LESSON 1: Building a Solid Foundation

Investing successfully is more about attitude than about money. Even an imminent
inheritance and a good-paying job offer little hope of financial success without a
positive, constructive attitude that leads to a rational, systematic investing approach.
The solution to avoiding a stressful retirement and enjoying financial freedom starts
by examining your attitudes. With a thorough self-assessment under your belt, you can
begin learning sound investment fundamentals.

Profit by Understanding the Risk and Return Relationship

What is something you do really well -- better than most people? Whatever it is, your
special skill or knowledge is probably characterized by two critical attributes:

 It's rewarding. Whether the reward is financial or simply the satisfaction of doing
something worthwhile, you profit by it in some way.

 Developing your special skill or knowledge required some type of sacrifice.

Investment reward is called return. Return is the financial benefit of risking your
money in the market. It is expressed as "rate of return." Investment sacrifice is called
risk. The essence of investment risk is the chance you take that the value of your
investment will decline. Investment risk is usually expressed in terms of volatility in
the value of the investment. The value of some investments, such as government
bonds, does not change much, so the chance of losing money is slight. On the other
hand, the value of stocks issued by many Internet companies rapidly rises and falls
and may not recover. After analyzing your personality and grasping the concepts
behind risk and return, you are ready to tackle the one simple fact that underlies the
importance of investment risk and return: they are both positively and linearly related.

In order to earn higher returns, you have to assume higher risk. If you are unwilling to
accept high risk, your returns will be relatively low. In the long term, all investment
securities and portfolios operate this way. The key to successful investing lies in a
plan that is not only well thought-out and consistently applied, but one that accounts
for and manages risk as well. A risk management plan expresses your personal
tolerance for risk in terms of the kinds of investments you should own.

Assessing Your Risk Tolerance

Your risk tolerance is about personal preferences and goals. The cornerstone of a
consistently applied risk management plan lies in an assessment of your own tolerance
for risk and volatility. This leads to an investment plan reflecting both your
personality and tolerance. A thorough risk tolerance assessment taps two key
attributes: cash flow needs and your attitude about short-term fluctuation in the value
of your investments. Cash flow is money coming in and then going out for expenses.
If you depend on investment income to fund your cash flow, your investments should
include safe stocks and bonds paying high dividends and interest. If you depend on
employment income to fund your cash flow, you can invest in riskier, low-income
stocks and bonds with greater potential to grow in value over the long-term.

Your financial obligations and preferences determine cash flow needs. If you are
approaching retirement, you may not currently have large cash flow needs. But upon
retirement, your income source may shift from salary to earnings on your investments.
It is at this moment when knowing yourself becomes extremely important, since you
will be able to anticipate your reaction to seeing the value of your portfolio take
occasional dives and experience long periods of no growth. By anticipating your
reaction, you'll be prepared either to adjust your investment strategies or to sit back
and ride out the storm.

Matching Reward Expectations with Risk Tolerance

If stock prices rise, it means the market believes profits will rise at roughly the same
rate. In the long run, the economy cannot grow fast enough to sustain high double-
digit profits. Therefore, stock prices could not sustain the high double-digit returns we
witnessed in some recent years.

A reasonable long-term return expectation hovers between 8 and 10 percent if the

investor's risk tolerance permits allocating 60 to 80 percent of the portfolio to stocks
and the remainder to fixed income investments. Investors with lower risk tolerance
should expect less of a return.

It can take both discipline and foresight to put money in low-risk investments.
Nevertheless, a mismatch between realistic expectations and risk tolerance is a sure
formula for disappointment. A well-conceived risk management plan matching risk
tolerance and realistic expectations can prevent disaster while yielding respectable
long-term returns.