Before we dive into the deep end of what the big words in the title represent, if you missed my blog post about the first step of the AAII PRISM Wealth-Building Process, you can read it here.
PRISM is a five-step method for aligning my investment decisions with my goals, created by AAII Journal editor Charles Rotblut. The second step of PRISM contains nine lessons and three worksheets for discovering my risk tolerance for each of my investing goals and how I need to diversify my investments to correlate with the level of risk I can handle.
Charles discusses many types of risk, but the most important seem to be financial and psychological. How much money and sanity can you handle losing on your investments? But risk isn’t just about losing money, it can also lower the purchasing power of the money you already have. This was an argument I heavily relied on when I opened two high-yield savings accounts instead of letting thousands of dollars sit pretty in my joke of a regular savings account. The interest rate on regular savings accounts is far too low to keep up with inflation, so over time that money has less value.
Though risk sounds like a bad thing, Charles says that some risk can be an opportunity if you know how to use it right. For instance, when the market is down (like it was for most of last year) that lowers the price of investments, which in turn gives individual investors more options to buy stocks and funds at a discount.
The Assessing Your Risk Tolerance worksheet can be used for each of my investing goals that I outlined in my walkthrough of PRISM Step 1. For instance, my risk tolerance for retirement is high due to the long-term timing of the goal.
Allocation is the other big word in this step; it refers to how your portfolio is divided among different classes of investments. These include stocks, bonds and cash. AAII has three asset allocation models for different goal time horizons that correspond with how to diversify your investments for each goal.
With my retirement’s long investment horizon, it lands me in the aggressive investor column. This correlates with an allocation of 10% to fixed income, or bonds, and 90% to diversified stocks. My retirement portfolio is 100% invested in stocks, but I think it’s still too early in my investing journey to add bonds to the mix. I will need to do a lot more research before I feel comfortable investing in something I currently don’t understand.
I can apply these lessons to each of my investing goals to ensure that the allocation I have in place supports the investment’s time horizon and level of risk.
Follow along with me as I venture through the PRISM Wealth-Building Process and solidify my financial plan for the future!