Investing is the way regular people-those who aren’t born with a silver spoon in their mouths-can achieve long-term wealth. As Woody Allen once said, “Money is better than poverty, if only for financial reasons.” One of the most effective ways for middle class individuals to achieve wealth is to invest their money.
The core elements of your portfolio should include a combination of stocks, bonds, and cash. To what extent you maintain exposure to stocks depends on how much risk you’re willing to endure for greater returns. The riskier the investment type, the greater its performance over the long term.
Determine your risk tolerance
The fact is, over a ten-year period, stocks almost always outperformed all other types of investments, including bonds and “cash instruments” such as CDs and money market funds.
So when you begin to build your investment portfolio, it’s important to first determine what role stocks should play in your overall asset allocation. To do this, you must first establish your tolerance for market risk.
To help you determine your own level of risk tolerance, consider the following questions:
Of the following three investment scenarios of $20,000, which would you feel most comfortable owning?
- One with values fluctuating between $30,000 and $15,000 in one year
- One with values fluctuating between $25,000 and $17,000 in one year
- One with values fluctuating between $22,500 and $19,500 in one year.
Say you’ve been earning 10% a year on your investment for the past five years. The next year you lose 20%. Do you…
- Buy more of the investment
- Sell all or a portion of your investment
If you answered “a” to both questions, you probably have a high tolerance for market risk, and may wish to allocate a larger portion of your investment to stocks.
If you answered “b” to both, you’re probably medium tolerant and would do better with a portfolio balanced with a mix of stocks, bonds, and cash.
If you answered “c”, you probably have a lower threshold for market risk, and may prefer a comparatively lower designation of stocks.
Of course, there may be other factors-such as age, income, financial goals, etc-that also play a part in determining your investment risk and portfolio allocation. For more information about determining risk and asset allocation, see our related links and visit the Investment Resource Center.