How to Weigh Risk and Return in Stock Investments - dummies

How to Weigh Risk and Return in Stock Investments

By Paul Mladjenovic

How much risk is appropriate for you in your stock investments, 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 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 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’s a relatively low rate of return.

    The important point is that you don’t have to knock yourself out trying to double your money with risky, high-flying investments; some run-of-the-mill bank investments will do just fine. All too often, investors take on more risk than is necessary. Figure out what your financial goal is so that you know what kind of return you realistically need.

  • 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. Even if you lose big-time, you still have a long time to recoup your money and get back on track.

    • However, if you’re within five years of 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’re no longer employed.

  • Asset allocation: Retirees should never put a large portion of their retirement money into a high-tech stock or other volatile investment. But if they still want to speculate, that’s not a problem as long as they limit such investments to 5 percent of their total assets.

    As long as the bulk of their money is safe and sound in secure investments (such as U.S. Treasury bonds), they can feel safe playing with some of their money.

    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.