Portfolio Planning and Risk Management
In choosing between the various investment vehicles available, you need to address asset allocation, risk tolerance, and net worth. These are issues that require you to take a more global perspective about your current financial situation and prospects for growth. It is wise to consult with a financial professional when making such decisions.
Whatever investment choices you make, you want to make sure that your overall investment portfolio is correctly allocated and diversified. Asset allocation is the process of dividing investor funds among several classes of assets to limit risk and increase the chance for greater returns. Assets are spread among stocks, bonds, liquid accounts, and real estate. When your assets are properly allocated, you will be nicely diversified and should be reasonably insulated from negative returns.
Though we know that it is best to not "put all your eggs in one basket", that is exactly what we become tempted to do when one class of investment has been doing well for us. Tempting as it is to centralize your investments, doing so is akin to playing Roulette with all your money bet on "Red, 8". You might win big, but there is now an unacceptably large chance that you will lose big too. Spreading your risk over several different types of investments helps ensure that you will always be making money in the market even when some sectors are not doing well. As previously pointed out, when the market is not doing well and interest rates are going down, bond yields tend to increase.
Though a properly diversified portfolio makes sure that risk is spread out among different types of investments, it does not correct for poor investment choices. Recall that investments may be selected either on the basis of growth prospects, or because they appear to be undervalued, and should increase in value as the market corrects over time. Too much emphasis on either of these philosophies could place your total investments at more risk than you might like!
Hand in hand with asset allocation is risk tolerance. Risk tolerance is an investor's willingness and ability to withstand negative returns. That is, how much can you afford to lose financially (and emotionally) given the number of years before you will need to rely on invested funds and on your unique emotional temperament. Whenever you invest money, you are required by law to answer a series of questions that will help your investment advisor place you on a risk tolerance scale. People who will not need invested funds for 10-20 years or more generally fall into the highest risk category. That means that they can afford, financially at least, to withstand negative returns in the short term with the expectation that they will experience positive returns in the long run. People who will need invested funds within 5-10 years fall into the least risky category. They do not have enough time to recover from negative returns, so their monies need to be placed into investment vehicles with the least amount of risk. Risk tolerance goes hand-in-hand with asset allocation. You should always invest in accordance with your ability to withstand negative returns. Don't take on high-risk investments if your time horizon is limited, or if doing so will keep you up at night with worry.
The point of having a carefully balanced, allocated portfolio is to increase your overall net worth; to provide a maximum practical return on your investment. You need to periodically calculate how well your various investments have performed, so that you know whether you are getting closer to or further away from your investment goals. If you are losing money in particular investments, you will then know to shift money away from those investments and into safer investments. If you are making money, you can hold on to the investments you presently have.
Net worth is the difference between your liabilities and your assets. In other words, net worth can be calculated by subtracting all you owe from the value of all the things you own. Net worth is important because it is an overall measurement or gage of how close you are to reaching your financial goals. Of course, the idea of net worth as a gage assumes that you have set a target amount of money that you will need in order to retire. The actual amount of money you will require in retirement will vary greatly depending on the lifestyle you want to lead and the number of years you have to reach your financial goals. There are a number of calculators available on the Internet which can help you to determine what your personal retirement figure will need to be. As is always the case, you will be wise to seek the advice of a qualified financial professional in setting your retirement goals.