Whether you are investing for retirement or for other financial goals, it's important to know what kind of investor you are. Every investor should be able to answer these three questions:
What is my tolerance for risk?
As an investor, you need to accept that some level of risk is inherent in all investments, and there will be ups and downs along the way. Your tolerance for risk—whether aggressive, conservative, or somewhere in between—determines how much growth potential you pursue with your investment portfolio. It's a fundamental principal that to earn a higher return, you have to be comfortable taking on more risk. So the question is: how much fluctuation in the value of your investments are you willing to accept, in exchange for the prospect of higher long-term returns?
Stocks have historically had higher risk but higher long-term returns than bonds or cash-based investments. If you choose to hold a high percentage of stocks in your portfolio, you should be willing to experience some volatility.
Bonds are generally less volatile than stocks but offer more modest returns. If you don't consider yourself an aggressive investor, then you might have a higher proportion of bonds in your portfolio.
Cash and cash equivalents, such as GICs and money market mutual funds, are the safest investments, but offer the lowest returns. The chances of losing money on cash-based investments are negligible, so they make sense if you're nearing a financial goal. But for a long-term investor, playing it safe with a higher percentage of cash in your portfolio makes less sense: returns may not keep up with inflation, and your purchasing power can gradually be eroded.
What is my timeline?
Your time horizon is the amount of time from now until you will need to access your investments. It's an important factor when considering risk and asset allocation. The key consideration is that the potential impact of market volatility is greater in the short term than it is over the long term.
For example, if you plan to borrow money from your RSP to buy a home within the next year, then you have a short-term time horizon, and safety of principal is paramount. You'll choose cash-based investments, even though the expected return will be low.
If you're building your RSP portfolio for retirement in 20 years, then you have a long-term time horizon. You can afford to be less concerned about short-term market volatility and choose growth-oriented investments.
Even if you're approaching retirement, your time horizon could still be quite long. Canadians are enjoying longer and healthier lives. Today, a 65-year-old is more likely than not to live well into his or her eighties. A typical retirement could last 20, 25 or even 30 years.
While safety of principal naturally becomes a higher priority at retirement, it still makes sense for most retirees to keep a portion of their RSP or RIF assets in longer-term, growth-oriented investments. In most cases, a balanced portfolio that includes equities, fixed income and cash makes the most sense.
How involved do I want to be in my investment decisions?
If you enjoy following the markets, researching companies, and learning how to evaluate the quality of individual securities, and you're able to spend the time required to monitor your holdings, then you can choose to build a retirement savings portfolio of individual securities.
If you prefer to spend less time evaluating and tracking investments, you can still maintain control of your self-directed portfolio by choosing ETFs, professionally managed mutual funds, or complete portfolio solutions.
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