Saturday, September 19, 2009

Weighing Risk

Don't be afraid of learning about your money/investments. This will make you powerful, and less likely to get taken advantage of in your financial affairs.

Ever notice that phrase at the bottom of every mutual fund advertisement? Something along the lines of "Past performance does not guarantee future results"

What does this mean in English? We hope we will do as well or better in the future but we really have no idea. Now as a potential investor, you have probably heard often that there are "safe" investments, and "risky" investments. Stocks over time have had a good rate of return, but always have the risk of going down. As evidenced in the financial markets last year, stocks do not always go up. As an investor, you should be ready for the type of drop we saw last year. I understand this is a tough thing to think about, and I respect your fear of losing money. I too have that fear.

Thinking of the big picture, long term investment time lines of 5 or more years should see better returns with stock exposure. But imagine, (or maybe you are) someone who was ready to retire and then saw the stock market start falling last year. Hopefully you had a diversified, age appropriate mix of assets. Hopefully you had enough time left in your accumulation phase (or buildup) to weather the storm. At or near retirement age, most financial plans call for the increase in cash/bonds/money market accounts (MMA's), and the decrease in stocks as far as asset allocation goes. Many had these types of plans, but let the huge returns that had been seen for some time lure them into going astray of their plans.

The unfortunate scenario many investors found out last year is that stocks can go down just prior to your retirement and wipe out years of portfolio gains. This is why I am a big advocate of rebalancing, and increasing your amount in cash/Certificate of Deposits/bonds/MMA's as retirement age nears. If you stay too invested in stocks, you may not have enough time to see those "gains" materialize again.

Personally, I have chosen an asset allocation plan or in plain English, a "what the heck am I going to invest in" plan of a higher amount of bonds/cash equivalents than most financial magazines and media recommend. It is ultimately a personal decision, and one that can be an easy one. If you are less risk tolerant (Example: you never want to see your account balance drop like many with a high proportion of stocks did last year) then you may find it much easier to sleep at night with more of an allocation of bonds/cash equivalents.

If you are worried about long term returns, keep in mind that although accepting less risk is usually associated with lower returns, a healthy dose of bonds and the like can actually greatly reduce the risk of holding too much in equities (stocks.) The reduced risk of these assets can help "smooth" out the sharp ups and downs, or volatility, that can be seen in the equity markets on a daily basis.

Ultimately it is a personal decision, and one that should be an educated one. I encourage you to do your own research and soul searching and start thinking about your investment choices more instead of blindly following the advice of anyone, including the author of this blog!

Next time we will sample a "what the heck should I invest in" plan and look at the benefits/risks associated with it.

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