It’s GO time! Let’s choose investments.
Historically, when you pick investments, you want to have a portfolio that fits your risk tolerance….but as you know, we start with the return you NEED and THEN we see if we can make that fit your risk tolerance. I’ll show you how we’ll manage risk and returns today. It’s going to be fun.
So, you know the return you need for your goals. If not, it’ll be impossible to complete today’s work. Go back and do that first.
Assuming you’re still reading, let’s head back to Morningstar and find investments that fit.
Open up Morningstar.com.
The exercise we’re going to do today requires you to register for Morningstar. There is no fee, and you can uncheck the “send me stuff” box. I’ve been a member forever and had to remember my membership name because I rarely use it. Seriously, it’s been five years since I logged in.
However, Morningstar won’t let us use this free tool if we don’t register.
Once you’ve registered, click the “Tools” tab on the grey line of buttons across the top of your screen. You’ll find Tools near the right-hand side.
Scroll down to “Portfolio Management” and click on “Portfolio Planner.” If you don’t have Silverlight loaded, it’ll ask you to do so. Then it’ll bring up the Morningstar Portfolio Planner tool.
We’re going to use this backward. Instead of solving for a goal, we’re going to find the mix of investments you need for the return you want.
Fill in the box with the number of years until you reach your goal.
Ignore the other boxes.
Click on “Moderate” across the top and look at the numbers on the bottom right of the screen.
You should see “expected annual return” and “annual volatility.”
What do these mean?
Expected annual return is the return you should expect as a median over the course of your investment’s life.
Annual volatility is where we see how much risk you’ll need to accept. I’ll explain that more fully in just a moment.
Click on buttons across the top until you find the return you need to reach your goal in the “expected annual return” area.
Now, for the first time, we’ll consider risk.
I’m looking at a goal with a return of roughly 9.5%. However, the risk associated with it is about 16.25%. What does that mean?
It means that 66% of the time (the whole 66% thing is for another class…) your returns could be within 16.25% of that number. So, 2/3 of the time you’ll have returns that will be anywhere from 25.75% and -6.75%.
Worse yet? The other third of the time your investment will return OUTSIDE of those parameters.
If you just said “Wow” to yourself, you’re right. This investment mix screams volatility.
But there’s a bigger question. How do you feel about losing 7% of your money in a year? Are you okay with that? Let’s double that number for the “outlier” year. What if you lost 14% of your money? If you don’t think you can sleep with that rollercoaster, it’s time to back down the risk you’re taking…
…and that’s how you decide whether your risk tolerance is met or not.
(Of course, if you DO back down the risk tolerance, remember to go back and adjust your savings or your goal on your timeline and your four cornerstones).
Okay! Now you have your investment mix! The one I picked (9.5% return) says that it will take 95% stocks and 5% bonds to reach my allocation.
95% stocks? Okay….where do I go from there?
That’ll be in the next lesson!
Solidify the return you need on your investments using this Morningstar tool.