Risk refers to the volatility of your investment portfolio's value. The amount of risk you are willing to take on is an extremely important factor because investors who take on too much risk usually panic when confronted with unexpected losses and abandon their investment plans mid-stream at the worst possible time. While some people do become more risk averse as they get older, risk tolerance is not necessarily a function of age; a conservative investor will go through changes in asset allocation over his life cycle, as will an aggressive investor.
This refers to whether you need to emphasize growth or income in your investment portfolio. Most younger investors who are accumulating savings will want returns that tend to emphasize growth and higher total returns, which primarily are provided by emphasizing stocks in an asset allocation. Retirees who depend on their investment portfolio for part of their annual income will want returns that emphasize relatively higher and consistent annual payouts, such as those from bonds and dividend-paying stocks. Of course, many individuals may want their asset allocation to reflect a blending of the two—some current income, but also some growth.
Your time horizon starts when your investment portfolio is implemented and ends when you will need to take the money out. The length of time you will be invested in your portfolio is important because it can directly affect your ability to reduce risk. Longer time horizons allow you to take on greater risks in your asset allocation, with a greater total return potential, because some of that risk can be reduced by investing across different market environments. If your time horizon is short, you have greater liquidity needs—the ability to withdraw at any time with reasonable certainty of value. Volatile investments such as stocks lack liquidity and require a minimum five-year time horizon; shorter maturity bonds and money market funds are the most liquid.
Time horizons tend to vary over your life cycle. Younger investors who are only accumulating savings for retirement have long time horizons for their investment portfolio, and no real liquidity needs except for short-term emergencies. However, younger investors who are also saving for a specific event, such as the purchase of a house or a child's education, may have greater liquidity needs. Similarly, investors who are planning to retire, and those who are in retirement and living off of their investment portfolio income, have greater liquidity needs.
Identify your tolerance for investment risk and find the correct asset allocation.
AAII provides registered users of AAII.com with a simple and concise tool that can greatly assist you with your portfolio management and asset allocation decisions. Our Asset Allocation Models area allows users to determine their investor profile, choose a model asset allocation and review the associated investment return and risk characteristics. In a nutshell, you'll see how diversifying among the asset categories reduces investment risk while allowing you to build a portfolio that matches your investment profile.
AAII's Asset Allocation Models use historical data to illustrate how you can divide your assets between stocks, bonds and cash based on your risk/return profile.