When developing a financial plan, whether it be investing in mutual funds, Exchange Traded Funds (ETFs), or individual stocks and bonds, it is important to think about the following eight factors:
- Financial Goal: What do you want to achieve?
- Risk Tolerance: How much risk are you willing to accept? Generally, the level of risk you are willing to assume affects the level of returns you can achieve.
- Diversification: This is related to risk tolerance. Having a diversified portfolio can reduce the risk level of a portfolio. If you hold only one investment and the price falls 50% your portfolio is down by half. If you have two investments of equal value and one falls 50%, your loss is limited to one-quarter. Diversification reduces the effect of any one winner or loser in your portfolio.
- Time Horizon: When will you need to access the money? Over the long term, stocks provide a higher return than bonds and cash vehicles (e.g., CDs, money markets). However, in a given two or three year period, stocks may underperform. Therefore, if you think you'll need the money in one or two years, stocks or stock mutual funds may not be the best investment.
- Liquidity: This is related to the item above. Do you need quick access to the cash and preservation of principal? If so, you should consider cash vehicles.
- Tax Consequences: Do you have a high marginal tax rate? If you do and you invest in mutual funds, you might want to invest in tax efficient funds (see Turnover and Fund Returns) or municipal bonds or funds (as an added bonus, most are structured to avoid the Alternative Minimum Tax (AMT).)
- Management Effort: How much time can you invest in managing your assets? How much time do you want to invest?
- Interest Rate Cycle: What is going to happen with interest rates? While you probably don't know what the Fed plans to do with rates, by watching the direction of movement (i.e., increasing, decreasing, or flat), you can determine whether long- or short-term bonds provide the better risk-adjusted returns.
For more information about financial planning, see TD Waterhouse's Planning Suggestions and Financial Planning Tools.