Different types of investments are subject to different types of risk. On days when you notice that stock prices have fallen, for example, it would not be unusual to see a rally in the bond market.
Asset allocation refers to how an investor’s portfolio is divided among asset classes, which tend to perform differently under different market conditions. An appropriate mix of investments typically depends on the investor’s age, risk tolerance, and financial goals.
The concept of correlation often plays a role in constructing a well-diversified portfolio that strikes a balance between risk and return.
Keeping your cool can be hard to do when the market goes on one of its periodic roller-coaster rides. It’s useful to have strategies in place that prepare you both financially and psychologically to handle market volatility. Here are 11 ways to help keep yourself from making hasty decisions that could have a long-term impact on your ability to achieve your financial goals.
1. Have a game plan
Having predetermined guidelines that recognize the potential for turbulent times can help prevent emotion from dictating your decisions. For example, you might take a core-and-satellite approach, combining the use of buy-and-hold principles for the bulk of your portfolio with tactical investing based on a shorter-term market outlook. You also can use diversification to try to offset the risks of certain holdings with those of others. Diversification may not ensure a profit or guarantee against a loss, but it can help you understand and balance your risk in advance. And if you’re an active investor, a trading discipline can help you stick to a long-term strategy. For example, you might determine in advance that you will take profits when a security or index rises by a certain percentage, and buy when it has fallen by a set percentage.
Each type of investment has specific strengths and weaknesses that enable it to play a specific role in your overall investing strategy. Some investments may offer growth potential. Others may provide regular income or relative safety, or simply serve as a temporary place to park your money. And some investments may even serve to fill more than one role. Because you likely have multiple needs and objectives, you probably need some combination of investment types, or asset classes.
Balancing how much of each asset class should be included in your portfolio is a critical task. The balance between growth, income, and safety is determined by your asset allocation, and it can help you manage the level and types of risks you face.
If you’re like most people, you probably want to know what return you might expect before you invest. But to translate a given rate of return into actual income or growth potential, you’ll need to understand the difference between nominal return and real return, and how that difference can affect your ability to target financial goals.
Let’s say you have a certificate of deposit (CD) that’s about to expire. The yield on the new three-year CD you’re considering is 1.5%.
But that 1.5% is the CD’s nominal rate of return; it doesn’t account for inflation or taxes. If you’re taxed at the 28% federal income tax rate, roughly 0.42% of that 1.5% will be gobbled up by federal taxes on the interest. Okay, you say, that still leaves an interest rate of 1.08%; at least you’re earning something.
Sometimes you need to borrow money, especially to pay for a large purchase such as a home or a car. It’s easy to focus on your monthly loan payment, but to appreciate how much borrowing money might really cost, you also need to consider the amount of interest you’ll pay over time. The following tables illustrate the total interest paid over the life of three common types of loans that have a fixed annual interest rate and a fixed repayment term: mortgage loans, auto loans, and personal loans.
A home is often the biggest purchase you’ll ever make. Loan repayment terms vary; this chart illustrates the total interest paid over a 30-year repayment term.