Selecting investments to achieve your goals

James R. Cook, CFP ^®, RICP^®

Before you devise an investment strategy, define your goal.

Are you saving for retirement, to purchase a home, to fund your child(ren)’s education or something else?

In this article, we will focus on saving for retirement.

Risk tolerance and risk capacity

When investing for retirement, consider your risk tolerance and risk capacity. Risk tolerance is the degree of variability you are willing to withstand in terms of investment return. As the potential for higher return increases, so does the risk of greater losses. It is a personal and emotional measure.

To determine your risk tolerance, ask yourself the following questions:

• What do I hope to achieve in positive markets?
• What am I willing to live with in down markets?

Risk capacity can be thought of in two ways:

The level of risk you must take to reach your goal. This is the rate of return you must make on your investment to successfully reach your goal.

The level of risk you can accept and still reach your goal. This is the amount you could lose on your investment and still reach your goal.

Understanding asset classes

Different types of assets have different levels of risk and return. Examples of common assets you can invest in are stocks, bonds, cash or real estate.

Equities, or stocks, generally have a high potential return, but they also are high-risk. Government backed bonds — like U.S. Treasury Bills — have extremely low risk because they are backed by the U.S. government; however, they also provide very low return.

Constructing an investment plan is about selecting the right asset types to match your risk profile. Most investors will want a portfolio that contains a mix of different assets. While a younger investor might be tilted toward stocks, someone approaching retirement might be closer to a 50/50 mix of stocks and bonds. This is what is referred to as a diversified portfolio.

By diversifying, you attempt to reduce the risk in the portfolio by investing in assets that respond differently to the markets. When stocks are leading in the market, returns on bonds might be lower; but when stocks fall, the intent is that bond values would increase. Put simply, diversification means that at any point in time, your portfolio is likely to have a mix of winners and losers. Over time, however, they work together to achieve your investment goal with a level of risk you can accept.

Selecting your investments

The most obvious way to create your portfolio is to buy individual investments, such as individual stocks, bonds, CDs, and so on.

The downside of that approach is that unless you already have a sizeable amount of money, you are unlikely to be able to create a very diversified portfolio.

A better way for most individual investors is to use mutual funds, or exchange traded funds (ETFs).¹ These investment vehicles allow you to invest much smaller amounts and be diversified because these are pooled investments that hold many individual assets. A stock mutual fund could hold shares of hundreds of companies.

You could construct a simple portfolio with just a stock and bond fund, add an international stock fund if you wish, or take an even easier approach and choose a balanced fund.

Balanced funds are a special type of mutual fund, or ETF, that invests money in multiple asset classes, seeking to create a complete portfolio in one simple investment. Many companies offer multiple options so that you can choose between aggressive versions that are heavy on stocks and more conservative versions that lean toward bonds.

Target-date retirement funds are another type of specialized balance fund that manages your risk over time. These funds have a year associated with them (2030, 2035, and so on). You pick a fund with a target year that is close to the year you wish to retire. The funds create portfolios appropriate for the length of time until you retire. As you get closer to the "target date," the fund gradually reduces risk by shifting the investments within the fund from growth investments — such as stocks — toward more conservative ones, such as bonds.

There are a few principles of sound investing you should keep in mind.

#1: Monitor and rebalance your investment portfolio annually. Start by reviewing your target asset allocation and compare it to the actual allocation. Even if you are more than 5% out of alignment, buy and sell shares to balance your portfolio.

#2: Adjust your asset mix as your risk profile changes. As you approach retirement, your risk tolerance might decrease because you will have less time to recoup any losses. Consider adjusting your asset mix — decrease the stock percentage and increase the bond percentage.

#3: Manage fees and expenses. Before you invest, take the time to familiarize yourself with all the investment fees. Any reputable investment advisor should be willing to explain all the investment fees that you might pay. Even if you don’t work with an investment advisor, you’ll still pay fees. Be sure to read through the prospectus and any other documents to determine those fees.

Selecting investments to meet your goals begins with setting your goals, both short-term and long-term. Once you have determined and prioritized your goals, you will be able to develop an investment plan to meet them, whether on your own or with the help of a trusted investment professional.

James R. Cook, CFP^®, RICP^® is a Financial Planning Specialist. He brings expertise in comprehensive financial and retirement planning to his work at MMBB. Cook holds a B.S. in Psychology from Lewis & Clark College, a Master of Divinity degree from Fuller Theological Seminary, and an MBA from the University of Missouri Kansas City.

1 An exchange traded fund (ETF) is a basket of securities that trade on an exchange, just like a stock. ETF share prices fluctuate all day as the ETF is bought and sold; this is different from mutual funds that only trade once a day after the market closes.

This article is not intended to be investment advice. The promotional content is for informational purposes only; you should not construe the promotional content as legal, tax, investment, financial or other advice. Please consult your tax advisor regarding your particular tax situation.