Often, we set ourselves up for trouble before we even buy our first investment—by failing to consider why we’re investing. No, we shouldn’t invest to earn the highest possible return, amass as much money as possible or prove how clever we are. Instead, we invest now so we can spend later on important goals such as retirement, the kids’ college or a house down payment.
As you pursue these goals, the amount of investment risk you take should hinge on three factors. The most important of the three: How far off do your goals lie? If you have five years or less to invest, the biggest risk is short-term market declines, so you should probably focus on cash investments and short-term high-quality bonds. Cash investments include savings accounts, money-market funds and short-term certificates of deposit, where returns are modest but you can be confident you won’t lose money.
What if you have more than five years to invest? You’re likely more concerned with making your money grow, especially after taking into account inflation and taxes. In pursuit of higher investment returns, you might buy riskier bonds, stocks and possibly alternative investments. Alternative investments include a grab-bag of stuff, including real estate, private-equity investments, timber, gold, commodities and hedge funds. Stocks, riskier bonds and alternative investments can suffer severe short-term losses. But if your time horizon is more than five years, you should have time to ride out any market dips and earn decent long-run gains.
Time horizon, however, shouldn’t be the only driver of your so-called asset allocation, which is your basic mix of stocks, bonds, cash investments and alternative investments. You also need to give some thought to two other factors: your broader financial life and your stomach for risk.
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