risk and return analysis

How much risk is appropriate for you, and how do you handle it? Before you try to figure out your own risk tolerance, you should consider your financial goals.

Your financial goal: calculate how much money you’re going to need to become financially independent (presuming financial independence is your goal). Say that you need $500,000 in ten years for a worry-free retirement and that your financial assets (such as stocks, bonds, and so on) are currently worth $400,000. In this scenario, your assets need to grow by only 2.25 percent to hit your target. Getting investments that grow by 2.25 percent safely is easy to do because that’s a relatively low rate of return.

Your investor profile: Are you nearing retirement, or are you fresh out of college? Your life situation matters when it comes to looking at risk versus return.

**If you’re just beginning your working years, you can certainly tolerate greater risk than someone facing retirement. Even if you lose big time, you still have a long time to recoup your money and get back on track.

** However, if you’re within five years of retirement, risky or aggressive investments can do much more harm than good. If you lose money, you don’t have as much time to recoup your investment, and the odds are that you’ll need the investment money to cover your living expenses after you’re no longer employed

Asset allocation: For people in their 20s and 30s, having 75 percent of their money in a diversified portfolio of growth stocks (such as mid cap and small cap stocks; see Chapter 1) is acceptable. For people in their 60s and 70s, it’s not acceptable. They may, instead, consider investing no more than 20 percent of their money in stocks (mid caps and large caps are preferable).