Before investing your money it is wise to determine the goals of your investment. We are usually quite good at setting the primary goal of investment – Better retirement, college fund, buying a house and more. These ultimate goals should be carefully looked at and analyzed in order to adopt the most suitable investment strategy available. Therefore goals should be formalized and examined using the proper tools. Setting goals for your investment should be based on two major parameters (excluding the initial sum of the investment which should be known by now):
1. Risk and return (which always go hand in hand)
2. Term of investment
In setting investment goals you should ask yourself the three following questions:
1. How much of my initial investment am I willing to lose and what is the return I expect on the risk taken?
Risk, simplified, is the chance of losing some or all of your initial investment or not gaining the required return on your investment. Risk and return go hand in hand. As the risk on the investment grows so does the expected return. This is obvious and intuitive. The higher the risk you are willing to take the bigger the stock component of your portfolio should be over bonds and deposits.
2. What is my term of investment?
This question is of an utmost importance. Longer terms of investment allow for higher risk levels. This is due to the volatility in financial markets in the short term which are smoothed over in the long term (this is directly linked to diversification of investment which is treated in different articles).
Are you a young student investing for over 10 years or are you approaching retirement with a shorter investment horizon? This should directly affect the risk levels you are willing to expose yourself to. The longer the term of investment the bigger the stock component of your portfolio should be over bonds and deposits. Long term investment in stocks is considered to be over 10 years.
3. How much volatility can I tolerate? What is the level of liquidity I require?
Risk and return are often affected by volatility. High volatility is often the source of potential high returns. Your ability to tolerate volatility is mostly affected by your term of investment which is discussed above but is also affected by the chances of a financial surprise which will leave you wanting for cash. This is directly linked to the level of liquidity you require. Higher level of volatility tolerance and lower liquidity requirements allow for higher risk levels (Investing in stocks over bonds and deposits and vice versa as levels of volatility tolerance decrease).
Risk and volatility are highly connected. Conservative investors (which should allocate most of the investments to bonds and deposits) usually expose themselves to price deviations of up to 6%, more risky investors expose investments to price deviations of up to 10% and the riskiest go up to 15% and more.
After answering the questions above you can begin building a portfolio suitable for you.