4) Understand and Manage Risk
Asset allocation and diversification are strategies to help manage risk as you continue to build financial freedom.
Individual risk tolerance, or how we feel about taking risks and losing or gaining money, affects the way we invest. Understanding how you view risk can help you select appropriate investments. If you can't sleep at night because of your heavy reliance on technology stocks, you may want to review and change your investment portfolio.
Be sure to understand risk versus reward. More risky investments, such as stocks, can make a lot of money, but they can also lose a lot of money. Bonds are generally less risky than stocks, and cash equivalents are the least risky while generally providing the lowest returns.
Because of these risks, your goals and time horizon for investing are key to selecting appropriate investment vehicles. If you want to put a down payment on a house next year, is putting all of your money in stocks a good choice? No. For a short-term goal like this, stocks are too volatile and risky to reasonably achieve this goal.
Remember that you could lose money. Your stock could go down in price. A bond issuer could fail to pay you interest or return your principal. If interest rates go up, your bond value may go down because you're locked into the lower interest rate. Currency values and political instability can hurt international stocks. And don't forget inflation, which can erode any gains that you make, especially if your money is in cash, such as a money market account making little interest.
5) Diversify: Don’t Put Your Eggs in One Basket
Investing in different types of assets reduces risk. If one type of investment goes down, another may go up, so spread your money around.
- Different assets — stocks, bonds and cash
- Different industries — health, energy, metals, etc.
- Different-sized companies — small, medium, large
Don't invest your money in one stock (e.g., Enron).
With a pool of many stocks and/or bonds, mutual funds are a way you can get diversification. Each fund has to tell you what kind of company (small, medium or large, the industry or industries, location, etc.) it invests in.
Keep in mind that having three mutual funds does not diversify your portfolio if the funds all have similar objectives, such as U.S. large- cap or global energy.
How you allocate your money in different asset classes to reduce risk and meet your investment goals accounts for 90 percent of all investment success. Diversify across asset classes. Set a mix of cash, bonds and stocks to meet your goals.
When saving for retirement, typically your investments will be more aggressive when you are young and more conservative as you approach retirement.
6) Remember to Rebalance the Allocation of Your Investments.
Rebalancing helps you stick to your investment plan. For example, let's say your investment strategy is 60 percent stocks and 40 percent bonds. One year later, stocks are down and bonds are up. Now your portfolio is 55 percent stocks and 45 percent bonds, so it's out of balance with your strategy. Rebalance by selling some bonds and buying some stock. A good time to rebalance is annually when you get your Social Security statement or if you experience a major financial event.
It’s never too late to start planning for a better future — and that future can begin right now. The economy and the markets may do what they will, but if you take advantage of the many resources available to you, you will be better equipped to make the right choices at the right time.