Basic Investment Theory Explained

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The S&P 500 Index dropped more than 40 percent between March 2000 and March 2003, and almost anyone who entrusted their retirement savings to the bull market of the late 1990s saw their portfolio shrink, often in dramatic fashion. Now that the stock market is regaining some of its lost value, should people return to their bull market strategies for double-digit annual returns on their retirement savings?

In spite of the large fluctuations in the market, most investment advisors still offer the same guidance: consider both risk and return, determine one’s tolerance for risk and reassess this tolerance periodically, and diversify the share of funds allocated to risky investments. These rules of thumb are effective because they are based on widely-accepted results of economic and financial theory. In fact, theory emphasizes that the typical investor should focus primarily on one decision: how much to invest in risky assets. This brief explains why.