When I signed up for a retirement savings plan at work a couple of years ago, I had to answer a question: was I an "aggressive" investor, or was I a bit more nervous about putting all my eggs into a very shaky market? Or, on the other hand, was I conservative to an extreme, comfortable only with taking small and temporary losses in a bond portfolio? Those used to be the kinds of questions regularly posed to new investors by brokers, financial advisers and legions of retirement advisers to clients. You would fill out a questionnaire and then be pigeonholed neatly into one of three portfolios (or a combination for fine-tuning) that reflected your level of investment aggression. The whole exercise was meant to prod deeply into that ever-elusive characteristic: your appetite for risk.
While risk appetite remains an important facet of everyone's financial life, the thinking about investing based on risk is rapidly changing. Nowadays, investment firms and financial planners are realising that your time horizon and your goals, not just risk, are the best criteria from which to judge how you should allocate your investments. That approach makes tons more sense. Think about it: If you are investing to put a down payment on a house in 10 years, and you would have to earn 12 per cent per year on your investments to make that happen, you will not get there if you are labelled as "conservative" and can tolerate only a portfolio of bonds that returns three to four per cent a year. Likewise, if you want to retire in 20 years and have not started saving yet, you will not get there if you are overly skittish.
Knowing how much risk you can stand can help you gauge whether you will flee the market at the first sign of a downturn, but it cannot solve any real-world problems. So if you have been put into a portfolio or given an asset allocation based on risk, take a second look. Re-evaluate where you stand, based on where you want to be in five, 10, 20 or even 40 years, and you may be surprised - either that you are taking more risk than you need to or not nearly enough.
The best way to make the assessment: run a simple calculation. If your time horizon (the period after which you plan to spend the money) is a long one - 10 years or more - assume an eight per cent annual return for stocks and roughly half that amount for bonds. Begin with what you have now, add to the mix what you plan to contribute each year, put in a predicted return based on an assumed allocation to stocks and bonds and, voila! You have a pretty good idea of how much cash you will have at the end.
OK, OK, maybe that calculation is not such a cinch. Unless you happen to be a spreadsheet ace, it would probably take hours to churn out. Happily, there are a number of online calculators that will do all the work for you in seconds. Take, for example, the calculator at moneychimp.com/calculator/compound_interest_calculator.htm. Just type in all the relevant variables, hit the "calculate" button and you're done.
Here is an example of how this goal-orientated analysis can work for you: Say I want to buy a house in the UK in 10 years' time and I have started saving and investing to do that. I now have a portfolio worth £12,000 (Dh87,000). I know the kind of house I want - it's in Ilford and costs roughly £350,000 - and I also know how much I can save per year: £3,000. Now let's assume the house's value will go up in 10 years (that may seem like a big assumption now, but a 10-year slump in house prices is unlikely). This will put it at, say, £380,000 when I want to buy. Ideally, I will want a down payment of 20 per cent of its value, or £76,000. You can put down 15 per cent or less, but if you go below 10 per cent you will have to pay for mortgage insurance and a nasty "higher lending charge" that should be avoided at all costs. There is also a fee of about £800 for arranging the mortgage and a land registration fee of £200 or so, so I'll budget in an extra £1,000.
All told, I hope to have £77,000 in 10 years. Putting this information into the aforementioned calculator shows that with £12,000 saved and £3,000 annual contributions, I will need a return of a little over eight per cent a year to reach that goal. That means I need to invest most of my money in stocks; bonds will not get me there. If I were to put everything in bonds and made three per cent a year, I would wind up with just £51,550. I may not be happy about taking risks, but in this case I may have to.
Investing, at least for most of us non-Warren-Buffett types, is a practical matter. It is usually not a quest to become multimillionaires (or, in Zimbabwe, where inflation stands at over two million per cent, gagillionaires). That is why goal-orientated thinking, more than just considering how much risk you are willing to take, is crucial. You may be squeamish about risky plays in the market, but sometimes you must go beyond your comfort zone to get what you want.