Your Tolerance For Risk

By now, you should have a good idea of what your retirement goals are. You may also have a better understanding as to what you need to do investment-wise to realize those goals. But how will you invest? We all want to see our portfolios generate double-digit returns year after year, but high returns come at a price. There is a general rule of thumb associated with investing: Your total return is a function of the amount of risk you are prepared to take. It is important to be careful when making investment decisions because the pursuit of high returns can just as quickly lead to a loss of some or all your original investment.

As a starting point, you should know that nearly all investment options offered by financial institutions can be broadly categorized within three main "asset classes": Cash or Cash Equivalents, Fixed Income Investments, and Equity Investments. Each asset class represents different degrees of risk and investment return potential due to the collective nature of the investments that fall within them.

1. Cash or Cash Equivalents - Low Risk
   These are considered the safest investments because your assets remain liquid and are often backed by substantial assets (as collateral) or major insurance policies such as those offered by the Federal Deposit Insurance Corporation (FDIC). Examples of these assets include: savings accounts, government savings bonds, money market mutual funds and T-Bills.
2. Fixed Income Investments - Moderate Risk
   Fixed income investments tend to yield higher returns than cash or cash equivalents. They can provide a stable source of investment income because their income streams (interest payments) are known or “fixed”. Like cash and cash equivalents, fixed income investments are often secured by some form of asset(s). The depth or quality of the asset coverage can vary as well, depending on the size and stability of the company or entity that issues the fixed income investment. As a result, the income (usually interest) that is payable by the fixed income investment will vary depending on these and other risk-related factors. CDs and corporate bonds are just a few examples.
3. Equity Investments - High Risk
   Assets such as these tend to be riskier investments in the near-term, but there is also the potential to realize significant returns in the long-term. Unless you hold preferred company stock, equity investments do not always pay dividends. However, the market value of the assets can increase - sometimes substantially. Equity-based mutual funds and common or preferred company stock are among the more common investments that fall into this asset classification.

Assessing Risk

The amount of investment money you are prepared to allocate toward any of the three asset classes, and on what percentage basis, largely depends upon finding a balance between your investment objectives, net worth, time horizon, and the risks you are prepared to take. If you do not consider your tolerance for risk, you may not be able to build a retirement portfolio that will allow you to sleep peacefully at night.
Having a high tolerance for risk does not necessarily mean that a high-risk portfolio is for you. There are other factors you should consider when deciding what the mix of investments in your retirement portfolio should be:

• Your age - You may have tolerance for large price fluctuations that can last for extended periods of time, but having an investment portfolio containing 100% high-risk equities may not be a wise move if you are over the age of 65. You will still be relying on this portfolio to fund your income needs in retirement. Can you afford a dramatic price drop? If not, you may need to sell investments at an inopportune time to meet your monthly income requirements. You could risk losing all your money at a time when you cannot go back to work.
• Your net worth - If your retirement savings are barely large enough to meet your income requirements as you approach retirement, it would not be a good idea to adopt a high-risk investment strategy. Your portfolio may not be able to sustain large price fluctuations and you may be forced to sell your investments when it is not advantageous to do so.
• Your time horizon - Because of the increased volatility associated with higher risk investments, it may take longer to appreciate or reach the valuations you were originally intent on achieving. In fact, if you need a quick return on your investment, the price volatility can work against you.
• Your investment objectives - If in your retirement planning, you determine that all you need is a 7% rate of return over a certain period of time to reach your retirement goals, you may not need to make higher risk investments despite your tolerance for them.

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