How to Weigh Investment Risk against Return
How much risk is appropriate for you, and how do you handle it? Before you try to figure out what risks accompany your investment choices, analyze yourself. Here are some points to keep in mind when weighing risk versus return in your personal situation:
Your financial goal: In five minutes with a financial calculator, you can easily see how much money you’re going to need to become financially independent (presuming that financial independence is your goal).
Say that you need $500,000 in ten years for a worry-free retirement and that your financial assets (such as stocks, bonds, and so on) are currently worth $400,000. In this scenario, your assets need to grow by only 2.25 percent to hit your target. Getting investments that grow by 2.25 percent safely is easy to do because that is a relatively low rate of return.
Your investor profile: Are you nearing retirement, or are you fresh out of college? Your life situation matters when it comes to looking at risk versus return.
If you’re just beginning your working years, you can certainly tolerate greater risk than someone facing retirement. However, if you’re approaching retirement, risky or aggressive investments can do much more harm than good. If you lose money, you don’t have as much time to recoup your investment, and the odds are that you’ll need the investment money (and its income-generating capacity) to cover your living expenses after you are no longer employed.
Asset allocation: Retirees should not put a large portion of their retirement money into a high-tech stock or other volatile investment. But if they still want to speculate, they can do so as long as they limit such investments to 5 percent of their total assets.
Asset allocation beckons back to diversification. For people in their 20s and 30s, having 75 percent of their money in a diversified portfolio of growth stocks (such as mid-cap and small-cap stocks) is acceptable. For people in their 60s and 70s, it’s not acceptable. They may, instead, consider investing no more than 20 percent of their money in stocks (mid-caps and large-caps are preferable).
Check with your financial advisor to find the right mix for your particular situation.