The next step to successful investing is to understand your approach to risk and diversification.
There are 3 basic ways to approach risk:
Risk avoidance are investment strategies that do not place your principal at risk and often will offer some kind of guaranteed return. Risk avoidance strategies include CD’s, savings accounts or traditional fixed annuities. These strategies all come at a cost. The return on your investment is exceedingly small and some have fees if you want your money back before the agreed upon term. You also run the risk of your money not keeping up with inflation.
Accept risk. These are investment strategies that place your principal at risk, do not offer any contractual guarantees, only the potential of high returns.
Manage risk strategies attempt to manage the risk by spreading out your investments. Money managers, mutual funds and hedge funds are investment strategies that attempt to manage risk. Having multiple asset allocation strategies with diversified asset classes is another way to manage your risk.
Whether you hire a financial planner, money manager or manage your own investments, it’s important to know your approach to risk.
Ask yourself the following questions:
What percentage of my portfolio do I want in each risk category?
What is my target rate of return for each category of risk?
Do I consider myself a conservative, average or aggressive investor?
How much do I feel comfortable losing, how much risk am I willing to accept to get a greater return?
How active do I want to be with my investments?
Passive – invest and trust management team to deliver returns
Active – personally involved in management of the investment
Pactive – somewhere between active and passive
Determine asset classes
Armed with the answers to the questions above, start determining which asset classes you are most interested in investing. Asset classes include such things as:
Stocks, bonds, mutual funds, indexes, commodities, forex
Insurance and insurance-backed investments
Businesses/Direct Participation Programs/Private Placement Memorandum
Oil and Gas
Gold, Silver and Precious Metals
Cash on hand
Other (mortgage notes, tax liens, collectables, etc.)
Every investor needs to strive for diversification. The goal of diversification is to minimize risk and maximize return. Your strategy should include different asset classes and further diversification by buying several opportunities within that class.
Include diversifying yields. Your portfolio should include high level ROI combined with lower level expected returns.
Each asset class has its own rate of return and degree of risk. Draw a pie chart of each asset class you want to invest in and the percentage of your investible money for each class. Using the information developed in Step 1, determine how much money you have to invest in each asset class.
Now your homework begins; the phase called due diligence and money rules. Look for that coming up in Step 3 of our three-part series Investment Strategies and Money Rules – Due Diligence.