Good fundamental investing is all about maximizing return while minimizing risk. To do so requires an understanding of your financial objectives and your risk tolerance. You should also understand the historical returns of different stock and bond portfolio weightings.
The historical returns for stocks is between 8% – 10% since 1926. The historical returns for bonds is between 4% – 6% since 1926. Both asset classes have performed well over time. However, going forward, many investment houses are expecting lower returns.
The key is figuring what combination works best for your risk tolerance and financial objectives.
Write out your specific financial objectives on a piece of paper or in a word document. Some common financial objectives include:
To determine your risk tolerance, simply ask yourself how much you’re willing to lose in your investments before needing to sell. If you never plan to sell because you know the stocks and bonds have generally gone up and to the right for decades, perhaps you have a high risk tolerance.
If you plan to take profits if the stock market is down 20% or more, then perhaps you have a medium risk tolerance.
I’ve come up with the Financial SEER methodology to properly quantify your risk tolerance. The model is based on how many months you are willing to work to make up for potential stock market losses. The older you are, the less time you are willing to waste.
Just know that whatever you think your risk tolerance is, you’re likely overestimating your risk tolerance. When people started losing big money during the 2008-2009 financial crisis there was mass panic because they were also losing their houses and their jobs.
Then in March 2020, during the height of the coronavirus hysteria, many newbies who had never experienced a downturn before sold stocks. Knowing your risk tolerance is important. So is knowing the historical returns of different stock and bond portfolios so you better know what to expect.