I’m sure she meant well, really.
This happened to me a 8 years ago. I was going to open a mutual fund account with an investment company. As part of their paperwork requirements, I was to fill out a risk tolerance questionnaire. Basically, the questionnaire answers the questions: “Where should I invest my money? Should I go for bond funds, balanced funds or equity funds?” It was supposed to assess my risk appetite, investment experience and eventually guide me which type of mutual investment I was going to place my money in.
8 years later, after going through this awesome personal finance course, I just realized this, “Should your risk tolerance influence investment decisions?… THE HELL NO!“
In terms of pooled investments.. THIS IS THE QUESTION EVERYONE ASKS:
Where Should I Invest My Money?
THE WORST INVESTMENT ADVICE TO GIVE OR RECEIVE:
Build a “sleep-well” portfolio. (aka the risk personality approach) Define your personal risk tolerance and invest within your comfort zone. If you have a high tolerance for risk, you certainly should load up your portfolio exclusively with stocks. If you are comfortable with lower returns and lower chances for negative returns, you should position your portfolio accordingly.
Why is this the Worst Advice?
A risk-tolerance-based portfolio could fail to meet your investment objectives. For example, a conservative investor might end up with a portfolio that won’t eventually be worth enough to support his or her self during retirement. OR if an aggressive investor needs the money for a family vacation at the end of the year, they should not invest all of it in the stock market today because their value might drop suddenly, just when they need the money to book their holiday.
THE BEST INVESTMENT ADVICE TO GIVE OR RECEIVE:
Investing is about putting your money to work to achieve your personal goals. You must first start by identifying what you want to achieve, how much do you need and by when. (aka the goal-based investing approach)
How do I allocate my investments based on this approach?
First Step: Before you start putting money into the market, ask yourself this question: What exactly are you saving and investing for?
Second Step: Write your goals down. It helps motivate you to stick to your plan.
Third Step: Establish your time frame. By setting a specific time frame for each goal helps you stay on track and enables you to think about how much you can afford to invest and how long it will realistically take you to reach your goal. Remember, different goals will stretch over different periods of time. You may only have 6 months or a year to save for a holiday, but if you are saving for your retirement you might have 25 to 50 years. Determining whether goals are short-term or long-term, or somewhere in between, will help you work out how much investment risk you can afford to take.
Last Step: Allocate your money to investment products that best suits your investment goals. For example, if you are saving money for a holiday over a short period of time, place it in money market funds. If you are saving for a long-term goal, such as retirement in 25 years, place it in equity funds because you have time to ride out the ups and downs in the market. This means you can take on a higher level of investment risk that better matches your end outcome.
Here’s a guide you can use to develop your investment plan.
|What is it?
|Money Market Funds
(most secure type of investment)
|Fixed Income Funds
Certificates of Deposits
|1% - 3%
|1 - 2 years
|5% - 8%
|3 - 5 years
|6 - 9 years
|Equities or Stock Market
(has the highest risk,
but provides the greatest returns)
|Ownership of large enterprises
|10% and above
|11 years or more
Let’s take an example.
Juan is 30 Years Old, Married, with No Children. His financial goals are the following:
Buy a car 1 year from now
Downpayment on a home 5 years from now
Retiring at age 60, 30 years from now
Goal: Buy a car 1 year from now.
WHICH INVESTMENT: Money should be invested in money market instruments.
WHY? It is a short term goal. Money will gain a little, but that’s resonable because he has a short-term investing horizon
Goal: Down payment on a home 5 years from now
WHICH INVESTMENT: Money should be invested in bonds.
WHY? The investing horizon is between 3 to 5 years. The money will be placed in the short term but can grow in a higher rate than money market funds
Goal: Retire in 30 years from now
WHICH INVESTMENT: Money should be invested in Equities/Stock Market.
WHY? The investment is risky but in the long run, the stock market still gives the highest returns.
To summarize it all up.
In picking the right investment,the BIGGEST factor to consider is the time horizon of your investment goals. Just as you dress up differently for various occasions such wearing swimwear to the beach or wearing a nice dress to a wedding, it makes sense to be invested in different investments aimed at meeting different goals.
So, does this approach work for you? Are your investments based on your risk tolerance or your goals? Let me know what your thoughts are below.