Understanding risk
Investing starts with a goal. Are you saving to buy a house? Send a kid to college? Eventually retire? Your goal will help guide your time horizon – or how long your investments will make money before you need to draw from them.
Your time horizon in turn helps guide your risk tolerance – or how much you can stand to lose when the market goes down.
For example, if you are in your 20s saving for retirement, your risk tolerance may be fairly high because you have time for the market to recover and gain. That means you could invest more heavily in corporate stocks or mutual funds that hold stocks.
If you are in your 60s, your risk tolerance will likely be much lower because you are getting ready to start drawing from decades of investing. You could shift more to bonds and cash.
Over the last century, the stock market’s average rate of return is 10%. However, that is for the entire market over time. Individual stocks can lose money, and corporations can go out of business. In addition, the return on the entire stock market can fluctuate.
One thing about the stock market is certain: At some point it will go down. The history of the stock market is replete with bubbles, downturns, and crashes.
But time also shows that with every major drop, the market eventually recovers and surpasses where it was before.
Managing risk
The key to managing risk is simple: Don’t put all your eggs in one basket. Spread out your investments in two ways:
Make sure your money is in different types of investing — whether stocks, bonds, mutual funds, ETFs, and cash equivalents. This is what financial planners call asset allocation.
Within each type of investing, make sure your money is in a variety of funds — for example, several different mutual funds and ETFs, or stock from several different companies. This is what financial planners call diversification.
Asset allocation and diversification are another way of saying, don’t put all your eggs in one basket. Put a variety of eggs in a variety of baskets.
This helps protect you against risk because if one company’s stock goes down, another company’s stock may not -– and if the entire stock market goes down, bonds and cash-equivalents retain their value.
Investor profiles
Financial advisors often classify investors into profiles ranging from conservative to aggressive. In general, the more aggressive the investor, the more stocks in the portfolio. This is because stocks tend to make more money but can also be more risky.
Conversely, the more conservative the investor, the more bonds and cash-equivalents are in the portfolio. This is because the returns on bonds and cash are predictable and reliable, though they tend to be lower.
Usually, aggressive investors have a long time horizon of 15 years or more, giving their portfolio time to recover in the event of a market downturn.
Conversely, conservative investors often need the money from their investments in five years or less, so they prioritize not losing what they have over trying to make more.