In my blog post dated July 24, 2018, we addressed the second of six keys to creating a financial plan: Cash Management. I wrote about how paying down debt to fund college or retirement rests on a single discipline - Cash Flow Management.
The third key area in any sound financial plan is: Investment Planning. A big part of your financial picture involves your personal investments. Unfortunately, without a coordinated strategy, it will be difficult to build an effective investment portfolio that meets your financial needs. Today we will highlight some of the key concepts to consider in Investment Planning and Portfolio Development.
TIME HORIZON: Time horizon is one of the most important aspects of building an investment plan. Your time horizon is the expected number of months, years or decades you will be investing to pursue a particular financial goal. An investor with a longer time horizon may feel more comfortable taking on a riskier, or more volatile, investment because he or she can wait out slow economic cycles and the inevitable ups and downs of our markets. By contrast, an investor saving for a teenager’s college education would be less likely to take on risk because he or she has a shorter time horizon.
ASSET ALLOCATION: Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The process of determining which mix of assets to hold in your portfolio is a very personal one. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your risk tolerance.
DIVERSIFICATION: The practice of spreading money among different investments to reduce risk is known as diversification. Diversification is a strategy that can be neatly summed up by the timeless adage, “Don’t put all your eggs in one basket.” This strategy involves spreading your money among various investments in the hope that if one investment loses money, the other investments will more than make up for those losses.
RISK TOLERANCE: Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favor investments that will preserve his or her original investment. In the words of the famous saying, conservative investors keep a “bird in the hand,” while aggressive investors seek “two in the bush.”
RISK VERSUS REWARD: When it comes to investing, risk and reward are inextricably intertwined. You’ve probably heard the phrase, “no pain, no gain.” Those words come close to summing up the relationship between risk and reward. Don’t let anyone tell you otherwise. All investments involve some degree of risk. If you intend to purchase securities - such as stocks, bonds, or mutual funds - it’s important that you understand before you invest that you could lose some or all of your money.
The reward for taking on risk is the potential for a greater investment return. If you have a financial goal with a long time horizon, you are likely to make more money by carefully investing in asset categories with greater risk, like stocks or bonds, rather than restricting your investments to assets with less risk, like cash equivalents. On the other hand, investing solely in cash investments may be appropriate for short-term financial goals.
RELATIVE STRENGTH: The goal of investing is to sell something at a price that is higher than what the investor paid to buy it. The problem investors face is determining when prices are low enough to indicate a time to buy and high enough to decide that selling is the best choice. Relative strength addresses this problem by quantifying how an investment is performing compared to other options. The idea is to buy the strongest investments (as measured against the performance of the overall market or its peers), hold them while capital gains accumulate, and sell when their performance begins to deteriorate.
Unfortunately, investors, acting on their own, tend to follow the crowd and allow their emotions to drive decisions. These actions commonly result in buying high and selling low, which is the opposite of what we acknowledge a rational person should do.
As a Financial Advisor, I can help take the emotion out of investing by using disciplined investment processes such as relative strength. I will assess your objectives, risk tolerance and time horizon to help build a portfolio designed to pursue your goals.
Until next time, cheers!
The Motley Fool