A sound investments strategy is to allocate your assets in a way that maximizes returns without exceeding the level of risk you are comfortable with. Stocks, while generally the riskiest investments, usually have the highest potential for strong returns. Bonds are less volatile, but generally earn less than stocks do. Cash is the safest of the main investment types, but the returns tend to be very low. As you go through the process of allocation, you'll determine the percentage of each type of investment your portfolio should contain.
1. Assess your risk tolerance. This is not just based on how much you can stomach, but your investing time horizon. If you are approaching retirement age, you have a shorter investing time horizon and should not be taking on much risk. However, if you're decades away from retirement age you have a long time horizon, which means you can afford more risk because your portfolio has more time to rebound from any downturns or slumps.
2. Evaluate your investment goals and how far off they are. Funding retirement or children's educations are common goals. The longer you have to reach your goals, the most risk you're likely able to absorb.
3. Determine whether or not your tolerance for risk is compatible with your investment goals and the amount of time you have to reach them.
4. Base your asset allocation on the compromises you've decided to make. Increase stock holdings for higher potential earnings, albeit at an increased risk. Increase cash to add a measure of safety to your portfolio despite the low returns. Balance the two relative extremes with bonds.
- Rebalance your portfolio if the gains or losses alter your asset allocation percentages.
- Sell some of the type of investment types you want to reduce and purchase more of the types you want to increase in order to restore the appropriate percentage of your portfolio that's devoted to each type of investment.
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