How to Establish Realistic Goals
Your current savings, retirement spending needs, and personal goals are unique to your situation. Because different kinds of investments carry different levels of risk and can be expected to provide different rates of return over time, it is important that you consider investing in a set of assets that will best support your goals and that you create a written plan that clarifies your intentions. Your investing plan won't automatically meet or exceed all of your financial goals, but not creating one will almost certainly make you worse off — potentially leaving you unable to meet basic long-term financial needs.
You can create a state-of-the-art investing plan by adhering to two basic rules: Create and commit to an asset allocation plan, and diversify your stock, bond, or mutual fund holdings.
Fact
An asset class is a collection of investments that tend to move up and down together and have similar characteristics. Typical asset classes include domestic stocks, domestic bonds, foreign stocks, real estate, gold, or art.
Your Asset Allocation Plan
Creating a plan to diversify your assets is one of the most important decisions you can make. Give serious thought to various asset classes (gold, commercial real estate, stocks, bonds, and so on) in terms of their level of risk and how long you are willing to wait for returns, and then allocate your assets to balance risk and the rate of return. It's important to write down your plan — you'll need this to stick to your plan when markets fall and doubt creeps in. Asset classes like domestic stocks or bonds typically have wider variants of fluctuating risk and return than real estate or precious metals.
Diversify Your Holdings
Don't put all your eggs in one company basket or mutual fund. Creating a diverse stock or mutual fund portfolio (mixing large-cap, small-cap, international growth, and bonds) decreases volatility, or risk. A class of investments that all go up at the same time and then down at the same time limits your return and increases your risk. If you diversify stock or mutual fund investments, some will be up while others are down, increasing your portfolio's return while decreasing its risk level.
Choosing Asset Classes
When it comes time to select asset classes, and to figure out the allocation of your available investment funds within each class, you first need to determine how long it will be before you need to spend your invested money. The longer you have, the more risk you can take. If the time is short, you may want to keep your investments liquid — easily retrieved without incurring harsh penalties — and limit your investments in risky asset classes.
Essential
Investors define “risk” as the level of investment volatility. If one stock goes up or down 2 percent while another goes up or down 1 percent, the first stock is considered riskier even though it may increase your proceeds (returns) over time. Greater fluctuations in value increase the risk that a downturn may limit your ability to meet timely short-term payments.
If you are deciding between two investments with the same return, your choice is obvious: Choose the less risky investment. The same logic has historically resulted in riskier (more volatile) asset classes, like small-cap stocks, returning more than less-risky securities, like bonds. You should expect a higher return over many years' time on more volatile asset classes; however, you always risk losing a substantial amount of money in the short run by buying into the riskier asset classes.
