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Risk is a part of God’s game, alike for men and nations – Warren Buffett

June 19, 2012

Investment portfolio should consider age, risk tolerance
A couple of weeks ago was one of the best weeks of the year for the stock market, which followed one of the worst weeks of the stock market. When you see situations like these, it is best to go back to the basics.

This past week, I wrote about the first question asked in the book “The Investment Answer” by Daniel Goldie and Gordon Murray. This week I’m discussing the second and third question they believe every individual needs to answer when it comes to their investing decisions.

After deciding if you want to go it alone or hire an advisor, each individual needs to decide how much risk he or she can tolerate, and then look at determining the investments to acquire.

There are a wide variety of risks. On one end, you may invest in an asset that can grow a lot or decrease a lot, but is very inconsistent; on the other end, you have inflation risk, which, if you put your money in the safest investments, your money may have less purchasing power than when you saved it.

Remember, investments that have higher returns also have higher risk. You will not find an investment with low risk and high returns. If this was the case, everyone would invest in this product, and that amount of money would turn a high-return product into a low-return product.

For long-term investments, Goldie and Murray recommend stocks (in mutual funds) and bonds. Over the long term, smaller company stocks have averaged around 12%, while larger company stocks have averaged around 10%, and long-term government bonds have been around 5.5%. Even though this is the case, in a period of five years, you will have much larger gains and losses in small company stocks, while the bonds will still be around a positive 5% gain most years.

It is good to get the higher returns over the long haul, but they aren’t for everyone. If you are young, you can buy investments with a higher risk and return as you have time to weather the ups and downs of the market. But, if you need money in the next five years, you do not want to have to depend on the stock market to keep all your money there and growing.

Another factor to keep in mind is your own tolerance for risk. If a 20% to 30% decline in a single year will freak you out, you want to have a more conservative mix in your investments. Even though this will mean you will have to save more, it will prevent you from continuing to buy high and sell low.

When you determine your risk tolerance level, then you can decide what asset classes you want to purchase. The S&P 500 represent 500 of the largest companies in the U.S. and represent about 70% of total U.S. market capitalization.

Because this invests in larger, generally more solid companies, this is a good place to start. You can get the benefit of investing in stocks, but have a little less risk of losing huge amounts than if you invest in smaller companies or international companies.

Even though the S&P 500 represents a solid place to start with investing in stocks, it probably isn’t where you should stop. To add a little more risk, but also the opportunity to get a little more return, it is important to add some investments in smaller companies and international companies. Then, to bring your risk down a little, it is important to invest some in bonds as you get older to help protect your money.

When investing in all of these stocks, remember that you should not buy individual stocks. You never know when you are holding the next Enron or pets.com that is going to go bankrupt, but when you buy a mutual fund that was invested in Enron, it probably also was invested in Apple, which has seen great growth. Report after report has shown, in your spare time, you can’t beat the market consistently, so find a good mutual fund that mirrors parts of the market.

Not only was this advice I saw in this book, it also is what I do with my own retirement investments. Unlike most public employees, I’m not saving in a pension fund, but in a defined contribution plan, which is more like a 401(k) or 403(b). Currently, I save 50% into a large U.S. company mutual fund, 25% into a small and mid-sized company mutual fund, and 25% into an international company mutual fund.

This is a very aggressive mix. I will see greater ups and downs than most investors, but I know I have 30 years or longer until retirement, so I can weather the higher risk for the higher return. As I get older, I will start to shift some of these into bonds to make it more conservative.

With this being said, I did look at my age and risk tolerance to decide the type of portfolio I wanted to have. For everyone it may be slightly different, but by analyzing your risk tolerance and age, you can come up with the right investment mix to get you to retirement.

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