1) Your risk tolerance: There are two definitions of risk:
- Risk of loss = the possibility that the value of your investment could decrease.
- Risk of slow growth = the possibility that your investment does not appreciate enough.
You can Google “risk tolerance surveys” to assess your risk tolerance and to learn more. http://www.isi-su.com/new/risktol2.htm
2) Your time horizon: Time horizon is the length of time until you need to sell your investment. Investing for a long-term goal is very different from a short-term investment goal. Horizons can be short, medium, or long-term.
- Short term is ❤ years. You can not take chances and must invest in guaranteed securities like CD’s, money market accounts, etc.
- Medium term is 3-10 years.
- Long term is >10 years. This time horizon can include riskier investments.
3) Asset allocation: Asset allocation is the process of choosing among the various kinds of investment categories. Although there is no special formula, a good general rule of thumb is 100 – age = % to put in stocks or stock mutual funds.
Examples of asset classes include:
- cash (money market funds)
- real estate
- foreign currency
- natural resources
- precious metals
4) Asset selection: After determining the proportion of your portfolio that you would like to invest in, you need to decide on what exact stock, bonds, etc you will hold in your portfolio.
5) Diversification: Diversification means reducing your risk by investing in a variety of assets in which returns are not directly tied over time. That is, don’t place all your eggs in one basket.
By understanding these five things and managing your asset allocation/diversification strategy appropriately for your investing horizon and risk tolerance, you will have gone a long way in minimizing your risk of loss in a stock market crash.