Another way of dealing with risk
People who worry about investment risk often deprive themselves of good returns by sticking to what they perceive to be low-risk investments.
There is another way. It’s called “asset allocation” and people can use it to control their investment risk without having to pass up better returns in the long.
It involves dividing your savings/investment portfolio among the three major asset classes: cash, stocks and equity-related investments and bonds (fixed incomes). Studies have shown that over 80 per cent of a portfolios long-term performance can stem from the asset mix allocation.
There are three main steps to consider when determining the appropriate asset allocation for your investment portfolio. First, your financial goals and time horizons. Are they long-term or short-term? A large proportion of equities will give you long-term growth, whereas a portfolio weighted in bonds will give you a steady stream of income. All portfolios allow for some cash on hand.
The second step is understanding your risk-comfort level. How comfortable are you with investments that fluctuate in price? Some investors can accept this ‘movement’ or short-term risk, in exchange for great long-term growth. Others, however, cannot. But remember, lower interest rates also come with a certain degree of risk, for example, if interest rates decline, and the fixed income investments do not earn enough interest to sustain the income required from your portfolio.
So the third step to consider is the right mix of investments. This should best be arrived at with the help of a financial advisor. Generally, people’s investment patterns tend to follow a demographic wave, from early adulthood to retirement. This is called the financial life cycle. As investors’ financial goals and personal circumstances change over time, so too will the asset allocations within their portfolios.
The pre-retirement years
The latter years in a person’s working life often provide the greatest opportunity for building wealth. Children have grown and become more financially independent; mortgages and other debts have been paid down or eliminated — and salary income is high. Your ability to save soars. But retirement is no longer a distant dream and the asset allocation in your portfolio must reflect this fact. For many people, this means taking less risk through a more conservative, balanced portfolio approach
The retirement years: 65-plus
When you eventually stop earning a living from your employment, your earning power changes. It’s at this point you could start to consume your accumulated savings. Your investment portfolio must now provide you with an income so that you may continue to enjoy the lifestyle to which you’ve become accustomed. And remember, retirement could last 20 or 30 years — sometimes more. Asset allocation provides investors with a structured way to maximize returns while maintaining a comfortable level of risk. It’s important to re-evaluate your portfolio from time to time; your risk comfort level may change, or you may be at risk of not meeting your future expectations. The steady downtrend in interest rates is a clear example of why you must always review and occasionally realign the mix.
It helps to track the progress of your investments from time to time, to make sure you’re meeting the goals of your financial plan. Even if you’re working with a financial advisor, it pays to assume some of the responsibility of financial management. Specifically, you should monitor any trading activity on a regular basis, while keeping in mind your current financial situation.
It’s relatively easy to monitor your trades by reading the daily business news and, of course, by talking regularly with your advisor. You should also review any written trade confirmations sent to your broker. When trades are infrequent you can still review the monthly and quarterly statements that will continue to arrive as long as you have cash or securities in your account. Check for discrepancies and errors, and report them immediately.
You should also want to monitor your personal financial situation. Have your financial status or goals changed? If so, be sure to keep your financial investor informed so that they can be informed and make appropriate adjustments to your portfolio. By regularly monitoring your investments, you can ensure you’re making returns appropriate for your long-term investment goals.
Financial calculations and charts help project how much money you’ll need, or how much money you’ll have saved for retirement. If your projections indicate a possible shortfall in savings, you may need to alter your current spending or saving habits accordingly — or perhaps extend the time until you retire.
For all these reasons, develop a good relationship with a financial advisor so that you may both ensure your current portfolio of investments is on the right track. And remember, it’s never too late to start charting a new course.