subject: Allocate For Purpose Then Diversify To An Acceptable Risk [print this page] Everyone needs an investment approach that serves his situation. Your situation determines both the purpose and associated risk your choice of investments must achieve. This article provides an understanding about how to choose investment types for your situation.
Investments types fall into categories that mainly produce either growth in equity or annual income, hold cash equivalent, or hedge to preserve principal - or a combination of each. But the nature and risk of each type of investment varies greatly. So, just what should you be investing in?
We're continually told to allocate or diversify our investments. But after awhile we can get mixed up and lose track of what we're doing what for! Those beginning their retirement must keep track of what's what to be consistent with the situation they're in.
You invest to achieve a purpose based on your current status. If you're 65, beginning retirement and need to rely - at least in part - on your investments for yearly income for the next 25 years, you'll want to generate income as well as preserve the value of your investment.
*How you allocate among the investment categories determines your purpose for investing:
Your purpose of investing is reflected in how you allocate your money among the different asset categories. Each category has its own purpose.
You, as a new retiree, should allocate according to your situation. So, depending how much income you get from your pension and Social Security, you might allocate perhaps 50% of your money to income investments for help with living expenses, 35% in equity investments to grow and 5% in precious metals to maintain your portfolio value against the effects of inflation through your retirement years, with the 10% (or 6 months expenses) to cash equivalents so you can handle cash problems that can come up without harming your other investments by being force to sell them prematurely.
You can see that the overall purpose of this allocation derives from the purpose and percentage you ascribe for each allocation category you invest in. That's because choosing your allocation strategy is the first and most important investment choice you make. Sticking with that choice - which may include rebalancing every year - maintains you on track to fulfill your purpose.
But implementing your allocation strategy means choosing actual investments within each asset category. And that means recognizing your tolerance for risk - given your circumstance - and choosing investments accordingly. So your situation determines not only your allocation strategy but the level of risk your willing to allow for your specific investment choices.
Though the average returns from each asset category differ, the investments within each category show a range of returns, too, and associated risks. And, generally, higher returns are associated with higher risks.
A 30 year old with a good job and many years to save, can tolerate market set backs and fluctuations. He has a high tolerance for risk; he'd allocate most of his money to equity growth investments and, within that category, to 'higher' risk investments for their higher returns.
The 65 year old retiree, would be far more conservative. His risk tolerance for both his yearly income investments and his equity investments would be low to moderate. He wants to count on the income he has and be assured he maintains investments that'll carry him through his retirement.
*Allocation of risk level for return level within each category:
You can choose your individual investments according to their expected return and risk level. Small cap stocks generally return more than large cap stocks but at greater risk. How you choose among actual investments should reflect what risk you're willing to take for its expected return.
*Diversify to minimize unnecessary risk:
Whatever risk level you choose for specific investments, you'll want to minimize the unnecessary risk associated with them - and that can be done through diversification.
The first rule of diversification is "Don't put all your eggs in one basket". So no matter what risk level you choose for its expected return, you should always spread your money among many equivalently risky investments. Don't buy one stock for high growth, buy 10 or more of similar growth potential. Mutual funds are made for minimizing unnecessary risks for each level of return. Such diversification protects you against company failures - and the fact that some companies within your risk level will do a little better while others will do a little worse.
Understanding what you're investing in and why keeps you on track to achieve the purpose for which you're investing.
