Page 565 - Introduction to Business

CHAPTER 15 Personal Financial Planning 539

ment, remember that risk and return are a trade-off. As a rule, higher rewards are
earned only by riskier investments.
Practically speaking, investment risk can be defined as the probability that you investment risk The probability that an
will lose all or part of your investment. In general, the greater the potential return individual will lose all or part of an
investment
on an investment, the higher the risk. How well a person predicts the future is an
important factor in determining the risk involved. The further in the future a return
is expected, the greater the risk involved, since it is hard to predict the future with EXHIBIT 15.8
any degree of certainty. The shorter the time horizon, the less the uncertainty Investments and Relative
involved, so the lower the risk. The more variable the rate of return, the greater the Risk
uncertainty.
Many people are risk averse, meaning that they prefer investments with Highest Risk/
low risk. How much risk can you tolerate? The greater the risk involved, the Highest Return
greater the potential compensation, but also the greater the chances of loss.
Insured certificates of deposit (CDs) and T-bills are the least risky investments • Exploratory drilling
and have low levels of uncertainty. Exploratory drilling for oil and futures con- • Production funds
tracts are risky investments; they involve a great amount of uncertainty. Exhibit • Commodity futures
15.8 shows a number of possible investments and their relative risk. • Collectibles
• Undeveloped land
• Investment real estate
Managing Investments • Put and call options
• Junk bonds
Investing today to accumulate money for future needs is at the heart of finan-
• Oil and gas participation
cial planning. An important consideration before deciding if you should
• Precious metals
manage all or part of your investments is whether you have the time neces- • Common stocks
sary to do so. Managing your own investments requires that you read and • Mutual funds
analyze daily all information that concerns your investments. Being your • Corporate bonds
own investment manager requires time and a sound basis for your invest- • Variable life insurance
ment decisions. • Variable annuities
You must decide how to divide your money among stocks, bonds, real • Municipal bonds
estate, money market funds, and other investment instruments. This process • Government securities
is called asset allocation. The amount you decide to put into each type of • Non-variable annuities
• Homes
investment has much to do with individual goals and objectives. Asset allo-
• Money market funds
cation can have a major impact on your total portfolio return. Asset alloca-
• Treasury bills
tion is more critical than specific stock selections. A diversified portfolio is
• Certificates of deposit
one asset allocation strategy, and a diversified portfolio enables you to with-
• Guaranteed life insurance
stand market volatility with less risk.
• Series EE and HH bonds
A key consideration in developing your portfolio is your time horizon. • Savings accounts
Your time horizon refers to the number of years you have to achieve your • Checking accounts
financial plan. Developing your portfolio requires you to consider your time • Cash
horizon, where you are now and where you want to be in the future, and your
reasons for investing. These considerations are determined by your age, Lowest Risk/
annual income, family make-up, future financial obligations, and need for Lowest Return
liquidity. For example, the portfolio allocations of a newly married couple in
their twenties with no children, a couple in their early forties with two teenagers
soon to be entering college, and a single individual at age 55 should be substantially asset allocation The process of dividing
different because of their different time horizons and financial goals. one’s money among stocks, bonds, real
estate, money market funds, and other
Equity investments should be allocated among the major sectors of the econ-
investment instruments
omy. These sectors include the automotive, banking, computer, energy, industrial,
time horizon The number of years an
pharmaceutical, retail, and utility industries. If you are employed by a firm in one individual has to achieve her or his
industry, don’t be afraid of investing in competitive companies that you know are financial plan
well managed. Be cautious about investing too much in your employer’s stock. If
the company in which you work fails, you could lose both your job and your
investment.

Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.