Basics

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Station 1 - Planning your trip:
Investing basics || Keys to successful investing || Understanding risk

Why do so many people never obtain the financial independence that they desire? Often it's because they just don't take that first step-- getting started. Besides procrastination, other excuses that people make are that investing is too risky, too complicated, too time consuming, and only for the rich.

The fact is, there's nothing complicated about common investing techniques, and it usually doesn't take much time to understand the basics. Investing is for everyone, not just the rich. And the biggest risk you face is not educating yourself.

Saving versus investing

Both saving and investing have a place in your finances. But don't confuse the two. With savings, your principal typically remains constant and earns interest or dividends. Savings are kept in certificates of deposit (CDs), checking accounts, money market accounts, and passbook savings accounts. By comparison, investments can go up or down in value and may or may not pay interest or dividends. Examples of investments include stocks, bonds, mutual funds, collectibles, precious metals, and real estate.

Why invest?

You invest for the future, and the future is expensive. For example, college expenses are increasing at double the rate of inflation, and people are retiring earlier and living longer. You have to take responsibility for your own finances--nobody else is going to. Government programs like Social Security will probably play a less significant role in your life than they did for previous generations. Corporations are switching from guaranteed pensions to plans that require you to make contributions and choose investments. The better you manage your dollars, the more likely it is that you'll have the money you want for your retirement.

Because everyone has different goals and expectations, everyone has different reasons for investing. However, it simply comes down to managing your money to provide a comfortable life and financial security for you and your family.

What is the best way to invest?

* Get in the habit of saving. You must set aside a portion of your income as often as possible.
* Invest in financial markets so your money can grow at a meaningful rate.
* Ignore short-term price fluctuations, and focus on long-term potential.
* Ask questions and become educated before making any investment.
* Invest with your head, not with your stomach or heart. Avoid the urge to invest based on how you feel about an investment.

Before you start

Organize your finances to help manage your money more efficiently. Remember, investing is just one component of your overall financial plan. Get a clear picture of where you are today. What's your net worth? Compare your assets with your liabilities. Look at your cash flow. Get a grasp on the amount of income that you're receiving, and where that income is going each month.

List your expenses. You can typically identify enough expenses to account for at least 95 percent of your income. If not, go back and look again. You could use those lost dollars for investing. Are you drowning in credit card debt? If so, pay it off as quickly as possible before you start investing. Every dollar that you save in interest charges is one more dollar that you can invest for your future.

Establish a solid financial base: Make sure you have an adequate emergency fund, sufficient insurance coverage, and a realistic budget. Also, take full advantage of benefits and retirement plans that your employer offers.

Understand the impact of time

Take advantage of the power of compounding. Compounding is the earning of interest on interest, or the reinvestment of income. For instance, if you invest $1,000 at 8 percent, you will earn $80.

By reinvesting the earnings and assuming the same rate of return, next year you will earn $86.40 on your $1,080 investment. The following year, $1,166.40 will earn $93.31.

Use the Rule of 72 to judge an investment's potential. Divide the projected return into 72. The answer is the number of years that it will take for the investment to double in value. For example, an investment that earns 8 percent per year will double in 9 years.

Consider working with a financial planner

Whether you need a financial planner depends on your own comfort level. If you have the time and energy to educate yourself, you may not need any assistance. However, don't underestimate the value of the experience and knowledge that a professional financial planner can offer. A financial planner can help you define your goals and objectives, make a net worth statement and a spending plan, decide the level of risk that's right for you, and work with you to create a comprehensive financial plan. For many, working with a professional advisor is the single most important investment that they make.

Review your progress

Financial management is an ongoing process. Keep good records and recalculate your net worth annually. This will help you for tax purposes and show you how your investments are doing over time. Once you take that first step of getting started, you will be better able to manage your money to help afford today's needs and pay for tomorrow's goals.

Few terms in personal finance are as important, or used as frequently, as "risk." Nevertheless, few terms are as imprecisely defined. Almost universally, when financial advisors or the media talk about investment risk, their focus is on the historical price volatility of the asset or investment under discussion.

Advisors label as aggressive or risky an investment that was prone to wild price gyrations in the past. The presumed uncertainty and unpredictability of this investment's future performance is perceived as risk. Assets characterized by prices that historically have moved within a narrower range of peaks and valleys are considered more conservative. Unfortunately, this explanation is seldom offered, so it is often not clear that the volatility yardstick is being used to measure risk.

Before exploring risk in more formal terms, a few observations are worthwhile. On a practical level, we can say that risk is the chance that your investment will provide lower returns than expected or even a loss of your entire investment. More to the point, you are concerned about the chance of not meeting your investment goals. After all, you are investing now so you can do something later (e.g., pay for college, retire comfortably). Since every investment carries some degree of risk, it makes sense to understand the kinds of risk as well as the extent of risk that you choose to take, and to learn to manage it.

What you probably already know about risk

Even though you might never have thought about the subject, you are already familiar with many kinds of risk from life experiences. For example, you know intuitively that a scandal or lawsuit that involves a particular company will likely cause a drop in the price of that company's stock, at least temporarily. You assume that if one car company hits a home run with a new model, that would be bad news for all competing automakers. In contrast, you'd expect an overall economic slowdown and stock market decline to hurt companies and their stock prices across the board, not just in one industry.

You must be mindful of these and other kinds of risks going forward. Volatility is a good place to begin, however, as we examine the elements of risk in more detail.

Volatility--why is it risky?

Suppose that you had invested $10,000 in each of two mutual funds 20 years ago, and that both funds produced average annual returns of 10 percent. Imagine further that one of the funds, Steady Freddy, returned exactly 10 percent every single year, unlike any real investment. The annual return of the second fund, Jekyll & Hyde, alternated--5 percent one year, 15 percent the next, 5 percent again in the third year, and so on. What would these two investments be worth at the end of the 20 years?

It seems obvious that if the average annual returns of two investments are identical, so will be their final values. But this is a case where intuition is wrong. If you plot the 20-year investment returns on a graph, you'll see that Steady Freddy's final value is over $2,000 more than what you'd get from the variable returns of Jekyll & Hyde. The shortfall gets much worse if you widen the annual variations (e.g., try plus-or-minus 15 percent, instead of plus-or-minus 5 percent).

This example illustrates one of the effects of investment price volatility: Short-term fluctuations in returns are a drag on long-term growth. (Note: This is a hypothetical example and does not reflect the performance of any specific investment. This example assumes the reinvestment of all earnings and does not consider taxes or transaction costs.)

Although past performance is no guarantee of future results, historically the negative effect of short-term price fluctuations has been reduced by holding investments over longer periods. But counting on a longer holding period means that some additional planning is called for. You should not invest funds that will soon be needed into a volatile investment. Otherwise, you might be forced to sell the investment to raise cash at a time when the investment is at a loss.

Different types of risk:
* Market risk: This refers to the possibility that an investment will lose value because of a general decline in financial markets, due to one or more economic, political, or other factors.
* Inflation risk: Sometimes known as purchasing power risk, this refers to the possibility that prices will rise in the economy as a whole, so your ability to purchase goods and services would decline. For instance, your investment might yield a 6 percent return, but if the inflation rate rises to double digits, the invested dollars that you got back would buy less than the same dollars today. Inflation risk is often overlooked by fixed income investors who shun the stock market completely, fearing the risks found there.
* Interest rate risk: This relates to increases or decreases in prevailing interest rates and the resulting price fluctuation of an investment, particularly bonds. There is an inverse relationship between bond prices and interest rates. As interest rates rise, the price of bonds falls, and vice versa. If you need to sell your bond before maturity, you run the risk of loss of principal if interest rates are higher than when you purchased the bond.
* Reinvestment rate risk: This refers to the possibility that you will have to reinvest funds at a lower rate of return than the original investment. Your five-year, 3.75 percent certificate of deposit might mature at a time when your only choice is to buy a new certificate of deposit at just 3 percent.
* Default risk (credit risk): This refers to the risk that a bond issuer will not be able to pay its bondholders.
* Liquidity risk: This refers to how easily your investments can be converted to cash. Occasionally (and more precisely), the foregoing definition is modified to mean how easily your investments can be converted to cash without significant loss of principal.
* Political risk (for those making international investments): This refers to the possibility that changes in foreign governments or politics will adversely affect the financial markets there or the companies you invested in.
* Exchange risk (for those making international investments): This refers to the possibility that the fluctuating rates of exchange between U.S. and foreign currencies will negatively affect the value of your foreign investment, as measured in U.S. dollars.

The relationship between risk and reward

In general, the more risk you're willing to take on (whatever type and however defined), the higher your potential returns, as well as potential losses. This proposition is probably familiar and makes sense to most of us. It is simply a fact of life--no sensible person would make a higher-risk, rather than lower-risk, investment without the prospect of a higher return. That is the tradeoff. Your goal is to maximize returns without taking on more risk than you can bear.

Understanding your own tolerance for risk

The concept of risk tolerance is twofold. It refers to both your personal desire to assume risk and your financial ability to endure risk. It also assumes that risk is relative to your own personality and feelings about taking chances. If you find that you can't sleep at night because you're worrying about your investments, you've assumed too much risk. Your financial ability to endure risk has more to do with your age, stage in life, how soon you'll need the money, and your financial goals. If you're investing for retirement and you're 35 years old, you can endure more risk than someone who is 10 years into retirement, because you have a longer time frame before you need the money. With 30 years to build your retirement fund, you have the ability to withstand short-term fluctuations in hopes of a greater long-term return.

Reducing risk through diversification

Don't put all your eggs in one basket. You can potentially help offset the risk in any one investment by spreading your money among several asset classes. Diversification strategies take advantage of the fact that forces in the markets do not normally influence all types or classes of investment assets at the same time or in the same way. Swings in overall portfolio return can be smoothed out by diversifying your investments among assets that tend not to experience price fluctuations that mirror each other. In a slowing economy, for example, stock prices might be going down or sideways, while falling interest rates cause the price of bonds to rise.

In addition to diversifying among asset classes, you should consider diversification within an asset class. There are different types of investments within an asset class. For example, when investing in stocks, you can choose to invest in large companies that tend to be less risky than small companies. When investing in bonds, you can choose between Treasury securities and the more risky corporate securities. Or, you could decide to allocate a portion of your investment funds among all four types of investments. Diversifying within an asset class helps reduce the risk to your portfolio due to the impact of any one particular type of stock, bond, or mutual fund.

Evaluating risk--where to find information about investments

You should become fully informed about a product before you invest. There are numerous sources of information about investment products. You can find information in third-party business and financial publications and websites, as well as annual and other periodic financial reports. Obtain a prospectus if the investment is a mutual fund or an initial public offering, or an offering circular if the investment is a limited partnership or hedge fund.

Third-party business and financial publications can provide credit ratings, news stories, and financial information about a company. For mutual funds, third-party sources provide information such as ratings, financial analysis, and comparative performance relative to peers.

The prospectus for a mutual fund provides a vast amount of information, including the fund's investment objectives, the types of securities it invests in and risks that go along with those securities, past performance, expense information, and financial reports. If you are considering investing in an initial public offering (IPO), it is extremely important that you read the prospectus.

The prospectus contains information about the company's products and/or services, operating history, future prospects, and management. The offering circular of a limited partnership or hedge fund should contain information similar to that of a prospectus for an IPO, as well as information regarding the general partner, special risks of investing in the product, and liquidity.

You can also check with the Securities and Exchange Commission (SEC). There, you can obtain reports disclosing significant events (e.g., the CEO plans to sell a large amount of shares; an investor plans to purchase a large amount of shares for a takeover) and financial reports. One of the easiest ways to get information is to go to the SEC's website.

A successful investor maximizes gain and minimizes loss. Here are six basic principles that may help you invest successfully.

Long-term compounding:
Your nest egg may get bigger, and bigger, and bigger ... It's the "rolling snowball" effect. Put simply, compounding pays you earnings on your reinvested earnings. The longer you leave your money at work for you, the more exciting the numbers get.

For example, imagine an investment of $10,000 at an annual rate of return of 8 percent. In 20 years, assuming no withdrawals, your $10,000 investment would grow to $46,610. In 25 years, it would grow to $68,485, a 47 percent gain over the 20-year figure. After 30 years, your account would total $100,627. (Of course, this is a hypothetical example that does not reflect the performance of any specific investment.)

This simple example also assumes that no taxes are paid along the way, so all money stays invested. That would be the case in a tax-deferred individual retirement account or qualified retirement plan, or even if you just bought and held shares of a stock that paid no dividends. The compounded earnings of deferred tax dollars are the main reason experts recommend fully funding all tax-advantaged retirement accounts and plans available to you.

While you should review your portfolio on a regular basis, the point is that money left alone in an investment offers the potential of a significant return over time. With time on your side, you don't have to go for investment "home runs" in order to be successful.

Endure short-term pain for long-term gain: ride out market volatility.

It sounds simple, doesn't it? But what if you've invested $10,000 in the stock market and the price of the stock drops like a stone one day? On paper, you've lost a bundle, offsetting the value of compounding you're trying to achieve. It's tough to stand pat.

There's no denying it--the financial marketplace can be volatile. Still, it's important to remember two things. First, the longer you stay with a diversified portfolio of investments, the more likely you are to reduce your risk and improve your opportunities for gain.

Second, during any given period of market or economic turmoil, some asset categories and some individual investments historically have been less volatile than others. Bond price swings, for example, have generally been less volatile than stock prices. Although past performance cannot predict future results, you can minimize your risk somewhat by diversifying your holdings among different classes of assets, as well as different individual assets within each class.

Asset allocation: spreading the wealth

Asset allocation is the process by which you spread your investment dollars over several categories of assets, usually referred to as asset classes. These classes include stocks, bonds, cash (and equivalents), real estate, precious metals, collectibles, and insurance products.

For many average investors, the focus is almost entirely on stocks, bonds (or mutual funds of stocks and bonds), and cash. You'll therefore also see the term asset classes used to refer to subcategories of these investments, such as aggressive growth stocks, long-term growth stocks, international stocks, government bonds (U.S., state, and local), high-quality corporate bonds, low-quality corporate bonds, and tax-free municipal bonds.

There are two main reasons why asset allocation is important. First, the mix of asset classes you own is a large factor--some say the biggest by far--in determining your overall investment portfolio performance. In other words, the basic decision to divide your money 80 percent in stocks and 20 percent in bonds is probably more important than your subsequent decisions over exactly which companies to invest in, for example.

Second, by dividing your investment dollars among asset classes that do not respond to the same market forces in the same way at the same time, you can minimize the effects of market volatility while maximizing your chances of return in the long term. Ideally, if your investments in one class are performing poorly, you will have assets in another class doing well. The gains in the latter will offset the losses in the former, minimizing the overall effect on your portfolio.

Consider liquidity in your investment choices

Liquidity refers to how quickly you can convert an investment into cash without loss of principal. Generally speaking, the sooner you'll need your money, the wiser it is to keep it in investments with comparatively less volatile price movements. You want to avoid a situation, for example, where you need to write a tuition check next Tuesday, but the money is tied up in a long-term mutual fund whose price is currently experiencing a loss.

Therefore, your liquidity needs should affect your investment choices. If you'll need the money within the next one to three years, you may want to invest in short-term bonds, certificates of deposit, a money market account, or a savings account. Your rate of return will likely be lower than that possible with more volatile investments such as stocks, but you'll breathe easier knowing that the principal you invested is relatively safe and quickly available, without concern over market conditions on a given day.

Dollar cost averaging: doing it consistently and often dollar cost averaging is a method of accumulating shares of stock or a mutual fund by purchasing a fixed dollar amount of these securities at regularly scheduled intervals over an extended time. When the price is high, your fixed-dollar investment buys less, but when the prices are low, the same dollar investment will buy more shares. A regular, fixed-dollar investment should result in a lower average price per share than you would get buying a fixed number of shares at each investment interval.

Remember that, just as with any investment strategy, dollar cost averaging can't guarantee you a profit or protect you against a loss if the market is declining. To maximize the potential effects of dollar cost averaging, you should also assess your ability to keep investing even when the market is down.

An alternative to dollar cost averaging would be trying to "time the market," in an effort to predict how the price of the shares will fluctuate in the months ahead so you can make your full investment at the absolute lowest point. However, market timing is generally unprofitable guesswork. The discipline of regular saving is a much more beneficial strategy, and it takes no mental effort or study.

Review your portfolio and game plan: buy and hold, don't buy and forget

Unless you plan to rely on luck, your portfolio's long-term success will depend on periodically reviewing it. Maybe your uncle's hot stock tip has frozen over. Maybe economic conditions have changed the prospects for a particular--or a whole class of--investment.

Even if nothing bad at all happens, your investments will appreciate at differing rates, so after a while, your asset allocation mix will change. For example, if you initially decided on an 80 percent to 20 percent mix of stocks to bonds, you might find that the total value of your portfolio has become divided 88 percent to 12 percent. When that's the case, you'll need to rebalance your portfolio.

Rebalancing involves restoring your original asset allocation decisions by shifting your funds among investment classes to restore the ratios you decided on in first designing your portfolio. Many investment advisors recommend using shifts of 5 percent or more as a trigger for rebalancing. Others recommend doing it every year.