5 questions to determine your ideal investment strategy
You may feel comfortable taking risks when investing, but can you afford to take them? Even if you don’t mind volatility, your circumstances may dictate the equity exposure you should have.
This is why it is important to take into account both your ability to take risks and your tolerance for risk before making a single investment. You can do this by answering the following six questions.
1. What is your time horizon?
How old are you? When will you use your money? These questions are important because they help narrow your time horizon. The sooner you need your money, the more careful your accounts should be. And the further away you are from planned spending (whether it’s retirement or a major investment like buying a home), the more risk you could potentially take with greater equity exposure.
2. Do you have any major purchases coming soon?
When is your next big expense? And what is its size? If you have $ 300,000 in assets to invest but plan to use it over the next year to purchase a home, the way you invest it will be different from your next most expensive purchase. important. If you put that money into riskier investments and the stock market experiences a correction, you might have a hard time reaching your goal. For example, if in March 2020 you had the money to buy a house invested in large cap stocks, you would have seen your investments drop 34% to $ 198,000 due to COVID-19 fears, and that may have delayed your plans.
3. How stable is your income?
Over the next few years, will your income increase, stay the same, or decrease? If your income goes down and your expenses don’t go down proportionately, you could end up supplementing your bills by dipping into your investment accounts. And having more conservative holdings might help you avoid doing so if they end up trading at big losses. If your income stays the same, then if nothing else has changed, your risk tolerances probably won’t either, and your asset allocation model will stay the same. And if your income grows and your expenses don’t increase as dramatically, you may be able to bear more risk as your higher income can better withstand unforeseen expenses.
4. How do you react to a market correction?
If there was a significant loss in one of your investments, how would you react? How have you reacted in the past? If a stock you are considering takes a big hit, does that scare you or see it as a buying opportunity? Sometimes a great way to tell how comfortable you are with risk is by looking at your reactions. If you usually have nerves of steel when the stock market is rough, your appetite for volatility is probably higher than if you bite your nails and panic about losing all your money.
5. How are you investing now?
How diversified are your holdings? What types of businesses do you like to invest in? If you have all of the stocks, you are probably more comfortable with risk than someone with 50% stocks and 50% bonds. And if you invest in stable, dividend-paying companies, you’re probably a more conservative investor than someone buying shares in the brand new tech startup.
Finding the right asset allocation model
How you answer these questions will determine your asset allocation model or the percentage of stocks, bonds and cash you hold. If you are extremely risk averse or unable to take risks due to factors like a short time horizon or low liquidity, you are likely to be a more cautious investor and may end up primarily holding bonds. If you are very comfortable with volatility and your circumstances require you to bear risk, you are likely to be an aggressive investor. Your portfolio can be made up entirely of stocks.
You can also fall somewhere in the middle and be a moderate or moderately aggressive investor. A moderate investor is more on the conservative side, but can manage some exposure to stocks, maybe even up to 50% of their portfolio. A moderately aggressive investor comfortably owns mostly stocks, but owns a portion of bonds to protect against declines.
If you invest too carefully, the rate of return you receive may not be enough and your accounts will not grow fast enough. But if you invest too aggressively, you might find the ups and downs of the stock markets scary and sell your investments in order to avoid losses. This could lead to lower returns. That’s why finding your perfect combination of risk and reward is an essential first step in achieving your goals.