As you begin your professional career, now is the perfect time to start thinking about your financial future. Investing is a great way to build wealth over time. But if you’re like most people, you may not even know where to begin.
Not to worry. We’re here to help you by outlining the basics of investments, so that you can make informed choices that you can be comfortable with.
When it comes to investing, there is no one right answer for everyone. We all have different goals and different tolerances for risk, all of which affect the investment choices we make. Let’s start by exploring the concepts of risk tolerance and time horizons.
Risk Tolerance
In an efficient portfolio, risk and return are directly related. The more risk you take, the higher your returns are likely to be. That being said, you’re not making a choice between high risk or low risk, you’re finding the level of risk that is comfortable to you.
Before making a single investment, it’s important to examine your level of comfort with the ups and downs of the market. Sure, you’re happy when you see a 10% return. But how would you feel when there’s a downturn in the market, and you see a 10% loss? For each person, the answer is different.
There are three components of risk tolerance that you should consider before making any investment:
- What is your willingness to take risk: Will you lose sleep when the market is down? If so, you have a lower risk tolerance and should look at investments that are not as susceptible to large fluctuations in the market.
- What is your ability to take risk: Are you in the financial position to take a loss? How much will a loss impact your current income needs?
- What is your need to take risk: Risk is also related to the amount of growth you need to reach your specific goals.
Time Horizon
While assessing your risk tolerance is certainly critical in choosing your investments, it is also important to look at how long you’ll keep the investment. Your ability to take risk increases directly with the length of time that investment will be active. For you, retirement may be 30 or more years away. At this time in your life, you may be more comfortable with growth-oriented investments for a majority of your portfolio. As retirement draws closer, you’ll want to transition into more conservative investments.
You may also have short-term goals that you are trying to reach. Perhaps you’re investing to build a down payment for a home that you want to buy in three years. For this bucket of money, you’ll also want to invest more conservatively in order to protect your earnings and keep your plans on track.
Investing is complex. Assessing your risk tolerance and time horizon are the first steps to building a portfolio that works for you.
Next Up: Investment 101 – Understanding Account Types
