For the beginner, there are three things you should consider before investing: risk tolerance, time horizon and diversification.
First, you need to determine the amount of risk you are willing to take and the amount of money you are willing to risk. Remember, the stock market makes no guarantees…you can and will lose money along the way. However, you do not need to be extremely aggressive. Risk tolerance ranges from conservative to aggressive, depending on your goals, the amount of time you have to reach those goals and your level of comfort.
Risk tolerance is defined as the degree of uncertainty that an investor can handle in regard to a negative change in the value of his or her portfolio. While the concept of risk tolerance can be complex for the new investor, it is best to begin with a realistic view. A higher-risk stock generally yields a higher return but is also more volatile in price. If you are young, inexperienced and have limited funds to invest for your retirement, your risk tolerance is probably low to moderate. Although you have time on your side, you must consider your limited knowledge and funds. It is a balancing act, not to be confused as an outright gamble. Further, I have known many financial advisors who advise their clients to invest in ways that allow them to sleep at night. Investing in the stock market should not keep you fraught with worry.
Risk tolerance is also associated with the Risk-Return Tradeoff when investing. Consider the following explanation of the tradeoff. Because of the risk-return tradeoff, you must be aware of your personal risk tolerance when choosing investments for your portfolio. Taking on some risk is the price of achieving returns; therefore, if you want to make money, you can't cut out all risk. The goal instead is to find an appropriate balance - one that generates some profit, but still allows you to sleep at night.
Time horizon is defined as “the length of time a sum of money is expected to be invested” and must also be considered when creating a financial plan. Since higher-risk stocks have more changes in price, it is best to invest in them only for the long term. If you need to your money within a year or less, you want to have it in a more secure, liquid investment.
For example, if your goal is to fund a retirement plan, you will need to determine what kind of lifestyle you want when you retire and how much money you will need. A good rule of thumb is to think of this in terms of the salary you receive now. What kind of ‘salary’ do you need from your retirement plan when you retire? Will you have a mortgage or a car payment? You will need to plan for other expenses such as health insurance and medication, as well as everyday living expenses. Remember to consider inflation, which is generally considered to be three percent for financial planning purposes. Consider the following scenarios: