personality will affect your underlying risk tolerance, your stage of life also will affect it. Are you just getting started, supporting a growing family or approaching retirement? The amount of risk you feel comfortable taking may be very different at each of these stages in your life.

Most people aren’t prepared for the risk posed by being 100% invested in stocks. But younger investors saving for retirement may be able to afford the risk of placing the bulk of their money in stocks. Why? Because in modern U.S. stock market history, investors have never lost real money investing over a 15-year period. Over a 10-year period, the odds of making money are more than 90%. So stocks have proven to be the best investment over the long term and will likely continue to be unless the U.S. economy crashes to a halt.

On the other hand, as you move closer to retirement, or if you will need a portion of your money in the short term, you may be better off foregoing the highest returns and putting your money in investments that are more secure, such as bonds or money market accounts.

But even investors with similar personalities and in the same stage of life may have different risk tolerances because of such factors as:

• Job security and future employment prospects. If you work in an industry with high turnover, you may be willing to risk less than if you are in a stable position with room for growth.
• The amount of disposable income available for investing. If you are investing millions you may be more comfortable taking risks than if you have only a few thousand dollars to work with.
• The risk of an unexpected financial burden. If you are the sole income provider for your family, your tolerance may be lower than if your spouse also earns a good living.

Sunday, November 30th, 2008

The Importance of Asset Allocation

Diversifying your funds among different types of investments is an important way to minimize your investment risks. It can also play a large role in the return you can expect. In fact, how you allocate your investments among asset classes (stocks, bonds, mutual funds, etc.) may be the most important factor, by a significant margin, in determining portfolio performance. That means making asset allocation choices should be one of your first steps in the investment process.

The objective of any asset allocation plan should be to find the asset mix that provides the appropriate combination of expected return and expected risk that will allow you to achieve your financial goals. Choosing the optimal asset allocation for your investments can, however, be extremely difficult.

The asset allocation most appropriate for a single, 32-year-old investor who is earning $75,000 a year might be quite different from that of a 55-year-old with two children in college who is planning for retirement. But whatever your situation, the right investments for you will be those with potential rates of return that can help you meet your financial goals with risk levels you find comfortable.

Two factors involved in choosing your appropriate asset allocation are your time frame and your risk tolerance. Also important is understanding the current economic conditions and how they affect your investment opportunities.

Saturday, November 29th, 2008

Using Mutual Funds In Your Portfolio

If you want to invest in the stock market but don’t have a large enough portfolio to achieve the diversity you want through individual stock purchases, mutual funds may provide the solution you are looking for.

Mutual funds are a collection of stocks designed to meet a stated investment objective or strategy. For instance, you may be able to choose between a fund that holds small- or mid-sized companies, large blue chip companies, or government bonds. Some funds are designed to provide growth, others to give you income.

Fully diversified mutual funds can offer you access to more than 50 individual stocks or bonds. Achieving a similarly diversified portfolio by purchasing individual stocks is more difficult and costly. The trading costs for buying and selling stocks can quickly eat away a smaller portfolio’s value. This is less of a problem if you have a larger sum of money to invest.

Understanding the Risks

Mutual funds provide a stated objective or strategy, giving you some understanding of the level of risk and the potential for return. You can get an understanding of the fund’s objective and past performance by reading its prospectus. But a fund’s stated objective may not tell you the whole story.

Many funds have a great deal of latitude in which stocks they may actually buy. Therefore, even if you own shares of six different funds, each supposedly invested under a different type of overall objective, you may not be as diversified as you think. Each of the six funds may hold shares of the same stock. This would increase your vulnerability to market corrections, even though you may not be aware of the risk.

A mutual fund’s performance depends in large part on its portfolio manager. So, what happens if the fund’s manager changes his or her strategy during the investment period or the fund changes managers? Having an investment advisor who meets regularly with the fund’s manager to determine his or her strategies and meets with the fund company to determine its policies for hiring and maintaining quality portfolio managers can help you minimize this risk.

Reading A Mutual Fund Prospectus

A mutual fund prospectus should outline these six factors that allow you to evaluate the fund and its potential place in your plan.

1. Investment objective. Is the fund seeking to make money over the long term or to provide investors with cash each month? You’ll find the answers in this section of the prospectus.

2. Strategy. This section should spell out the types of stocks, bonds or other securities the fund plans to invest in. It may look for small, fast-growing firms or large, well-established companies. If it’s a bond fund, it may hold corporate bonds or foreign debt. This section may also mention any restrictions on what the fund can invest in.

3. Risks. The prospectus should explain the risks associated with the fund. For instance, a fund that invests in emerging markets will be riskier than one investing in the United States or other developed countries. A bond fund should also discuss the credit quality of the bonds it holds and how a change in interest rates may affect those holdings.

4. Expenses. Different funds have different sales charges and other fees. The prospectus will spell out those fees so you can compare them with the fees of other funds. It should also explain the percentage of the fund’s return that is deducted each year to pay for management fees and operation costs.

5. Past performance. Although you shouldn’t judge a fund solely by its past performance, this can show how consistently the fund has performed and give some indication of how it may fare in the future. This section of the prospectus will also show you the fund’s income distributions and its total return.

6. Management. This section may do nothing more than list the fund manager or managers, or it may give specific information about the management team’s experience. If the prospectus doesn’t contain enough detail, you may be able to find this information in the fund’s annual report.

Friday, November 28th, 2008

Other Investments

Often, some of the best real estate investments may be those you make on your own, such as purchasing your own home, vacation properties or investment properties ranging from vacant land to apartment buildings and office buildings. But, real estate investments are also available through the financial markets. These include real estate investment trusts (REITs) and partnership investments ranging from small “private placements” to larger nationally syndicated and publicly traded partnerships. The era of the real estate tax shelter ended in the mid-1980s, but some of the current partnerships provide some tax-shelter elements. More important today, though, is an evaluation of a project’s potential for financial success and its liquidity. If you invest in a partnership, be prepared for the additional delay and complication that a partnership Schedule K-1 may add to your own tax return.