When building your investment portfolio, there are five time-tested principles that can help you enjoy a life of financial health and independence. However, a lifetime of successful investing also requires two things in addition to your portfolio: 1.) You need a cash reserve. A minimum of three months’ living expenses absorb costs and limit portfolio withdrawals when life turns unpredictable. 2.) You need a plan. Your investments should serve the broader financial plan - without a plan, you’ll never know how much is enough to retire with confidence.
THE 3 R’s
Every investment requires compromise among the three R’s...
Risk: The Potential For Loss
Reward: The Potential For Gain
Readiness: The Immediate Accessibility of Invested Funds
No investment provides the optimal combination of low-risk, high-reward and full readiness. You can always select one R, and often even choose from two R’s, but no legitimate investment option can provide all three R’s.
The Implication: Rank and choose your R’s differently for individual goals and accounts.
RISK IS MULTI-DIMENSIONAL
Risk is more complex than a simple measure of potential for loss. Risk has at least two dimensions...
Absolute: The Potential For Loss Is Measured In Dollar Or Percentage Terms
Time: The Character Of Absolute Risk For Any Investment Changes For Different Holding Periods
The Implication: A given investment becomes more or less risky as your ownership period increases or decreases.
RISK IS UNAVOIDABLE
Every investment, from the bank certificate of deposit, to the leveraged option, includes some type of risk. However, risk can take many forms...holding cash in reserve can result in diminished purchasing power due to inflation, or investments can result in reduced principal values.
The Implication: Consider which type of risk is most likely to harm your portfolio given your timeframe for withdrawing money.
RETURN IS COMPENSATION
The returns your investments provide should be viewed as compensation for your assumption of risk or accepting limits on the readiness of funds - or both.
The Implication: When comparing investment options, accept no uncompensated risk.
The investment profession has a number of tools designed to ensure that your portfolio’s relative risk level is “tolerable” but your ability to absorb or tolerate risk is often considered without reference to the portfolio mix required to meet your timeframe goals.
The Implication: The likely timeframe for when you need to withdraw your funds should determine which of the three R’s receives the greatest weighting.