Risk Tolerance & Time Horizon are the keys

As a Self directed Investor many of you are very much aware of the fact that Risk plays a key role in your investment return. If you are novice investor, you know in general terms more return needs more risk. It always the fight between Risk versus Return. Investors has to get their act together to find a balance between the level of risk they are willing to take in order to get a reasonable return for their investment.

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The investing strategy decisions shouldn’t be only based on Risk tolerance but also accompanied by another factor, Time. Time Horizon is second major factor to drive your financial planning decisions. Even though there are other factors involved in financial planning, these two factors Risk Tolerance and Investment Horizon are key to achieve your financial goals.

Risk Tolerance
Risk tolerance is all about how much risk one is willing to take to achieve expected return. As many theories explain, high return needs high risk which is associated with high level of uncertainty. But if you are satisfied with low return, low risk with low uncertainty would be the way to go. It is the argument about whether to put the money in savings, CD’s, Bonds Versus Equities. The simple chart below shows clearly that as the risk increase return increase and vice versa.

The starting point of the line is where one can get risk risk-free rate of return which normally associated with US Securities like Treasuries and Bonds. There is no risk associated with these type of investing to get low rate of return as US securities never defaulted. As you diversify your investment by investing in equities like stocks and Mutual funds, your risk increase as well expected return increase. Risk tolerance level changes depending on one’s age and financial goals. If you are 30 and planning to invest for retirement, your risk tolerance is high compared to one approaching retirement. That brings up to second key factor, Time Horizon.

Time Horizon
In above example, 30 year old has more time to build the wealth needed to reach the goal by taking more risk compared to one approaching the retirement. Taking the Risk tolerance level and combining with time horizon would lead to various asset allocation strategies which can be implemented depending on your financial goals. See the below chart.

Risk Averse Investor
It is good to take high risk to get expected returns but if you have two investments with similar returns but varied risk. It is wise to go with low risk investment. These type of investors are called Risk Averse Investors. As per Modern Portfolio theory, risk-averse investors try to construct portfolios to maximize their expected return based on a given level of market risk. Don’t try to over smart the market, try to be Risk Averse Investor to achieve your financial goals smartly.

Investment Tools
You don’t have to be expert investor or financial geek, there are lots of tools available these days for ordinary consumers. In recent past few years, many veteran mutual fund companies like TRowePrice, Vanguard and small fund companies which serves more online clients like Betterment.com, Funds.com have built their own tools based on these two main key factors. These tools simply drive the customers to make a decision on which funds to select by setting their risk tolerance level and time horizon. It is the simplest way to start investing for your future financial goals.

In conclusion, always try to remember that right amount risk level and proper time period is driven by your financial goals and helps to implement efficient investment strategies to reach your financial well being.

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