These days, investing is essential. Gone are the days when individuals could retire with just their pension or bank savings. Now, the responsibility to have a comfortable retirement lies in the hands of individuals – for better or for worse.
If you’ve started investing and are just thinking about tackling your investment portfolio on your own, it’s worth taking a look at these key considerations before you take the plunge.
1) Assess your risk tolerance
As you start building your investment portfolio, it helps to first understand your risk tolerance by determining your investor profile. These range from conservative (for those seeking lower investment risk), moderate, to aggressive (able to tolerate greater investment risk).
Risk tolerance can be measured by these metrics: ability and willingness:
The process of assessing an investor’s risk tolerance is all about determining his or her willingness to take investment risk, and their financial ability to bear that risk, and matching those two to come up with an appropriate investment portfolio.
This is most commonly done with a risk tolerance questionnaire that posits a series of questions about time horizon, the need for income, and attitudes about risk and market volatility. The objective is to calculate a “risk score” and determine the portfolio that goes with it.
The combined final score will then be used to map an appropriate portfolio. High scores are typically tied to an aggressive portfolio, moderate scores to a moderate growth portfolio, and a low score tied to a conservative portfolio.
IMPORTANT: While age is an important factor to consider when planning your investment portfolio, it should not be the only component to determine risk tolerance. Other important factors to consider include your existing capital, attitude towards risk and investment objectives.
2) Understand the risk/reward ratios of different asset classes
Your investment options typically fall within three classes – equities, bonds and cash. Within these three classes are subclasses (the variations within each category). Some subclasses and alternatives include:
Equities have the highest potential returns, but also the highest risk. Meanwhile, bonds come with lower risk, but also provide lower potential returns.
This is known as the “risk-return trade-off”. High risk choices are more suitable for investors with a high-risk tolerance, can stomach wide fluctuations in the market and who have a longer time horizon to recover from losses.
It is because of the risk-return trade-off – which says that potential returns rises with an increase in risk – that diversification through asset allocation is important. Because different assets carry different risks and market fluctuations, proper asset allocation insulates your financial portfolio from the ups and downs offrom one single class of equities.
3) Consider your asset allocation
Asset allocation is based on the principle that different assets perform differently in different market and economic conditions. And so, dividing your investment portfolio across various asset classes can help balance your portfolio risk and rewards. Consider it the opposite of “putting all your eggs in one basket.”
Every investor profile has an associated asset allocation—the percentage of investments including stocks, bonds and cash that a portfolio holds.
Your asset allocation should be based on your investing time frame, goals and risk tolerance. Below are some general guidelines on how your investment portfolio should look like based on your individual investor profile:
Image source: Merrill Edge
The first step to understanding optimal asset allocation by defining its meaning and purpose. Then, take a closer look at how allocation can benefit you and the right mix of assets that will best help you achieve and maintain it.
Like most things in life, there are no hard and fast rules for investing. But suffice to say that the best investment portfolio balance for you is simply one that fits the criteria you set. And of course, when you assess your unique financial situation and regard your capacity for risk and reward with utmost frankness.