Smart Investing Begins with the Basics
Let's say you're shopping for a new car. At the dealership, the salesperson asks you a series of questions. Two doors or four? Manual or automatic transmission? Leather or cloth interior? By understanding each option and pinpointing your preferences, you'll be more likely to drive off in the vehicle that best suits your tastes and needs.
Choosing your investments follows this same principle. Understanding basic investment concepts helps you to make educated decisions about where, when, and how to invest your money, allowing you to create the vehicle that best meets your needs.
Basic Concept #1: Compounding
Receiving compound returns on your investment is one of the most powerful ways to build wealth. In the financial realm, the term "compounding" means your interest earns interest. So, the longer you save, the more your money compounds and grows.
Consider this hypothetical situation: Ava starts contributing to an IRA at age 25. She invests the maximum annual amount of $5,000 for five years, making a total contribution of $25,000. Cory, on the other hand, waits until he is 35 to start investing $5,000 annually into an IRA over a 10-year period, making a total contribution of $50,000. At the end of a 30-year period, Ava has accumulated assets of $216,957. Cory, who has invested twice as much and twice as long, has only accumulated assets of $168,887. This shows that by getting a head start, you'll see considerably larger returns on your investment.
Basic Concept #2: Inflation
When reviewing your investment strategy and estimating your future expenses, be sure to take into account the effects of inflation. Over time, a gradual increase in the prices of goods and services reduces your purchasing power and standard of living. When considering that the rate of inflation has been approximately 3% since 1926, we can predict that today's dollar will only be worth 97 cents next year. In two years, it will be worth just 94 cents and, over 30 years, only 41 cents.
Although there's no guarantee that future price increases will be exactly the same as previous years, it's a good idea to use historical rates of inflation as a benchmark when creating an investment plan to cover your future expenses.
Basic Concept #3: Asset Allocation
In today's fluctuating stock market, every investor needs some expert guidance in asset allocation and diversification. The basic strategy of diversification involves spreading your dollars among stocks, bonds, and cash to minimize the risk of placing all assets in any one single investment. Asset allocation takes diversification one step further, determining how your money should be divided among the various funds. Through asset allocation, you can pursue an investment return consistent with your goals, timetable, and risk tolerance.
It's also important to gain a basic understanding of the main asset types:
Stocks: Publicly owned companies issue, or sell, stock to raise capital for their business. When you buy stock in a company, you become a shareholder in that company. Some corporations also pay dividends, which are a portion of a company's profits paid to investors. Many stocks provide the potential for growth through both price appreciation and income from dividends. If a publicly held company does not perform well, its stock may decrease in value.
Bonds or Debt Investments: When you buy a bond (or debt investment), you're lending money to a corporation or government entity for a specific period of time. In exchange for the use of your money, the issuer of the bond promises to provide regular income payments in the form of interest at an agreed-upon rate and timetable. Bonds are often referred to as fixed-income investments, because the terms of interest rate and life span are set when the bond is issued. Because their value shifts conversely to changes in interest rates, bonds are considered to be less risky than stocks but riskier than cash. Investors are compensated for this risk with the payment of interest and, to a small degree, a potential capital gain. Bonds will vary by such factors as the organizations that issue them, their credit quality, and their maturity (life span).
Cash: Also referred to as cash equivalents or money-market funds, this type of asset carries the least amount of risk. Money market funds invest in such instruments as U.S. Treasury bills, certificates of deposit, savings deposits, and short-term corporation debts. Low-risk cash assets are often valued at a fixed price of $1.00, and thus have low potential returns. Typically, the underlying securities that make up a cash or money market fund are short-term in nature, often held less than 12 months, and are considered very liquid. Income is generated with these investments in the form of regular interest. Although these investments carry a lower risk, they offer little long-term growth reward, and also may not keep pace with inflation. A cash or money market fund may be appropriate for an investor who wants to avoid the volatility of stocks and bonds.
Basic Concept #4: Mutual Funds
Building a portfolio with individual securities can be time-consuming. For a quicker, more economical option, consider choosing mutual funds to carry out an asset allocation plan. Mutual funds add instant depth to a portfolio by investing in dozens or even hundreds of different securities within each asset class. (Keep in mind that investing in mutual funds does involve risks, including loss of principal.)
Follow Your Plan
As an investor, it's important to always keep your long-term financial objectives in mind. Understanding the basics of investing can help you avoid potential pitfalls, like chasing last year's highest return or pulling out of the market prematurely during an economic downturn. Review your investment strategy periodically to determine whether your personal circumstances warrant a shift in your approach. To get the most benefits out of diversifying your portfolio, be sure to consistently reallocate your assets to maintain their\desired balance between stocks, bonds, and cash holdings.
Your timetable and risk tolerance will likely change as you get older. Re-balancing your portfolio on a regular basis will help keep it current with market conditions and your shifting financial goals.
Remember, when it comes to investing, it's not about where you start, but how you finish.
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