Before making an investment decision you first should consider your objective behind that investment.
There are a 3 things one should consider as an investor to align ones investments with ones objectives. The first is your duration of investment; then how much risk can you tolerate?; and finally what is your desired yield?
Determining how long you are willing to keep your money tied up in an investment is an important part in making an investment decision.
If you're investing for your retirement and you just started your first job, obviously you have a longer investment duration than someone who is investing to save money for a car in 2 years.
Depending on your end goal, there are different levels of risk tolerance.
Let's say someone is looking to buy a new car in 2 years. And they are somewhat indifferent to whether it's an economy or luxury model, but they would really prefer the luxury model. Their risk tolerance would be higher than someone saving for a college in 2 years.
Here is a simple explanation of Duration and Risk Tolerance, also known as Risk Time Horizon.
Desired yield ties into risk tolerance. Increased desired yield also implies increased risk.
Since people are generally risk-averse, one needs a higher yield to take a higher risk. The markets show this as well.
How to Align a Portfolio With Your Investment Goals
Every investment vehicle can be easily categorized according to three fundamental characteristics: 1) safety, 2) income, and 3) growth which also correspond to the types of investor objectives mentioned earlier.
While it is possible for an investor to have a portfolio with more than one of these characteristics, the success of one must come at the cost of the others.
There is no such thing as a completely safe and secure investment.
However, the investment with the least risk is government-issued securities in stable economic systems. Another lower risk investment is purchasing the highest quality corporate bonds issued by blue-chip companies. Such securities are arguably the preferred means of preserving principal while receiving a specified rate of return.
Other investments with a lower risk profile are often found in the money market and include such securities as Treasury Bills, certificates of deposit, and commercial paper. They may also be found in the fixed income market in the form of municipal and corporate bonds. The securities mentioned above are listed according to the characteristic spectrum of increasing risk and, in turn, increasing possible yield.
To compensate for their higher risk, corporate bonds return a greater yield than Treasury Bills.
It is important to realize that there is a vast range of relative risk within the bond market. At one end are government and high-grade corporate bonds, which are considered investments with lesser risk. At the other end are junk bonds, which have a lower investment grade and may have more risk than some of the more speculative stocks.
In other words, it's incorrect to think that corporate bonds are always safe.
Growth of Capital
Capital gains are entirely different from yield in that they are only realized when the security is sold for a price that is higher than the price at which it was originally bought.
Selling at a lower price is referred to as a capital loss. Therefore, pursuing capital gains are for an investor who seeks the possibility of longer-term growth. It is not for those who need a fixed source of investment returns from their portfolio.
Growth of capital is closely associated with the purchase of common stock, particularly growth securities that offer low yields but sizeable opportunity for increase in value. For this reason, common stock generally ranks among the most speculative of investments as their return depends on what will happen in an unpredictable future.
Blue-chip stocks, by contrast, can potentially offer reasonable risk, modest income, and potential for growth in capital generated by long-term increases in corporate revenues and earnings as the company matures. Yet rarely is any common stock able to offer the reduced risk and income-generation of government bonds.
Depending on your duration you need to look at the liquidity of an investment, which means the time it takes to sell the security.
If the security is illiquid they cannot be immediately sold and easily converted into cash. Achieving a degree of liquidity, however, requires the sacrifice of a certain level of income or potential for capital gains.
Common stock is often considered the most liquid of investments, since it can usually be sold within a day or two of the decision to sell. Bonds can also be fairly marketable, but some bonds are highly illiquid, or non-tradable, possessing a fixed term. Similarly, money market instruments may only be redeemable at the precise date at which the fixed term ends.
If an investor seeks liquidity, money market assets and non-tradable bonds aren't as suitable to be held in his or her portfolio.
As you can see from each of the three characteristics discussed in this post, the advantages of one often come at the expense of another. If an investor desires growth, for instance, one must often sacrifice some income and increase one's risk tolerance. Therefore, most portfolios will be guided by a single objective, with all other potential objectives playing a less significant role in the overall strategy.
Choosing a strategic objective and assigning weighting to all other possible objectives is a process that relies on such factors as the investor's temperament, his or her stage of life, marital status, family situation, and so forth.
Of all the possibilities out there, each investor will find the proper mix of investment vehicles.
One should take time considering one's objectives before initiating an investment strategy.
After that, one should spend the proper amount of time and effort in finding, studying and deciding on the opportunities that match those objectives.