- What long-term rate of return do you expect on your investments? This will help you determine the types of investments needed to meet that target. Review historical rates of return over a long time period to see if your estimates are reasonable. High return expectations can cause you to invest in asset classes you aren't comfortable with or that you may be tempted to sell frequently. A better alternative may be to lower your expectations and invest in assets you are comfortable owning.
- What length of time are you investing for? Some investments, such as stocks, should only be purchased for long time horizons. Using them for short-term purposes may increase the risk in your portfolio, since you may be forced to sell during a market downturn.
- How long are you willing to sustain a loss before selling? If you have weathered a long market decline, you have some indication of how comfortable you are holding investments with losses.
- What types of investments do you own now and how comfortable are you with those investments? Make sure you understand the basics of any investments you own, including the historical rate of return, the largest one-year loss, and the risks the investment is subject to. If you don't understand an investment or are not comfortable owning it, you may be tempted to sell at an inopportune time. Over time, your comfort level with risk should increase as your understanding of how risk impacts different investments increases.
- Have you reassessed your financial goals? Market declines can mean that many financial plans may need to be revamped. Otherwise, you may find you won't have sufficient resources in the future to meet your goals. Faced with that possibility, you may start to invest in alternatives you aren't comfortable with to try to make up lost ground. Based on your current investment values, determine what needs to be done to meet your financial goals. You may not like the answers that result from this analysis. You may need to save more, change or eliminate some goals, or delay your retirement date.
- Do you understand ways to reduce the risk in your portfolio? While all investments are subject to risk, there are some risk reduction strategies you should consider, including:
Diversify your portfolio. You should diversify among several different investment categories,including cash, bonds, and stocks, as well as within investment categories, such as owning several types of stocks. A properly diversified portfolio should contain a mix of asset types whose values have historically moved in different directions or in the same direction with different magnitudes. The theory is that when one asset class is declining, other assets may be increasing in value
Use dollar cost averaging. Rather than accumulating cash so you have a large sum to invest, invest small amounts regularly. Dollar cost averaging is a method of investing where you invest a certain sum of money in set amounts at regular intervals. This spreads your purchases over a period of time, keeping you from making one major purchase at high prices. Because you are investing a set amount, you purchase more shares when prices are lower and fewer shares when prices are higher. While a valuable investment strategy, dollar cost averaging does not ensure a profit or protect against losses in declining markets.
Before starting a program, consider your ability to continue purchases during periods of low price levels. This strategy requires the discipline to invest consistently, regardless of market prices, and can help develop a habit of regular investing.
Ensuring your investments are compatible with your risk tolerance is an important component of your investment strategy.