How to Analyze Risk Vs. Return With Personal Money Management Software
An investor's tolerance for risk helps to determine the types and amounts of investments she makes. In general, riskier investments provide a higher return, because investors demand more compensation for taking higher risks. Personal money management software has features to show you the risks as well as returns on your investments. It also can provide suggestions for changing your risk profile.
Just about any money management software allows you to track a portfolio and download online quotes. A good software package shows you, graphically and in report form, how your portfolio has performed over time. This information helps you figure out when to sell a security to lock in a gain or remove underperforming investments. The software also provides historical trends to show how your current performance stacks up against that of previous years.
Diversification and Asset Allocation
The way you allocate assets to your portfolio plays a decisive role in your risk and returns. A well-diversified portfolio -- in which you hold an array of stocks, bonds, mutual funds and other investments -- lowers the risk of suffering a major loss from a punk investment, because you've limited the amount you invest in any one security. According to certified public accountant Hunter Nottingham of Atlanta, "With the uncertainty in our world economy, having a diversified portfolio is as important as ever. If you get too caught up in one type of industry or one type of investment, you could end up either putting yourself at too much risk of loss or missing out on earnings potential in an area you neglected to invest." The most useful money management software displays your current asset allocation, allows you to set a target allocation and suggests different allocation schemes based on your risk profile. It should also reveal the expected risk and return of your current asset allocation versus that of a target, so you can see whether your expected return is high enough and doesn't carry unnecessary risks.
Your risk profile is based on your investment time frame, your primary goal -- such as capital growth, preserving capital or staying ahead of inflation -- and your ability to tolerate risk. Typically, money management software allows you to enter your risk profile and respond by displaying an appropriate asset allocation, along with its expected return and standard deviation, which is a measure of risk. A helpful feature of better software products like Quicken is the chart generated that shows the standard deviation of your portfolio and that of key asset classes, such as large-cap, small-cap and international stocks, as well as bonds and money markets. It also gives specific recommendations for how much to buy or sell in each asset class to achieve your target allocation.
An important activity in determining return is accounting for tax effects. Says Nottingham, "Whether you're investing in your primary account or a tax-deferred investment plan, you need to know exactly what type of tax implications your investment will incur. This way, you can optimally allocate funds to better increase your overall rate of return." Money management software reports basic tax-related information, including your tax bracket and the split of your investments between short- and long-term holdings. When you sell long-term holdings as compared with short-term holdings, your capital gains taxes are lower, which makes your after-tax return higher. Full-feature software estimates your potential capital gains tax bill from the sale of a security, indicates how to offset the gains with current and carryover losses and suggests security sales to generate the cash you'll need to pay the taxes.