When you invest, your dual goals are accumulating valuable assets and increasing your income. Investing means using the money you have to build a portfolio of assets that you expect to grow in value over time, provide current income, or, in some cases, provide both growth and income.
For example, investing just $96 a week for 30 years can add up to more than $400,000 if you have an average annual return of 6%. Return, which is typically reported as a percentage of the amount you invested, is the combination of change in an investment’s market value, up or down, plus any income it has provided.
There are two things to keep in mind about return:
- It isn’t guaranteed. While it could be 6% or higher, it could also be less, or even negative, in some years, reducing the annual average.
- To select investments to meet your goals, you need to understand what the choices are, the return that’s possible with different choices, and the risks you’ll take.
There are three core investment categories, called asset classes: stocks, bonds, and cash.
- Stocks are ownership shares in a corporation.
- Bonds are loans to a corporation or government.
- Cash investments include certificates of deposit (CDs) and US Treasury bills.
To invest, you typically buy and sell through a brokerage firm account. In some cases, you can buy directly from the issuer. In others, you invest through an account in a plan offered by your employer or the state where you live. You can purchase individual investments or invest indirectly by choosing mutual funds or exchange-traded funds (ETFs) that own stocks, bonds, or cash—or sometimes a combination of asset classes. The combination of assets you own makes up your investment portfolio.
Investment account types
Just as there are different types of investments, there are different types of investment accounts. You can invest as much as you can afford in a taxable account each year, purchase any investments you choose, and withdraw as you wish. You pay tax on investment earnings and on capital gains from selling investments for more than you paid to buy them.
You may choose tax-exempt accounts to invest for retirement, education, or healthcare expenses. You invest after-tax income in all except a healthcare account. If you follow the rules, no tax is due on the earnings as they accumulate or when you withdraw. But, there may be restrictions on how much you can invest each year and how you use the withdrawals.
Choosing investment type
As you evaluate an investment for your portfolio, you consider it on its own merits and how it complements the investments you already own. For example, if you hold a number of stocks issued by large, well-known companies, you may decide to choose the stock of a smaller or newer company to add variety. You’ll also want to consider a number of personal factors, including your financial goals, your time frame, and your risk tolerance, as you make your selections. For example, a stock mutual fund that’s appropriate for a retirement account may not be a good choice when you’re trying to accumulate a down payment for a home.
Liquidity and volatility
The issues, in this case, are liquidity and volatility. The term liquidity refers to how quickly you could convert an investment to cash with little or no loss of value. Volatility is a measure of how quickly and how often an investment’s price changes. You don’t need liquidity in a retirement account, but you probably do in an account you’re planning to withdraw from in the near future. Since volatility tends to flatten out over time, it’s not a concern in retirement accounts but is if you have a short time frame.
Time and risk
The range between an investment’s high and low price over a period of time—such as a year—is a measure of its volatility. The smaller the percentage of change, the less volatile the investment is. Volatilty poses the biggest risk to investment values in the short term. If you hold onto a stock when the price drops, the losses may be reversed and the value of your shares may reach or exceed their previous high, though that isn’t guaranteed. Or, if you hold bonds until they mature, changing market values have no impact on what you earn.
Another way to deal with volatility is to capitalize on it. If investment increases dramatically in value, you can sell it and make another purchase. If the price drops in the future, you might buy it again and wait for the cycle to repeat itself. In fact, some stock investors consider falling prices a buying opportunity that will let them take full advantage of future gains. The risk, of course, is that those gains can’t be guaranteed even if your research shows the company to be a sound investment.
Two strategic investment approaches
You might decide that the way to meet your long-term goals is to put money into equities you expect to grow in value. This strategy helps you concentrate on specific types of investments, first on equities in general and then more narrowly on those that seem likely to perform best over the long haul. If you are investing to meet both long- and short-term goals, you might select stocks and stock mutual funds that strive to provide both growth and income, in addition to those emphasizing growth alone. By reinvesting your dividends and capital gains, it’s possible to build your investment base more quickly.
Of course, stocks and stock mutual funds are more volatile than some other types of investments. So you may lose money if the market takes a sharp downturn. If you’ve retired and want to begin collecting income from your portfolio, you may want to shift some of your assets to income-producing investments, such as bonds and dividend-paying stocks. Any strategy, however, requires attention to basic details: understanding risk, volatility, diversification, and asset allocation, and evaluating yield and return.
Keeping on track
Picking the right investments is only the first step in achieving your financial goals. You also have to monitor their performance regularly, asking whether these investments are still right for your portfolio as your goals shift and your lifestyle changes. And — this is where many investors falter you have to be ready to make adjustments, sometimes even major changes, when you redefine your goals, or when the investments you’ve made aren’t performing the way you expected. It can be hard to move in new directions.
If you feel comfortable relying on the investments you already know — perhaps CDs, money market accounts, or stock in the company you work for — there’s always the temptation to stick with them. And while they may have their place in your investment plan, tying up your money in one or two places exposes you to greater investment risk.
Though your savings earn interest, they may actually shrink in value over time. That’s because the interest you earn is rarely more than the rate of inflation. On the other hand, insured savings, such as money market accounts and certificates of deposit (CDs), are well suited for meeting short-term goals, such as the down payment on a home you hope to buy within a year or two, since your principal is safe.
There’s also a middle ground between saving and investing, where short-term bond funds and US Treasury bills fit. You generally earn more than on insured accounts, but the market values of these investments fluctuate as interest rates change.
10 Types Of Investment Risks And How To Cope With It by Inna Rosputnia
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