Learn Investment

Building a Solid Foundation

Investing successfully is more about attitude than about money. Even an imminent inheritance and a good-paying job offer little hope of financial success without a positive, constructive attitude that leads to a rational, systematic investing approach. The solution to avoiding a stressful retirement and enjoying financial freedom starts by examining your attitudes. With a thorough self-assessment under your belt, you can begin learning sound investment fundamentals.

Profit by Understanding the Risk and Return Relationship

What is something you do really well -- better than most people' Whatever it is, your special skill or knowledge is probably characterized by two critical attributes:

• It's rewarding. Whether the reward is financial or simply the satisfaction of doing something worthwhile, you profit by it in some way.

• Developing your special skill or knowledge required some type of sacrifice.

Investment reward is called return. Return is the financial benefit of risking your money in the market. It is expressed as "rate of return." Investment sacrifice is called risk. The essence of investment risk is the chance you take that the value of your investment will decline. Investment risk is usually expressed in terms of volatility in the value of the investment. The value of some investments, such as government bonds, does not change much, so the chance of losing money is slight. On the other hand, the value of stocks issued by many Internet companies rapidly rises and falls and may not recover. After analyzing your personality and grasping the concepts behind risk and return, you are ready to tackle the one simple fact that underlies the importance of investment risk and return: they are both positively and linearly related.

In order to earn higher returns, you have to assume higher risk. If you are unwilling to accept high risk, your returns will be relatively low. In the long term, all investment securities and portfolios operate this way. The key to successful investing lies in a plan that is not only well thought-out and consistently applied, but one that accounts for and manages risk as well. A risk management plan expresses your personal tolerance for risk in terms of the kinds of investments you should own.

Assessing Your Risk Tolerance

Your risk tolerance is about personal preferences and goals. The cornerstone of a consistently applied risk management plan lies in an assessment of your own tolerance for risk and volatility. This leads to an investment plan reflecting both your personality and tolerance. A thorough risk tolerance assessment taps two key attributes: cash flow needs and your attitude about short-term fluctuation in the value of your investments. Cash flow is money coming in and then going out for expenses. If you depend on investment income to fund your cash flow, your investments should include safe stocks and bonds paying high dividends and interest. If you depend on employment income to fund your cash flow, you can invest in riskier, low-income stocks and bonds with greater potential to grow in value over the long-term.

Your financial obligations and preferences determine cash flow needs. If you are approaching retirement, you may not currently have large cash flow needs. But upon retirement, your income source may shift from salary to earnings on your investments. It is at this moment when knowing yourself becomes extremely important, since you will be able to anticipate your reaction to seeing the value of your portfolio take occasional dives and experience long periods of no growth. By anticipating your reaction, you'll be prepared either to adjust your investment strategies or to sit back and ride out the storm.

Matching Reward Expectations with Risk Tolerance

If stock prices rise, it means the market believes profits will rise at roughly the same rate. In the long run, the economy cannot grow fast enough to sustain high double-digit profits. Therefore, stock prices could not sustain the high double-digit returns we witnessed in some recent years.

A reasonable long-term return expectation hovers between 8 and 10 percent if the investor's risk tolerance permits allocating 60 to 80 percent of the portfolio to stocks and the remainder to fixed income investments. Investors with lower risk tolerance should expect less of a return.

It can take both discipline and foresight to put money in low-risk investments. Nevertheless, a mismatch between realistic expectations and risk tolerance is a sure formula for disappointment. A well-conceived risk management plan matching risk tolerance and realistic expectations can prevent disaster while yielding respectable long-term returns.