Don’t worry, it’s not rocket science. We cut through the jargon in this step by step introduction.
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We’re bombarded with financial news, whether we want it or not. We know when the market’s booming or crashing and every so often, we have to stomach some cocktail party chat with Gordon Gekko Jr. droning on about the Dow.
But unless you work in finance, the flood of data can be overwhelming, especially when it comes to actually putting your money to work. All that jargon makes investing feel like homework. But here’s the thing: once you translate it into plain English, the basic principles of investing are pretty simple.
What do you want to accomplish? Wealth and riches, of course, but how much are you willing to lose? And how quickly do you need to spend what you make? Thoughtful answers will drive whether you buy stocks or bonds and how long you’ll hold those investments.
Think of it as a checklist, something you use instinctively when buying clothes, say. You know when you need to stock up on basics versus blowing a paycheck on those crazy gladiator heels. So you’ve created a set of rules, though they may be subconscious (and yes, sometimes you break them).
There are two things to consider when creating your rules for investing:
Are you saving for something big in the next few years, like a home or a five-star trek through Asia? Or are you trying to stash some cash away for 15 or 20 years from now? Whatever money you need in the next three to five years should be in safe, short-term investments, because you can’t really afford losses. On the other hand, investing over a longer time period typically evens out ups and downs in the market (that’s volatility) and can yield bigger returns. So map out what money you’ll need and when you’ll need it.
How much risk are you willing to take? Are you comfortable betting big with your savings or would you rather play it safe and settle for slowly growing a cozy, smaller nest egg? Here’s a quiz to help you honestly assess your risk appetite. (There are others, but this one was built by academics not looking to snare you as a client.)
How will you divvy up your cash between investment options? The best way is to mix it up (that’s diversification), so that you’re not overly exposed to disaster in one company, one industry or one sector of the market.
Asset allocation can have a huge impact – more than individual stock picks — on how your portfolio performs. Remember when the dot-com bubble burst in 2000? While tech stocks tanked, homebuilding stocks soared as investors shifted into real estate, driven by low interest rates and fear of the market. So not having all your eggs in one metaphorical basket would have helped limit your losses.
(We also know that the housing market eventually built its own bubble, so it’s worth paying attention when we talk later about periodically rebalancing your portfolio.)
The first choice is how much to invest in bonds versus stocks. Stocks are typically riskier but higher risk can mean higher returns. Then there are different categories to consider. With stocks you can pick US versus international stocks, and also go – based on company size – for large cap, mid-cap or small cap companies. And with bonds, the range is based on the credit rating of the company and number of years it wants to borrow money. (There are also alternative asset classes, like real estate and commodities, but let’s keep it simple for now.)
There are loads of different asset allocation models so you should take what you’ve learned about your risk profile and walk through your options with a professional. But check out this simple tool to visualize how different factors might shift your choices.
If you’re new to this, you probably shouldn’t be picking individual stocks. Walk before you run, and all that. You’re better off going into a fund run by a professional who follows the markets daily, so your challenge is this: how to pick a manager and a fund. (Pay attention to fund fees though, because they can eat into gains.)
If you’re so type A that you just can’t resist trying your hand at stock picking, focus on the company fundamentals rather than investor psychology or timing the market. Figure out how the company makes money, and look at how research analysts (who forecast future earnings) feel about its future. Consider whether the stock price makes sense based on those projected earnings. These tutorials might help: Investopedia Fundamentals Tutorial and Khan Academy: Stocks and Bonds.
Investments, like relationships, need to be reevaluated periodically. Even if the market hasn’t changed much, your priorities might have. Maybe you’ve got a great new job and can take a little more risk. Or maybe you want to go back to grad school and need some investment income temporarily. Book some time at least annually to go through your portfolio with your new goals in mind and see if you need to update your choices.
Elizabeth Marcellino is a freelance journalist who spent a dozen years on Wall Street as an investment banker and portfolio manager.
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