Updated: 1/24/2010 9:48 PM ET|
The right way to risk your money
Day traders may thrive on volatility, but long-term investors can ignore the gyrations if they are properly diversified. Here's how to minimize market risk.
With its ups and downs, the market can be a scary place to hang out.
Sure, some thrill seekers can't get enough of the peaks and plummets, but many grow queasy watching their savings balances soar and sink.
Although people have different risk tolerances, it is important to learn to stomach these market fluctuations with confidence by balancing your portfolio to thwart disaster. To take risks wisely, you'll need to understand:
- Your risk tolerance.
- That different asset classes carry different levels of risk.
- That diversification can smooth your investing path.
Most of the time, basic psychology is the investor's worst enemy, says John Bogle, the founder of Vanguard Funds and a pioneer of diversified investing.
"When the stock market is at its peak, optimism is at its peak as well. On the other hand, when the stock market hits a low, pessimism is high, and people are scared," Bogle says. "Your emotions tell you to buy at the top, and your emotions tell you sell at the bottom. But that's not a good idea. Eventually you won't have any money left."
So what's the answer? Diversification.
Instead of loading all your investment money into stocks, which are among the highest-risk investments, balance your portfolio with bonds and maybe some cash. That way, when the market is high, your stock holdings work magic by making lots of money, but in down times, the bonds and cash help maintain a more stable balance -- not to mention your blood pressure.
Depending on the investor, a balanced, diversified portfolio could include real estate, high-risk penny stocks and maybe private business ventures.
Intellect vs. emotion
The key to understanding the balance that's best for you is twofold, says Michael Kay, the president of Financial Focus, a financial-planning company. First, get a grasp of your risk tolerance. Second, assess your goals.
"Risk tolerance is a moving target," Kay says. "But what we do know is that if you spread your assets over the spectrum, it gives people a greater satisfaction and a greater chance of staying true to their investment objectives. If people see wild swings, they feel they're in the wrong place. That's when people sell low and buy high."
The key is to look into your investing soul and ask yourself how much emotional turmoil you can withstand. "How much pain are you willing to suffer before you can't put your head on the pillow at night?" Kay asks.
If you break into a cold sweat every time headlines mention a dip in the Dow Jones Industrial Average ($INDU), that's a good indicator you're not properly diversified or not sufficiently educated about the market, or both. In many cases, it's wise to seek counsel of a professional adviser who makes you feel comfortable that your money reflects both your risk tolerance and your goals. Not only are professional financial advisers experts in investing, they can also take some of that dangerous emotion out of the equation.
Most people want to keep their stock investments spread over a variety of asset classes. The most common include:
- Small -cap, mid-cap and large-cap stocks. These classifications indicate the capitalization, or the company's total value in the stock market. In general, small-cap companies are those with a market value of less than $1 billion; large-caps have market values of roughly $8 billion or more. Larger companies tend to be more stable, while smaller companies often have more growth potential -- and more risk.
- Growth stocks and value stocks. Growth stocks are those deemed to have the strongest long-term potential for growth. Value stocks are considered to be cheap and are attractive because of the possibility that their true value has yet to be realized. The risk with growth stocks is that growth may stall. The big risk with value stocks are that their true value isn't ever recognized or that a flaw in their businesses persists or gets worse.
- Domestic and international. Sticking to companies based only in the United States means your portfolio's fate is closely tied to the ups and downs of the domestic economy. By putting assets overseas, you may benefit from stronger growth in other economies and from the often-supercharged growth of emerging markets such as China and Brazil. In some cases, the diverging paths of the world's economies help smooth out the gains in a portfolio.
Properly managed portfolios are adjusted over time, becoming less risky as investors near their goals. That way, you reap the juicy earnings associated with high-risk assets early in your investing life, when you have more time to ride out any rough patches, while lower-risk assets keep your money safer as you get closer to needing it (as in retirement).
Conservative investors in their 20s or 30s may mix their retirement funds with 40% fixed income and the rest in stocks. An aggressive investor of the same age may feel comfortable with 90% or 100% in stocks. If you find a mix that fits with your goals and risk tolerance, the next step is to diversify your stock and fixed-income investments. There are mutual funds, known as target retirement funds, that do a good job of not only setting the stock-bond mix but also in spreading your money across asset classes. Those investors who can find a good balance of investments and hold on for the long term will come out ahead, adviser Kay says.
Studies and expert thinking about diversification has evolved over the years. Not so long ago it was believed that, for example, domestic and international stocks were inversely related -- when U.S. companies were doing well, foreign stocks were in tank -- and vice versa. Diversification worked because when one asset class was up, the other could be expected to be down, but over the long run the investor always came out ahead.
Globalization means that foreign and domestic stocks are more likely to move in tandem. But that doesn't mean diversification is any less important, Kay says. Diversifying spreads risk and increases your chances of profiting.
"You'd rather have more opportunities to do OK than fewer opportunities to boom or bust," he says.
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