The Big Picture
Before you even think about investing, you should have some basics in place. If you have credit card debt, get rid of it before diverting money to investments. Why put your money into an investment with a low or uncertain return when you can immediately earn 15 percent to 20 percent by paying off the balance on your high-interest credit card? If you don't have an emergency fund that would cover three to six months of basic expenses if you lost your job or became unable to work, establish one before tying up your cash in investments. If you're not taking advantage of company matching in your employer's 401(k) plan, you're ignoring a great opportunity. You're never too young to start saving for retirement, and a 401(k) is the best way to do it. Not only do you postpone taxes on your earnings, your employer probably matches some portion of your contribution.
If You're Ready
Once you have these three basics taken care of, you're ready to start investing. If you allow yourself to be intimidated by the complexities of the stock market, you'll miss out on the benefits of one of the best investments available. Forget about gold, futures, options, puts and calls, and all those confusing terms you hear bandied about by news analysts. The average investor never deals with them. You're probably not going to be making a living as a stock picker or day-trader, either, and hopefully you won't be throwing your hard-earned money into high-risk investments.
Keep the Goal in Sight
Your overall investment objective is to create wealth. If you've read Chapter 1, you've already thought about the specific things you'd like to do with your money. You may want to save for a down payment on your first house, finance your kids' college educations, go on a luxury vacation, provide for a comfortable retirement, or achieve any number of other objectives. Investing is nothing more than a means to an end (reaching those goals), so don't get caught up in the hype and complexity of the financial markets.
Where's the best place to invest my long-term savings?
If you don't need the money for at least five years, the stock market is the best option. You can buy individual stocks and bonds or — better yet — you can lower your risk by buying mutual funds, which invest in the stocks and bonds of many different issuers.
Each of your financial goals has a time frame that will influence your decision regarding the types of investments you choose. The shorter the time frame, the more conservative the investment should be. The longer the time frame, the more aggressive the investment can be. That's why the bulk of your 401(k) plan or other retirement funds should be in stocks or mutual funds when you're young and won't need the money for several decades. If you're saving for a down payment on a house that you hope to buy in three years, your money should be in much more conservative investments, such as CDs and other places to stash your short-term cash. These investments are discussed in Chapter 4.
Risk Tolerance and Asset Allocation
Before you can begin investing intelligently, you need to assess your risk tolerance. This is your ability to watch your investments decline in value in the short term because you believe they'll increase in the long term. The higher the risk, the greater the potential reward, and vice versa. You may risk only the impact of inflation if you put your money in an interest-bearing savings account at an FDIC-insured bank, but there's no chance that you're going to make more than the prevailing interest rate. You risk everything if you put your money into junk bonds or highly speculative stocks, but there's a small chance that you could strike it rich. The key is to strive for a balance between risk and return without losing sleep worrying about your choices.
What's Your Risk Level?
If you can tolerate fluctuations in market value by focusing on the long term, consider investing in aggressive assets, such as stocks. If you become nervous and uncomfortable when your investments suffer even a small decline in value, then conservative, low-risk choices are probably more your style. Even if you have a high tolerance for risk, don't gamble with your money by following hot tips or investing in companies you don't really understand.
How do you know what risk level you'd be comfortable with? High-risk investors are willing to take major risks in exchange for the possibility of substantial returns. They can still sleep at night even if they lose large amounts of money. Moderate-risk investors are willing to take low to medium risks to increase their chances of investment growth. Conservative investors are uncomfortable at the thought of losing money in their investments and will give up the chance of high returns for the stability and safety of conservative investments with more predictable income. They are more concerned about losing money than they are about the potential for higher returns.
Low-risk investors face a significant risk: not having enough money for retirement. If you don't invest in stocks, you miss out on the most financially rewarding investment. Historically, the stock market has always outperformed other investments (and the pace of inflation) over time.
The highest-risk investments are futures, commodities, limited partnerships, collectibles, real-estate investment trusts (REITs), penny stocks (stocks that cost under $5 per share), speculative stocks (such as stock in new companies), foreign stocks from volatile nations, and high-yield (or “junk”) bonds. Moderate-risk investments include growth stocks (companies that reinvest most of their profits to grow the business), corporate bonds with lower ratings, balanced mutual funds, aggressive mutual funds, rental real estate, annuities, index mutual funds, blue-chip stocks, and international stocks in developed nations. Limited-risk investments are corporate and municipal bonds with high ratings. The lowest-risk investments are treasury bills, U.S. savings bonds, bank CDs, and money market funds. You should have a little bit of exposure to each of these investments, but the proportions will change depending on your risk preference.
Practicing Wise Asset Allocation
Asset allocation uses a formula to divide your portfolio among the three main types of investments: stocks, bonds, and cash equivalents. An aggressive asset allocation might include 80 percent stocks, 15 percent bonds, and 5 percent cash. A conservative asset allocation might include 40 percent stocks, 40 percent bonds, and 20 percent cash. Because different types of investments grow at different rates, it's a good idea to reallocate (or “rebalance”) your investments once a year. For instance, after you've been investing for a while, you might have a conservative portfolio of 40 percent stocks, 40 percent bonds, and 20 percent cash. If your stocks have a banner year and bonds are sluggish, the value of your portfolio might change to 60 percent stocks, 20 percent bonds, and 20 percent cash. This could cause your portfolio to change from conservative to aggressive without you even realizing it, so you may want to realign it by making some changes in your investments.
Choosing what percentage to invest in each category depends on a number of factors, including your risk tolerance, your age or how much time you have to invest before you need the money, the current state of the market, and what direction interest rates are headed. Most experts recommend that you invest as much as 90 percent of your portfolio in stocks or stock mutual funds if you're in your twenties or thirties.
It's not a good idea to buy bonds when interest rates are expected to rise soon, because you'll be stuck with a lower-than-market interest rate and will be earning less than you would have if you'd waited a short time.
Diversify, Diversify, Diversify!
Diversification means not putting all your eggs in one basket. The more you spread out your investments between different kinds of securities and different sectors of the market (financial services, biomedical, technology), the lower the risk of substantial losses.
A well-diversified portfolio includes cash or cash equivalents (Treasury bills, CDs, etc.), stocks, bonds, and mutual funds. The latter should be divided between small-cap, mid-cap, and large-cap (more on this to follow). Usually when one sector or type of investment has low returns, another has high returns, so diversifying evens out some of the ups and downs of the market.
