Learning To Invest Summary Instead of settling for a well known index, create your own index which is tailored to your risk tolerance.

Accessing your risk tolerance is the key.

Look to the past to see how volatile different asset classes can be.
What's Your Limit
Recall, from the last tutorial, the benefits of index investing in efficient markets like the US. Many investors realize this, as demonstrated by the size of some index funds, especially the prominent Vanguard S&P 500 fund. However, many investors fail to realize that indexing is not limited to existing indexes, which might be mismatched for you. Why not create your own index, or basket of stocks, bonds, and mutual funds which accurately reflects your risk preferences? The problem then becomes which securities to include out of the thousands available. The key lies in assessing your own risk tolerance, that is, your sensitivity to seeing your hard earned money go down the drain when the market declines. Indexing relies on your discipline to stick out any downturns in the market, so you must determine how much you can stand losing before you sell out. There are several ways to accomplish this. For example, look at the past volatility of different asset classes; treasury bonds, corporate bonds, high yield bonds, small, mid, and large-capitalization stocks, and foreign equities. By examining the track record of each you can predict your reaction to typical declines. For example, the summer of 1998 brought a 20% decline in the price of large-cap stocks in just a few days. Ask yourself if you could stand it if your retirement fund loses a fifth of its value in one month. If so, look at the next riskier class, mid-cap stocks and so forth. Check out our risk line to see what to expect, and for definitions of mid-cap, large-cap, etc. Find the riskiest level you can withstand and invest at that plateau. After all, risk is what you are paid for, so you want to maximize it within the constraints of your preferences. Finding the best level is often difficult for a new investor, so side on the conservative side initially. Then if you find yourself nervously checking the stock market on a daily basis, consider putting future investment dollars in even more conservative vehicles. Conversely if the movement of your portfolio seems so dull that you don't even bother opening your quarterly statement, put future dollars in more aggressive vehicles. To further help you identify your level, we present a series of "scenarios" for you to compare your situation with.

At this point, you know what types of securities you should invest in, however many questions remain unanswered. Should you buy just one security in this asset class? How should you divide your money? This is where diversification comes into play.
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