Take a little extra time now to understand the investment process and develop an investment strategy tailored to your individual needs. To develop your investment strategy, professional advisors generally recommend that you:
A. Understand risk and the risk/reward relationship.
What is risk?
There are several types of risk to consider, including:
Inflation Risk is the risk that the future purchasing power of your investment will be eroded by inflation, particularly over the long term. For example, if your fund has earned 4% per year, but the inflation rate is 6% per year, you have actually lost purchasing power.
Price Risk is the potential change in the price or market value of your investment. The greater the range of change in price or market value, the riskier the investment. For example, if the share price of your account is up 20% one year and down 10% the next, it is considered riskier and more volatile than one that grows at a steady 4% per year.
What is the relationship between price risk and reward?
According to investment professionals, there is normally a correlation between the amount of risk you are willing to assume and the amount of reward you may realize. If you don't assume the risk, you have less potential for gaining the higher reward; if you do assume the added risk, there is absolutely no guarantee you will be rewarded commensurately. In fact, your investment could lose value, particularly in the short run.
B. Identify, as specifically as possible, your goals or objectives and your attitude toward risk.
Is your goal to preserve the value of your original investment and, therefore, avoid all price risk?
Perhaps your goal is to realize a stream of higher current income to guard against inflation. If so, you must generally be willing to accept some price risk.
Perhaps you may seek the potential for growth in the value of your investment over time. Are you willing to accept possibly significant price risk along the way in return for this growth?
You may have a combination of objectives and therefore may want to balance your investments by diversifying your choices. Investment professionals generally believe that this is one of the most effective ways to manage risk.
C. Establish your investment time horizon.
Are you investing for just a few years?
If so, your capital must be there when you need it. You may want to avoid exposure to price risk.
Are you able to leave some or all of your money invested for over 5 years? 10 years? 20 years? 30 years?
If so, you will probably be investing through many market cycles, both up and down. You may, therefore, be able to tolerate more price risk to protect yourself against inflation risk.
D. Consider your other savings and investments.
Is most of your money in bank savings accounts or CDs?
If so, you might want to consider adding bonds or stocks to your portfolio for some growth.
Or is most of your money in stocks?
If so, you might want to consider adding bonds or money market funds to add some stability and balance to your portfolio.
E. Match the objectives of the investments offered with your own goals and willingness to accept risk.
Do the investments offer stability and safety of principal? current income? growth in the value of your original investment?
What kinds of securities are held in the investments? treasury bills? bonds? stocks?
Answers to these questions can be found in prospectuses and annual reports. Always request and read these publications before you invest.
Finally, remember that investing for retirement is a long-term process. What is appropriate today may not always be. Therefore, while you should feel confident and committed to your strategy, you should review the appropriateness of your plan at least once a year. As you progress along your career path and get closer to retirement, your goals may shift from an emphasis on growth to a concern for current income and stability. Appropriate changes in your investment should be made to match shifts in your goals. Samples of some investment strategies that many advisors consider appropriate for people at various stages of their careers can be found in the section on Balancing Your Portfolio.