If you invest too much, you may not be able to sleep at night; if you invest too little, you may not be able to reach your financial goals. By considering your present and future financial needs, you can begin to make strides toward your intermediate and long-term financial goals. Look closely at your resources, the economy, your risk tolerance and your future financial needs to determine your investment level.
Factors affecting your level of investment include your amount of surplus income, current economic conditions, your personal risk tolerance, your future needs and the expected return you want to receive.
Amount of Surplus Income
Your level of investment will be largely determined by how much surplus income you have each month after paying bills and setting aside a bit of cash for emergencies. The greater your surplus income, the higher your potential level of investment. If you do not have a lot of surplus income, your investment level will be restricted until your surplus income rises. Avoid investing so heavily that you have difficultly meeting your current financial obligations.
Current Economic Conditions
The economy affects everyone, and it can affect your level of investment. During tough economic times, household incomes may drop due to economy-related layoffs or cutbacks, resulting in a decrease in the funds available for investments. Alternatively, during an economic boom, your income is more likely to increase. If your surplus income rises more than your cost of living, you can afford to increase your level of investment without sacrificing your current lifestyle.
Your cost of living is at least partially dictated by inflation. Inflation occurs for multiple reasons, such as supply constraints or increasing demand for products, but regardless of the cause, it raises your cost of living. As everyday products become more expensive, if your income does not rise to compensate, the amount of surplus income you have to invest will decrease.
Personal Risk Tolerance
Not everyone has the same risk tolerance; some people are conservative, while others are more aggressive in how they invest their funds. Asset classes can also be categorized on a scale of risky to safe.
Stocks and commodities are considered riskier than high-grade bonds or T-bills, for example. This is because your return is unknown when you purchase stocks or commodities, but your return is known at the outset with bonds and T-bills. Your willingness to assume potential losses in higher-risk investments such as stocks, commodities and related mutual funds determines your investment level in each asset class.
If you have a low risk tolerance, most of your funds will be put into investments like certificates of deposit, T-bills, high-grade bonds and money market mutual funds. If your risk tolerance is high, more funds can be directed toward stocks and commodities. No matter what your risk tolerance, diversification is an important element of any portfolio.
Your Future Needs
Whether your future plans involve a new condo, new car or retirement to a lake house, addressing your future financial needs today allows you to plan for those moments. The more funds your future plans require, the higher your investment level needs to be now to reach that goal. Contributing less now is likely to result in having less money in the future.
The one wild card is the return you are able to achieve on your investments. When investing in stocks and mutual funds, you won't know in advance what your return on those investments will be. The return you achieve on those investments is a significant factor in how much your money grows and your ability to reach your financial goals.
Your Expected Return
A diversified portfolio contains investments that are safe and typically yield lower long-run returns, as well as higher-risk investments, which generally yield higher returns over the long run. As your risk level increases, so does the expected return of your portfolio, although expected return does not necessarily equal the return you actually achieve. Therefore, your willingness to accept uncertainty in terms of the return you will achieve directly affects how much you will invest in assets such as stocks and commodities.