Return: The profit or loss on your investments.
Deciding how much risk to take is not just based on financial factors — it is also based on your emtoions. Some people are not comfortable watching the value of their investments go up and down with the markets. This means they have a lower risk tolerance. Others may be able to better handle this. They may be focusing more on long-term results and not reacting to short-term events. Regardless of your risk tolerance, a successful investment strategy should give you the maximum potential return within your investment comfort level.
To help my clients determine this, I have them consider the following two things:
1. Historical performance of investment options.
2. Investment Time Horizon (or the number of years you have left to save).
The volatility of the funds you are considering investing in can be examined by looking at their historical performance. If from that performance you see major shifts in that particular investment vehicle and this is something that makes you nervous, you may wish to look at other less unstable options.
The following chart is a good example of the volatility of the market over a 25-year period, showing the ups and downs of stocks, bonds, cash, and inflation:
Long-term horizon (15 or more years): If you have this much time to invest, you may want to consider placing at least some of your money in higher-risk investments to maximize potential returns. You have more time to take more risk.
Intermediate time horizon (5 to 15 years): You are still able to invest for higher returns, but you may want to limit your overall risk. A major setback could affect the amount you’ll have after retirement (remember, you could live 15 or 20 years into retirement).
Short-term time horizon (5 years or less): You will want to limit your risk even more. If anything major happens to your nest egg at this point, the chances are slim that you will be able to make it up with just a few years of investing to go. Do not take major risks here!