Lay out a course of action before you invest

Creating an investing plan may sound complex, but it can really be very simple. It starts with your goals and your tolerance for risk.

Set your goals.

If you haven’t done it yet, set your goals. Write down both your short-term and long-term goals. And make sure they’re realistic and actionable.

These goals—and the time you have to achieve them—play an important part in your investing plan.

Think about risk.

The reality of investing is that markets go up—and they also go down. Virtually any investment involves some level of risk, so it's very important that new investors understand how they feel about risk. This will help you decide if you want to invest more conservatively, moderately or aggressively. The investor profile questionnaire (PDF) can help you figure out your own risk tolerance.

Deciding how much risk you're willing to take is one of the first and most important steps. As the following chart shows, investments that have the greatest potential for return also carry the greatest risk.

Consider how time affects risk.

The amount of time you have to invest helps you decide how much risk is right for you. The longer you have to reach your goal, the more aggressively you may want to invest. That’s because you have time to recoup any potential short-term losses from the natural ups and downs of the market. As your goals get closer, you may want to shift to more stable (or conservative) investments.

A general guideline

If you’ll need your money in:

• Three years or less—You shouldn’t be investing in stocks. They're just too volatile. Consider cash investments like money market funds or CDs instead.
• Three to five years—It may be appropriate to invest as much as 60 percent of your money in stocks (depending on your risk tolerance), with the balance in bonds or cash equivalents.
• Five to 10 years or longer—You can add more stocks to the mix.

With a plan in place, you can now decide how you want to divide your investments between stocks, bonds and cash—your asset allocation.

What type of return can you expect from stocks and bonds over the long term? Recent research estimates that over the next 20 years, average annual returns will be:

• About 7.4 percent for large-cap stocks
• About 8.7 percent and 7.4 percent respectively for mid- and small-cap and international stocks
• Approximately 3.6 percent for bonds

While there’s no guarantee, you’ll want to factor these return estimates into your long-term plan.