Finding the Best Investment vs. Finding the Investment That’s Best for You.

When choosing an investment for a portfolio, investors often focus on return or reward. We hear questions such as “what is a good stock?” And “what is a good mutual fund to own?” Interestingly, when choosing an appropriate vehicle, deciding which particular asset to own is the last step in the five step financial planning process.

First, start with defining your goals. Are they short-term, such as saving for a house, building an emergency account or buying a new car? Or are they long-term, such as saving for retirement or leaving an estate to your heirs? If you are like most investors, you have a combination of short, intermediate and long-term goals.

Step number two is assessing your risk tolerance. Risk can mean loss of principal or less-than-expected returns. Risk can also be defined as volatility or price fluctuation over a given period of time. Understandably, risk tolerance can be very difficult to measure. By nature, we are not comfortable when our investments drop in value. However, owning investments that go both up and down in price usually has a place in most investors’ long-term strategies. Factors to consider when determining your risk tolerance are your age, time horizon and stated goals and objectives. For example, a short time horizon is probably best served with a conservative portfolio that emphasizes preservation of principal. On the other hand, the more time you have to invest, the greater the risk you may want to assume because you have time to recover from market downturns.

Step three entails determining which asset classes are appropriate and how much money should be allocated to each. In general, there are three major asset classes: stocks (growth), bonds(income) and cash (safety). The overall mix of asset categories will have more impact on your total return than the particular investments you own. For example, a portfolio comprised of 100% cash assets (i.e., savings accounts and money market funds) will likely give you a return that is close to inflation rates. Since the early 90s, this is approximately 1% - 4%. At the opposite end of the spectrum is a portfolio comprised of large capitalization stocks, which have historically returned approximately 10% per year. Stock A and Stock B, if in the same category, are not likely to have widely varying returns over time. However, either stock will likely perform very differently than a savings account over that same time period.

Mutual funds are an excellent tool that allows investors to more easily balance risk. By prospectus, mutual funds have a stated objective which can be matched to an investor's goals while allowing him or her to minimize risk. For example, if your long-term goal is growth of principal to achieve a comfortable retirement in 15 years, a well-diversified stock mutual fund is likely to be a good fit. Because mutual funds pool investors’ assets, they can invest in many companies across various categories and countries to help reduce risk to investors.

The final step is to select the appropriate investment. With more than 22,000 mutual funds available, it is much easier today to choose a savings vehicle that allows you to own growth-oriented assets with lower risk. Investors can easily own a portfolio of mutual funds that have different objectives, allowing even a relatively small amount of money to be well-diversified. Owning investments that perform differently in the same economic scenario is what gives a portfolio diversification.

So, the next time you go looking for a hot button investment, fight the urge to find the next Microsoft or Google. Taking the steps outlined above will make sure your selection has a place in your overall financial plan.