After reading the comments on my portfolio post from yesterday (and being amused as to how they point in different directions), I wanted to point out one key part of my philosophy on risk.

Whenever I wonder if an investment is too risky or not, I ask myself this: would five negative years in that investment alter my current way of life? If the answer to that is no, then I’m willing to invest in more risky things; if the answer is yes, then I get pretty conservative.

Let’s look at a couple of examples to see how that applies.

Saving for retirement Right now, I’m about thirty years from retirement. If the market now has five consecutive bad years, it’s not great, but it’s okay – I wouldn’t have any significant changes in my current way of life because I know that retirement savings for me is for the long haul.

However, I do recognize that a solid nest egg is vital, so my answer to the question with regards to retirement will slowly slide towards “yes” as I grow older. As the answer slides, so will my portfolio towards more conservative investments.

Saving for a “dream home” This idea of a “dream home” is just that – a dream. I’m not investing money in this account that is needed for me to live – it’s money that I’m setting aside for a potential “someday.”

What this means for the investment is that I can be as aggressive as I want. It is not a life-altering situation if the market goes down for a few years – in fact, I’ll view that as a buying opportunity. The only thing I really hope for is a few years of growth after those down years, because my investments will skyrocket.

The real key is to understand what your goals are. Why are you investing, and will bad returns on that investment negatively affect your life? If you can’t answer those questions, you’ll likely not make strong investment decisions.