Find Your Risk Tolerance
Thinking carefully about your risk tolerance before investing will save a lot of stress once you've made your investments and start watching your account balance change. Consider your time frame and whether the goal you're investing toward will stretch across many years, such as retirement, or whether it will be a one-time purchase or a short-duration expense, such as college tuition. It's important to stick with your asset allocation through market ups and downs, but it is also okay to start conservatively and increase the risk you take as you become more experienced.
Importance of Time Frame
Online asset allocation tools often depict your investment mix graphically as a colorful pie chart. Most brokerages, including Schwab, Fidelity, and E-Trade, present your current asset allocation on your statement or on their website. This is helpful because it clearly depicts the proportions of your portfolio assigned to each asset class — the most basic being U.S. and non-U.S. stocks; bonds or other fixed-income investments; and cash. Over time, each of the various asset classes swings through periods of growth or decline. In any given period, your stocks may be performing well while your bonds are not. Then it could reverse. Sometimes neither the bonds nor stocks gain value and you're glad you have some cash in your mix. Deciding how large each slice of the pie should be is dependent on your time frame and your risk tolerance.
When does an investment become a long-term investment?
Once you've owned the investment for one year, it is considered a long-term investment and enjoys the lower tax rate on profits if you sell. Beware the wash-sale rule! If you rebuy the exact same investment within thirty days of selling, you erase the previous sale for tax purposes.
In a perfect world, risk-taking is rewarded with higher return. But because this isn't a perfect world, the trick is to make sure that the return you're expecting is going to happen within the time that you'll need to start withdrawing your money. For instance, remember that, historically, stocks have grown faster than cash or bonds. The problem is that stocks are risky and can lose value over short periods of time. Because of this, stocks are a better choice for longer-term investments. If you need your money to grow over a short time — say five years or less — you're smart to invest in bonds or cash.
Investing for college is different than investing for retirement. Your asset allocation for retirement can remain aggressively invested in stocks even after you've actually retired. College investing needs to be more conservative because you're using the money over a very short period.
Stick with a Plan
The asset allocation you arrive at should consider how best to mix risk with return, considering your time frame and the amount of risk you're willing to take. You have a higher risk tolerance if you're not upset to see dramatic swings, downward as well as upward, in your account balances each month. If the goal you're investing toward is also long-term — say seven years or longer — then these short-term fluctuations probably won't bother you as long as the general trend is upward.
Sticking with your asset allocation may sometimes seem counterintuitive. Most investment advisors recommend that you check your investments against your target asset allocation at least once per year, and rebalance your portfolio. Your annual review assumes that some of your asset classes have performed better than others. The result is that the value of one asset class, say the stock portion, will have grown beyond the percentage that you originally targeted when you created your asset pie chart. At the same time, other classes will have been proportionately shrunk by the size of the larger sector, and you'll have to adjust the balance.
Assuming your target allocation remains unchanged, rebalance your portfolio by selling investments that are in the higher-performing, overly large class or classes and buying more of the lower-performing, undersized classes. You only need to sell and buy enough to restore the percentages you originally assigned to each class. Rebalancing helps ensure that you're taking profits when you should and that you are selling at a profit and buying low-priced assets whenever possible.
Changing Risk Tolerance with Experience
Don't worry if, at first, you don't want to take as much risk as your time frame, your asset allocation tool, or your investment advisor recommends. Start with a more conservative mix — with fewer stocks and more bonds and cash — and then work up to your allocation target when you become more comfortable. If you're still not sure, try setting up a hypothetical portfolio online, and then track it as its value changes. Financial sites such as
